6.3 Variable Lease Payments That Depend on an Index or a Rate

ASC 842-10

30-5 At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term: . . .

b. Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date. . . .

ASC 842-10 — Glossary

Variable Lease Payments

Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.

Leases frequently contain terms that revise or reset the amounts payable to the lessor over the lease term. Those adjustments to the amounts payable to the lessor are described in ASC 842 as variable lease payments. Generally, ASC 842 differentiates between two categories of variability in lease payments:

Variability based on an index or rate (e.g., escalators based on the CPI, or rents that are referenced to or are increased on the basis of SOFR).6
Other variability, including variability that is typically described as based on performance or usage of the asset (e.g., rents based on the percentage of retail store sales or on mileage driven in a leased car).

ASC 842 requires only that limited types of variable payments be included in the lease payments that will affect the lease classification and measurement. Specifically, ASC 842-10-30-5 states that “[a]t the commencement date, the lease payments shall consist [in part] of the following payments relating to the use of the underlying asset during the lease term”:

b. Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.

In addition, ASC 842-10-30-6 explicitly states that “[l]ease payments do not include [v]ariable lease payments other than those in paragraph 842-10-30-5(b).”

Paragraph BC211 of ASU 2016-02 states the following regarding the FASB’s decision to include variable lease payments that depend on an index or a rate in the lease payments:

For reasons similar to those for including in substance fixed payments in the measurement of lease assets and lease liabilities, the Board also decided to include variable lease payments that depend on an index or a rate in the measurement of lease assets and lease liabilities. Those payments meet the definition of assets (for the lessor) and liabilities (for the lessee) because they are unavoidable (that is, a lessee has a present obligation to make, and the lessor has a present right to receive, those lease payments). Any uncertainty, therefore, relates to the measurement of the asset or liability that arises from those payments and not to the existence of the asset or liability.

See Section 6.2.1 for information about in-substance fixed payments.

An entity should include variable lease payments that depend on an index or a rate in its lease payments on the basis of the spot index or rate at lease commencement.

In their initial proposals, the boards suggested that a lessee should remeasure variable lease payments that depend on an index or a rate whenever there is a change in contractual cash flows (e.g., a change in the CPI). However, as explained in paragraph BC236 of ASU 2016-02, some respondents “indicated concerns about the cost of performing reassessments and questioned whether the benefits for users of financial statements would justify the costs for preparers.” During redeliberations, the FASB agreed that the benefits of requiring lessees to remeasure variable lease payments upon changes in contractual cash flows would not outweigh the cost of performing the remeasurement. Consequently, as stated in paragraph BC237 of ASU 2016-02, the FASB decided that a lessee only “should remeasure variable lease payments that depend on an index or a rate when the lessee remeasures the lease liability for another reason.”7 See Sections 6.3.2 and 6.10 for additional guidance on the remeasurement of variable lease payments that depend on an index or a rate.

6.3.1 Initial Measurement of a Lease When There Are Variable Payments Based on an Index or Rate

The FASB included Example 25, Case A, in ASC 842-10-55-226 through 55-231 to illustrate the requirements related to measuring variable payments that depend on an index or a rate.

ASC 842-10

30-8 See Example 25 (paragraphs 842-10-55-225 through 55-234) for an illustration of the requirements on lessee accounting for variable lease payments . . . .

55-225 Example 25 illustrates how a lessee accounts for variable lease payments that depend on an index or a rate . . . .

Example 25 — Variable Lease Payments That Depend on an Index or a Rate . . .

Case A — Variable Lease Payments That Depend on an Index or a Rate

55-226 Lessee enters into a 10-year lease of a building with annual lease payments of $100,000, payable at the beginning of each year. The contract specifies that lease payments for each year will increase on the basis of the increase in the Consumer Price Index for the preceding 12 months. The Consumer Price Index at the commencement date is 125. This Example ignores any initial direct costs. The lease is classified as an operating lease.

55-227 The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 8 percent, which reflects the rate at which Lessee could borrow an amount equal to the lease payment in the same currency, over a similar term, and with similar collateral as in the lease.

55-228 At the commencement date, Lessee makes the lease payment for the first year and measures the lease liability at $624,689 (the present value of 9 payments of $100,000 discounted at the rate of 8 percent). The right-of-use asset is equal to the lease liability plus the prepaid rent ($724,689).

55-229 Lessee prepares financial statements on an annual basis. Lessee determines the cost of the lease to be $1 million (the total lease payments for the lease term). The annual lease expense to be recognized is $100,000 ($1 million ÷ 10 years).

55-230 At the end of the first year of the lease, the Consumer Price Index is 128. Lessee calculates the payment for the second year, adjusted to the Consumer Price Index, to be $102,400 ($100,000 × 128 ÷ 125).

55-231 Because Lessee has not remeasured the lease liability for another reason, Lessee does not make an adjustment to the lease liability to reflect the Consumer Price Index at the end of the reporting period; that is, the lease liability continues to reflect annual lease payments of $100,000 (8 remaining annual payments of $100,000, discounted at the rate of 8 percent is $574,664). However, the Year 2 payment amount of $102,400 (the $100,000 annual fixed payment + $2,400 variable lease payment) will be recognized in profit or loss for Year 2 of the lease and classified as cash flow from operations in Lessee’s statement of cash flows. In its quantitative disclosures, Lessee will include $100,000 of the $102,400 in its disclosure of operating lease cost and $2,400 in its disclosure of variable lease cost.

A lessee’s8 initial measurement of its lease liability and ROU asset should be determined on the basis of the lease payments, which, as stated in ASC 842-10-30-5(b), include “[v]ariable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate).” An entity initially measures variable payments based on an index or rate by using the index or rate at lease commencement (i.e., the spot or gross index or rate applied to the base rental amount). The use of the spot rate at lease commencement is largely based on the FASB’s view that (1) the cost associated with forecasting future rates would outweigh the benefits provided and (2) the use of forecasted rates or indexes would be inconsistent among preparers and often imprecise.

In contrast, payments based on a change in an index or a rate should not be considered in the determination of lease payments. Given the cost-benefit considerations related to the use of forecasting techniques, ASC 842 does not allow an entity to forecast changes in an index or rate to determine lease payments. Rather, adjustments to lease payments that are based on a change in an index or rate are treated as variable lease payments and recognized in the period in which the obligation for those payments was incurred (as illustrated in Example 25, Case A, in ASC 842-10-55-226 through 55-231, reproduced above).

For example, assume that lease payments are made in arrears and are based on a fixed amount (e.g., a $100,000 base amount) adjusted each year by SOFR at the end of the year. If SOFR at lease commencement was 2.7 percent, the total lease payments used to measure the lease liability would be $102,700 per year of the lease, which includes $2,700 in variable lease payments based on an index or rate at lease commencement. In contrast, if the payments were based on a fixed amount ($100,000) that will subsequently be adjusted in a manner corresponding to the change in SOFR each year throughout the lease term, the initial measurement of the lease liability and ROU asset would not take into account the future expected adjustments in SOFR. Therefore, the initial measurement of the lease liability and ROU asset would be based only on the fixed payments through the lease term (see the example below).

Example 6-12

A retailer enters into a lease of a retail space for five years with the following terms:

The first lease payment was made on January 1. Each subsequent payment is made on December 31. There were no initial direct costs or lease incentives. The lessee recognizes total lease expense and measures the lease liability and ROU asset in the manner shown in the table below (also see Chapter 8 for a detailed discussion of the lessee accounting requirements).

6.3.2 Subsequent-Measurement Implications of Index- or Rate-Based Payment Adjustments

The subsequent remeasurement of a lease depends on whether the variability is associated with an index or rate or arises for other reasons. Specifically, ASC 842-10-35-4 and 35-5 require, in part, the following:

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. [Emphasis added]

A lessee would not be required to remeasure a lease solely because of changes in an index or rate. On the basis of discussions with the FASB staff9 and of ASU 2018-10 on Codification improvements to ASC 842, we understand that the guidance on remeasuring a lease liability after the resolution of a contingency is not meant to apply to index-based escalators even when those escalators serve to establish a new floor for the next lease payment. Therefore, even when the index or rate establishes a new floor (such as when the CPI increases and establishes a new rate that will be used as a benchmark for determining future lease payment increases), that adjustment would not result in a remeasurement of the lease liability as variable lease expense and of the ROU asset. As a result, the additional payments for increases in the CPI will be recognized in the period in which they are incurred.

However, as highlighted in ASC 842-10-35-5, if a lessee remeasures the lease payments for any of the other reasons detailed in ASC 842-10-35-4, the lessee is required to remeasure variable lease payments that depend on an index or rate by using the index or rate in effect on the remeasurement date.

Bridging the GAAP

Lease Payments Based on an Index or Rate

While ASC 842 and IFRS 16 are generally converged with respect to the recognition and measurement of variable lease payments, there is a notable difference. Under IFRS 16, for lease payments based on an index or rate, the lease liability and ROU asset are remeasured when there is a change in cash flows as a result of a change in the index or rate. Therefore, entities that are subject to dual reporting under both U.S. GAAP and IFRS Accounting Standards (e.g., a parent entity that applies U.S. GAAP and has international subsidiaries applying IFRS Accounting Standards for statutory reporting) will be required to account for their leases under two different remeasurement models.

CPI and market interest rates are explicitly noted as examples of indexes and rates that should be considered in accordance with ASC 842-10-30-5(b). However, IFRS 16, which is converged with ASC 842 with respect to the initial measurement of variable lease payments that depend on an index or rate, also includes “payments that vary to reflect changes in market rental rates” as an additional example of variable payments that depend on an index or rate.

The next section discusses our interpretation under ASC 842 of the applicability of ASC 842-10-30-5(b) to variable payments based on fair market rental rates.

6.3.3 Rents Based on Market Rates

Some lease agreements (typically real estate leases) include variability in the form of a rent reset provision that requires the future lease payments after a specified point in time to be reset to the fair market rental rates at that time. For example, a 10-year lease of property in Chicago that requires annual rental payments of $100,000 for years 1–5 may also include a provision to reset the rental payments in years 6–10 of the lease to the updated fair market rent as benchmarked to published rates for Chicago.

Such a fair market rent reset feature should be accounted for in accordance with the guidance on variable payments that are based on an index or rate.

Paragraph BC211 of ASU 2016-02 states the FASB’s rationale for including certain variable lease payments that depend on an index or rate in the measurement of the lease liability and ROU asset:

While ASC 842 does not define “index” or “rate,” we believe that an index or rate is based on underlying economic performance (e.g., the CPI measures the variation in prices paid by a consumer household for certain retail goods and services). Similarly, fair market rent is indicative of the economic performance of a specific geographic region and is analogous to a formally published index or rate. Further, the FASB and IASB converged certain aspects of their guidance on leases, including the treatment of payments subject to market rate resets as lease payments that vary on the basis of an index or rate. Paragraph 28 of IFRS 16 explicitly states that a variable payment that is based on an index or rate would include, among other things, “payments that vary to reflect changes in fair market rental rates.”

Since variable payments based on fair market rental rates were determined to be analogous to variable payments based on an index or rate, we believe that the specific guidance on variable payments based on an index or rate (see Sections 6.3.1 and 6.3.2) should be applied to variable payments based on fair market rental rates (including those based on the fair market value of the underlying asset). Accordingly, a lessee should measure the lease liability and ROU asset and a lessor should measure the net investment in the lease on the basis of the fair market rental rate in effect at lease commencement. The lessee’s lease liability and ROU asset and the lessor’s net investment in the lease would not be remeasured as a result of any subsequent change in the fair market rental rate (although remeasurement could be required for another reason); such a change would be recorded as variable lease expense or income, respectively, in the appropriate period depending on the change in the fair market rental rate.

Footnotes

Note that an index or rate for these purposes does not include tax rates such as sales tax or VAT rates.

The IASB decided not to limit the remeasurement of variable lease payments that depend on an index or a rate to situations in which the lessee remeasures the lease liability for another reason. Rather, IFRS 16 requires lessees 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). See Appendix B for a summary of differences between ASC 842 and IFRS 16.

While this discussion specifically focuses on the consideration of variable payments based on an index or a rate when a lessee initially measures its lease liability and ROU asset, the concept would similarly apply when a lessor initially measures its net investment in a sales-type or direct financing lease.

In July 2018, the FASB issued ASU 2018-10, which makes Codification improvements to ASC 842 and amends ASC 842-10-35-4(b) and ASC 842-10-35-5 to clarify that changes in an index or rate alone would not give rise to a requirement to remeasure the lease. See Section 17.3.1.3 for further discussion of the ASU.

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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.