If a company does not own a facility, the company may need to rent a space to conduct business. This means the company has to pay rent to a landlord each month in order to continue using the space. A lease will indicate the rental cost per month, late fees and the length of the lease. A company recognizes money paid to a landlord as rent expense. When a company pays rent before the due date, it creates an account known as prepaid rent.
Paying rent in advance means the company does not have to worry about making monthly rent payments to a landlord. The rent expense account appears on a company’s income statement, also known as a profit and loss statement. Rent expense is the amount of rent a company pays over the period of time indicated by the heading on the income statement.
Unlike rent expense, which appears on an income statement, prepaid rent appears on a company’s balance sheet. The balance sheet indicates a company’s financial position at a specific point in time. Prepaid rent is classified as a current asset because it will be used within one year. When a company pays rent in advance, the company must debit the prepaid rent account for the amount of cash paid in advance. The company must write a credit entry to the cash account for the amount of the rent prepayment. For example, a company that pays $12,000 in advance for 12 months of rent must debit prepaid rent for $12,000 and credit cash for $12,000.
Just like any other expense, rent expense decreases a company’s revenue. Furthermore, rent expense decreases the amount of equity owners have invested in the business. Rent expense has a natural debit balance, which means a debit to the rent expense account increases the company’s expenses. A company does not have to prepay to pay rent in a timely fashion. A company that pays rent on time must debit rent expense for the monthly amount and credit cash for the amount of rent paid. For example, a company that pays $1,000 a month for rent must debit rent expense for $1,000 and credit cash for $1,000. This illustrates a decrease in an asset and an increase in the company’s expenses.
In the case of prepaid rent, the company must make an adjusting entry to account for the portion of prepaid rent that the company uses. For instance, assume a company prepays $12,000 for 12 months of rent and 6 months of rent have been used. In this case, the company must debit rent expense for $6,000 and credit prepaid rent for $6,000. This entry shows that $6,000 of rent expense has been incurred and the prepaid asset is decreased by $6,000 due to six months of rent usage.