Zoe Alvarez
The ASC 842 guidance has eliminated the deferred rent account, which was used under ASC 840 to record the difference between the monthly lease expense and monthly lease payments. Under ASC 842, the difference between the straight-line rent expense and the cash paid is reflected in the net activity in the lease liability and Right-of-Use (ROU) Asset accounts each month, which essentially functions as deferred rent. While the new recording procedures under ASC 842 are straightforward, the transition from ASC 840 to ASC 842 can be complex and time-consuming.
| Characteristics | Values |
|---|---|
| ASC 842 guidance | Operating leases greater than a year must be recognised on the balance sheet as right-of-use assets and related lease obligations |
| Deferred rent account | Eliminated under ASC 842 |
| Difference between straight-line rent expense and cash paid | Reflected in the net activity in the lease liability and ROU asset accounts each month |
| Lease liability | Represents the current value of the lessee's future obligations |
| Right-of-use (ROU) asset | Recognised on the balance sheet under ASC 842 and reflects the present value of lease payments, adjusted for any initial direct costs, prepayments, or lease incentives |
| Transition from ASC 840 to ASC 842 | Proper time to make the transition is the company's date of ASC 842 adoption |
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What You'll Learn
- ASC 842 does away with the deferred rent account
- Deferred rent is replaced by a Right-of-Use (ROU) Asset and Lease Liability
- The transition from ASC 840 to ASC 842
- Deferred rent is a liability resulting from the difference between actual cash paid and straight-line expense
- The process of recording rent expenses on a straight-line basis
ASC 842 does away with the deferred rent account
Under ASC 840, companies used the balance sheet account called deferred rent to enable straight-line rent expense. The deferred rent account was where companies held cash paid for rent that did not equal the average rent required by ASC 840. Under ASC 842, the account is not needed, but the concept presently remains in place.
FASB retained the concept of straight-line rent expense for operating leases. This is the major difference between ASC 842 and the IASB’s version of the leasing standard, IFRS 16. Therefore, the mechanics that FASB prescribed in ASC 842 are much more complicated than ASC 840. However, the net balance sheet and rent expense impact of leasing remain largely the same. Now, instead of deferred rent, we have right-of-use (ROU) asset and lease liability accounts. The net activity in these two accounts will be the same as deferred rent under ASC 840 for the same lease as long as all variables remain constant.
For any lease commencing after the transition to ASC 842, deferred rent is not recognized. Instead, the difference between the straight-line rent expense and the cash paid is reflected in the net activity in the lease liability and ROU asset accounts each month. ASC 842 requires the recognition of total rent expense on a straight-line basis over the lease term for leases classified as operating. Generally, accounting for the same lease under ASC 840 (before transition to ASC 842) and then under ASC 842 (after transition) has no impact on an entity’s net income. What changed upon transition to ASC 842 is that lessees must record operating leases on the balance sheet.
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Deferred rent is replaced by a Right-of-Use (ROU) Asset and Lease Liability
Under ASC 840, companies used a balance sheet account called deferred rent to enable straight-line rent expense. The deferred rent account is where companies held cash paid for rent that did not equal the average rent required by ASC 840. Under ASC 842, the account is not needed, and deferred rent is replaced by a Right-of-Use (ROU) Asset and Lease Liability. This is because, under ASC 842, the net balance sheet and rent expense impact of leasing remain largely the same, and the net activity in these two accounts will be the same as deferred rent under ASC 840 for the same lease as long as all variables remain constant.
The lease liability of any lease set up under ASC 842 is based unequivocally on the NPV of future payments. The ROU asset is based on the same value, even though adjustments are occasionally required. The ROU Asset represents the lessee's right to use the leased asset. It is calculated as the sum of the lease liability, prepaid lease payments, and initial direct costs minus any lease incentives. For basic leases, the ROU asset and lease liability will be equal upon lease commencement.
The transition to ASC 842 can be complex and time-consuming. On the date of transition, a lessee measures an ROU asset equal to the lease liability, adjusted for the following amounts: prepaid or accrued rent; the remaining balance of any lease incentives, initial direct costs, or deferred/prepaid rent. The proper time to make the transition is the company's date of ASC 842 adoption.
ASC 842 also brings many other changes. For example, companies transitioning from ASC 840 to ASC 842 may face challenges in understanding how to handle their deferred rent accounts and how to handle the transition appropriately.
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The transition from ASC 840 to ASC 842
With the adoption of ASC 842, companies are now required to report their lease liabilities on their balance sheets, providing a more accurate representation of their financial position. This increased transparency can benefit investors and stakeholders by offering a clearer understanding of the company's financial position and lease obligations. However, this change has left many lease accountants wondering about the appropriate handling of the transition and the accurate capturing of deferred rent going forward.
To address this challenge, companies can choose from different transition methods, including the modified retrospective approach and the full retrospective approach. The modified retrospective approach, also known as the comparative method, is the most commonly used and involves recognising a cumulative effect adjustment to the opening balance of retained earnings on the date of adoption. This method retains the contract line's history based on the old ASC 840 standard, with those contracts ending at the close of the 2018 financial year. On the other hand, the full retrospective approach requires restating comparative periods in financial statements, which can be more time-consuming.
The transition date for ASC 842 was January 1, 2019, for public companies and January 1, 2022, for private companies. Companies with short-term, low-value leases may elect a short-term lease exemption and continue accounting similarly to ASC 840, including the use of deferred rent. This transition process can be complex and time-consuming, and companies should carefully evaluate the impact of the new standard on their financial statements and lease administration.
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Deferred rent is a liability resulting from the difference between actual cash paid and straight-line expense
Deferred rent is a liability that occurs when there is a difference between the actual cash paid and the straight-line expense recorded on a lessee's financial statements. This can happen when a lessor provides a period of free rent or when there are escalating lease payments, resulting in the actual cash payment not matching the recognised straight-line expense. Under ASC 840, companies used a balance sheet account called deferred rent to account for this difference.
However, with the introduction of ASC 842, the deferred rent account is no longer used. Instead, the difference between the straight-line rent expense and the cash paid is reflected in the net activity in the lease liability and Right-of-Use (ROU) Asset accounts each month. This means that while the concept of deferred rent remains, it is not separately calculated or identified as it was under ASC 840. The net activity in these two accounts will be the same as deferred rent under ASC 840 as long as all variables remain constant.
The transition to ASC 842 can be complex, especially for companies transitioning from ASC 840. The proper time to make the transition is the company's date of ASC 842 adoption, where the lessee measures an ROU asset equal to the lease liability, adjusted for prepaid or accrued rent and any remaining lease incentives. While ASC 842 does away with the separate deferred rent account, the accounting for the difference between cash paid and straight-line expense continues to be recognised in the financial statements.
One challenge in managing accrued and deferred rent is ensuring that rent schedules align with actual payment timelines, especially for businesses with multiple lease agreements and long-term commitments. Additionally, the mechanics prescribed in ASC 842 are more complicated than ASC 840, requiring careful consideration and potentially impacting income tax due to temporary differences between financial statements and tax returns.
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The process of recording rent expenses on a straight-line basis
ASC 842 does away with the deferred rent account. All accounting for operating leases under the new standard is contained within a right-of-use (ROU) asset and lease liabilities, reported on the Balance Sheet Account. This means that the process of recording rent expenses on a straight-line basis has changed.
The straight-line expense method is an accounting technique used to recognise rent expense evenly over the lease agreement, regardless of the actual timing of rent payments. This method is used to confirm consistent expense recognition over the lease term. To recognise rent on a straight-line basis, divide the total lease payments by the lease term. Record the same amount as rent expense for each period, even if the actual payments vary.
For example, suppose a lessee has control of an underlying asset with a two-year lease term, and the contract states that there will be no lease payment for the first six months of the lease. The monthly lease payments starting in month seven are $1,000, totalling $18,000 for the remainder of the lease. To calculate the straight-line expense, divide the total lease payments ($18,000) by the full lease term (24 months), which gives a straight-line expense of $750 per month.
The straight-line expense method can also be used to account for lease incentives, such as when a lessor offers a lease incentive to entice a lessee to sign a lease. For example, if there is a $12,000 buy-out option at the end of a two-year lease with $1,000 monthly payments, the total expense including the buy-out is $36,000. To recognise this total expense evenly over the lease term, divide the total by the duration of the lease in months (24 months), which gives a straight-line expense of $3,000 each month.
It is important to note that rent abatements or rent-free periods, as well as rent escalations or increases in base rent payments, should be factored into the calculation of the straight-line rent expense.
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Frequently asked questions
Deferred rent is a liability that occurs when the cash rent payments are different from the recognised financial statements. This often happens when a lessee is given free rent for a period of time.
FASB Accounting Standards Codification (ASC) Topic 842, Leases, is a new standard for financial reporting of long-term leases. It was issued in February 2016 and created challenges for many entities.
Yes, the deferred rent account used under ASC 840 is eliminated under ASC 842. Instead, the difference between the straight-line rent expense and the cash paid is reflected in the net activity in the Right-of-Use (ROU) Asset and Lease Liability accounts each month.
