What Happens to Deferred Rent Under ASC 842?

ASC 842, introduced by the Financial Accounting Standards Board (FASB), significantly changed how companies report lease agreements. This standard, officially known as Accounting Standards Update (ASU) 2016-02, mandates that most leases be recognized on a company’s balance sheet. Its primary objective is to enhance transparency regarding an organization’s lease obligations, providing a clearer view of its financial commitments.

For public companies, ASC 842 became effective for fiscal years beginning after December 15, 2018. For private companies and non-profit organizations, it became effective for fiscal years beginning after December 15, 2021. This new guidance aimed to address concerns about off-balance sheet financing, where substantial lease commitments were not fully reflected in a company’s reported assets and liabilities.

Understanding Deferred Rent Prior to ASC 842

Before the implementation of ASC 842, lease accounting was primarily governed by ASC 840. Under ASC 840, “deferred rent” was a concept for operating leases. Deferred rent arose when the actual cash payments for a lease differed from the straight-line rent expense recognized on a company’s income statement.

Companies were required to recognize lease expense on a straight-line basis over the entire lease term, even if cash payments varied due to factors like rent holidays, escalating rent clauses, or tenant improvement allowances. For instance, if a lease offered free rent for the first few months, the straight-line expense would be higher than the initial cash payments, creating a deferred rent liability on the balance sheet.

Conversely, if initial cash payments were higher than the straight-line expense, a deferred rent asset would be recognized. This balance sheet item reconciled the timing difference between cash paid and expense recognized, ensuring that the total rent expense was evenly distributed across all periods of the lease.

Key Changes Introduced by ASC 842

ASC 842 fundamentally reshaped lease accounting by requiring most leases to be recognized on the balance sheet. This marked a significant departure from ASC 840, where operating leases were generally kept off-balance sheet. The new standard aims to provide a more complete picture of a company’s financial obligations.

Under ASC 842, a lessee must recognize a “Right-of-Use” (ROU) asset and a corresponding lease liability for nearly all leases with a term longer than 12 months. The ROU asset represents the lessee’s right to use the underlying asset for the lease term, while the lease liability reflects the present value of the future lease payments. This applies to both operating and finance leases, bringing previously off-balance sheet operating lease obligations onto the balance sheet.

Although both lease types require balance sheet recognition, their income statement impact and subsequent accounting differ. For operating leases, a single, straight-line lease expense is recognized on the income statement, similar to the expense recognition under ASC 840. Finance leases, however, result in separate recognition of amortization expense on the ROU asset and interest expense on the lease liability, typically leading to a front-loaded expense pattern.

Transitioning Existing Leases to ASC 842

When companies transitioned to ASC 842, they had to address their existing lease portfolios, including any accumulated deferred rent balances from ASC 840. The Financial Accounting Standards Board generally required a modified retrospective approach for transition, allowing companies to apply the new standard as of the effective date without necessarily restating all prior periods.

A primary aspect of this transition is how existing deferred rent balances are handled. Under ASC 842, the standalone deferred rent account is largely eliminated. Instead, at the date of adoption, any existing deferred rent (or prepaid rent) balance is adjusted against the newly recognized Right-of-Use (ROU) asset. For instance, if a company had a deferred rent liability, this amount would reduce the initial measurement of the ROU asset.

Conversely, if a prepaid rent asset existed, it would increase the ROU asset. This adjustment ensures that the ROU asset reflects the present value of future lease payments, factoring in any prior cash differences. The lease liability is initially measured as the present value of the remaining lease payments.

To simplify the transition process for existing leases, ASC 842 offered several practical expedients. One common expedient allows companies not to reassess whether existing contracts contain leases or their classification. Electing these expedients can reduce the time and effort required for adoption.

Ongoing Accounting for Leases Under ASC 842

Following the initial transition, the ongoing accounting for leases under ASC 842 changes the presentation of lease-related items on the balance sheet. The concept of “deferred rent” as a distinct line item largely ceases to exist. Instead, the economic effect of the timing differences between cash payments and straight-line expense is now embedded within the Right-of-Use (ROU) asset and lease liability balances.

For operating leases, the lease expense continues to be recognized on a straight-line basis over the lease term on the income statement. The balance sheet now reflects the ROU asset and lease liability. Each period, the ROU asset is amortized, and the lease liability is reduced as payments are made and interest accrues. The net change in these two balance sheet accounts effectively captures the difference between the cash paid and the straight-line expense, which was previously tracked in the deferred rent account.

For finance leases, the accounting treatment involves recognizing both interest expense on the lease liability and amortization expense on the ROU asset separately on the income statement. The lease liability is reduced by the principal portion of the lease payments, and the ROU asset is amortized over the shorter of the lease term or its useful life.