Understanding Rent Expense: Definition & Significance

Rent expense refers to the total cost of using rental property for each reporting period. It is typically among the largest expenses that companies report. Only two expenses are usually larger than rental expense: cost of goods sold (COGS)Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct and compensation (wages) expense.

Rent expense is the payment made to a landlord for the rental space that is used by the company. For manufacturing companies the expense is generally divided – on the income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or – between the production and selling & administrative business units. It may sometimes simply be listed in the selling & administrative section of the income statement.

Summary

• Rent expense is commonly one of the largest expenses a company reports.
• How a rental space is used affects what account the rent expense is listed under.
• Deferred rent is when a company is given one or more periods of free rent usually at the beginning of a new lease agreement.

Accrual Basis of Accounting

With the accrual basis of the accounting method, any revenue is listed on the income statement upon earning it, even if the cash hasn’t actually been received yet.

For rental expense under the accrual method, when rent is paid ahead of schedule – which happens rather often – then the rent is recorded in the prepaid expenses account as an asset. Once the business moves into the rental space, or time passes so that the expense becomes current, then the rent expense is then moved to the expense column.

Deferred Rent Asset or Liability

Across the board, companies are supposed to have a consistent rent expense documented every month. This is dictated in the generally accepted accounting principles (GAAP)GAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial. The major problem with this regulation is that monthly rent payments aren’t always consistent. In many cases, because of inflation, for example, monthly rent expense increases over time. On the other hand, the lessor might sometimes give the company a free month or a discount on the rent.

In order to deal with this situation, the balance sheet must include a deferred rent asset or liability account. This account must:

• Determine the cost of the lease for its entire period, including free months, discounted months, or months that go up because of inflation
• The amount must then be divided by the total number of months covered under the lease
• Every month must be listed under the original monthly rental expense, regardless of what was actually paid that month. It is listed in the expense account.
• Offsetting rent payments – reduction of cost or inflation of cost – is listed in the deferred rent asset or liability account.

How Rental Space Is Used

Rent expense can, in fact, be listed in a number of different places in a company’s financial records. It is often, as mentioned above, listed as a selling or administrative expense. If, for example, the space was used as a place to manufacture goods, the expense would then be listed as part of the cost of goods sold (COGS) for the products produced.

Location, Location, Location

For companies, location is everything, especially for real estate and retail companies. It’s important to be located in a place with a lot of foot traffic and access to the company’s target consumer base. Companies often allocate a large part of their rental expense towards prime locations. For such companies, it’s crucial to weigh the cost of the rent against the benefits and potential boost in revenue that comes from being in a prime location.

More Resources

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