Prepaid Rent

Prepaid rent is rent that a tenant has paid before the period to which it relates. When a business pays, for example, three months' rent at the start of a quarter, it has bought the right to use the property for those future months. Under accrual basis accounting, the payment is recorded as an asset and transferred to rent expense month by month as the property is used. Prepaid rent is one of the most common prepaid expenses and is usually reported as a current asset.

The opposite situation, where rent has been incurred but not yet paid, gives rise to accrued rent, a liability for the tenant. For the landlord, rent received in advance is unearned revenue, a liability, rather than income.

The usual approach is to debit prepaid rent when the payment is made and to make a deferral-type adjusting entry at each period end, debiting rent expense and crediting prepaid rent for the portion used. Some businesses instead debit rent expense on payment and, at period end, move any unused portion to prepaid rent. Either way, after the adjusting entries, the balance sheet shows only the rent that relates to future periods.

On 1 December, a design studio pays $9,000 for three months' rent on a small office under a short-term arrangement covering December, January and February. It records:

• 1 December: debit prepaid rent $9,000; credit cash $9,000.
• 31 December: debit rent expense $3,000; credit prepaid rent $3,000.

The monthly charge is:

Here $\text{Rent paid in advance}$ is the cash paid and $\text{Months covered}$ is the number of months the payment relates to. At the 31 December year end, the studio reports rent expense of $3,000 and prepaid rent of $6,000 on its balance sheet. In January and February, it records a further $3,000 of expense each month, and the prepaid balance falls to zero. If the studio had expensed the full $9,000 in December, its profit for the year would have been understated by $6,000.

Since ASC 842 (effective for US public companies from 2019 and private companies from 2022) and IFRS 16 (effective from 2019), most leases longer than twelve months are recorded on the tenant's balance sheet as a right-of-use asset and a lease liability. For these leases, rent paid in advance is not shown as a separate prepaid rent account. Instead, payments made at or before the start of the lease are included in the initial measurement of the right-of-use asset, and later payments reduce the lease liability. Under ASC 842's operating lease model, the tenant still records a single straight-line lease cost in the income statement.

Prepaid rent therefore remains relevant mainly for short-term leases of twelve months or less, which tenants may elect to keep off the balance sheet, for month-to-month arrangements, for leases of low-value assets under IFRS, and for small businesses that apply simpler frameworks such as tax-basis accounting. A lessee moving to the new standards had to reclassify existing prepaid and deferred rent balances into the right-of-use asset.

For US federal income tax, prepaid rent is generally deductible over the period to which it applies. A business may deduct it when paid only if the benefit does not extend beyond the earlier of twelve months after it begins or the end of the following tax year, under the 12-month rule. Common errors include failing to make the monthly adjusting entry, which overstates assets and understates expense; expensing a large advance payment immediately; and, for leases covered by the new standards, continuing to report a separate prepaid rent balance that should form part of the right-of-use asset. Readers can find the related accounting for rent receipts and payments in the entry on accrued rent expense and income.