When a business does not own a premise to conduct its day-to-day operations, it may hire a property and make periodic payments against it.
Such payments are considered rent. From an accounting perspective, rent can be defined as an expense or a cost of occupying/utilizing a property for a specific period.
After the cost of goods sold, it is one of the significant expenses for organizations of any size and nature. Either in accrual or cash-based accounting system, when rent is paid in advance (usually due on the first of each month) it is considered prepaid rent.
However, the benefits are availed in the future accounting period. In addition, prepaid rent is recorded on the balance sheet as an asset or liability depending on the nature of the transaction.
For instance, it is recorded as an asset when a payment to the third party is made in advance and liability when an entity receives rent from a third party.
Rent paid in advance is not a complicated concept to understand but surely requires attention at the month-end reconciliation as failure to record accurately may lead to material misstatements of financial records and poor decision making as a result.
Let’s take an example. ABC & Co. has paid rent accounting for $2,000 in advance (prepaid) for 5 months. The cash account will be credited (reduced) and the prepaid rent account will be debited (increased) by $2,000.
As each month passes, one rent payment ($2,000/5 = $400 per month) from the prepaid rent account will be credited and the rent expense account will be debited against it. These entries will continue to record until the full prepaid rent amount is recognized.
Accounting Treatment for Prepaid Rent
The accounting treatment for prepaid rent can be understood from two perspectives. Firstly, when the advance payment is made. Secondly, when the prepaid rent actually applies.
- Journal entry when advance payment is made:
| Particulars | Dr | Cr |
| Advance Rent Paid | ||
| Prepaid Rent A/C | Should be Debited | |
| Cash A/c (For rent being paid in advance) | Should be Credited |
When an advance payment for the rent is made by the entity, the prepaid rent account is debited and the cash account is credited as mentioned in the example earlier. Rent is treated usually as an expense but in this scenario, it is an asset.
When an advance payment for rent is made it becomes an asset as it will generate an economic value in the future for the organization. So, an increase in the asset is debited.
On the other hand, a cash account is treated as a current asset. Whenever prepaid rent is paid in cash it decreases the cash in hand balance. Considering the rules of accounting, a decrease in the asset is always credited.
- Journal entry when prepaid rent actually applies
| Particulars | Dr | Cr |
| Rent Expense Incurred | ||
| Rent Expense A/c | Should be Debited | |
| Prepaid Rent A/c (For rent expense being incurred) | Should be Credited |
The second entry is to amortize prepaid assets to prepaid expenses when rent is actually consumed.
As the asset (prepaid asset) is being utilized it will be credited. As now the expense has been incurred, the rent expense account will be debited in order to net off the effect.
The table below can help to understand the debits and credits in the discussed scenario.
| Accounting Rules | Dr | Cr |
| Increase in expense | ✔ | |
| Decrease in expense | ✔ | |
| Increase in asset | ✔ | |
| Decrease in asset | ✔ |
EXAMPLE #1: On Jan 1st, 2022, XYZ Co. paid rent of $5000 for February 2022 in advance. Be noted the payment was made in cash.
On January 1st, 2022, XYZ Co. will record the first aspect of the accounting treatment i.e. when advance payment is made to increase the expense account and decrease the asset account as discussed earlier.
| Date | Particulars | Dr | Cr |
| Advance Rent Paid | |||
| Prepaid Rent A/c | $5,000 | ||
| 1st January 2022 | Cash A/c (For rent being paid in advance) | $5,000 |
On February 1st, 2022, XYZ Co. will record the second aspect of the accounting treatment i.e. when advance payment is applied increase the expense account and decrease the asset account as discussed earlier.
| Date | Particulars | Dr | Cr |
| Rent Expense Incurred | |||
| Rent Expense A/c | $5,000 | ||
| 1st February 2022 | Prepaid Rent A/c (For rent expense being incurred) | $5,000 |
EXAMPLE #2: XYZ & Co. has signed a one-year lease contract with the landlord for a warehouse accounting for $10,000 per month. The landlord asks XYZ & Co. to pay the full amount ($10,000 * 12 = $120,000) in advance at the beginning.
XYZ & Co. will record the full amount as an expense at the beginning of the rental period.
| Particulars | Dr | Cr |
| Advance Rent Paid | ||
| Prepaid Rent A/c | $120,000 | |
| Cash A/c (For rent being paid in advance) | $120,000 |
On the other hand, an adjusting entry will be made each month for the portion actually being applied at the end of each month.
| Particulars | Dr | Cr |
| Rent Expense Incurred | ||
| Rent Expense A/c | $10.000 | |
| Prepaid Rent A/c (For rent expense being incurred) | $10,000 |
- Journal entries when prepaid rent is paid by Cheque
Unlike small businesses, the large entities pay their rents by Cheque to keep legal evidence for taxes and audit trail. In such scenarios, the journal entries will be as follows:
| Particulars | Dr | Cr |
| Advance Rent Paid | ||
| Prepaid Rent A/c | Should be debited | |
| Bank A/c (For rent being paid in advance) | Should be credited |
When an advance payment for the rent is made by the entity, the prepaid rent account is debited and the bank account is credited.
Like a cash account, the bank account will also be treated as a current asset. Whenever prepaid rent is paid by cheque it decreases the bank balance of the entity. Considering the rules of accounting, a decrease in the asset is always credited.
| Particulars | Dr | Cr |
| Rent Expense Incurred | ||
| Rent Expense A/c | Should be debited | |
| Prepaid Rent A/c (For rent expense being incurred) | Should be credited |
The adjusting entry will be the same as rent paid in cash. i.e. asset (prepaid asset) is being utilized it will be credited. As now the expense has been incurred, the rent expense account will be debited.
EXAMPLE#1: LMN & Co. pays rent for their warehouse by Cheque for next month accounting for $15,000 on 1st April 2022.
LMN & Co. will record the full amount as an expense at the beginning of the rental period.
| Date | Particulars | Dr | Cr |
| Advance Rent Paid | |||
| Prepaid Rent A/c | $15,000 | ||
| 1st April 2022 | Bank A/c (For rent being paid in advance) | $15,000 |
An adjusting entry for the portion actually being applied at the end of each month.
| Dat | Particulars | Dr | Cr |
| Rent Expense Incurred | |||
| Rent Expense A/c | $15,000 | ||
| 1st May 2022 | Prepaid Rent A/c (For rent expense being incurred) | $15,000 |
- Net Effect of Both Journal Entries
The initial journal entry i.e. prepaid expense to cash will not have any effect on the financial records of an entity as both are asset accounts and will neither increase nor decrease the balance sheet of an entity but rather net off the effects.
However, the adjusting entry is crucial as it can affect both profit & loss and the balance sheet of an entity. The rent expense account will decrease expenses on the income statement while prepaid rent will reduce assets on the balance sheet.