Accounting for variable lease payments by lessees
Accounting for variable lease payments by lessees
At the commencement date of a lease, the lessee must initially recognise a right-of-use asset and lease liability in its balance sheet. The lease liability is measured as the present value of lease payments, which includes both fixed lease payments and certain variable payments.
This article explains how different types of variable lease payments affect the measurement of lease liabilities.
Are all variable lease payments included in the lease liability?
No. Not all variable lease payments are included when measuring the lease liability. There are two types of variable lease payments as shown in the table below.
Type of lease payment |
Included in lease liability? |
Based on an index or rate Examples:
|
Yes. The lease liability is initially measured using the index or rate as at the commencement date of the lease. IFRS 16, paragraph 24(b) Subsequently, the lease liability is adjusted when there is a change in future lease payments because the index or rate has changed (for example, lease payments change as a result of a market rent review). The lease liability is only remeasured when there is a change in the cash flows (i.e. when the adjustment to the lease payments takes effect). The revised lease payments for the remainder of the lease term are based on the revised contractual payments. IFRS 16, paragraph 42(b) |
Based on performance or usage Examples:
|
No. Recognise in profit or loss (or in the carrying amount of an asset as required by another IFRS® Accounting Standard) when the event or condition that triggers the payment occurs. IFRS 16, paragraph 38(b)
|
Performance or usage-based variable lease payments
As noted above, variable payments associated with a lease (based on performance or usage of the underlying leased asset) are expensed in profit or loss (or recognised as part of the carrying amount of an asset, if appropriate) when the event or condition that triggers the payment occurs.
The following example illustrates how this works in practice.
Example 1
On 1 January 20X1, a lessee enters into a five-year lease of retail space in a shopping centre. Fixed payments are $100,000 per year, payable annually in arrears. There is an additional variable lease payment of 5% of annual sales each year.
The rate implicit in the lease is not readily determinable. The lessee’s incremental borrowing rate is 5% per annum. This rate reflects the fixed rate at which it could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a 5-year term, with similar collateral.
The lessee estimates its sales revenue for the next five years as follows:
- Year ended 31 December 20X1 $1,000,000
- Year ended 31 December 20X2 $1,100,000
- Year ended 31 December 20X3 $1,200,000
- Year ended 31 December 20X4 $1,300,000
- Year ended 31 December 20X5 $1,400,000.
Analysis
The fixed payments to be included in the lease liability at the commencement of the lease are $100,000 X 5 years, discounted at the lessee’s incremental borrowing rate of 5%.
The lessee recognises the following journal entry to record the initial value of the leased asset and lease liability on 1 January 20X1:
|
|
Dr |
Cr |
Right-of-use asset |
432,948 |
|
Lease liability |
|
432,948 |
Despite the lessee having estimated its future annual sales revenue, the variable lease payment for turnover rental is not based on an index or rate, and is therefore not included in the lease liability at the commencement of the lease (1 January 202X1).
The lessee records the following journal entries on 31 December 20X1 to accrue interest expense on the lease liability for the 31 December 20X1 year and to recognise the lease payment on 31 December 20X1:
|
Dr |
Cr |
Interest expense ($432,948 X 5%) |
21,647 |
|
Lease liability |
|
21,647 |
|
|
|
Lease liability |
100,000 |
|
Cash |
|
100,000 |
On 31 December 20X1, assuming annual sales for the 31 December 20X1 year were $1,000,000, the lessee recognises a liability (accrual) (or additional payment) for the turnover rental as follows:
|
Dr |
Cr |
Profit or loss (variable lease payments - turnover rental) |
50,000 |
|
Accrual/Cash |
|
50,000 |
Variable lease payments based on an index or rate
In contrast, variable lease payments must be included in the initial measurement of the lease liability if they depend on an index or rate. This could occur, for example, if the lease payments are linked to the CPI or a benchmark interest rate such as LIBOR, or if payments vary to reflect changes in market rental rates.
In such cases, they are included in the lease liability at the commencement date of the lease, based on the index or rate at that date. In other words, the lessee does not forecast what they think the index or rate (e.g. the CPI, benchmark interest rate or market rental uplift) will be in the future.
Subsequently, the lessee remeasures the lease liability when the cash flows change. This is when the change to the index or rate is known and takes effect. The revised lease liability will incorporate the revised contractual payments based on the index or rate change for the remainder of the lease term. That is, no forward predictions are made for future index and rate changes beyond what is known at the date the lease payment cash flows change.
In practice, we have observed lessees overstating their lease liabilities (and associated right-of-use assets) because the revised index or rate is uplifted for the remainder of the lease term rather than remaining steady. Example 2 below explains the appropriate accounting in more detail.
Example 2 - CPI
On 1 January 20X1, a lessee enters into a five-year lease for office premises. Fixed payments are $100,000 payable annually in advance (i.e. on 1 January each year). Lease payments will increase every year based on the increase in the Consumer Price Index (CPI) for the preceding 12 months.
The rate implicit in the lease is not readily determinable. The lessee’s incremental borrowing rate is 5% per annum. This rate reflects the fixed rate at which it could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a 5-year term, with similar collateral.
CPI on 1 January 20X1 is 100. At the end of year 1, 31 December 20X1, the CPI increase is published and is 102.
Analysis – Initial measurement
On commencement of the lease (1 January 20X1), the lessee makes its first lease payment of $100,000. The fixed payments to be included in the lease liability on this date are $100,000 X 4 years, discounted at the lessee’s incremental borrowing rate of 5%.
The lessee recognises the following journal entry to record the initial value of the leased asset and lease liability on 1 January 20X1:
|
Dr |
Cr |
Right-of-use asset |
454,595 |
|
Lease liability |
|
354,595 |
Cash |
|
100,000 |
When initially measuring the lease liability, the lessee does not estimate what it thinks the CPI will be in future.
The lessee then recognises the following journal entry on 31 December 20X1 to accrue interest expense on the lease liability for the 31 December 20X1 year:
|
Dr |
Cr |
Interest expense ($354,595 x 5%) |
17,730 |
|
Lease liability Balance on lease liability on 31 December 20X1 is $372,325 ($354,595+$17,730) |
|
17,730 |
Analysis – Subsequent measurement
On 1 January 20X2, the lessee remeasures its lease liability as $379,771 (being four remaining lease payments of $102,000 discounted at 5% for the remaining lease term) and recognises the revised lease payment of $102,000.
|
Dr |
Cr |
Right-of-use asset |
7,446 |
|
Lease liability ($379,771-$372,325) |
|
7,446 |
|
|
|
Lease liability |
102,000 |
|
Cash |
|
102,000 |
The lease liability is only adjusted on 1 January 20X2 when the lease payment changes from $100,000 to $102,000 (CPI uplift of 102/100). The revised lease payments factored into the calculation of the remeasured lease liability are $102,000 for the remainder of the lease term.
Example 3 – Market rent adjustments
On 1 January 20X1, a lessee enters into a five-year lease for office premises. Fixed payments are $100,000 payable annually in advance (i.e. on 1 January each year). Lease payments will increase every year on 1 January based on changes in market rentals since the previous rent review.
The rate implicit in the lease is not readily determinable. The lessee’s incremental borrowing rate is 5% per annum. This rate reflects the fixed rate at which it could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a 5-year term, with similar collateral.
The rent review on 1 January 20X2 resulted in revised lease payments of $102,000.
The same principles apply if the revised lease payments are based on a change in market rentals. The lease liability is remeasured when the cash flows change (i.e. when the adjustment to the lease payments takes effect), and the revised lease liability is based on the latest market rentals for the remaining lease term. The lessee does not assume any further market rental increases (or decreases) in its lease liability calculation.
The calculation for the revised lease payments is the same as for Example 2 (CPI) above.
Common error – variable payments based on an index or rate
A common error we see when lessees recalculate their lease liabilities to account for changes in an index or rate is the assumption that the same CPI uplift or percentage increase in market rentals will endure over the remaining lease term. Using the fact patterns in Example 2 and Example 3, the table below shows how this incorrect approach results in the overstatement of lease liabilities.
Correct lease payments per Example 2 |
Common error in lease payments |
||||||
20X2 |
20X3 |
20X4 |
20X5 |
20X2 |
20X3 |
20X4 |
20X5 |
$102,000 |
$102,000 |
$102,000 |
$102,000 |
$102,000 |
$104,040 |
$106,120 |
$108,242 |
Revised lease liability on 1 January 20X2 |
|||||||
$379,771 |
$390,845 |
||||||
Other issues affecting the accounting for variable lease payments
The above examples show simplified fact patterns where lease payments change due to only one variable (CPI index or market rent changes), and the change in the variable coincides with the date that the revised lease payments become effective. However, more complicated scenarios arise, for example, where:
- There is an unresolved rent review at the reporting date
- The renewal terms are at negotiated rental rates
- There are multiple rent reviews within a single lease
- There are multiple rates or indices affecting lease payments.
For more information, please refer to Examples 5.6.1, 5.6.2, 5.6.4 and 5.6.5 in our IFRS in Practice publication.
More information
Our IFRS in Practice publication contains in-depth discussion and examples to help you apply other aspects of IFRS 16 to your organisation.
Need help?
BDO offers comprehensive support for your lease accounting needs. Our cloud-based system, BDO Lead simplifies the complexities of implementing IFRS 16. We also provide outsourced leased management services, handling your lease accounting using BDO Lead. These products are particularly helpful when lease liabilities need to be remeasured each year for rental adjustments.
For assistance, please contact BDO’s IFRS & Corporate Reporting team.