6.10 Subsequent Measurement of Lease Payments

ASC 842-10

35-4 A lessee shall remeasure the lease payments if any of the following occur:

The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term. However, a change in a reference index or a rate upon which some or all of the variable lease payments in the contract are based does not constitute the resolution of a contingency subject to (b) (see paragraph 842-10-35-5 for guidance on the remeasurement of variable lease payments that depend on an index or a rate).
There is a change in any of the following:
1. The lease term, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments on the basis of the revised lease term.
2. The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option.
3. Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees.

35-5 When one or more of the events described in paragraph 842-10-35-4(a) or (c) occur or when a contingency unrelated to a change in a reference index or rate under paragraph 842-10-35-4(b) is resolved, variable lease payments that depend on an index or a rate shall be remeasured using the index or rate as of the date the remeasurement is required.

35-6 A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.

The table below summarizes the guidance in ASC 842-10-35-4 through 35-6 for both lessees and lessors.

	Lessee Remeasures Lease Payments Under ASC 842?	Lessor Remeasures Lease Payments Under ASC 842?
The lease is modified, and that modification is not accounted for as a separate contract (Chapters 8 and 9)	X	X
Contingency underlying variable lease payments that do not depend on an index or a rate is resolved and, as a result, some (or all) of the remaining payments become fixed for some (or all) of the remaining lease term (Section 6.9.1)	X
Change in the lease term (Section 5.4)	X
Change in whether the lessee is reasonably certain to exercise a purchase option (Section 6.4)	X
Change in the amount that it is probable the lessee will owe under a residual value guarantee (Section 6.7)	X

Bridging the GAAP

Remeasurement of Lease Payments

Under ASC 842, when a lessee remeasures its lease payments for any of the reasons illustrated in the table above, the lessee should remeasure variable lease payments that depend on an index or a rate by using the index or rate as of the remeasurement date. As noted in Section 6.3, this requirement differs from the requirement under IFRS 16 to remeasure variable lease payments that depend on an index or a rate whenever there is a change in contractual cash flows (e.g., changes in the CPI).

6.10.1 Accounting for a Lease Liability and Corresponding ROU Asset in an Arrangement Involving a “Minimum Annual Guarantee” Payment Structure in Which a New Lease Payment Floor Is Established Each Year

Leasing arrangements may have a “minimum annual guarantee” (MAG) payment structure in which a lessee guarantees a minimum annual payment and only the minimum amount for the first year is known upon lease commencement. After year 1, the MAG will reset on the basis of the revenue, usage, consumption, or another similar factor for year 1. The reset mechanism can result in an increase or decrease compared with the amount of the year 1 MAG, indicating that, at lease commencement, there is no established floor for any year after year 1.

Example 6-19

Company B enters into a three-year real estate lease. The arrangement includes a rent payment structure in which the annual rent is an amount equal to 5 percent of annual revenue, with a MAG in year 1 of $210,000 (i.e., a fixed payment). For each subsequent year, the MAG is an amount equal to 5 percent of the prior year’s revenue, which establishes a payment floor for that year (e.g., the rent in year 2 will be the greater of 5 percent of year 2 revenue or 5 percent of year 1 revenue). Importantly, as of lease commencement, there are no fixed or in-substance fixed payments other than the MAG in year 1 of $210,000, since the sales each year, which are unknown, could result in a MAG that is higher or lower (or potentially zero) for subsequent years. The lease is classified as an operating lease.14 The table below illustrates the MAG for each year, which is based on the assumed annual revenue over the lease term.

When analyzing arrangements such as the one in the example above, it is critical for an entity to determine the substance of the pricing mechanism. We believe that these mechanisms are designed to establish minimum payments for future use rather than to impose incremental payments for past use. The discussion below reflects our views on the accounting related to these arrangements; these views are based on our view of the substance of the MAG payment structure.

6.10.1.1 Measuring and Accounting for the Lease Liability

The MAG in year 1 of the real estate lease represents an in-substance fixed payment for year 1 only, because a floor is being set by the MAG (see Section 6.2.1 for additional discussion of in-substance fixed payments). In the example above, B would calculate the lease liability at lease commencement on the basis of the present value of the MAG for the first year. We believe that the in-substance fixed payment is limited to the MAG in year 1 because the MAG amounts after year 1 (the MAG amounts applicable to years 2 and 3) could increase or decrease. Since the subsequent-year MAG amounts can decrease, as of the commencement date of the lease, a payment floor does not exist beyond year 1.

At the end of each year,15 B would calculate a new MAG for the following year (e.g., a MAG calculated on the basis of year 1 revenue establishes a rent floor for year 2), which constitutes a remeasurement event in accordance with ASC 842-20-35-5(c), since the resolved uncertainty associated with year 1 revenue represents the resolution of a contingency affecting B’s future lease payments. When a contingency is resolved, a lessee must remeasure the lease liability to reflect changes to the lease payments, as described in ASC 842-10-35-4(b), which states, in part:

A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments.

See Section 8.5.4.2 for more information about accounting for a change in lease payments resulting from the resolution of a contingency. Through the effective interest method, the year 1 lease liability will be reduced to zero by the time the MAG is reset at the end of year 1 (once the total sales for year 1 are known), at which point the new MAG will be used to determine the year 2 liability (the new MAG represents an in-substance fixed payment for year 2 since it establishes a payment floor for that year). Similarly, the year 2 liability will subsequently be amortized as B makes the year 2 payments. This accounting will continue over the remainder of the lease term. The expense recognition profile of the corresponding lease cost is discussed in the section below.

6.10.1.2 Subsequent Measurement and Recognition of the Lease Cost

As discussed above, when the MAG is reset each year, Company B must consider the guidance in ASC 842-10-35-4(b) and remeasure the lease liability and ROU asset as of each reset date.

We believe that there may be more than one acceptable approach to recognizing the lease cost. We have outlined two acceptable alternative approaches below that we believe an entity can use to recognize the in-substance fixed payment (i.e., lease cost) on a straight-line basis over (1) the remaining lease term or (2) the year to which the MAG is related:16

Recognize the lease cost for each MAG over the remaining lease term — The in-substance fixed payment in the form of a MAG represents payment for the right to use the underlying asset over the remaining lease term. This approach is supported by the guidance in ASC 842-20-25-6(a), which states, in part:

After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]

Under this approach, each additional ROU asset would be layered on once the MAG is reset in each annual period. That is, in the example above, the MAG lease cost of $210,000 in year 1 would be recognized over the entire three-year lease term (i.e., $70,000 of lease cost in all three periods). The lease cost of $230,000 related to the reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would be recognized over the remaining two-year lease term (i.e., an additional $115,000 of lease cost in the two remaining periods). Accordingly, the balance of the ROU asset at the end of year 2 would include the remaining unamortized balance from both the year 1 MAG and the year 2 MAG. This accounting would continue for the remainder of the lease arrangement. This approach will result in higher expense recognition in the latter years of the contract (i.e., back-loaded lease cost), as illustrated in the table below.
Recognize the lease cost for each MAG in the year to which the MAG is related — Under this approach, the lease cost would be reflected for each MAG on the basis of the use of the underlying asset for one year only. Such cost recognition is aligned with the frequency at which lease payments are reset and in turn would be aligned with the physical-use pattern of the space. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:

After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]

The lease cost resulting from the year 1 MAG would be recognized on a straight-line basis over year 1, and the corresponding ROU asset would thus be fully amortized by the end of year 1. The reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would trigger a resolution of a contingency in accordance with ASC 842-20-35-5(c) (see Section 6.10.1.1), in which the payments associated with the MAG for year 2 become an in-substance fixed payment. Accordingly, the lessee would recognize a separate lease liability and a corresponding ROU asset for the year 2 MAG only, which would be completely amortized in year 2. This accounting would continue for the remainder of the lease term. The table below illustrates the total lease cost recognized in each year (and is based on the same facts as those in the example above). Overall, this approach may be easier to apply than the previous approach since an entity will not have to track separate layers of an ROU asset as a MAG is reset over time. Rather, the entity will record a new ROU asset and lease liability each time a reset occurs, both of which will be exhausted during the year to which they are related. This approach may also better reflect the economics of a variable payment leasing structure with a floor mechanism that fluctuates over time.

Note that we are aware of different views in practice regarding the substance of, and appropriate accounting for, leases that contain pricing reset mechanisms similar to the MAG structure discussed above. According to one such view, the MAG reset is considered to be a variable lease expense associated with the period that establishes the new MAG. For example, the year 2 MAG of $230,000 in the example above would be treated as variable lease cost for year 1. This view therefore has a front-loading effect on recognition of lease costs. Given the diversity of views on the substance of these reset mechanisms and the related accounting requirements, we encourage entities affected by this issue to discuss their proposed accounting treatment with their auditors or accounting advisers.

Footnotes

This section is written with an operating lease in mind, but similar considerations would apply to a finance lease. However, one notable difference between the two classifications pertains to the expense recognition pattern of the lease cost and the corresponding amortization of the ROU asset. Operating lease cost is recognized on a straight-line basis, while the expense recognition pattern for finance lease cost is front-loaded. The corresponding ROU asset amortization also depends on the classification. See Section 6.10.1.2 for more information about the expense recognition pattern for the lease cost and ROU asset amortization.

For simplicity, we have assumed that the metric that establishes the MAG for each year can increase or decrease over the course of the entire year and therefore does not establish an in-substance fixed payment for the following year until the measurement period ends. This could be the case with revenues, for example, which can decrease on the basis of customer returns. Depending on materiality to interim reporting, to the extent that the metric that establishes the MAG cannot decrease over time (i.e., in future interim periods), the accounting described in Section 6.10.1.1 may be accelerated and may involve multiple remeasurements.

The amortization of the ROU asset will be consistent with the method outlined in ASC 842-20-35-3(b) for an operating lease in which the amortization of the ROU asset generally increases in each period as the liability accretion decreases as a result of a declining lease liability balance. In contrast, the amortization of an ROU asset for a finance lease will generally be on a straight-line basis in accordance with ASC 842-20-35-7. Only the operating lease cost is illustrated in this example.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.