Key Takeaways
- Variable payments linked to an index or rate are included in the lease liability using the current rate at commencement
- Variable payments based on usage or performance are expensed as incurred - not included in the liability
- When index-linked payments change, remeasure the liability using the original discount rate
- Don't forecast future index changes. When the payment actually adjusts, remeasure the liability at that point
- "In-substance fixed" payments that appear variable but will inevitably be paid are treated as fixed
Types of Variable Lease Payments
Variable lease payments are payments whose amount is not fixed at commencement and may change because of an index, rate, usage, performance, or other factors. IFRS 16 distinguishes between two key categories with very different accounting treatments:
Index/Rate-Linked
Payments that depend on an index or rate (e.g., CPI, RPI, market rental rates)
Treatment: Included in lease payments used to measure the lease liability
Usage/Performance-Based
Payments that depend on usage, output, or other variable factors
Treatment: Recognised in profit or loss when the triggering event or condition occurs
Index-Linked Payments
Payments linked to an index (such as CPI or RPI) are included in the lease liability measurement. The key principle is to use the current index value - not forecast future changes.
Initial Measurement
At commencement, calculate the lease liability using the payment amounts based on the current index value. Don't forecast future index increases.
Example
A 5-year lease with annual rent of £100,000, increasing annually by CPI:
- At commencement, include £100,000 × 5 years in your payment schedule
- Don't include estimated future CPI increases
- At each contractual rent review date, when the payment adjusts, remeasure the liability
Subsequent Remeasurement
When the contractual rent review takes effect and the payment amount changes, the lease liability must be remeasured using:
- The revised lease payments (based on the new index value)
- The original discount rate (not a revised rate)
When to Remeasure
Remeasure when the cash flows actually change - typically at the rent review date specified in the lease contract, not when the index is published.
Worked Example: CPI Increase
Scenario
A CPI-linked lease has its annual rent review. CPI has increased 3%:
- Current annual rent: £100,000
- CPI increase: 3%
- New annual rent: £103,000
- Remaining lease term: 4 years
- Lease liability before remeasurement: £340,000
Recalculate the liability using £103,000 for the remaining 4 years, discounted at the original rate. Assume the revised liability is £350,000, an increase of £10,000.
For more detail on remeasurement mechanics, see our Remeasurement guide.
Usage & Performance-Based Payments
Variable payments that depend on future usage, performance, or sales are not included in the lease liability. These are recognised in profit or loss in the period in which they are incurred, unless another standard requires the cost to be included in the carrying amount of another asset (e.g. inventory under IAS 2).
Common Examples
| Payment Type | Example | Treatment |
|---|---|---|
| Turnover rent | 5% of retail sales above £1m | Expense as incurred |
| Mileage-based | £0.10 per km over 20,000 km/year | Expense as incurred |
| Usage-based | £5 per machine hour | Expense as incurred |
| Output-based | £2 per unit produced | Expense as incurred |
Rationale
The IASB excluded these payments partly because they don't represent an unconditional obligation at the commencement date (the lessee can avoid the payment by not using the asset or not generating sales), and partly due to the measurement uncertainty involved in estimating future usage or performance at inception.
Journal Entry
In-Substance Fixed Payments
Some payments may appear variable but are economically fixed because they will inevitably be made. These "in-substance fixed" payments are included in the lease liability.
Characteristics
Payments are in-substance fixed if:
- The payment is structured as variable but has no genuine variability
- There is no realistic possibility of avoiding the payment
- The conditions for avoiding payment have no commercial substance
Examples
| Scenario | Classification | Rationale |
|---|---|---|
| Payment required unless asset is totally unusable | In-substance fixed | No realistic possibility of avoidance |
| Base rent plus turnover above threshold | Base: fixed; Turnover: variable | Base will definitely be paid |
| £100k rent reducing to £80k if turnover < £50k | £80k fixed; £20k variable | £80k will definitely be paid |
| Minimum annual payment regardless of usage, with additional amounts per unit | Minimum is in-substance fixed; per-unit excess is variable | The minimum will inevitably be paid |
| Rent of 5% of turnover, but only on turnover above £1,000 | In-substance fixed | The threshold is so low that the payment is virtually certain to arise |
Disclosure Requirements
Variable lease payments require specific disclosures:
- Variable lease payments that depend on an index/rate - included in liability, disclosed in maturity analysis
- Variable lease payments not included in the liability - disclosed separately in total lease expense
- The nature and variability of payments should be explained qualitatively
For complete disclosure requirements, see our Disclosure Requirements guide.
Variable Payment Summary
| Payment Type | Include in Liability? | Remeasure? | Discount Rate |
|---|---|---|---|
| Fixed | Yes | No (unless modification) | N/A |
| In-substance fixed | Yes | No (unless modification) | N/A |
| Index-linked | Yes (current index) | Yes, when contractual rent review takes effect | Original rate |
| Usage/performance | No | N/A (expensed) | N/A |
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.