ASC 842 & Variable Payments
The ASC 842 lease accounting standard, introduced by the Financial Accounting Standards Board (FASB), has transformed how businesses record their lease agreements on the balance sheet.
A significant part of this new standard is how it deals with variable lease payments, which are payments that change because of events after the lease begins. Variable lease payments require special consideration under ASC 842. For a comprehensive understanding of how variable payments interact with other lease accounting requirements, see our ASC 842 Complete Guide. This article breaks down the concept of variable lease payments under ASC 842, offering easy-to-understand examples for each type.
ASC 842 at a Glance
ASC 842 requires companies to show lease assets and liabilities on their balance sheets, giving a clearer picture of a company's financial obligations. A lessee may elect to keep short-term leases off the balance sheet: a lease term of 12 months or less, including option periods that count toward the lease term, and no purchase option it is reasonably certain to exercise (ASC 842 glossary, short-term lease; ASC 842-20-25-2).
What are Variable Lease Payments?
A variable lease payment is an amount a lessee pays for the right to use the asset that changes because of events after commencement. The passage of time alone does not make a payment variable (ASC 842 glossary). Rent that follows sales, usage or an index is variable. Rent that rises on a set schedule is fixed, because only time changes it.
Variable lease payments change with events after commencement, such as an index, sales or usage. Let's look at the different types and see examples of each.
Types of Variable Lease Payments and Examples
Indexed or Rate-Based Payments
Definition: Payments adjusted based on a specific index or rate, like interest rates or inflation.
Example: A company leases office space with rent that is adjusted each year by the change in the Consumer Price Index (CPI) over the prior 12 months. A fixed 2% annual increase is different: it is a fixed payment, not a variable one (ASC 842-10-30-5(a)).
Performance-Based Payments
Definition: Payments that change based on how well the leased asset performs or how much revenue it generates.
Example: A restaurant agrees to pay 5% of its monthly sales from a leased food truck as part of its lease payment.
Usage-Based Payments
Definition: Payments determined by how much the leased asset is used.
Example: A construction company leases a crane and pays based on the number of hours it's used each month.
Real Estate Taxes and Insurance
Definition: Payments that fluctuate with changes in real estate taxes or insurance premiums.
Example: A retailer's lease payment for a store includes a portion that varies each year, depending on the property tax assessed on the building.
Performance Incentives
Definition: Payments that adjust when certain targets or goals are met, potentially leading to reduced lease payments.
Example: A business leasing solar panels may have lease payments decrease if the panels generate more electricity than a set target.
Market Rate Adjustments
Definition: Payments that reset to the current market rent at a set date. ASC 842 does not name market rent as an index or rate. Grant Thornton, KPMG and EY treat it as one; Deloitte treats it as analogous to one, and PwC takes the same approach for renewal periods the lessee is reasonably certain to exercise (see Sources and further reading below). The payments go into the lease liability at the market rent in effect at commencement.
Example: The lease for a boutique shop includes a clause allowing for rent adjustment to the current market rate at the midpoint of the lease term. On the firms' treatment, the liability includes the later payments at the market rent in effect at commencement; if the actual reset rent differs, the difference is expensed when it arises, unless the liability is remeasured for another reason.
How ASC 842 Treats Variable Lease Payments
Only variable payments that depend on an index or a rate go into the lease liability (in-substance fixed payments are treated as fixed, below) (ASC 842-10-30-5(b)). Every other variable payment stays out and is expensed when the obligation for it is incurred (ASC 842-10-30-6(a)).
Indexed or Rate-Based Payments are initially included in the lease liability and amortization schedule if they impact payments at the start. However, future changes are recorded as they happen and do not alter the amortization schedule unless the liability is remeasured for another reason (ASC 842-10-35-5).
Performance-based and usage-based payments, performance incentives, and real estate taxes and insurance that fluctuate (as in a net lease) are not included in the initial lease liability or amortization schedule (ASC 842-10-30-6(a)). These are recorded in the periods they occur, reflecting the company's financial situation accurately without adjusting the original lease amortization plan.
Two points are worth stating more precisely, because they are where this goes wrong in practice.
The index is fixed at commencement. Under ASC 842-10-30-5, variable payments that depend on an index or a rate go into the lease liability measured using the index or rate as it stands at commencement. You do not forecast where CPI will go. And once set, a later movement in that index does not by itself trigger a remeasurement — ASC 842-10-35-5 reopens the liability when lease payments change for other reasons, and the index catch-up rides along at that point. Between remeasurements, the difference between what you actually pay and what the schedule assumed is simply period expense.
In-substance fixed payments are not variable at all. A payment dressed up as variable but unavoidable in practice is treated as a fixed payment and included in the liability (ASC 842-10-55-31). Two cases: a usage fee with a guaranteed minimum, where the minimum is in-substance fixed and usage above it stays variable, however certain; and a choice between sets of payments where the lessee must make one, where the lower set is in-substance fixed. It is the category most often missed, because it looks variable in the contract and behaves fixed in reality. The full set of what belongs in the measurement is in what makes up the lease liability.
Which Payments Land in the Liability
The short version, if you only take one thing from this page:
Payment type In the lease liability? Fixed payments Yes In-substance fixed payments Yes — treated as fixed Variable, based on an index or rate Yes, at the index in force at commencement Variable, based on usage or performance No — expensed as incurred Real estate taxes and insurance that fluctuate No — expensed as incurred Rent reset to fair market rent Yes, at the market rent in force at commencement (the firms' view; ASC 842 does not name it)
The dividing line is not how much a payment moves; it is whether the payment depends on an index or rate, or is unavoidable in substance (ASC 842-10-30-5(a) and (b)). An index gives you a number to start from, so it goes in. A share of next year's sales does not, so it does not — and it becomes expense in the period the sales happen. Where an index-linked payment sits alongside a floor, look again: that floor may be in-substance fixed.This page covers which payments count and why. The debits and credits for them are on our journal entries page.
Worked Example: Base Rent, a CPI Step and Percentage Rent
Take a five-year operating lease of office space. Base rent is $50,000 a year, paid at the start of each year. The rent for each later year is $50,000 multiplied by the current CPI and divided by the CPI at commencement, which is 250.
The lease also charges 1% of annual sales above $1,000,000, and the tenant pays property taxes under a net lease, $8,000 a year. The incremental borrowing rate is 8%. Initial direct costs are ignored. The example is illustrative, not a template for your lease.
The taxes are the landlord's cost, and the lease has no non-lease components (KPMG, Handbook: Leases, section 4.2.1).
What goes into the lease liability at commencement
The year 1 payment of $50,000 is made at commencement, so it is not part of the liability. ASC 842's own Example 25 treats an upfront first payment the same way (ASC 842-10-55-228). The liability is the present value of the four remaining payments, each measured at the commencement CPI, so each is $50,000. That is $50,000 × 3.3121 = $165,606 at 8%.
The right-of-use asset is the liability plus the $50,000 prepaid rent (ASC 842-20-30-5(b)), or $215,606. The table below shows how each payment is treated, using year 2 as the test year: the CPI is 255 and sales are $1,500,000.
Single lease cost is the straight-line expense for an operating lease.
| Payment | Amount | In the liability at commencement? | Recognized |
|---|---|---|---|
| Year 1 base rent, paid at commencement | $50,000 | No: already paid, so it is prepaid rent in the asset | Within single lease cost |
| Base rent, years 2 to 5 | 4 × $50,000 | Yes: present value $165,606 | Within single lease cost |
| CPI increase in year 2 (255 against 250) | $1,000 | No: the liability uses CPI 250 | Expensed in year 2 as variable lease cost |
| 1% of sales above $1,000,000 | $5,000 | No | Expensed as incurred |
| Property taxes (net lease; the landlord's cost, no non-lease components) | $8,000 | No | Expensed as incurred |
The year 2 rent payable is $51,000: $50,000 plus the $1,000 CPI increase. The liability still assumes $50,000, and the extra $1,000 is not capitalized (ASC 842-10-55-231 shows the same result). In year 2 the liability and the asset still follow the $50,000 schedule; the variable amounts do not change them.
What year 2 costs
The fixed payments total $250,000 over five years, so single lease cost is $50,000 a year on a straight-line basis (ASC 842-20-25-6(a)). Variable lease cost adds $1,000 + $5,000 + $8,000 = $14,000. Total year 2 lease cost is $64,000.
In the quantitative disclosures, ASC 842's illustration splits the cost the same way: the fixed portion is operating lease cost and the index increase is variable lease cost (ASC 842-10-55-231). Here, $50,000 is operating lease cost and $14,000 is variable lease cost.
When percentage rent is expensed
Percentage rent is expensed in the period the obligation is incurred (ASC 842-20-25-5(b) and 25-6(b)). If a sales target triggers the payment and reaching it is probable, the lessee recognizes the cost before the target is met, including in interim periods (ASC 842-20-55-1). It reverses that cost when it becomes probable that the target will not be met (ASC 842-20-55-2).
Payments That Look Variable but Follow Different Rules
Several payments are often misclassified. The most common are these:
- Scheduled rent steps. A fixed 2% increase each year changes only with time, so it is fixed and is part of the liability (ASC 842-10-30-5(a)).
- In-substance fixed payments. A minimum payment, or the lower of two sets of payments the lessee must choose between, is unavoidable and is included (ASC 842-10-55-31).
- Payments that follow a tax rate. KPMG states that a tax rate, such as a property tax mill rate, is not an index or a rate for this purpose. A payment that follows one is variable but is not index-based, so it stays out (KPMG, Handbook: Leases, section 5.4, paragraph 5.4.115).
- Gross-lease taxes and insurance. When these are fixed within the rent, they are part of the consideration in the contract and are allocated to the lease and any non-lease components (KPMG, section 4.2.1).
- Non-lease services. Amounts allocated to non-lease components, such as maintenance, are not lease payments (ASC 842-10-30-6(c)). A lessee may elect, by class of asset, not to separate them; the services are then accounted for as part of the single lease component (ASC 842-10-15-37).
When a variable payment becomes fixed
A variable payment can turn into a fixed one. If a contingency is resolved and payments tied to performance or use become fixed for the rest of the term, the lessee remeasures the lease payments (ASC 842-10-35-4(b)). A change in the index alone does not count as that resolution. See remeasurement and modifications.
Sources and further reading
The paragraph references above are to ASC 842-10 and ASC 842-20. For the firms' own explanations of how variable payments are measured, see Deloitte's Roadmap: Leases, section 6.3 and KPMG's Handbook: Leases. On rent that resets to market, see Grant Thornton's Leases: Navigating the guidance in ASC 842 (section 1.4), PwC's Leases guide, section 3.3 and EY's Lease accounting (section 2.4.2).
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