Variable rent leases: Accounting best practices for ASC 842 & IFRS 16

When ASC 842 and IFRS 16 were first announced, there was quite a bit of uncertainty about how the accounting would work for variable rent leases. Large public companies found themselves in the role of early adopters, and had to work out many complex accounting calculations and processes that had never been done before.

FASB and IASB have since provided revised guidance, and accounting advisors and technology providers (like Visual Lease) have learned valuable lessons from the experience of helping public companies move toward compliance in 2018.

If you are part of the next wave of organizations ramping up your lease accounting compliance efforts for the 2019 deadline, you’re in luck. You can benefit from the best practices developed over the past year, and avoid time-consuming mistakes and delays.

What are variable payments?

Variable payments are payments that can fluctuate or change in amount based on specific factors or events. These factors could include variables such as usage, sales volume, market conditions, or other predefined triggers. Unlike fixed payments, which remain constant over time, variable payments can vary up or down depending on the circumstances they are tied to. These payments can be found in various contexts, including lease agreements, loans, contracts, and other financial transactions where the payment amount is subject to change based on certain conditions being met.

Why are variable rent leases so complex from an accounting standpoint?

In the past, the difficulty with variable rent leases was only about calculating the correct payment, whether that was based on on a variable interest rate, CPI increase, a percentage of sales, or some other variable factor.

Under ASC 842 and IFRS 16, variable leases require much more complicated accounting. You’ll need to understand how to break out all the components of variable rent leases, including non-lease components, so you’ll be able to properly represent them on your balance sheet. Also, you need to consider how the accounting treatment will change over time.

Here’s just one example to illustrate some of the issues that will arise with variable rent leases:

Let’s say you have a lease that starts at $10,000 per month, with straightforward CPI increases over time. That base rent of $10,000 goes into the calculation of your ROU asset and liability, and the CPI increases are treated separately as variable payments.

That process continues the same way (although the amounts of CPI increases may change each year) until something happens that requires a remeasurement of the lease, such as exercising an option. Upon remeasurement, all those CPI payments that were variable before now get treated as fixed payments that go into the calculations for ROU assets. Only the future CPI increases (after the remeasurement) qualify for the variable payment treatment.

That’s just for leases with simple CPI increases. What happens if your increase has a floor? Let’s say each increase can’t be less than 2 percent. In that case, the 2 percent becomes part of the fixed payment, and only increases above 2 percent are treated as a variable payment. To complicate matters further, if you also report under IASB or other non-US GAAP standards, CPI increases are handled differently.  Your accounting standard must be capable of handling multiple methods simultaneously.

Needless to say, there’s a great deal to learn. When it comes to handling all the complicated scenarios for variable rent leases, you will need guidance from your accounting advisors. Here’s what is critical to know now as you begin preparing for compliance with the new lease standards:

How are variable rent leases accounted for under ASC 842 and IFRS 16?

Under both standards, variable rent leases are classified as finance leases. This means that the lessee must recognize a right-of-use asset and a lease liability on the balance sheet. The lease liability is calculated as the present value of the future lease payments, including any variable payments. The right-of-use asset is calculated as the cost of the lease, less any lease incentives received.

The variable payments under a variable rent lease are treated as part of the lease liability. This means that the lease liability will increase or decrease each time the variable payments are adjusted. The lessee must also recognize interest expense on the lease liability over the lease term.

The main difference in the treatment of variable rent leases under ASC 842 and IFRS 16 is how the variable payments are estimated. Under ASC 842, the variable payments are estimated using the most recent information available at the commencement of the lease. Under IFRS 16, the variable payments are estimated using the best available estimate at the commencement of the lease.

The difference in the treatment of variable rent leases under ASC 842 and IFRS 16 can have a significant impact on the lessee’s financial statements. For example, if the variable payments are estimated to be higher under ASC 842 than under IFRS 16, the lease liability will be higher under ASC 842 and the lessee’s interest expense will also be higher.

What are the key considerations for tracking and reporting variable rent lease data?

• Identifying all of the variables that affect the lease payments. This includes the index or rate that the rent is tied to, the amount of usage of the leased asset, and any other factors that are specified in the lease agreement.
• Tracking the values of the variables over time. This will allow you to accurately calculate the lease payments and update your accounting records accordingly.
• Recording the lease payments in your accounting system. This will ensure that the lease payments are properly reflected in your financial statements.
• Reporting the lease payments to your stakeholders. This may be required by law or regulation, or it may be necessary for internal reporting purposes.

What are the challenges of accounting for variable rent leases?

There are several challenges to accounting for variable rent leases, including:

• Complexity: Variable rent leases can be more complex to account for than fixed rent leases because the lease payments can fluctuate over time. This can make it difficult to accurately calculate the lease liability and right-of-use asset.
• Volatility: The value of variable rent leases can be more volatile than the value of fixed rent leases. This is because the lease payments can be affected by changes in the index or rate that the rent is tied to, or by changes in the amount of usage of the leased asset. This volatility can make it difficult to forecast the future cash flows from the lease and to manage the lease risk.
• Data management: Variable rent leases require careful data management to track the variables that affect the lease payments and to calculate the lease liability and right-of-use asset accurately. This can be a challenge if the lease agreement is complex or if the variables that affect the lease payments are not well-defined.
• Compliance: Variable rent leases can be complex to comply with accounting standards and regulations. This is because the accounting treatment of variable rent leases can vary depending on the type of lease, the index or rate that the rent is tied to, and the amount of usage of the leased asset.

Despite the challenges, it is important to properly account for variable rent leases. This is because variable rent leases can have a significant impact on a company’s financial statements. By carefully managing the challenges of accounting for variable rent leases, companies can ensure that their financial statements are accurate and that they are in compliance with accounting standards and regulations.

Best practices for recording and tracking variable rent lease data

1. Identify all the variables in your lease payments

It’s not enough to capture the fact that a lease obligation has a variable component. Different variable payment structures qualify for different accounting treatments. And to further complicate things, under the US standard (ASC 842) variable leases may be treated one way, whereas under the international standard (IFRS 16) variable leases may be treated differently. If you must comply with both, you may need to apply two different accounting treatments to the same lease. That’s why it’s so important to understand and capture every parameter that affects how lease payments change over time.

You’ll need the advice of your accounting partners to decide how you’ll treat different variable payment scenarios as well as what practical expedients you plan to take. Then you can work out what data you’ll need to create the calculations.

2. Isolate every variable in your lease management and accounting system

Create separate line items for every variable; don’t make the mistake of combining them with the overall obligation that’s being increased over time. If everything is lumped together, when a remeasurement occurs you’ll be forced to go back and spend a lot of time making manual accounting adjustments.

3. Creating the data right structure

It’s essential to create the right relationship between your fixed rent components and your variable payment components in your lease system.

On one hand, you need to connect them so that you can combine them for payment purposes. But you must also be able to treat them separately as needed for accounting purposes that change over time.

When a remeasurement event occurs, you’ll be in the best position to make a smooth and easy transition to a different accounting treatment.

Visual Lease accommodates complex lease structures and makes your workflow simple

It’s no secret that accounting for variable rent leases (or any leases that have a variable payment component) is complicated. That was true even before the new lease accounting standards, but under ASC 842 and IFRS 16 the complexity has increased exponentially. Plus, with leases more visible on the balance sheet and making a bigger impact on your financial reporting, the stakes are higher and you need to be sure you get it right.

That’s why Visual Lease has taken what we’ve learned working with the early adopters and built best practices into our tools that adapt to the complexities of variable rent leases. With our smart and flexible data architecture and the ability to change accounting treatments automatically, you not only get to compliance fast, but you do it right so you avoid re-work later. Your Day 2 workflow is simple and efficient

Ready to see how it works? Request a demo now.

FAQs:

What are the different types of variable rent leases?

There are two main types of variable rent leases:

1. Index-based leases: These leases tie the rent payments to an external index, such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR). The rent payments will increase or decrease in line with the index.
2. Usage-based leases: These leases tie the rent payments to the amount of usage of the leased asset. The rent payments will increase or decrease depending on how much the asset is used.

How are variable lease payments treated in accounting?

Variable lease payments are handled differently based on lease type. For operating leases, they’re recognized as expenses when incurred. In finance leases, they become part of the lease liability and noted as interest expense over the lease term.

What are variable lease payments under IFRS 16?

In IFRS 16, variable lease payments are payments influenced by events beyond time, like asset usage or market changes. These include percentage-of-sales payments, usage thresholds, or market price adjustments.

Are variable lease payments included in lease liability?

Yes, variable lease payments must be included in the lease liability and asset. They’re added initially if known, or later when event-dependent.

What’s the difference between variable and fixed loans?

Fixed loans maintain a constant interest rate, ensuring steady payments. Variable loans have rates that change due to market shifts, impacting monthly payments.

What is an example of a variable rate?

Examples of variable rates include adjustable rate mortgages (ARMs) and credit cards, where rates change based on indices or market conditions.