Lease agreements are rarely as simple as a fixed monthly payment. Many contracts include variable elements, whether tied to an index, a market rate, sales performance, or actual usage of the leased asset. Under IFRS 16, how these variable payments are treated depends entirely on what they are linked to, and getting this classification wrong is one of the more common errors in lease accounting.
If you have ever paused while reviewing a lease agreement, unsure whether a payment clause belongs in the lease liability or not, this breakdown should help clear things up.
The Core Distinction IFRS 16 Draws
IFRS 16 separates variable lease payments into two broad categories. The first includes payments that depend on an index or a rate, such as payments linked to a consumer price index or a benchmark interest rate. These are included in the initial measurement of the lease liability, based on the index or rate at the commencement date.
The second category includes payments that depend on future performance or usage, such as a percentage of sales revenue or payments based on how many hours a piece of equipment is used. These are not included in the lease liability at all. Instead, they are recognized as an expense in the period in which the event or condition that triggers the payment occurs.
Why This Distinction Exists
The reasoning behind this split comes down to measurability. Payments linked to an index or rate can be reasonably estimated at the start of the lease, even if the exact future value fluctuates. Usage or performance based payments, on the other hand, depend on outcomes that cannot be reliably predicted at lease commencement, such as future sales figures or how intensively an asset will be used.
Including unpredictable, performance based payments in the initial lease liability would require speculative estimates that do not align with the reliability standards IFRS 16 aims for.
Examples That Make This Clearer
A lease payment that increases annually based on a consumer price index adjustment falls into the first category. Since the index value at lease commencement is known, this payment is included in the initial lease liability calculation, even though future adjustments will need to be accounted for as the index changes.
A retail lease where rent is calculated as a percentage of the tenant’s monthly sales falls into the second category. Since sales figures are unknown at lease commencement and depend entirely on future business performance, this payment is expensed as incurred rather than included in the lease liability.
A vehicle lease with payments based on mileage driven is another example of usage based variable payments, which are also expensed as they occur rather than estimated upfront.
What Happens When an Index Changes
Even though index linked variable payments are included in the initial lease liability based on the rate at commencement, that does not mean the liability stays fixed. When the index or rate used to determine lease payments actually changes, and the change affects future lease payments, the lease liability needs to be remeasured to reflect the updated payment amounts.
This remeasurement is different from a reassessment of lease term, since it relates specifically to a change in the payment amount rather than a change in judgment about lease duration.
A Common Mistake Worth Avoiding
One mistake that shows up often is treating all variable payments the same way, either by excluding index linked payments from the lease liability entirely, or by attempting to estimate and include usage based payments upfront. Both approaches are inconsistent with IFRS 16 and can lead to inaccurate lease liabilities and misstated expenses.
Reviewing each lease agreement carefully to identify exactly what triggers a variable payment, whether it is an index, a rate, sales, or usage, is the only reliable way to apply the correct treatment.
Documenting Your Classification Decisions
Since variable payment clauses can sometimes be worded in ways that are open to interpretation, it helps to document the reasoning behind each classification decision at the time a lease is signed or reviewed. This creates a clear record that can be referred back to during audits or when preparing disclosures, rather than relying on memory or having to reinterpret the contract later.
Disclosure Requirements for Variable Payments
IFRS 16 also requires disclosure of expenses relating to variable lease payments not included in the measurement of lease liabilities. This means usage and performance based payments need to be captured and reported separately in your financial statement notes, giving readers a clearer picture of the full cost of your leasing arrangements beyond what appears in the lease liability itself.
FAQS
Are all variable lease payments included in the lease liability under IFRS 16?
No. Only variable payments linked to an index or rate are included in the initial lease liability. Payments based on usage or performance, such as sales or mileage, are expensed as incurred rather than included upfront.
What happens if an index used for variable lease payments changes during the lease term?
If the index change affects future lease payments, the lease liability needs to be remeasured to reflect the updated payment amounts based on the new index value.
Do usage based variable lease payments need to be disclosed even if they are not in the lease liability?
Yes. IFRS 16 requires disclosure of expenses related to variable lease payments not included in the lease liability, so these amounts still need to be reported separately in the financial statement notes.
Final Thoughts
Variable lease payments add a layer of complexity to IFRS 16 compliance, but the underlying principle is fairly consistent once you understand it. Payments tied to a known index or rate belong in the lease liability. Payments tied to unpredictable future performance or usage do not. Taking the time to classify each variable payment clause correctly, and documenting the reasoning behind it, will save your team from reporting errors and give auditors confidence in your numbers.
