When you lease instead of own property, you make a promise to pay rent, maintenance fees and other expenses to the landlord. The cash you pay each month or quarter is called a rent expense. This money gets recorded on your income statement during the month to which the rent relates. Prepaid rent is rent that you pay in advance of the due date. It represents an advance payment for a future benefit, so you'll record it as an asset to the company.
When a business leases premises such as an office, retail store or factory building, the rent is generally due in advance for the month or quarter covered by the rent payment. For example, June's rent may be due on May 31 or June 1. Many businesses pay rent by check. This means they must be organized and get the check in the mail a few days before the due date. Otherwise, the landlord may not receive the rent check on time, and the business could be hit with serious commercial consequences such as interest, late fees and a possible eviction notice.
Prepaid rent is simply the amount paid for rent in advance of the rental period to which it relates. When you write a check in May that covers the rent for June, you have made a prepaid rent payment. Some businesses might prepay rent by a few days each month to ensure the rent check arrives on time. Others choose to pay several months' worth of rent upfront for commercial reasons, for example, to get a rental discount or just for the reassurance of knowing the rent is paid. Whatever your reasons, if you are cracking open the checkbook before the rent is due, you're prepaying the rent.
Rent expenses are all the costs associated with leasing a property during a reporting period. It obviously includes the rent you pay each month or quarter, but it also includes any other expenses necessary to utilize a property. For example, you might pay extra cash to cover such things as insurance, maintenance, repair of the common areas of the building and security.
Rent expenses are fixed costs, as opposed to variable costs, which means you have to pay them each month or quarter regardless of how much product you are producing. Even if you shut down operations for a month, you still have to pay your rent and other lease commitments. As such, rent expenses can be a material drain on a company's operating income.
In layman's terms, the difference is simple: A rent expense is the amount you have to pay under a lease agreement, and prepaid rent is any rent expense that you pay in advance of the due date. In accounting terms, things get a little more complicated.
Rent expenses generally fall under the category of Selling, General and Administrative Expenses that make it onto the income statement. Other SG&A items include such diverse expenses as salaries, office supplies, insurance and litigation. Rent expenses are classified as SG&A because a business uses its real estate to operate and make money.
Manufacturing companies may treat their rent expenses slightly differently. It's much more common for these companies to include rent expenses as part of factory overhead. That's because rent for factory premises is tied to production – without a factory, there would be no product. Rent not tied to production such as office space is charged to SG&A. At the end of the day though, it doesn't really matter which category the rent expense appears in – the bottom line effect is the same.
What is the bottom line effect? Whenever you accrue a rent expense, you'll credit the cash account and debit the rent expense/SG&A account. On the income statement, the SG&A expenses are listed under revenue and appear in the same block as other expenses, such as depreciation and the cost of goods sold. Total revenues minus the cost of goods sold gives your gross profit. Gross profit, minus operating expenses – SG&A – equals operating income. Operating income is a measure of how much of your revenue will eventually become profit after accountants have deducted things like taxes. So, the greater your rent expenses are, the lower the operating income will be. Rent expenses have a direct impact on the amount of cash in your corporate vault.
To understand how prepaid rent fits into this analysis, you need to know that a rent expense entry will list the cost of occupying space during the time interval indicated on the income statement – even if the rent was not paid within that period. So, if ABC company is preparing its income statement for June, and June's rent comes to $5,000, then ABC would record a rent expense of $5,000. The company makes the same entry regardless of whether it paid the rent in June or in May.
To deal with this timing anomaly, the company must record the amount of rent paid in advance that has not yet been consumed. It does this in the current assets section of the balance sheet. Returning to the above example, if ABC paid the rent in May, it would record the $5,000 prepayment as current assets until the cost is actually incurred. For accounting purposes, prepaid rent is a benefit that the company has not yet enjoyed, but will enjoy at some point in the future. It is an asset to the company.
Businesses mostly use prepaid rent out of commercial necessity. One of the essential clauses of a commercial lease concerns the rent payment due date. Customarily, the annual rent is due in 12 equal payments on whatever date the lease specifies or in four equal payments. Where rent is paid quarterly, the lease will specify the four rent payment dates such as Jan. 1, April 1, July 1 and Oct. 1. There's no magic to these dates – they have just sprung up by convention.
What you will find, however, is that you will always be asked to pay rent one month or three months in advance, which gives rise to a prepaid rent situation. Banks and mortgage lenders usually insist that landlords have the rent payments coming in before the mortgage payment is due for the same period; there's a greater chance the mortgage payment will be covered by the rental income. So, you'll have a hard time finding a landlord who will let you pay rent in arrears.
In some instances, you may choose to pay more than one rental payment in advance. For example, you might offer to pay a full year's rent up front to secure a particular property when competition is fierce. Or, you might agree to pay a few months' rent in advance in return for some other sweetener such as a 10 percent discount on the rent. Each business will have its own commercial drivers for putting an envelope of cash on the table.
The one thing you can't use prepaid rent for is to get additional tax deductions. Generally, a business will claim a deduction in the same year that it pays the business expense. So, if you paid a $2,000 insurance premium in 2018, you would claim the deduction in 2018. Now, imagine that you have a multiyear insurance contract at a rate of $2,000 per year. If you wanted, you could pay the 2018 and 2019 premiums at the same time and deduct the $4,000 payment in 2018. This may be advantageous depending on your tax situation. Sadly, prepaid rent is an exception to the deduct when you pay rule. If you pay $50,000 in June for a years' worth of rent, you could only deduct seven months of that rent on December 31.
One important feature of commercial leasing is that the rent rarely stays consistent over the lease term. Most businesses sign leases with terms of five or 10 years, with a provision that the rent will increase annually, either as a fixed-percentage increase or in line with inflation. Rather than account for fluctuating rent payments, it's common to list a company's rent expenses as a consistent amount from month to month. This is known as the straight-line method of accounting.
For example, suppose that XYZ company signs a one-year lease to start on Jan. 1. The rent is $2,000 per month for the first six months. After that, the rent is $2,500 per month. Using the straight-line method, XYZ will average out the rent payment for the entire lease term. In this example, the rent is six months at $2,000 and six months at $2,500, or $27,000 total. Divide this amount by the 12-month lease term, and you get an average payment of $2,250 per month. The company records this rent expense on the monthly income statement.
Of course, the rent expense figures do not match up with reality. During the first six months, XYZ is paying $250 less than the recorded rent expense each month. In the second six months, it is paying $250 more. To reconcile these differences, the company needs to use a deferred rent expense account.
Quite simply, XYZ Company will add $250 per month into the deferred rent expense account from January through June, then deduct $250 from the deferred rent expense account from July through December. In December, the account will show a balance of zero. Using the deferred rent expense account ensures that XYZ Company is recording rent expenses in line with the straight-line rules, while capturing the actual rental cash being paid on the income statement.
Prepaid rent is shown as a current asset in the company's balance sheet. Each time the company pays rent in advance, it must debit the current assets account for the amount of the rent prepayment, then write a simultaneous credit entry to the cash account. So, if XYZ Company paid the entire $27,000 annual rent in advance, it would debit the current prepaid assets for $27,000 and credit cash for $27,000.
XYZ Company must then make an adjusting entry to account for the portion of prepaid rent that it uses up each month. It does this by transferring the prepaid expense to the income statement for the period during which the company uses up the rent. So, at some time during each month of the 12-month lease, it would recognize (debit) a rent expense of $2,250 and draw down (credit) the prepaid asset by this same amount. This finally charges the prepayment to expense.
In summary, when dealing with rent prepayments, store the prepaid rent as an asset on the balance sheet until the month in which the rent is consumed. Then, you'll charge it to expense. If you forget to move the prepayment into the rent expenses account in the month to which the rent relates, your financial statements will over-report the asset and under-report the expense. It's essential to keep track of the prepaid rent section of the current assets account and update the list before closing the books at the end of each month.