Prepaid rent

Prepaid rent
See also

The Prepaid rent (or rent in advance) is an additional good faith sum of money that the tenant puts upfront to finalize the agreement. Prepaid rent is not required or charged by all landlords and is alike more negotiable than the deposit itself. This prepaid rent usually concerns the first, second, or third month of the lease term once the lessee opens for business. Prepaid rent is not a deposit. A deposit or a portion of it is generally held for the entire lease term and when they move out it is returned to the tenant [1].

Prepaid rent is the example of prepaid expenses [2].

Companies commonly pay some expenses, including those for insurance, supplies, and rent, in advance. These costs are described as prepaid expenses. By the end of an accounting period, a piece or all of prepaid goods or services will have been used or have expired [3].

Prepaid Rent In Law Firms

Prepaid rent is ordinarily used by law firms. As year-end approaches, law firms that have had lucrative years often try to find deductions to drop the partnership's taxable income. Because the lower the firm's income allows that the partners pay the less taxes. The rent is one of the largest expense items and that is why it is garnered attention.

Putting aside for the moment the hoped-for tax-saving advantage behind paying rent in advance, there are other reasons that law firms may pay prepaid rent. These include the time when:

  1. a lessor insists on remittance of the last year's rent (or some other period at the end of the lease term) as a form of security deposit
  2. a cash-flush lessee negotiates an advance payment in order to gain more space or better terms
  3. a cash-short lessor provides a considerable discount for paying rent in advance

But even where such non-tax reasons are present, companies hope that advance payment will pass muster as a necessary, typical and ordinary business expenses for tax purposes.

However, if the only business objective of paying rent in advance is to achieve a tax advantage, the chances of having the IRS (Internal Revenue Service) agree that the payment is deductible in the year paid are very small [4].

Accounting For Prepaid Rent

Tenants are required by some landlords to pay rent in advance. This prepayment generates an asset for the Smart Touch prepays three months' office rent of $3000 ($1000 per month x 3 months) on 1 June 2014. The entry in the register of payment is as follows [5]:

1 June Prepaid rent (A+) 3000
Cash (A-) 3000
Paid rent in advance

After posting, Prepaid rent has a debit balance of $ 3,000. The trial balance at 30 June 2014 lists Prepaid rent with a $3000 debit balance. During June, Prepaid rent keeps this balance. But $3000 is not the sum of Prepaid rent for the balance sheet at 30 June. At 30 June, Prepaid rent should be reduced for the amount that has been used up. The used-up part is one month of the three months prepaid, or one-third of the prepayment. Remember that an asset that has expired is an expense. And eventually, the adjusting entry transfers $1000 ($3000 x 1/3) from Prepaid rent to Rent expense.

30 June Rent expense (E+) 1000
Prepaid rent (A-) 1000
To record rent expense

The Prepaid rent is an illustration of an asset that was overstated prior to posting the adjusting entry. We can see the same analysis that refers to the prepayment of three months of insurance. The account titles are the only difference in it. Prepaid insurance would be applied instead of Prepaid rent and Insurance expense would be used instead of Rent expense [6].

Footnotes

  1. D. Willerton, J. Grandfield, 2013, page 121
  2. J. M. Flood, 2015, page 51
  3. B. E. Needles, M. Powers, S. V. Crosson, 2011,2008, page 108
  4. John P. Quinn, Joseph A. Bailey (Jr.), David E. Gaulin, Stanley Kolodziejczak, 1986,1994,2001, pages 17-45, 17-46
  5. C. Horngren, W. Harrison, S. Oliver, P. Best, D. Fraser, R. Tan, 2013, pages 119
  6. C. Horngren, W. Harrison, S. Oliver, P. Best, D. Fraser, R. Tan, 2013, pages 120

References

Author: Monika Mendak