How to account for rentals depending on inflation and future sales?

Variable lease payments are the payments that can change depending on something in the future, for example inflation rate, future sales, asset use etc.

There is some confusion related to the accounting for these payments and incorporating them to the lease accounting schedule, thus in this post and video (in the end), I responded to questions that are frequently popping up. So here it goes:

“We are a large retail chain and we rent the premises for our stores from various property owners, mostly in the high-class shopping malls.

In some cases, the rental payments are calculated as a fixed fee per month plus a percentage of our sales generated in the store during that year.

This is because the shopping malls promote our store and help us to bring in more customers.

Also, the monthly fixed fee is adjusted every two years for the inflation rate.

We are aware that under IFRS 16 we need to determine the right-of-use asset and the lease liability as the present value of all unpaid lease payments.

How to do it when there are lots of uncertainties and contingencies? We don’t know how much we are going to pay based on the future sales and how the fixed fee is going to increase due to inflation adjustment after 2 years.”
 

IFRS Answer: What do these payments depend on?

Very good question because let’s face it – the new standard IFRS 16 brings the lessees a few complication with so-called operating leases.

The main reason is that under older standard IAS 17, you just accounted for operating leases straight in profit or loss as an expense.

However, this dramatically changed with IFRS 16 and you need to recognize certain right-of-use asset and the lease liability equal to present value of the unpaid lease payments.

That’s simplification, I know, but I wrote a few articles about this topic, like this one and this one, so you can go through it.

Now, let’s focus on these uncertainties related to the future lease payments.

IFRS 16 calls them “variable lease payments” because their amount varies depending on something.
 

How to treat the variable lease payments?

It depends on what how they are determined.

Basically, the variable lease payment may depend on:

• Index, or a rate – like inflation rate, benchmark interest rate (e.g. LIBOR), consumer price index, etc., or
• Future sales, use of underlying asset or other items unrelated to index/rate.

Before I explain how to treat these kinds of variable payments, let’s explain what the lease payments are.
 

What are the lease payments under IFRS 16?

Under IFRS 16, the lease payments for the purpose of the lease accounting consist of:

1. Fixed lease payments less any lease incentives;
2. Variable lease payments depending on an index or a rate;
3. Exercise price of a purchase option (if the lessee will exercise it); and
4. Penalties for terminating the lease (if the lessee will terminate).
5. Residual value guarantees.

Now let’s break the variable payments into easy pieces.
 

I. Variable lease payment depending on an index or a rate

Variable payments that depend on the index or a rate are a part of the lease payments – you can see it from the definition.

So, the lessee must take the inflation adjustment of the lease payments into account when applying IFRS 16.

OK, but how?

1. Initially, you never know how much the inflation adjustment will be after some time.

   Are we going to estimate it?

   No, not at all.

   In fact, it’s easier than that.

   Initially, you ignore it.

   You will calculate your lease liability and the right-of-use asset based on unadjusted lease payments as known at the commencement date.

2. Subsequently, when the lease payments really change as a result of inflation, you will account for the remeasurement of the lease.

   You will simply recalculate the new lease liability by discounting adjusted lease payments with the original discount rate.

   Then, you will account for the difference as an adjustment of right-of-use asset.

So, yes, it’s a little work, but the good news is that you don’t have to make unnecessary guess work of how the future will look like.

You will take care about it when it happens.
 

II. Variable lease payments depending on the future sales or use of the asset

Well, under the definitions in IFRS 16, the payments NOT depending on the rate or index DO NOT enter into your lease payments.

In other words they are excluded.

Instead, they are recognized in profit or loss when incurred.

Isn’t that beautiful and easy?

The reason for such simplification is that estimating the future sales and other items would represent very high level of uncertainties and thus the information would not be of any use.

It does not apply only to the rentals depending on future sales, but also on the future use of an asset.

Just a small example from my own life – my son is farsighted and we visit eye doctor time to time.

The doctor uses the special machine for measuring his diopters – it looks like a gun and the measurement is done with one push of the button.

The doctor explained to me that she must pay the rental fees for every single push of the button, on top of the fixed fee.

So, this is exactly the example of the variable lease payments depending on the use of an asset.

Now, let’s wrap it up and let me illustrate it shortly.
 

Illustration: Variable lease payments

Imagine you rent a space for the store for 5 years and you agree to pay the fixed monthly fee of 1 000 and annual fee of 1% of your sales.

The fixed fee will be increased by the inflation rate once in 2 years.

At the commencement date, you assume that your sales will be 200 000 per year, the discount rate is 3% and the inflation rate will be 2% per year.

So, initially, you will calculate your lease liability based on the fixed monthly fee of 1 000 paid over 5 years.

How?

Well, just discount the monthly payments of 1 000 for 5 years with the annual discount rate of 3% – careful, because when the payments are monthly, you must calculate the monthly rate out of your annual rate.

I’ve done this for you this time.

Our monthly rate is 0.25% and the present value of all monthly lease payments over 5 years is CU 55 708.

This is your right-of-use assent and the lease liability at the commencement date.

You would recognize it as:

• Debit Right-of-use asset: CU 55 708
• Credit Lease liability: CU 55 708

Then, you should split each monthly payment into 2 parts:

1. Interest charged on the remaining lease liability, and
2. Repayment of the lease liability.

The short example of how to do it is in this article.

I cover the full recalculations of the rates, variable lease payments, irregular lease payments and many other complications in my IFRS Kit, so please sign up it if interested.

You would ignore the adjustment for the inflation and also ignore the fee of 1% of your sales.

Then when you pay 1% of your sales, you will simply book it in profit or loss.

And, when after 2 years the fixed fee is adjusted by 2% from 1 000 to 1 020, you would recalculate the lease liability by discounting the fees of 1 020 paid over the remaining lease term of 3 years with original rate of 3% and book any difference as an adjustment to the right-of-use asset.

I’ve done that for you again:

• The original lease liability before adjustment of the lease payments after 2 years is CU 34 408;
• The new lease liability after adjustment of the lease payments is CU 35 906
• The difference between these two is CU 1 498 and it is recognized as:
  • Debit Right-of-use asset: CU 1 498
  • Credit Lease liability: CU 1 498

Again, I have lots of practical examples solved in Excel related exactly to these issues within my IFRS Kit, so make sure you check that out.

Here’s the video that sums it all up:

Any comments? Please let me know below this article. Thank you!