Not an uncommon question we see come up around prepaid rent is the question of “is it asset or a liability?”. This of course depends on whether you are the tenant or the landlord – and its today focus in our accounting tutorial series.
If you are rather short on time the answer is if you are the tenant it is an asset and if you are the landlord it is a liability. If you would like further details as to why … please read on.
What is Prepaid Rent?
As we stated above the answer of asset or liability depends on whether you are the tenant or the landlord. So let’s look at both below.
Why is Prepaid Rent an Asset?
Prepaid rent is an asset for the tenant because they are owed a bunch of economic benefits (ie the use the property) as a result of paying for the rent in advance. Under current accounting conceptual frameworks this meets the definition of an asset … its that simple really.
We like to go to the International Financial Reporting Standards (IFRS) Conceptual Framework for our point of reference in definitions. It defines as asset as “… a present economic resource controlled by the entity [or person] as a result of past events” (para 4.3). And goes onto define an economic resource as “… a right that has the potential to produce economic benefits” (para. 4.4).
The focus of these conceptual frameworks over the last few decades has been very much to focus on assets and liabilities – rather than income and expenditure as they use to. This makes the classification of transactions much simpler in many ways. As in our case with prepaid rent, the tenant has an asset (most if not all of it a current asset) because their payment creates a bundle of economic benefits in the form of having control over the use of a property for a specific period of time.
Why is Prepaid Rent a Liability?
Let us know turn to the landlord and see why they have a liability (of course it makes “natural sense” they do if the tenant has an asset … but let’s check it out anyway). The IFRS Conceptual Framework referenced above defines a liability as “… a present obligation of the entity to transfer an economic resource as a result of past events” (para 4.26). So yes, it just takes the opposite side to the asset discussion above.
In our case the landlord has a bundle of economic obligations through the requirement to allow the tenant to control the use of the property for the period covered by the prepayment.
Prepaid Rent Asset and Liability Example and Journal Entries
The first journal entry below is that for the tenant. Let us assume our beloved example company, ABC Ltd, was offered a good discount to pay rent upfront on a new storage unit they needed for the next six months. We are going to ignore any discount received in this example and just record the actual rent paid. The net price per month, for a six month contract, is $1,000. So the journal entry for ABC accounts team is:
|July 10||Prepaid Rent||6,000|||
The debit entry creates the prepaid rent current asset for ABC. And the credit of course reflects the reduction in their bank balance with the $6,000 going to their new landlord.
How prepayments are dealt with in more detail check out our tutorial here.
Now for the landlord. The journal entry, unsurprisingly, is just the opposite to the above entry ABC Ltd made. The landlord would record:
|Revenue in Advance||6,000|
The debit entry increases the bank current asset as the landlord now has the cash. While the credit creates a liability with the use of the revenue in advance current liability account. If you would like more information on income received in advance (often called unearned revenue) check out our tutorial here.
We trust this article helps answer the question for you regarding whether prepaid rent is an asset or liability. We have a growing range of accounting tutorials on the site, please let us know what you think or if there any different ones you would like to see.