Lease contracts often include variable payment terms. Key types are:

payments tied to usage or performance (e.g., $X per machine-hour, or a percentage of the lessee’s sales); and
payments linked to an index or rate (e.g., inflation-indexed rent or interest rate indices).

Truly variable payments (performance or usage-based)

Under all frameworks, payments that vary based on usage or performance are not included in the initial lease liability because they are not fixed or determinable at commencement (Financial Accounting Standards Board, 2016b; IASB, 2016). Instead, such payments are recognized in profit or loss as incurred – typically in the period when the performance or usage occurs. For example, if lease rent is 5% of monthly sales, the lessee will simply record rental expense each month based on 5% of that month’s sales (no amount is part of the lease liability or ROU asset). Similarly, percentage-of-revenue rental arrangements or payments per unit of output are expensed as incurred. (IFRS and US GAAP differ slightly in phrasing: IFRS says “recognize in profit or loss when the event or condition that triggers payment occurs”; US GAAP says “recognize in profit or loss when it becomes probable that the target is achieved,” but in practice this is usually the same timing (RSM US LLP, 2020).) The only exception is if those payments are structured in-substance to be unavoidable minimums – which brings us to in-substance fixed payments.

In-substance fixed payments

Both IFRS 16 and ASC 842 require that any payments that are disguised variable payments but are, in effect, unavoidable, be treated as fixed. For instance, if a lease’s payments are ostensibly variable but the contract is designed such that a minimum amount will be owed regardless of circumstances, that minimum is an in-substance fixed payment (IASB, 2016). These must be included in the lease liability like fixed rent. Example: a retail store lease has rent equal to 5% of sales with a minimum of $10,000 per month. Even if sales are low, the lessee will pay at least $10,000 – therefore $10,000 is in-substance fixed and is included in the lease liability. The lessee would then treat any additional rent above $10,000 (due to higher sales) as a true variable payment expensed as incurred. In practice, determining what constitutes in-substance fixed can require judgment; lessees and auditors examine contract terms carefully. Typical cases include clauses with abnormally high variable rates that effectively guarantee a fixed outcome, or related-party leases where variable terms might not be at arm’s length. IFRS 16 offers examples in its guidance (B42) of in-substance fixed payments (IASB, 2016).

Index- or rate-linked payments

If lease payments vary based on a consumer price index (CPI), inflation rate, or market interest rate, the accounting diverges:

IFRS

Include such payments in the initial lease liability using the index or rate as at the commencement date (effectively the current index value as a proxy for future values) (IASB, 2016). Do remeasure the lease liability whenever the cash flows change due to changes in the index or rate (IASB, 2016). In other words, if rent is CPI-linked, the lessee initially measures the lease liability based on the CPI at commencement. When CPI updates (say an inflation adjustment to rent occurs), the lessee recalculates the remaining lease liability using the new rate and adjusts the ROU asset accordingly. No immediate gain/loss arises from such remeasurements; instead, the ROU asset is adjusted (and depreciation going forward changes). This approach ensures the balance sheet reflects the current expected cash flows. For example, if a property lease’s rent was CU 10,000 per year at IFRS 16 adoption and is linked to CPI, and after one year CPI increases rent to CU 10,300, the lessee will increase the lease liability to reflect the higher future payments and increase the ROU asset by the same amount (with prospective adjustment to depreciation). These changes are made at the time the index change takes effect.

US GAAP

In contrast, ASC 842 does not remeasure the lease liability solely for index or rate changes (Financial Accounting Standards Board, 2016b). The lessee also initially measures the lease liability using the index/rate at lease commencement (so starting under the same assumptions as IFRS). However, subsequent changes in lease payments from index or rate movements are treated as period expenses rather than adjustments to the liability. Using the same example, the US GAAP lessee would initially book the lease at CU 10,000/year. When CPI increases the rent to CU 10,300, the extra CU 300 that year is recorded as variable lease expense in Income Statement; the lease liability remains based on the original CU 10,000/year schedule (RSM US LLP, 2020). This means the balance sheet under US GAAP does not reflect the higher payments until each payment is made. The Income Statement, however, will show the full CU 10,300 as lease expense for that year (if an operating lease, or CU 10,000 as lease expense plus CU 300 as variable lease cost disclosed separately; if finance lease, interest and amortization plus the variable portion as additional rent expense).

Implication: IFRS smooths the impact of index-based variability by updating the asset and liability and spreading the effect via depreciation and interest, whereas US GAAP results in more volatility in earnings as each index change hits the Income Statement immediately (RSM US LLP, 2020). Nonetheless, over the lease’s life the total expense recognized will be identical under both standards; they differ in timing and presentation. US GAAP’s approach was chosen largely to avoid reassessing lease liabilities for every index change, simplifying application, whereas IFRS’s approach reflects the updated obligation on the balance sheet, consistent with IFRS’s fair value and remeasurement ethos.

UK GAAP

Under the 2022 amendments to FRS 102, lessees will follow the IFRS 16 approach (FRC, 2022). This means that in UK GAAP financial statements, lease liabilities will be remeasured when an index- or rate-linked payment changes, and variable payments not based on an index or rate will be expensed as incurred. Prior to these changes, FRS 102 (2018) had no concept of remeasuring operating leases for such changes since leases were mostly off-balance-sheet; now it converges with IFRS.