Contingent Lease Accounting Under ASC 842

A contingent lease is an agreement where some payments depend on a future event or metric instead of being fixed. These arrangements are common in industries like retail and manufacturing. For instance, a retailer’s rent might be tied to its monthly sales, or a manufacturer’s lease payment for equipment could depend on units produced. This flexible structure benefits both the property owner (lessor) and the user (lessee) and introduces variability that requires specific accounting considerations to ensure financial statements are accurate.

Determining Contingent Rent Payments

The calculation of contingent rent payments is based on predetermined metrics outlined in the lease agreement. These metrics link the rent amount to the performance or usage of the leased asset. The agreement must clearly define the basis for the contingency, how it will be measured, and when payments will be adjusted.

Percentage Rent

A prevalent form of contingent rent, particularly in the retail sector, is percentage rent. This model involves a base rent plus an additional amount calculated as a percentage of the lessee’s sales or revenue. For example, a lease for a retail store might stipulate a base monthly rent of $5,000 plus 5% of any gross sales exceeding a $100,000 threshold. If the store achieves $150,000 in sales, the contingent portion of the rent would be $2,500. This structure allows the landlord to share in the tenant’s success.

Usage-Based Rent

Another common structure ties rent payments to the level of activity or utilization of the leased asset, often seen in leases for equipment. For instance, a lease for manufacturing equipment might require a payment per unit produced. A vehicle lease could have a charge for each mile driven beyond a certain limit, connecting the cost of the lease to the economic benefit derived from using the asset.

Index-Based Rent

Lease payments can also be linked to a broader economic indicator, such as the Consumer Price Index (CPI). This type of contingency adjusts the rent periodically to account for changes in the economic environment, protecting the lessor from the effects of inflation. The lease specifies which index to use and how often the adjustment will occur, ensuring that the rent keeps pace with market conditions.

Lessee Accounting Treatment

Under the accounting standard ASC 842, the lessee’s accounting for contingent rent depends on the nature of the contingency. The standard distinguishes between payments based on an index or rate and those based on future performance, such as sales or asset usage. This distinction dictates whether the payments are included in the initial measurement of the lease liability and the corresponding right-of-use (ROU) asset.

Payments Based on an Index or Rate

For variable lease payments that depend on an index or rate, like the CPI, ASC 842 requires the lessee to estimate these payments at the beginning of the lease. This initial measurement is based on the index or rate as it exists at the lease commencement date. These estimated payments are then included in the calculation of the lease liability and the ROU asset.

If the index or rate changes in subsequent periods, the lessee must remeasure the lease liability and adjust the ROU asset to reflect the new payment stream. This treatment brings a portion of the uncertainty onto the balance sheet from the start, based on the best information available at the time.

Payments Based on Sales or Usage

In contrast, contingent payments based on future sales or the usage of an asset receive different accounting treatment. These types of variable payments are not included in the initial measurement of the lease liability or the ROU asset. Instead, they are treated as variable lease expenses and are recognized on the income statement in the period the obligation is incurred.

This approach avoids capitalizing uncertain future costs on the balance sheet. For example, if a retail lessee’s rent is tied to a percentage of sales, the contingent portion is expensed only when those sales occur. This links the cost to the period in which the underlying business activity took place.

Lessor Accounting Treatment

From the lessor’s perspective, the accounting for contingent rent under ASC 842 mirrors the logic applied to lessees, focusing on the contingency type to determine the timing of income recognition. This determines if the income is part of the initial net investment in the lease or recognized as it is earned.

Income Based on an Index or Rate

When a lease includes variable payments based on an index or a rate, the lessor includes these payments in the initial measurement of their lease receivable and net investment in the lease. This calculation is performed at the lease commencement date, using the index or rate effective at that time. As the index or rate changes, the lessor adjusts the lease receivable to reflect the updated cash flows they expect to receive.

Income Based on Sales or Usage

For contingent income based on a lessee’s sales or usage of the asset, the lessor does not include this potential income in the initial measurement of the lease receivable. Instead, this variable lease income is recognized in the period in which it is earned. This occurs when the specific event triggering the payment happens, such as the lessee making a sale or using the asset.

This treatment prevents the premature recognition of uncertain revenue. Income is recorded on the lessor’s income statement as it accrues, in line with the underlying activity. This ensures income is only booked when the lessee’s performance meets the thresholds specified in the lease agreement.

Financial Statement Disclosures

ASC 842 mandates specific disclosures to provide a clear understanding of the financial impact of an entity’s leasing activities, including contingent payments. These requirements apply to both lessees and lessors, ensuring transparency about the amount, timing, and uncertainty of cash flows from leases.

Lessee Disclosures

Lessees are required to disclose qualitative and quantitative information about their variable lease arrangements. This includes a description of the basis, terms, and conditions of the contingent payment provisions. Quantitatively, the lessee must disclose the total amount of variable lease cost recognized in the income statement for the reporting period, separate from the fixed lease costs. This allows investors to see the magnitude of costs that are subject to future uncertainty.

Lessor Disclosures

Lessors must also provide detailed disclosures about their lease agreements. They are required to present a breakdown of their lease income, showing fixed and variable lease income separately. Lessors also need to disclose how they manage risks associated with the residual value of their leased assets and provide details about their leasing arrangements, including the basis and terms of any contingent income provisions. This information helps users understand the lessor’s revenue streams and risk exposures.