The Accounting Treatment for Contingent Rent

Contingent rent is a lease payment that is not fixed, but instead depends on a future event or performance metric. This structure is common in commercial real estate, creating a flexible arrangement for the property owner (lessor) and the tenant (lessee). It aligns their financial interests by allowing both to share in the successes or downturns of the business. If a tenant’s business thrives, the lessor shares in that success through higher rent, while underperformance can result in lower rent for the tenant.

Common Contingent Rent Structures

One form of contingent rent is percentage rent, common in retail leases. The tenant pays a percentage of its gross sales from the property, often after sales exceed a pre-negotiated threshold, or “breakpoint.” For example, a lease might require a tenant to pay 5% of all gross sales over $1 million annually. A retailer achieving $1.2 million in sales would owe an additional $10,000 in contingent rent.

Another structure ties rent to an economic indicator, like the Consumer Price Index (CPI). In this index-based rent, the lease specifies that the base rent will be adjusted periodically based on the percentage change in the index. This method helps protect the lessor’s rental income from inflation over a long-term lease.

A third type is usage-based rent, where the payment is linked to the level of activity at the property, often in industrial settings. For instance, a company leasing a production facility might pay a certain amount per unit manufactured or per machine hour operated. This connects the rent expense to the operational output of the leased asset.

Lessee Accounting Treatment

From the lessee’s perspective, accounting for contingent rent under Accounting Standards Codification (ASC) 842 depends on the contingency’s nature. For payments based on an index or rate, like the CPI, the lessee must estimate future payments at the beginning of the lease. This estimate uses the index or rate existing at the lease commencement date and is included in the calculation of the lease liability and the right-of-use (ROU) asset.

This initial measurement capitalizes the index-tied rent as part of the asset and liability. Subsequent changes in the index do not require remeasuring the lease liability or ROU asset. Instead, these variations are recorded as variable lease expenses in the period they occur.

Contingent rent based on performance or usage, such as percentage rent, is treated differently. These payments are not included in the initial measurement of the lease liability and ROU asset because they are considered too speculative to capitalize. Instead, these amounts are recognized as an expense on the income statement in the period the triggering event occurs.

Lessor Accounting Treatment

For lessors, the accounting treatment for variable payments is symmetrical to the lessee’s. Payments that depend on an index or a rate are included in the initial measurement of the lessor’s net investment in the lease. This calculation is based on the index or rate in effect at the lease commencement date.

Variable payments not based on an index or rate, such as those tied to performance or usage, are excluded from the initial measurement. These payments, like percentage rent, are recognized as income in the period when the triggering events occur. This prevents the premature recognition of income that has not yet been earned.