Summary of Rent-Free Period Accounting Treatment
- How do you account for rent free periods?
- What is a free rent period?
- How to account for rent abatements?
- What is the 90% rule in leasing?
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Rent-free periods are accounted for by
spreading the total cash payments over the entire lease term using the straight-line method, rather than recognizing expense only when cash is paid. A “deferred rent” liability or accrued lease payment asset is recorded to reflect the difference between recognized expense and cash paid.
Key Accounting Principles (ASC 842/IFRS 16)
Total Lease Value: Calculate the total rent payable over the full lease term, including any periods where no cash is exchanged.
Straight-Line Method: Divide the total cost by the total number of periods in the lease to determine the monthly expense.
Recording Expenses: Recognize a constant, monthly rental expense even during the rent-free period.
Balance Sheet Impact: In early, rent-free months, record a “deferred rent” liability, as the expense recognized exceeds the cash paid.
Rent Incentives: Free rent is treated as a lease incentive (or reduction/abatement), reducing the overall cost per month.
Example
A 12-month lease with the first month free at
$
1
,
000
/
month
$
1
,
0
0
0
/
m
o
n
t
h
:
Total Payments:
11
months
×
$
1
,
000
=
$
11
,
000
1
1
m
o
n
t
h
s
×
$
1
,
0
0
0
=
$
1
1
,
0
0
0
.
Monthly Expense:
$
11
,
000
÷
12
months
=
$
917
/
month
$
1
1
,
0
0
0
÷
1
2
m
o
n
t
h
s
=
$
9
1
7
/
m
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h
.
Entry (Month 1): Debit Rent Expense
$
917
$
9
1
7
, Credit Deferred Rent/Liability
$
917
$
9
1
7
.
Rent-Free Period Accounting Treatment – IFRS 16 (Lease)
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Rent-Free Period Accounting Treatment – IFRS 16 (Lease)
One of the main points in measurement in IFRS 16 (Lease) is “determination of the lease term”. Where the entity applies the period during which the lease contract is enforceable.
Generally, several contractual arrangements such as extension (renewal) of the lease period and the right to terminate (either full or partial termination) have been widely discussed in the illustrative examples (IE) of IFRS 16.
In practice, some industries may receive “rent-free” incentives from the lessor for not paying cash flow rental payments in a certain period.
Next, How is rent-free accounting treated?
IFRS 16 B36 states “The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.”
Simple Illustration
To illustrate this statement, the author takes a simple illustration.
XYZ Bank (as lessee) rents a building owned by C Corp. (Lessor) with a lease term of 10 years, where the lease payment is $10,000 per year (made at the end, ordinary). The implicit interest rate is not known to the lessee, so the lessee applies an incremental borrowing rate (IBR) of 6.5%. C Corp. provides facilities in the form of a rent-free period for 2 years at the start, so that Bank XYZ does not make rental payments in the first two years (rent-free).
Additional Note: the lease contract meets the definition of a lease under IFRS 16, and does not meet the “exemption criteria” because it is not a low-value asset and is not a short-term lease.
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Step 1. Initial Recognition – Commencement Date
At the commencement date, the lessee will recognize the right of use asset (RoU) and lease liability (LL) using a “present value” approach from all relevant cash flows related to future lease payments. Because the first two years, lessee receive rent-free, the present value calculation is only based on the annual payment from years 3-8 (total: $80,000).
Step 2. Subsequent Measurement
In subsequent periods, RoU (with the cost method) will be depreciated over 10 years (including 2 years during the rent-free period). Assumption: Straight line method.
For lease liability, it will increase through interest accrual over 10 years, and decrease over 8 years (in years 3-8). The difference of 2 years at the beginning did not result in any cash outflow (lease payment) which reduced the carrying amount of the lease liability.
Step 3. Accounting Entries
Even though there was no movement in cash flow in years 1-2, recognition of profit and loss items such as depreciation expense and interest accrued was still carried out on an accrual basis. Meanwhile, in years 3-10, there are annual rental payments which result in a reduction in the carrying value of the lease liability.
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