Thursday, March 19, 2009

Contingent rent, now and future

One of the more confusing aspects of lease accounting is dealing with contingent rents. The FASB defines these as "The increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors (other than the passage of time) on which lease payments are based..." [FAS 29, para. 11] Typical causes for contingent rents are inflation adjustments, percentage of sales, a rental amount based on a floating interest rate (like LIBOR), property taxes, and maintenance fees.

Under FAS 13, contingent rents are handled in one of two ways. Both are based on the overall concept of making a one-time estimate at the beginning of the lease, and expensing the difference between the estimate and the actual payment when the payment is made.

1) If the amount to be paid is based on usage, such as a percentage of sales or machine hours of use, the up-front estimate is zero. All payments based on usage are considered contingent rent, and fall outside of the "minimum lease payments" for the lease (since if you end up not using the asset, your minimum charge is 0); they are expensed as incurred.

2) If the amount to be paid is based on a rate or index, such as LIBOR or the consumer price index, the minimum lease payments are calculated as if the rate or index will be the same over the entire life of the lease. This calculation is not changed over the entire life of the lease (unless the agreement is renegotiated). The difference between the estimate and the actual payment is expensed as incurred; note that this difference could be positive or negative.

One question that often comes up is whether to treat the CPI as a rate or as an index. Officially, CPI is an index, showing the value of a basket of goods and services. The overall value was normed to 100 in 1967; the percentage increase that is broadcast on the news is the change in that index. While some companies take the position that they should assume the current rate of increase in calculating their minimum lease payments, a strict reading of FAS 13 seems to indicate that instead one should assume that the index will not change, i.e., there will be no inflation (or deflation), and future inflation adjustments will be treated entirely as contingent rent.

Of course, if the increases in rent are specified in advance, they must be considered part of the minimum lease payments, even if they're supposedly intended to cover inflation. The key is whether the rent amount is known at inception, or dependent on future events.

The current version of EZ13, v2.2, does not track contingent rents at all, because they're not part of the minimum lease payments. However, we are currently working on a new release which will include the ability to record and report contingent rents; that will be released later this year.

The FASB/IASB revision plans to change this. According to the boards' current thinking, lessees will need to estimate their rents for all types of contingent rent. Unfortunately, the two boards have differing opinions on how to estimate: The FASB wants to use a "best estimate" approach, while the IASB wants a probability-weighted expected outcome approach. Both want lessees to remeasure their leases at each reporting date (normally every fiscal quarter), with the obligation changed by the change in present value of the remaining rents. They disagree about how to balance the change transaction: for changes caused by contingent rents, the FASB wants an immediate recognition of profit or loss, with no change to the carrying value of the asset, while the IASB wants to add or subtract the change to both the obligation and the asset. The depreciation on the asset would then be altered to depreciate the remaining asset over the remaining life.

Since the boards intend to release a united standard, some negotiation between the boards will be necessary to resolve this. Further, it remains to be seen how companies and users of financial statements will respond to this idea; clearly this is a potentially large increase in the complexity of accounting for leases, with the possibility that valuations would change every quarter with corresponding changes in interest and depreciation, along with the change in the actual rent.


  1. Hello,

    Our index will be increase YoY based on the HICP (something similar to the CPI). When reading this, do you say that we would only need to apply the index today ? So if the index today would be 3%, do we need to take 103% in year 2, 106% in year 3, ... or do we keep a flat 103% over the full term of the rent ?

  2. The plan under the new lease accounting standard that the IASB & FASB are working on would be to apply the current inflation rate to all future years. Thus, year 2 would be 103% of the first year's rent, year 3 would be 106.09% (because inflation compounds), year 4 would be 109.27%, etc.

    The rule under the current IAS 17 standard for IFRS users is different; you show the first year's rent for the entire life of the lease, with any inflation adjustment treated as contingent rent and simply expensed as incurred (no impact on the future rent commitments). The FAS 13 standard (in the U.S.) is normally interpreted the same way.

  3. Thank you Kevin. In this case it is under FAS 13.

    So I understand correctly that in the future setup it would compound, but that in the current FAS 13 ruling, it doesn't.

    Do you have by any chance examples / valid sources that show this ?

    This is an extract of the guidance "such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable"

    But it does leave room for interpretation. It doesn't mention whether we need to apply it in a compound way or not. Valid examples/sources would be very helpfull

  4. I know of companies that do it both ways (setting the lease up with increasing rents, or setting it up with just the original rent). I think most companies set up just the original rent as the minimum lease payment, for simplicity (and to reduce reported future rent due). FAS 13 itself, or more precisely, FAS 29, which defines contingent rent in paragraph 11, is a bit ambiguous--it depends on whether you think of the CPI as an index, which it really is, or as a rate, which is what people typically think of it. If you consider it an index, then the effect of changes in the index is all contingent rent.

    A quick Google search did turn up a book called "Accounting for Real Estate" ( which states, "In practice, rentals based on a change in CPI are treated as contingent rentals."