With the economic uncertainty surrounding COVID-19, many lessees are looking for rent concessions that will ultimately be granted by many lessors through the form of free or reduced rent for a certain period of time, the deferral or straight-line rent concept, or some other type of relief.
Straight-line rent, amongst all the others mentioned, is the most used concept that provides total liability under a rental arrangement, so the rent should be charged to expense on an even periodic basis over the term of the contract.
The straight-line concept is similar to straight-line depreciation, where the cost of an asset is charged to expense on an even basis over the asset’s useful life.
The straight-line concept is also based on the idea that the usage of the rental arrangement is consistent over time. That being said, the rented asset should be used at about the same rate from month to month.
How Straight Line Rents Work
If a leased space is renewed early, the rent is thereby extended throughout some period over which the rental income is amortized. But – how do you book the unamortized balance from the first lease?
Well, we have two options to try out.
Option Number 1
Option number 1 is what we call the “Carry Forward”, and it describes the balance and amortization through the life of the new lease. This could seem a bit problematic because you are amortizing a balance in a period that it should not even be in.
This is the best option to choose if you are depending on the lease change and balance.
Option Number 2
Option number 2 should be to book the entire remaining balance in a single period. This is a more practical way but it could show a wild fluctuation in rental income for that period. You don’t have a smooth cost, it’s basically the opposite.
The accounting for deferred rent for operating leases with scheduled rent increases requires the recognition of rental income on a straight-line basis, and it generates accrued but unpaid rent (deferred rent) on the lessor’s balance sheet.
The Existence Of Uncertainty
Questions have arisen as to the disposition of the receivable when a lease is extended before the end of the original lease term, or when uncertainty exists as to the receivable’s realizability.
If an operating lease is extended before the end of the lease term, including the early exercise of renewal options, we believe that the lessor should amortize any deferred rent on its balance sheet over the combined period of the remainder of the original lease term plus the extended lease term.
Similarly, if an operating lease is terminated and a new lease is entered with the same lessee, the lessor should amortize the deferred rent over the term of the new lease agreement.
Lessee Rent Referral Example
Assume that the landlord defers one period of the tenant’s rent, which will be paid in equal installments over the remaining life of the lease. The lessee has adopted this and classified it as an operating lease.
At the end of the period for which rent is deferred, the lessee records look like a normal leasing journal entry, including the straight-line rent expenses, and the changes in the lease liability, and the right-of-use (ROU) asset.
Instead of crediting cash, the accrues are relieved when the deferred rent is paid. Under this method, there is no impact to rent expense, the lease liability, or the ROU asset.
Under the method in the second bullet, the lessee reduces both the lease liability, the ROU asset, and recognizes straight-line rent expense. But, instead of crediting cash, the lessee reduces rent expense in the period of the deferral and recognizes a variable rent expense.
Straight Line Rent Example
Assume that the lessor defers one period of rent, which will be paid in equal installments over the remaining life of the lease. The lessor has now adopted the “ASC 842” and has classified the lease as operating.
Under the first method, the lessor records its normal straight-line rental income at the end of the period for which rent is deferred.
By recognizing the normal straight-line rental income relieved over time, the Lessee pays deferred rent now. and remains subject to the collectibility guidance in the operating leases. Under this method, there is no impact on rental income.
How To Calculate Straight-line Rent
To calculate straight-line rent, aggregate to rent payments’ total cost and divide it by the total contract term.
The result is the amount that needs to be charged for the expense in each month of the contract.
This calculation should include all discounts from the normal rent and extra charges that can reasonably be expected to incur over the life of the arrangement.
The calculation of straight-line rent may result in a monthly rent expense that differs from the actual amount billed by the owner. This is usually because the owner has built escalating rent payments into the contract.
In such a case, the straight-line rent amount should be charged higher than the actual amount billed during the first few months of the contract, and lower than the amount billed during its final months.
This initial disparity, where the amount of the expense is greater than the amount paid, can be charged to a deferred liability account.
The latter disparity reverses the deferred liability account, where the amount paid is greater than the expense amount. By the end of the contract, the deferred liability account will have a zero balance.
Hopefully, this was enough to understand the basic implementation of how straight-line rent works, but if you have any questions considering lease services, audits, and tenant/landlord services – do not hesitate to contact me, or any member of our team.