Leasing - Accounting for variable lease payments

Video , PwC US Jun 21, 2018

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Video: Leasing - Accounting for variable lease payments

Under the new leases guidance, variable lease payments can impact both lease measurement and classification for a lessee. Therefore, it is important to understand what variable lease payments are, which of these payments are included when measuring and classifying a lease, and how to account for changes in these payments.

| Duration: 6:05

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Hi! I'm Suzanne Stephani, a Director in PwC's national office.

Today, we’re continuing our leases video series with a discussion on variable lease payments. These payments will impact lease measurement and classification for a lessee under the new leases guidance.

A lease liability and a right-of-use asset will be recorded on the lessee’s balance sheet for virtually all of its leases. 

In this video I’ll cover:

  1. What are variable lease payments;
  2. Which of these payments are included when you measure and classify the lease; and
  3. How to account for changes in these payments.

So to start, what are variable lease payments?

They're any payments made for the right to use an asset that vary because of changes in facts or circumstances occurring after the commencement date, other than for the passage of time.

Variable lease payments are broken down into two categories.

The first category is payments that change based on an index or a rate, such as the consumer price index, or "CPI", or a benchmark interest rate, such as LIBOR.

The second category is all other changes, such as factors based on usage or performance.

The second category includes payments based on the use of the leased asset, such as payments based on excess mileage under a car lease. Or payments based on performance, for example, when a company has to pay the lessor a percentage of its sales in a retail store lease.

Only the first category, that is, variable lease payments based on an index or a rate, are included when measuring and classifying a lease.

So how does a company include a payment that’s going to change over time when it doesn’t know the actual amount that will be paid over the lease term?

Well, the company should use the index or rate at lease commencement for all of the payments throughout the lease term.

Any subsequent change from the original index or rate would be treated as variable lease expense.

The lease liability should NOT be remeasured when the index or rate changes. The only time that it would be updated is when the lease liability is remeasured. For example, if there was a contract modification that’s not accounted for as a separate contract or a change in the assessment of lease term. 

Let’s illustrate this by walking through an operating lease example:

  • Say a company is leasing retail space for 5 years.
  • The company is required to make an annual lease payment at the beginning of each year. According to the lease agreement, the payment is calculated as $4,000 times the prior year’s CPI.
  • The prior year CPI was 250 at lease commencement.
  • So the initial payment due at lease commencement is calculated as $4,000 * 250, or $1 million.
  • The lease payment will be used to measure and classify the lease because the payment is based on an established index.
  • But the annual payment will change every year as CPI changes. So what amounts should be used for each year's annual payment?
  • Well, the company needs to use the index at lease commencement that is a CPI of 250, to calculate the annual lease payments for the entire lease term.
  • So the amount of the lease payments would be $1 million per year, or $5 million for the entire five year lease, which will be used to calculate the straight line lease expense.
  • The company will record the lease liability at the present value of the four remaining $1 million payments due during the lease term. The right-of-use asset will equal that amount plus the initial $1 million payment. 

So what happens when the lease payment changes in year 2?

  • Let's say that CPI for the following year was 255. This results in the second year payment to be calculated as $4,000 * 255 or $1,020,000 at the beginning of year 2.
  • How should the company account for that payment?
  • One million dollars is already factored into the lease liability and the straight-line lease expense because that part of the payment was based on the CPI at lease commencement.
  • The additional $20,000 should be recorded as variable lease expense in the period in which it is payable.

So let's wrap up. With the effective date of the new leases standard quickly approaching, companies will have a lot of work ahead of them getting ready for the new guidance. But the good news is there are many resources available to help.

For more information, please refer to the Leases page on CFOdirect.com. Thank you.

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Heather Horn
US Strategic Thought Leader, National Professional Services Group, PwC US
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David Schmid
IFRS & US Standard Setting Leader, National Professional Services Group, PwC US
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