Overview
A lease escalation is a contractual increase in rent over the lease term. Under IFRS 16, the accounting depends on whether the increase is fixed or variable:
| Escalation type | At commencement | When the increase takes effect |
|---|---|---|
| Fixed percentage or fixed amount | All escalated payments included | No remeasurement |
| CPI or other index | Included at the index on commencement, not forecast | Remeasure at the original discount rate |
| Market rent review | Included at the current rent | Remeasure at the original discount rate |
| Floating interest rate | Included at the rate on commencement | Remeasure at a revised discount rate |
| Turnover or usage | Excluded | Expensed as incurred |
Lease payments in the lease liability include fixed payments and variable payments that depend on an index or a rate (IFRS 16.27). Other variable payments are excluded (IFRS 16.38). See variable lease payments for the wider framework.
This article forms part of our full IFRS 16 guide.
Fixed Escalations
Fixed annual escalations, such as 8% per year, are standard in South African commercial property leases. Stepped rentals, where the contract sets a specific amount for each period, and fixed amount increases, such as 2,000 per year, work the same way.
Because every future payment is known at commencement, each escalated payment is discounted and included in the lease liability from day one. Nothing is remeasured when the increase takes effect.
Example: 8% Fixed Escalation
A lessee enters into a three-year lease of office space. Rent is 100,000 for the first year, escalating at 8% per year, payable annually in arrears. The incremental borrowing rate is 10%.
The lease liability at commencement is the present value of 100,000, 108,000 and 116,640, which is 267,799.
| Year | Opening | Interest (10%) | Payment | Closing |
|---|---|---|---|---|
| 1 | 267,799 | 26,780 | (100,000) | 194,579 |
| 2 | 194,579 | 19,458 | (108,000) | 106,037 |
| 3 | 106,037 | 10,603 | (116,640) | - |
The right-of-use asset of 267,799 is depreciated at 89,266 per year. Total expense is highest in year 1 (116,046) and lowest in year 3 (99,869), even though the cash payments rise each year.
Model a fixed escalation in our free lease liability and right-of-use asset calculator.
CPI and Index-Linked Escalations
CPI-linked payments depend on an index, so they are included in the lease liability, but only at the index level on the commencement date (IFRS 16.27(b)). Future inflation is not forecast. The IASB concluded that forecasts would be costly and often unreliable (IFRS 16.BC155).
The liability is remeasured when the cash flows change, meaning when the escalation takes effect, not when a new CPI figure is published (IFRS 16.42(b)). The remaining payments are updated to the new index, and the original discount rate is kept (IFRS 16.43). The adjustment goes against the right-of-use asset (IFRS 16.39).
Example: CPI-Linked Escalation
Assume the same lease, but rent of 100,000 escalates annually by CPI.
At commencement, payments are assumed to stay at 100,000. The lease liability and right-of-use asset are 248,685.
At the start of year 2, the rent increases by CPI of 5% to 105,000. The liability before remeasurement is 173,554. The remaining two payments of 105,000, discounted at 10%, total 182,231.
| Remeasurement journal | Dr | Cr |
|---|---|---|
| Right-of-use asset | 8,677 | |
| Lease liability | 8,677 |
The right-of-use asset becomes 174,467 (248,685 less year 1 depreciation of 82,895, plus 8,677), depreciated at 87,234 per year over the remaining two years. The process repeats at each annual escalation.
Practical point
A CPI lease with a five-year term triggers four remeasurements, each needing an updated schedule, a journal and a revised depreciation charge. Across a portfolio, this is where spreadsheet-based lease accounting becomes difficult to control.
Market Rent Reviews
IFRS 16.28 lists payments that vary to reflect changes in market rental rates as payments that depend on a rate. The accounting follows the CPI model:
- At commencement, the current rent is included for the full lease term.
- When a review takes effect, the liability is remeasured for the new rent at the original discount rate, with the adjustment against the right-of-use asset.
Upward-only reviews are treated the same way, as the current rent is already the minimum.
Interest Rate-Linked Payments
Some leases, particularly vehicle and equipment leases, link rent to a floating rate such as prime. These payments are included at the rate on commencement. When the rate changes, the liability is remeasured using a revised discount rate that reflects the change in interest rates (IFRS 16.43). This is the only escalation type that changes the discount rate.
Floors, Caps and Collars
Contracts often escalate by "the higher of CPI or 6%" or by "CPI, capped at 8%":
- Floor: the minimum increase cannot be avoided, so it is an in-substance fixed payment (IFRS 16.B42) and included at commencement. The liability is remeasured only when CPI exceeds the floor at a reset date.
- Cap: the increase is measured using the index on commencement, as for any CPI lease. The cap limits the increase at each later remeasurement.
- Collar: the floor is included as fixed, and CPI above the floor is remeasured up to the cap.
Turnover and Usage-Based Rent
Rent linked to the lessee's sales, such as a percentage of turnover in a retail lease, or to usage, does not depend on an index or a rate. It is excluded from the lease liability and recognised in profit or loss when incurred (IFRS 16.38(b)). Where the contract sets a minimum turnover rental, that minimum is in-substance fixed and included in the liability.
Exempt Leases and Lessors
For leases under the short-term or low-value exemption, fixed escalations are recognised on a straight-line basis over the lease term, which creates an accrual in the early years.
For lessors with operating leases, fixed escalations are also recognised on a straight-line basis (IFRS 16.81). CPI and market-linked increases are recognised from the date they take effect. See lessor accounting.
Escalations already set out in the contract are not lease modifications. A modification arises only when the parties agree new terms.
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Conclusion
Under IFRS 16, the treatment of an escalation depends on whether it is fixed or variable. Fixed percentage and fixed amount escalations are included in full at commencement and never remeasured. CPI-linked and market rent escalations are included at current levels and remeasured at the original discount rate each time an increase takes effect. Interest rate-linked payments are the exception, requiring a revised discount rate. Floors are in-substance fixed, while turnover-based rent stays outside the lease liability.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.