Variable Lease Payments Under ASC 842 and IFRS 16: What Goes in the Liability

Variable lease payments are amounts payable by a lessee that change after the lease commences. Their accounting depends on the reason for the change: some are included in the lease liability, while others remain outside it. Misidentifying that distinction leads to an incorrect balance sheet.

Black Owl Systems keeps lease payment records and accounting schedules together. Teams reporting under ASC 842 or IFRS 16 need to distinguish index-linked charges from usage and sales-based charges.

For Canadian private companies, the ASPE 3065 comparison below explains the relevant framework. The lessor accounting section covers the treatment of variable receipts. A centralized lease management record retains payment formulas and policy elections. Black Owl’s implementation and advisory services can support that workflow.

Which variable payments belong in the lease liability?

Start by identifying what causes the amount to vary. Payments linked to an index or a rate enter the lease liability. Payments determined by usage, sales, or performance do not.

Payments linked to an index or a rate

ASC 842-10-30-5(b) requires index-linked payments to be included in the liability using the index applicable at commencement. The calculation does not anticipate future CPI movements or incorporate an expected annual increase.

For a lease with annual rent of $50,000 adjusted for CPI, the initial measurement therefore uses $50,000 for every year of the term. It treats the index as unchanged throughout the lease. Future movements may be expected, but the standard still requires this assumption.

Any amount above that commencement-date level is recognized as variable expense when incurred. An individual rent payment can consequently contain both an amount included in the liability and an amount excluded from it.

Payments determined by usage or sales

Usage-based and sales-based payments are excluded entirely from the lease liability. ASC 842-10-55-226 confirms their exclusion because there is no unavoidable payment obligation at commencement.

For a payment determined solely by store sales, no sales means nothing is payable. There is no present obligation to measure or recognize on the balance sheet. The expense is recorded in the period in which the relevant sales or usage occurs.

Although preparers describe both categories as variable payments, only the index- or rate-linked category enters the liability. Reviewing the commercial lease arrangements that commonly contain these provisions can help establish which category is involved.

Accounting for percentage rent in retail leases

Retail leases often contain a percentage rent provision, also known as turnover rent. It requires the tenant to pay a fixed base amount plus a percentage of sales exceeding an agreed threshold.

Suppose a store pays $50,000 in base rent and 4% of annual sales above $2,000,000. With sales of $2,400,000, the additional rent is 4% of the $400,000 excess, or $16,000.

At commencement, the $50,000 base rent is included in the lease liability. The $16,000 percentage rent is not included and does not subsequently enter that balance. It is recognized as variable lease expense in the year the sales take place.

Keeping the amount outside the liability does not remove the need to record it separately. ASC 842 requires variable lease cost to appear as its own line in the lease cost table.

Retail tenants often encounter this reporting requirement at their first reporting date after adoption. Previously, percentage rent may have been combined with ordinary rent expense. Identifying those amounts in the general ledger afterward is more difficult than recording them separately as they arise.

When a seemingly variable payment is fixed in substance

A contract may describe a payment as variable even though the lessee has no realistic way to avoid it. ASC 842-10-30-6 identifies these as in-substance fixed payments, which must be included in the liability.

Three arrangements recur in practice. In the first, the payment is called variable but only one outcome is possible. In the second, the lessee appears to have a choice between two payment streams, but one is uneconomic.

The third involves a minimum guarantee within a variable payment clause. Percentage rent with a guaranteed minimum of $30,000 contains a fixed payment of $30,000. Sales performance cannot reduce the obligation below that floor.

Auditors identify more errors in this area than elsewhere in variable lease payment accounting. The decisive question is whether the lessee can avoid paying, not how the contract describes the amount. Accepting that description without examining the obligation is the starting point for many common ASC 842 errors.

Initial measurement of index-linked payments

Use the index or rate in effect when the lease commences, applying it to payments throughout the term without assuming any subsequent change.

When inflation is positive, this approach produces a liability below the amount that would include future rent increases. The standard accepts that result to avoid making measurement dependent on a forecast. Initial measurement of the right-of-use asset follows the same commencement-date convention.

The discount rate is also established at commencement. A movement in the index does not, by itself, require that rate to be updated.

Does a CPI increase require remeasurement?

ASC 842 and IFRS 16 reach different answers after an index changes, creating a difference in the reported liability.

This example is illustrative.

Consider a five-year retail lease for one store unit. Annual base rent is $50,000, payable in arrears and adjusted each year for CPI. The lessee uses an incremental borrowing rate of 5%.

The opening liability under either standard is $216,474, representing the present value of five annual payments of $50,000.

At the beginning of year two, CPI increases by 3%, raising annual rent to $51,500. The liability carried forward under the original schedule is $177,298 at that date. The subsequent treatment differs as follows:

Under ASC 842, the CPI movement leaves the balance sheet unchanged. The additional annual payment of $1,500 is expensed as variable lease cost when incurred.

IFRS 16.42(b), by contrast, requires the liability to be remeasured when an index or rate changes future payments. The four revised payments are discounted at the original 5% rate, with the resulting adjustment recorded as follows:

An identical index movement on the same lease therefore produces different balance sheet amounts. The difference grows with each year of index movements, making it important for groups reporting under both standards.

The expense effect moves in the opposite direction. ASC 842 recognizes the additional $1,500 directly as variable lease cost when incurred. IFRS 16 adds the adjustment to the right-of-use asset and recognizes it over the remaining term.

The ASC 842 filer consequently reports a smaller liability and a slightly higher current-year expense. Neither approach is more conservative over the full lease term; the difference concerns where the amount is recorded and when it is recognized.

Other events can require remeasurement under ASC 842, even though an index change alone does not. Changes in the lease term or the assessment of a purchase option are among the events that reopen lease measurement.

When one of those events triggers remeasurement, the calculation also incorporates the index then in effect. Determining the discount rate to use for that recalculation is a separate assessment.

Common area maintenance, insurance, and property taxes

A lease invoice can include charges that are not lease payments. Common area maintenance, or CAM, is one example: the payment covers a service rather than the right to use the property.

ASC 842-10-15-30 treats those services as non-lease components. Allocate the contract consideration between lease and non-lease components according to their relative standalone prices, unless the company has elected not to separate them.

Property taxes and insurance reimbursed to the landlord are neither lease components nor non-lease components. They repay costs incurred by the landlord and are expensed as incurred.

The distinction between fixed and variable CAM charges also matters. A specified fixed CAM amount is a fixed payment for a non-lease component. A charge based on a share of actual costs is variable and remains outside the liability regardless of the component election.

Electing not to separate components has a substantial effect. Under that election, every payment for the property enters the lease liability, with CAM included in the lease payment rather than accounted for separately.

The election reduces allocation work at the cost of a larger balance sheet. Payments made by the landlord to the tenant work through the corresponding allocation in the opposite direction.

How lessors account for variable payments

The lessor’s treatment differs from the lessee’s, particularly following a rule change addressing losses at commencement. As originally issued, ASC 842 could cause a lessor to recognize a day-one loss on a lease with significant variable payments, even when the arrangement was profitable over its full term.

ASU 2021-05 addressed that outcome in 2021. A lease with substantial variable payments is now classified as an operating lease when it would otherwise be sales-type or direct financing and produce a commencement loss.

Usage-based and sales-based payments become income for the lessor when they arise. Recognition occurs in the same period that the lessee records the expense, keeping the timing aligned. However, applying the requirements from the lessor’s side can produce a different classification conclusion for the same contract.

Comparing ASC 842, IFRS 16, and ASPE 3065

The three frameworks exclude usage-based payments, but they differ in their treatment of index-linked amounts and subsequent index movements.

ASPE 3065 retains the older term “contingent rentals” rather than “variable payments.” The Canadian private enterprise standard arrives at a similar exclusion through a different accounting model.