Upon moving into an office, warehouse or apartment, a new tenant would typically pay the landlord the first and last months' rent. However, only the first month's rent is accounted for as rent revenue in the current period, and the remainder is recorded by the landlord as unearned rent on the balance sheet until it is ultimately earned during the final month of the lease, when it is reclassified into revenue on the income statement.
The Matching Principle
A new tenant who paid the first and last months' rent would have an asset consisting of prepaid rent on his books until it is "spent" on the last month of the lease. Conversely, the landlord would have received payment for the two months, but one month's sum is still unearned rent because it is for a period in the future; today it represents an unfulfilled obligation, hence a liability is recorded by the landlord for this amount.
This landlord has accounted for the receipt of cash from the tenant for last month's rent as unearned rent. However, a different way to view the same transaction is by accounting for it as deferred revenue. Classifying a payment as deferred revenue instead of unearned rent can help avoid misunderstanding its purpose, and serve as a reminder that it represents the advance receipt of revenue which must wait to be recognized until is properly earned, and not a liability in the traditional sense.
Cash is the asset that is recorded upon receipt of funds, and since assets must equal liabilities plus equity, the other side of the journal entry must be a liability account. That being said, unearned rent does not remain a liability forever. When the last month of the lease is over, for example, the unearned rent credit balance is debited, and the rental revenue account is credited, essentially moving it from the balance sheet to the income statement.
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Unearned rent, or deferred revenue as it may be called, is an account for landlords only, not tenants. Tenants' balance sheets will often have a prepaid rent asset account, and rarely an unearned rent liability account. Only if the business is both a landlord AND a tenant (in the case of a property manager that leases its office space, for instance) would its books properly have both prepaid rent and unearned rent accounts.
Jeff Clements has been a certified public accountant and business consultant since 2002. He has also worked in private practice as an attorney. Clements founded a multi-strategy hedge fund and has served as its research director and portfolio manager since its inception. He holds a Juris Doctor, as well as a master's degree in accounting.