NetLease - Variable Lease Payments
Background
Lease contracts have multiple components that range from base rent, common area maintenance, taxes, insurance, etc. These payments can be fixed or variable. ASC 842 requires different treatments for different types of payments. So what exactly should be entered into NetLease for payments?
Fixed payments
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:
a. Fixed payments, including in substance payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
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.
c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
d. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset of applying paragraph 842-10-25-2(d).
f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).
For the vast majority of leases, just the fixed, known payments will be entered. For example, if a two-year office lease payments are $10,000 for the first year and $10,500 for the second year, those will be the payments entered. This is a very simple example, but if the lease specified lease payments that increased with CPI, revenue generated in the leased space, or even a clause about paying common area maintenance (CAM) expenses, things would be less straightforward.
Variable Payments Based On Index or Rate
While variable payments are usually excluded from lease payments, ASC 842-10-30-5(b) above states that variable payments that depend on an index or a rate should be included lease payments. The example of CPI will be used, but the same principle could be applied to other rates like LIBOR or treasuries.
An important distinction exists between payments based on a rate vs payments based on a change in rate.
Like the guidance says, if a payment is based on a rate then the amount should be included in payments at commencement. For example, a lease states that payments will be $10,000 for five years and will be adjusted by the annual CPI as a percentage. If the CPI is 3% at commencement, payments will be entered as $10,000 for the first year and $10,300 for each of the four remaining years. After the first year, the CPI rate may actually be 4%. At that point, the difference between the payment entered for year two at commencement and the actual year two payment is $100 ($100 = $10,400 - $10,300). This $100 will be recognized as a variable lease payment and expensed during the period incurred (year two). Note that no modification is required to change future lease payments to reflect the 4% CPI. In practice, this variable payment based on an an index or rate is very rare. Variable rates based on a change in the CPI index are far more common.
If a payment is based solely on the change of a rate, no adjustment is made to the base lease payments at commencement date. Similar to the above example, a lease states that payments will be $10,000 for five years and will be adjusted by the change in annual CPI. In this case, lease payments would be entered as $10,000 for all five years. When the year two payment is made, the change in CPI was 5%. The payment due would be $10,500 and the lessee would expense the $500 as a variable lease payment during the period incurred. Again, no modification is required in this example. See ASC 842-10-55-226 through 55-231 for another detailed example of CPI-adjusted payments.
Alternatively, some lease contracts contain a floor to variable increases. Consider the example where lease payments are $10,000 a year for five years. Years two through five will be adjusted by the greater of 3% and CPI. In this case, the 3% becomes part of the fixed payment. Payment for year two would be input as $10,300, year three would be $10,609, year four would be $10,927.27, and year five would be $11,255.09. If CPI exceeds 3% and lease payments are adjusted over the entered payments, the difference would be expensed during the period incurred. No modification is required.
Percent of Revenue
Some lease contracts include a fixed price for rent plus a percentage of revenue. In this case, only the fixed portion of lease payments will be included at commencement. For example, a lessee is required to pay monthly rent of $10,000 plus 2% of sales. The fixed payments would be entered as $10,000 for the life of the lease and the lessee would recognize the variable expense relating to sales during the period incurred. See ASC 842-10-55-232 through 55-234 for another performance-based lease payment example.
Other Variables
If a lease contains a provision stating that other variable payments are due, these payments are typically not included in payment inputs. If a lessee is required to pay CAM expenses that vary, they would just be expensed during the period incurred. One caveat is if CAM expenses are fixed. If that's the case, then the amount would be included in the fixed payments for the life of the lease (note this is only if the practical expedient to combine non-lease components is elected).