Variable lease payments, or contingent payments, are defined in the
ASC 842 Glossary and further discussed in the Basis for Conclusions in
ASU 2016-02.
Definition from ASC 842 Glossary
Variable Lease Payments: Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.
ASU 2016-02 BC205
Some or all of the lease payments for the right to use an asset can be variable. That variability can arise because lease payments are linked to:
a. Price changes due to changes in an external market rate or the value of an index. For example, lease payments might be adjusted for changes in a benchmark interest rate or the Consumer Price Index.
b. The lessee’s performance derived from the underlying asset. For example, a lease of retail property may specify that lease payments are based on a specified percentage of sales made from that property.
c. The use of the underlying asset. For example, a car lease may require the lessee to make additional lease payments if the lessee exceeds a specified mileage.
Variable lease payments that depend on an index or a rate should be included in the calculation of lease payments when classifying a lease and in the measurement of the lease liability. Variable lease payments should be calculated at lease commencement, using the index or rate at lease commencement; no increases or decreases to future lease payments during the lease term should be assumed.
Variable lease payments other than those that depend on an index or a rate should not be included in lease payments for purposes of classification and measurement of the lease, unless those payments are in substance fixed lease payments.
If a lease includes a renewal option that the lessee is reasonably certain to exercise and the payments during the renewal period are based on the fair market rents at the beginning of the renewal period, we believe the renewal period rents should be treated similar to variable lease payments that depend on an index or rate. This approach is consistent with IFRS 16.28, which says that variable lease payments that depend on an index or rate include payments that vary to reflect changes in market rental rates.
Subsequent to the lease commencement date, when the actual payments in the renewal period are known, the lessee would not remeasure the lease payments. Rather, any changes would be a period cost during the period in which they are incurred. The lessor would record the changes as earned during the period they occur.
See
LG 5.3.1 for information on when to remeasure lease payments, including the impact of variable lease payments on remeasurement.
Example LG 3-9, Example LG 3-10, and Example LG 3-11 illustrate when to include variable lease payments in the calculation of lease payments when classifying a lease.
EXAMPLE LG 3-9
Lease payments – variable lease payments tied to an index
Lessee Corp enters into an agreement with Lessor Corp to lease office space for a term of 60 months. Lease payments during year one of the lease are $10,000 per month. Each year, lease payments increase by an amount equivalent to the percentage increase in the Consumer Price Index (CPI). For example, if the CPI increases by 3%, lease payments during year two of the lease would increase 3% to $10,300 per month. If the CPI decreases or remains consistent, lease payments remain at the rate in effect during the previous year.
What are the lease payments for purposes of classifying the lease?
Analysis
Increases in lease payments are tied to the percentage change in the CPI and movements in the CPI subsequent to lease commencement are unknown. As such, only the initial lease payments of $10,000 per month would be included in the calculation of lease payments when classifying the lease.
See Example LG 4-6 for an example of the initial measurement of a lease with a variable lease payment tied to an index.
EXAMPLE LG 3-10
Lease payments – variable lease payments tied to real estate taxes
Lessee Corp and Lessor Corp enter into a 10-year lease of an office building for fixed annual lease payments of $85,000. Per the terms of the lease agreement, Lessee Corp is required to pay Lessor Corp an amount equal to all real estate taxes associated with the building during the lease term. Real estate taxes are expected to be $15,000 for the first year of the lease.
What are the lease payments for purposes of classifying the lease?
Analysis
The lease payments are $85,000. Although the terms of the lease require Lessee Corp to pay Lessor Corp an amount equal to the real estate taxes, real estate taxes vary on an annual basis. As such, they would be considered variable lease payments that are not dependent on an index or a rate. As a result, they should be excluded from lease payments for purposes of classification and measurement.
As discussed in Example LG 3-8, real estate taxes do not represent a separate lease component. See
LG 2.4 for additional information on identifying lease and nonlease components.
EXAMPLE LG 3-11
Lease payments – variable lease payments tied to fair market value
Lessee Corp enters into a five-year noncancellable office lease with Lessor Corp. The lease contains a 5-year renewal option that Lessee Corp is reasonably certain to exercise. The lease payments are fixed at $600k annually for each of the first five years. The annual lease payments for the renewal option will be set at the beginning of the renewal period based upon the fair market rent at the beginning of the renewal period.
Should the lease liability include amounts related to the renewal period even though the amount of the annual lease payments for that period is unknown at the lease commencement date?
Analysis
Yes. Similar to variable lease payments that depend on an index or rate, lease payments during the renewal period should be included in lease payments when classifying and measuring the lease at lease commencement. The renewal period rents should be based on the market rental rate at lease commencement (i.e., $600k per year), not the estimated market rental rate at the beginning of the renewal period.
In substance fixed lease payments
Variable lease payments that are considered in substance fixed lease payments should be included in the calculation of lease payments for classification and measurement.
ASC 842-10-55-31 provides guidance on in substance fixed lease payments.
Excerpt from ASC 842-10-55-31
In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following:
a. Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance)
b. The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments.
Variable lease payments based on performance or use are excluded from the calculation of lease payments for classification and measurement. This is true even if there is a high probability of some payment for usage during the lease term. Accordingly, a reporting entity would not include payments that vary solely on the basis of future use or performance in lease payments, regardless of the probability of occurrence (except in cases where the arrangement contains a guaranteed minimum payment or penalty that effectively amounts to a floor for lease payments).
Some lease payments are contingent in form, but are in effect, unavoidable; for example, payments due to clauses that lack economic substance or that provide a choice of payment type, but no ability to avoid a payment.
For example, consider a 10-year lease that provides for an increase in rent beginning in year six, which is calculated as five times the change in the CPI over the prior five-year period, with any increase in rent capped at 5%. It is reasonable to conclude a 5% rent increase commencing in the sixth year of the lease term is unavoidable; therefore, the 5% rent increase should be included in lease payments by the lessee and lessor.
There is often some portion of a contingent lease payment that is highly probable of being paid (e.g., some level of payment will generally be required in a lease that provides for percentage rent based on sales derived from the output of the leased asset). However, because the payment provision creates genuine variability, the total payment should be considered a variable lease payment and excluded from the lease payments.
A lease may include protective rights that impact the amount of lease payments due. Protective rights are generally rights that protect a lessee from the requirement to make payments during periods when the underlying asset is not available for use. For example, lease payments due may be substantially reduced during periods of excessive downtime for maintenance or inspection, when a lessor defaults on its obligations, or when weather conditions render the underlying asset unavailable to the lessee. The effect of protective rights should be disregarded when determining lease payments for purposes of classification and measurement.
Example LG 3-12, Example LG 3-13, Example LG 3-14, and Example LG 3-15 illustrate how to determine if variable lease payments are considered in substance fixed lease payments.
EXAMPLE LG 3-12
Lease payments – payments tied to sales
Lessee Corp enters into a 10-year lease for retail office space with Lessor Corp. The annual lease payments are $20,000 plus an amount equal to 5% of Lessee Corp’s sales. Lessee Corp’s annual sales have exceeded $200,000 since it began operations and are projected to grow at a rate of 10% annually.
What are the lease payments for purposes of classifying the lease?
Analysis
The lease payments for purposes of classifying the lease are the fixed annual lease payments of $20,000.
Although there is a high probability of some variable lease payments being made in light of Lessee Corp’s historical results and projections, the variable lease payments are based exclusively on, and vary with, the performance of the underlying asset and do not represent in substance fixed lease payments.
EXAMPLE LG 3-13
Lease payments – in substance fixed lease payments
Lessee Corp enters into a five-year lease for office space with Lessor Corp. The initial base rent is $10,000 per month. Rents increase by the greater of 1% of Lessee Corp’s generated sales or 3% of the previous rental rate on each anniversary of the lease commencement date.
What are the lease payments for purposes of classifying the lease?
Analysis
The lease payments for purposes of classifying the lease are the fixed monthly payments of $10,000 plus the minimum annual increase of 3%.
Lessee Corp is required to pay no less than a 3% increase regardless of the level of sales activity; therefore, this minimum level of increase is an in substance fixed lease payment.
EXAMPLE LG 3-14
Lease payments – payments tied to use of medical device consumables
Lessee Corp enters into a three-year lease for a medical device with Lessor Corp. Annual fixed lease payments are $100,000. Lessee Corp is also required to purchase at least $1 million of consumables to be used in the operation of the medical device by the end of the lease term. If Lessee Corp does not order $1 million of consumables, it is required to make a shortfall payment equal to the difference between the total consumables purchased and $1 million.
The measurement and allocation of contract consideration are not addressed in this example. For simplicity, assume all payments are allocated to the lease component (i.e., the medical device).
What are the lease payments for purposes of classifying the lease?
Analysis
The lease payments for purposes of classifying the lease include both the $300,000 fixed lease payments (3 years × $100,000 per year) and the in substance fixed lease payment of $1 million for consumables.
Although the payment for consumables varies based on use, because Lessee Corp is required to make payments of at least $1.3 million regardless of its consumable use, the $1 million minimum payment is an in substance fixed lease payment.
See Question LG 3-18 for information on the differences between payments included in lease payments and payments included in contract consideration. See
LG 2.4 for information on measuring and allocating contract consideration to identified lease and nonlease components.
EXAMPLE LG 3-15
Lease payments – protective rights
Lessee Corp enters into a 5-year lease for equipment with Lessor Corp. The arrangement provides that Lessor Corp will maintain the equipment and operate it in accordance with instructions provided by Lessee Corp.
Payments due from Lessee Corp to Lessor Corp are based on the daily operation of the equipment (i.e., performance-based rates assigned to the nature of the activities performed each day throughout the term of the contract) as follows:
- Each day the equipment is available for use and operated by Lessor Corp, Lessee Corp must pay $1,000;
- Each day the equipment is available for use and Lessor Corp is available to operate the equipment, but the asset is not utilized as instructed by Lessee Corp, Lessee Corp must pay $750;
- Each day the equipment is (a) unavailable for use at the request of Lessor Corp (e.g., maintenance, required inspections), (b) unavailable for use due to events outside of both Lessee Corp and Lessor Corp’s control (e.g., weather conditions), or (c) available for use, but Lessor Corp is not available to operate the equipment, Lessee Corp must pay $500. If the aggregate days the equipment is not operational due to (a), (b), or (c) exceeds 15 in a year, no payment is due from Lessee Corp for non-operational days exceeding the 15 day maximum. Based on historical experience with similar contracts, it is probable the total number of nonoperational days will exceed the 15 day maximum.
What are the lease payments for purposes of classifying the lease?
Analysis
Daily fixed payments are $750.
The daily rate of $750 represents the lowest amount the lessee would pay the lessor when the underlying asset is available for use. The additional $250 the lessee would pay when it uses the asset is a variable payment based on usage, and, therefore, is excluded from lease payments. The $500 payment level (and $0 payment) only apply when the lessor is unable to make the asset available for the lessees use, i.e., they result from a protective right. Payments (or payment reductions) resulting from a protective right are not considered in determining lease payments. Thus, any reductions in rent below $750 are (negative) variable payments. Variable payments are excluded from lease payments even though Lessee Corp and Lessor Corp concluded it is probable that the total number of nonoperational days will exceed the 15 day maximum, resulting in days when Lessee Corp is not required to make payments to Lessor Corp.
The daily rate of $750 represents the lowest contractual rate that is not the result of a protective right (i.e., it is the in substance daily fixed payment). Accordingly, the total annual consideration in the contract is $273,750 ($750 per day × 365 days), which should be allocated between the lease and nonlease components. Only the payments allocated to the lease should be considered for purposes of classifying the lease.