There are numerous resources online explaining the basics of ASC 842, but discussions often skim over the accounting treatment of prepaid rent. How does this fit into the amortization schedule, and what kind of journal entries should be made?

We prepared this guide to address the topic of prepaid rent under ASC 842 with a step-by-step example. We will explain the rules and concept, provide a detailed amortization schedule, and walk through the treatment with journal entry examples.

## How Prepaid Rent is Treated Under ASC 842

Prepaid rent refers to payments made by a lessee for a lease period that has not yet occurred. This advance payment is common in lease agreements and requires specific accounting treatment.

In situations where a lease is not governed by ASC 842, such as in short-term or month-to-month leases, prepaid rent is treated as a typical prepaid expense:

- When the prepayment was made: debit Prepaid Expenses (Asset) and credit Cash/AP
- When the expense has incurred: debit P&L/Expense and credit Prepaid Expenses

The “problem” with ASC 842? **There is no recognition of prepaid expenses.** Instead, you would do the following:

- Calculate the lease liability by using the present value of the annuity formula for the remaining lease payments without accounting for the prepaid amount.
- Once the lease liability amount is determined, add it to the prepaid amount to establish the Right-of-Use (ROU) Asset balance.

Consider an example where the present value (PV) of lease payments, excluding the prepaid amount, is $8,000, and the prepaid rent is $2,000. In this case, the lease liability recognized is $8,000, and the Right-of-Use Asset balance totals $10,000 ($8,000 lease liability + $2,000 prepaid).

In essence, there is no such account named “prepaid rent” on the balance sheet under the rules of ASC 842. Instead, such an asset is recognized as part of the Right-of-use (ROU) Asset balance.

The next question is: how do we calculate the interest expense, liability reduction, and ROU asset amortization, especially when the lease liability doesn’t equal the ROU asset balance? See below for a step-by-step analysis & example.

## Real-World Example: Accounting for Prepaid Rent Under ASC 842

**Assumptions**

**Lease Term**: The lease is for a duration of 3 years.**Payment**: $36,721 a year, made annually.**Prepaid Rent**: The first year is prepaid ($36,721), and the regular payment is due at the end of Year 2 and Year 3.**Discount Rate**: 5%.**Lease classification**: assuming the lease is classified as an Operating Lease

**Calculations**

By applying the present value (PV) formula or a PV calculator, the PV of the remaining payments is determined to be $65,028. It is important to note that in this calculation, **the first period is accounted as ‘zero’** in the annuity/cash flow. This is because it has already been prepaid and is not included in the lease liability. See below.

According to the principle, the Right-of-Use (ROU) Asset balance is calculated by adding any prepaid amount to the lease liability. Therefore, our initial recognition amount is the following:

**Lease Liability**: $65,028**Right-of-use (ROU) Asset**: $101,749 ($65,028 Lease liability + $36,721 Prepaid rent)

When booking journal entries, the difference (or plug) would be a credit to AP or Cash to account for the prepayment. All journal entries applicable to this scenario are illustrated in detail below.

**Amortization Schedule & Analysis**

**Lease Payment (A)**: The $36,721 per year is given by the assumption. Year 1 has a “Zero” because the amount has been prepaid. Therefore, it’s excluded from calculating the lease liability since we don’t “owe” that amount.**Beginning Lease Liability (B)**: This is the outstanding lease liability at the start of each year. Initially, it’s the present value of the lease payments ($65,028), and it decreases over time as payments are made. Besides Year 1, the subsequent period beginning lease liability is always the same as the previous year’s ending lease liability (E).**Interest Expense (C)**: Calculated annually as the product of the beginning lease liability (B) and the discount rate (5%). This represents the cost of financing the lease liability.**Reduction in Lease Liability (D)**: This is the portion of the annual lease payment that reduces the lease liability. It is calculated as the lease payment (A) minus the interest expense (C).- Note that the Year 1 number is negative because interest has accrued without payment to offset (payment was prepaid at the beginning of the lease and excluded from total lease liability). Therefore, the ending lease liability in Year 1 actually went up.

**Ending Lease Liability (E)**: This is the remaining lease liability balance at the end of each year. It is calculated by subtracting the reduction in lease liability (D) from the beginning lease liability (B)**Beginning ROU Asset (F)**: This is the beginning Right-of-use Asset Balance. Year 1 is $101,749 ($65,028 lease liability + $36,721 prepaid rent). The subsequent year’s beginning balance is always the same as the ending balance of the previous year (H)**Amortization of ROU Asset (G)**: This is the amount by which the ROU Asset is reduced each year, equivalent to the lease payment (A) minus the interest expense (C). This ensures that the ROU Asset is fully amortized over the lease term.- Note that the prepaid amount
**is included**in the calculation for ROU Asset amortization. This is because the “prepaid amount” only affects liability (what we owe) and has nothing to do with the asset amortization. Therefore, the Year 1 amount is not negative, unlike “Reduction in Lease Liability” (D).

- Note that the prepaid amount
**Ending ROU Asset (H)**: The remaining balance of the ROU Asset at the end of each year. It is calculated by subtracting the amortization of ROU Asset (G) from the beginning ROU Asset balance (F)

**Journal Entries**

**Initial recognition**

To recap, we determined the lease liability to be $65,028 (PV of remaining payment excluding the prepaid Year 1 rent). We then add the prepaid amount of $36,721 to establish the Right-of-use (ROU) Asset balance, which comes out to be $101,749.

The journal entry to record the initial recognition is a debit to the ROU Asset account for $101,749, a credit to Lease Liability for $65,028, and a credit to Cash or AP for the prepaid amount of $36,721.

**Year 1**

As we already prepaid the Year 1 rent, there won’t be a reduction to lease liability (remember – the beginning lease liability excluded that). However, we still need to account for the “interest” component, which is calculated by multiplying the outstanding lease balance of $65,028 by the 5% discount rate, coming out to be around $3,251.

On the other hand, the Right-of-use (ROU) asset amortization is the difference between the payment and the interest component, which is $33,469 ($36,721 payment – $3,251 “Interest”).

Therefore, the entry on the liability side is a debit to Lease Expense for $3,251 and a credit to Lease Liability for the same amount. The entry for the ROU asset is a debit to Lease Expense for $33,469 and a credit to Right-of-use (ROU) Asset for the same amount to record the amortization.

**Year 2**

The “interest” component in Year 2 is calculated by multiplying the outstanding lease balance of $68,279 by the 5% discount rate, totaling around $3,414. Since a payment is made, the lease liability reduction amount is the difference between the lease payment and this interest component, which is $33,307 ($36,721 payment – $3,414 “Interest”).

On the other hand, the Right-of-use (ROU) asset amortization is also the difference between the payment and the interest component, which is $33,307 ($36,721 payment – $3,414 “Interest”).

The entry on the liability side is a debit to Lease Expense for $3,414, a debit to Lease Liability for $33,307, and a credit to Cash or AP for $36,721 to record the payment. The entry for the ROU asset is a debit to Lease Expense for $33,307 and a credit to Right-of-use (ROU) Asset for the same amount to record the amortization.

**Year 3**

Similarly to Year 2, the Year 3 “interest” component is calculated by multiplying the outstanding lease balance of $34,972 by the 5% discount rate, totaling around $1,749. The lease liability reduction and the ROU asset amortization are the difference between the payment and the interest component, which is $34,972 ($36,721 payment – $1,749 “Interest”).

The entry on the liability side is a debit to Lease Expense for $1,749, a debit to Lease Liability for $34,972, and a credit to Cash or AP for $36,721 to record the payment. The entry for the ROU asset is a debit to Lease Expense for $34,972 and a credit to Right-of-use (ROU) Asset for the same amount.

**Wrapping up**

At the lease’s end, the Lease Liability and Right-of-use (ROU) Asset account have both been reduced to zero. The lease expenses for each year are $36,721, which perfectly reflects the payment made every year (even if Year 1 was prepaid).

## Key Takeaways

- Unlike the traditional method, where prepaid rent is recorded as a prepaid expense (asset), under ASC 842, there is no separate recognition of prepaid rent. Instead, prepaid rent is included in calculating the Right-of-Use (ROU) Asset.
- The initial lease liability is calculated based on the present value of the remaining lease payments, excluding any prepaid amounts. The ROU Asset is then determined by adding the prepaid amount to this lease liability.
- There is no reduction to the lease liability in the year where the lease is prepaid because it’s excluded from calculating the total lease liability. However, the “interest” component still needs to be accrued and expensed, and the ROU asset must still be amortized.