IFRS 16 Variable lease payments

Variable lease payments that depend on an index or rate are initially included in the lease liability using the index or rate at the commencement date of the lease. Variable lease payments include payments linked to a consumer price index, payments linked to a benchmark interest rate (such as EURIBOR) or payments that vary to reflect changes in market rental rates. Variable lease payments

After the commencement date, the lessee increases the carrying amount to reflect interest on the lease liability and reduces the liability for lease payments made. It also remeasures the carrying amount to reflect changes in the lease payments arising from changes in the index or rate.

In remeasuring the carrying amount, the lessee uses an unchanged discount rate unless the change in lease payments results from a change in floating interest rates. In that scenario the lessee shall use a revised discount rate that reflects changes in the interest rate.

Case – Variable lease payments dependent on an index

Entity Q enters into a ten-year lease of a property with annual payments of CU5,000 payable at the beginning of each year. The agreement specifies that the lease payments will increase every two years based on the increase in the consumer price index for the preceding 24 months. The Consumer Price Index at commencement is 125. Entity Q estimates its incremental borrowing rate at 5% per annum; i.e. the fixed rate at which it could borrow for the amount equivalent to the value of the right-of-use asset for the same term and in the same currency.

Resulting accounting under IFRS 16 Leases
At commencement, Entity Q measures the lease liability at CU35,539, being the present value of the remaining nine payments of CU5,000 discounted at 5%. It measures the right-of-use asset at CU40,539, being the present value of the lease liability plus the CU5,000 lease payment made at commencement.

At the end of year two, the lease liability is CU33,932, being the present value of the eight remaining payments of CU5,000. The consumer price index is 135, and the rental payment for year three is set at CU5,400, being “CU5,000 X 135 / 125”.

Because there is a change in the future lease payments, Entity Q remeasures the lease liability to reflect the net present value of the eight remaining payments of CU5,400, discounted at the original discount rate of 5%. This increases the lease liability by CU2,714. This is the difference between the lease liability of CU33,932 and the remeasured liability of CU36,646. A corresponding adjustment is made to the right-of-use asset.

Case – Variable lease payments linked to sales

Assume the same fact pattern as for the first case above but Entity Q is also required to make variable lease payments equal to 0.1% of sales generated from the leased property. At commencement, the lease liability is measured at the same amount as in the first case above. This is because the additional lease payments, while variable, are linked to future sales rather than an index or rate. As a result, they do not meet the definition of lease payments under IFRS 16 and are not included in the measurement of the lease liability or the right-of-use asset.

Resulting accounting under IFRS 16 Leases Variable lease payments
During the first year of the lease, the lessee generates sales of CU800,000. Entity Q incurs an additional expense of CU800 (CU800,000 X 0.1%). This is recognised in profit or loss during the first year.

Case – Variable lease payments becoming fixed

Entity S enters into a four-year lease for a specialised photocopier. The lease payments are CU500 per month if the copier is used to produce 100,000 copies or less over the lease term. If the copier is used to make more than 100,000 copies, then the monthly rental is adjusted to CU700 per month (which is applied from the commencement of the lease).

The copier exceeds 100,000 copies at the start of year three. At this point Entity S is required to make a catch-up payment of CU4,800. The remaining payments are adjusted upwards to CU700 per month.

Resulting accounting under IFRS 16 Leases
On commencement the lease liability is based on lease payments of CU500 per month. 
At the start of year three the catch-up payment is recorded in profit or loss. The right-of-use asset and lease liability are adjusted for the increase of CU 200 per month for the remaining lease term (on a discounted basis). This is because these payments have become in-substance fixed payments.

Case – Property tax payments

A contract to lease a building specifies that the lessee must reimburse the lessor for property taxes paid. While this tax will ultimately be paid by the lessee, it isn’t a tax obligation of the lessee because the taxing authority imposes the tax on the lessor, as owner of the property.

The lessee needs to ascertain whether this represents a lease payment and, if so, whether it is variable based on an index or a rate and therefore should be included when calculating the right-of-use asset and lease liability.

Resulting accounting under IFRS 16 Leases
This represents a lease payment. Whether or not it is included in the lease liability will depend on whether it represents a variable payment based on an index or rate, and the exact wording used in the lease agreement to describe the payment will be key. There are mixed views within the marketplace on this issue. While the answer will ultimately be driven by the facts and circumstances specific to each situation, judgement will be required and as a result we expect some diversity in practice to arise.

IFRS 16 Variable lease payments

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