How are variable lease payments accounted for under IFRS 16, and what is the difference between index-linked and performance-based variable payments?

Variable lease payments are a key area under IFRS 16 (and ASC 842) because their classification determines whether they are included in the lease liability calculation or expensed as incurred.

Two Categories:

1. Index-linked or rate-based (e.g., payments tied to CPI or a benchmark interest rate)

• Included in the lease liability measurement
• Use the index/rate at the commencement date for initial measurement
• Remeasured when payments change due to index/rate updates

1. Performance-based or usage-based (e.g., payments based on revenue, sales volume, miles driven)

• Excluded from the lease liability
• Recognized as expense when incurred

Rationale:

Index-linked payments are considered reasonably predictable — the lessee knows they will pay something based on an external, observable rate. Performance-based payments are too uncertain to reliably estimate.

Worked Example — Ashbury Retail Stores:

Ashbury leases retail space with the following terms:

• Base rent: $200,000/year for 10 years
• CPI adjustment: rent increases annually by the change in CPI (current CPI = 280)
• Revenue kicker: 2% of annual gross sales above $5,000,000

Discount rate: 6%

Lease Liability Calculation:

PV of lease payments = $200,000 × PV annuity factor (6%, 10 years)

= $200,000 × 7.3601 = $1,472,020

The revenue kicker is NOT included. If in Year 1, gross sales = $6,500,000:

Variable payment = 2% × ($6,500,000 − $5,000,000) = $30,000

This $30,000 is expensed entirely in Year 1 — it does not affect the ROU asset or lease liability.

CPI Remeasurement:

If CPI increases to 294 in Year 2:

New annual payment = $200,000 × (294/280) = $210,000

The lease liability is remeasured using the revised payments and the original discount rate, with a corresponding adjustment to the ROU asset.

Analytical Implications:

1. Companies with significant performance-based variable payments have lower reported lease liabilities than those with fixed payments — potentially understating leverage.
2. Analysts should read lease disclosures to estimate total lease costs (fixed + variable).
3. IFRS 16 requires disclosure of variable lease payments not included in the liability.
4. Retailers with percentage-rent clauses may have material off-balance-sheet lease costs.

Key Exam Points:

1. Index/rate-based → in the liability; performance/usage-based → expense as incurred.
2. Remeasure for index changes; NO remeasurement for performance changes.
3. The ROU asset adjusts when the liability is remeasured for index changes.
4. Variable payment classification significantly affects reported leverage ratios.

Practice lease accounting in our CFA Level II FRA course.