Variable Lease Payments Guide - IFRS 16: Definition, Examples, and Accounting Treatment

What are variable Lease Payments

Variable lease payments are a key area of complexity under IFRS 16. This article explores their types, examples, and the appropriate accounting treatment for both lessees and lessors

Variable lease payments refer to the portion of payments made by a lessee to a lessor for the right to use an underlying asset during the lease term that vary because of changes in facts or circumstances occurring after the commencement date, other than the mere passage of time. A key characteristic of variable lease payments is that the exact amount of the payment is not known at the commencement date of the lease.

There are two types of variable lease payments:

• Payments that depend on an index or a rate. For example, payments linked to a consumer price index (CPI), payments linked to a benchmark interest rate such as LIBOR, or payments that vary to reflect changes in market rental rates. These payments are included within the definition of lease payments under IFRS 16, which has implications for the lease liability (lessees) and net investment in the lease (lessor).

• Other variable payments. These do not depend on an index or a rate and are treated differently in the financial statements.

Lessees: Accounting for variable lease payments

For lessees, variable lease payments that depend on an index or a rate are included in the initial measurement of the lease liability at the commencement date. Conversely, variable lease payments that do not depend on an index or a rate are not included in the initial measurement of the lease liability. Instead, these payments are recognised in profit or loss in the period in which the event or condition that triggers those payments occurs. In the statement of cash flows, such payments are classified as cash outflows from operating activities. Furthermore, entities are required to disclose the expense relating to variable lease payments that are not included in the measurement of lease liabilities separately in the notes to the financial statements.

Lessors: Accounting for variable lease payments

Finance leases: variable lease payments that depend on an index or a rate are included in the measurement of the net investment in the lease at the commencement date. Variable lease payments that do not depend on an index or a rate are not included in the net investment in the lease. Instead, such payments are recognised in profit or loss in the period in which the event or condition that triggers those payments occurs. These payments are classified as operating activities in the cash flow statement. Lessors must also disclose such income separately.

Income relating to variable lease payments not included in the measurement of the net investment in the lease must be disclosed separately.

Operating leases: Lease income relating to variable lease payments that do not depend on an index or a rate is recognised in profit or loss as it is earned.

Remeasurements or Modifications

Variable lease payments that depend on an index or a rate are remeasured by lessees and lessors when the relevant index or rate changes. It is common for lease agreements to stipulate a variable escalation in payments on an annual basis. For example, the lease agreement may state that payments shall escalate annually, on the anniversary of the commencement date, at a rate equal to the CPI inflation rate. A frequently asked question in such scenarios is whether an entity should forecast future lease payment escalations based on expected changes in the index or rate, or whether the entity should assume that payments remain constant after the most recent escalation. The preferred approach, supported by the IASB, is the latter. An entity is not required to forecast future changes in the index or rate. Instead, it should assume that payments will remain fixed after applying the index or rate applicable at the remeasurement date. This position is supported by paragraph BC155 of the IFRS 16 Basis for Conclusions, which states:

Forecasting changes in an index or a rate requires macroeconomic information that entities may not have readily available, and forecasts can often be unreliable. In the boards’ view, the usefulness of the additional information obtained using such a forecast would not justify the costs of obtaining it.

Lessees are required to remeasure the lease liability, with a corresponding adjustment to the right-of-use asset, when payments are remeasured due to changes in the index or rate. The discount rate remains unchanged unless the change in lease payments results from a change in a floating interest rate.

Lessors, in the case of finance leases, must remeasure the net investment in the lease. Annual escalations or payment adjustments do not change the classification of the lease (e.g. from a finance lease to an operating lease) and do not represent a scope increase. These are simply changes in the amounts of lease payments. Therefore, the basic modification requirements of IFRS 9 apply. The lessor would accordingly remeasure the net investment in the lease (lease receivable), with a corresponding entry recognised in profit or loss.

For more information on lease modifications, please see our article on lease modifications:

In-Substance Fixed Lease Payments

In-substance fixed lease payments are lease payments that may appear to contain variability in form, but in substance are unavoidable. Such payments are considered in-substance fixed if, for example: Payments are structured as variable lease payments, but there is no genuine variability. The clauses giving rise to variability lack real economic substance. E.g., A lease agreement states that rent is based on a percentage of sales, but the lessee operates in a fixed-fee contract environment with no variable sales, making the rent effectively fixed in substance.

There is more than one set of payments that a lessee could make, but only one of those sets is realistic. In this case, the entity shall treat the realistic set of payments as lease payments. E.g., A lease offers the lessee a choice between paying CU1,000 per month or CU100 per month with a CU500,000 balloon payment at the end, but only the monthly CU1,000 option is commercially viable, and thus it is treated as the lease payment.

There is more than one realistic set of payments that the lessee could make, but the lessee must make at least one of them. In this case, the entity shall consider the set of payments that aggregates to the lowest amount (on a discounted basis) as lease payments. E.g., A lease allows the lessee to choose between paying CU10,000 upfront or CU1,000 annually over 15 years, both being viable, but since at least one must be paid, the entity treats the lower present value option as the in-substance fixed lease payment.

Conclusion

This guidance ensures consistency and clarity in the treatment of variable lease payments under IFRS 16, aligning lease accounting with the economic substance of lease arrangements.

For any clarification, guidance, or feedback on our article, please reach out to us on insight@leash.co.za.