FASB nixed proposal to remeasure liability for variable rent leases

Tessa Author

A proposed amendment for an option to allow remeasurement of the lease liability for the leases with index-based variable rent was dismissed.

Lease accounting is integrated into lease administration, whether you’re prepared for it or not. 

To grow, lease analysts should accept that accounting matters and open themselves to learning how it impacts their scope of work and objectives. 

Here are a few basics you need to know as a well-rounded lease professional.

New Lease Standards Basics

Although the new lease accounting standard, known as Topic 842, was issued in 2016, 2021 is the third year in a mandatory application for public companies. 

In 2016, FASB and IASB issued updated lease accounting standards that provide users of financial statements with better information. The main change is the leases are now an item on the balance sheet, where before, it was just a comment in the notes. 

Questions in the application and rapid change in the economic environment have triggered several amendments to the initial law, and more are in the works. You can find more information on the FASB’s implementation website. 

Accounting for Standard Leases

You typically know how much rent will be during the term and how long the lease will last in the standard lease arrangement.

Of course, we can get into the weeds, but you need to focus on what you know and what’s reasonable certain. 

There are several components you need to know to calculate the balance sheet impact of an operating lease, all except the last one should be in the lease:

- Rental amount to be paid over the lease term

- The amount and frequency of the payments

- Lease Term

- Incremental Borrowing Rate (provided by the treasury)

Using these components, you can calculate the lease liability defined as the present value of the future lease payments. 

Present value is a finance term that measures the value of the future payments today based on the specified interest rate. You can learn more about the time value of money here.

The idea is to place the value of the total future rent payments at lease commencement on the balance sheet as a lease liability, similar to a loan, and a right-of-use asset, like a purchased building or tools. The balance sheet accounts are reduced over time as lease payments are issued to the landlord and should be zero at lease expiration. 

However, significant changes in the economic terms of the lease (e.g., change in space, lease period, or both) will require a remeasurement of the lease liability and asset. 

Income statement accounting is mostly unchanged for operating leases.

Accounting for Index-based Variable Rate Leases

Under the current GAAP rules, only the initial portion of the rental payment is on the balance sheet. The variable part is considered a period expense and recorded on the income statement when incurred.

Therefore, for leases where the rental amount is dependent on indexation, only the initial portion is recorded on the balance sheet, and any increase after that is treated as a rental expense. 

The rules expressly prohibit the lease liability’s remeasurement solely for the changes in the index rate referenced in calculating variable rent.  

Unfortunately for dual reporting companies (those who follow the U.S. and the International standards), this treatment differs from that prescribed by the International Financial Reposting Standards (IRFS). 

Under IFRS 16, Leases, the tenant must remeasure the lease liability in subsequent periods when a change to the lease payments resulting from a shift in a reference index takes effect. 

Proposed Changes and Current Status

In July 2020, the Board agreed to consider an option to permit a practical expedient election that would allow entities to remeasure the lease liability to reflect the change in the index alone. 

The Board issued an exposure draft in the fall of 2020. Nearly 30 practitioners responded with various thoughts and concerns about implementation guidance and timing.

The main objective of the proposed change was to reduce the administrative burden required by dual reporting; however, as proposed, the changes would not have yielded a significant reduction in effort. 

Although there’s no denying that the lease liability balance would be more accurate, the change would have an immaterial impact on the users of financial statements.

After reviewing feedback from the staff, users, and practitioners, the Board decided to dismiss the proposal for practical expedient and remove the issue from the technical agenda. 

During the deliberations, the group agreed that the issue is relevant and should be monitored as private companies implement the standard in the coming years. 

What does that mean for Lease Administration?

There are a few best practices for lease administrators regarding managing variable rate leases that depend on the index. 

Review the rent schedules

For an index-based lease, only the initial fixed portion of base rent is on the balance sheet. In contrast, the amount of the index-based escalation passed to rent expense on the P&L. Therefore, it’s prudent to keep the fixed Base Rent line separate from indexation escalations by assigning it a different account name. 

Mind you data

Besides collecting information about the rental amount and lease term, consider tracking indexation adjustments components and effective dates as part of the lease compliance process. You may not pay the escalated rent before the landlord bills you, but it doesn’t mean you shouldn’t know how much it’s going to be.    

Update lease records timely

You already know that lease data is widely useful throughout the organization; therefore, providing users with the latest available information sets everyone up for success, including you. By proactively monitoring indexation-based leases, you can avoid retroactive payments, which can be a hassle to set up. 

In Conclusion

It’s always a good idea to review your rent schedules to ensure variable rent has been accounted for appropriately. 

And, although the outcome of the last FASB meeting may not have been the one dual-reporters were expecting, it’s not a significant loss for lease administrators and accountants. Yet, unquestionably, one that adds complexity to the administration process, especially if you manage an international portfolio. 

The key to remember is that accounting treatment differs for fixed and variable rate leases under GAAP. And, the treatment of the index-based variable leases remains different between US GAAP and IFRS. 

Finally, be aware there are a couple more amendments to the Leases standard in the works, including the one on lease modifications, yet noting final to report there at this time. 

Categories: : Lease Accounting