GAPS in GAAP — Accounting for an operating lease that containS contingent rentals

Fact pattern
A lessee enters into a new lease agreement for retail property with a lessor. The lease agreement has a term of 5 years with no renewal or purchase option. No rents are due for the first year (the ‘rent-free’ period). For years 2 through 5, the rent is set at 18% of the lessee’s annual sales, with no minimum rent payable. The rental rate will not be revised during the lease term, i.e., there are no market resets or other adjustments during the lease term. (The lease agreement actually states that rent is set at 18% of annual sales, and the lessor has agreed to forego the first year’s rent as an incentive to the lessee to enter into the lease.)

Analysis
Paragraph 3 of AS-19 defines contingent rent as that portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (e.g., percentage of sales, amount of usage, price indices, market rates of interest, etc.).

Contingent rents are not included in the definition of minimum lease payments, and hence do not determine whether a lease is a finance lease or operating lease. In the case of an operating lease, with regards to the lessee, paragraph 25(c) requires disclosure of lease payments recognised in the statement of profit or loss for the period, with separate amounts for minimum lease payments and contingent rents. Similarly, with regards to the lessor, paragraph 46(c) requires disclosure of total contingent rents recognised as income in the statement of profit and loss for the period. In other words, in the case of an operating lease, the disclosure requirements both for the lessor and the lessee seem to suggest that the accounting of contingent rent should be in the period to which they relate to.

Further, AS-19 requires straightlining of operating lease income/expense. The relevant paragraphs are reproduced below:

23. Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss on a straightline basis over the lease term, unless another systematic basis is more representative of the time pattern of the user’s benefit.

40. Lease income from operating leases should be recognised in the statement of profit and loss on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which benefit derived from the use of the leased asset is diminished.

View 1 — All payments under the lease are considered contingent rent

The lessee and lessor record the actual rent amounts as expenses and income when they are incurred. In the fact pattern above, the lessee does not record any rent expense in year 1. For years 2 through 5, the lessee recognises rent expense, calculated as 18% of its annual sales, as amounts are incurred (i.e., as sales occur). Consistent with the amounts of rent recorded by the lessee, the lessor does not record any rent income in year 1; for years 2 through 5, the lessor recognises rental income, calculated as 18% of the lessee’s annual sales, as earned.

Reasons for View 1
AS-19 is not explicit in the treatment of contingent elements of operating lease rentals, and whether straightlining would be required.

Paragraph 3 of AS-19 excludes contingent rents from the determination of minimum lease payments for ascertaining rental income in finance leases. Notwithstanding that AS-19 uses different terminology to describe the determination of rental income for finance leases (‘minimum lease payments’) and operating leases (‘lease income’), it is inappropriate to purport that contingent rents cannot be determined for ascertaining total finance lease revenue but that they could be determined for ascertaining total operating lease revenue. Accordingly, lease payments or receipts under operating leases exclude contingent amounts.

A similar issue was also discussed by IFRIC in the context of similar IFRS standard. In its May 2006 meeting, the IFRIC considered a request for clarification of the requirements of IAS 17 with respect to contingent rentals. In particular, the IFRIC was asked to consider whether an estimate of contingent rentals payable/receivable under an operating lease should be included in the total lease payments/lease income to be recognised on a straight-line basis over the lease term. The IFRIC noted that although the standard is unclear on this issue, a consistent application is being adopted; that is, current practice is to exclude contingent rentals from the amount to be recognised on a straight-line basis over the lease term. Accordingly, the IFRIC decided not to add the issue to its agenda.

In practice, contingent rent payments or receipts made in connection with operating leases are recognised in the period in which they are incurred. Since no rent is paid in year 1 of the lease, no expense/income is recorded in the first year. Importantly, no amount of rent is due or receivable based upon sales in year 1 and such rents only accrue upon the future sales after year 1 (i.e., sales in years 2 through 5). In years 2 through 5, the contingent amounts are recognised as expense/income when they are incurred.

View 2 — The rent-free period is taken into consideration to determine lease expense/income

The rent-free period is taken into consideration to determine the rent expense and income for each period. In the fact pattern above, the lessee amortises the rent-free benefit (determined either based on expected sales for year 1 or actual sales for year 1) over the term of the lease on a straight-line basis.

Assume that sales in the first year are approximately Rs.1,945,000. Using the contingent rental rate applicable for years 2 through 5, the incentive related to the rent-free period is calculated as Rs. 350,000 (Rs.1,945,000 x 18%). Since the term of the lease is 5 years, the annualised benefit for the lessee is Rs.70,000. The lessee accrues rent payable of Rs.280,000 (total incentive of Rs.350,000 less amortisation of year 1 benefit of Rs.70,000) in year 1 and recognises that amount as rent expense in year 1. The accrued amount is amortised as a reduction of rental expense (i.e., the amounts due based on the sales in each year) over the remaining years.

Similarly, the lessor recognises lease income and a receivable of Rs.280,000 in year 1 and amortises the accrued amount as a reduction of rental income (i.e., the amounts receivable based on the sales in each year) over the remaining years.

Reasons for View 2
Accounting for the rent-free period in the above manner is consistent with the requirement of paragraph 23 and 40 of AS-19. The rent-free period, is an integral part of the net consideration agreed for the property and it should be recognised on a systematic basis over the term of the lease, even though the rent receipts or payments in the lease are all contingent on performance.

Even though the IFRS Interpretations Committee concluded in its May 2006 meeting that current practice was to exclude contingent amounts from operating lease receipts or payments, it noted that IAS 17 is ‘unclear’ as to whether an estimate of contingent rent under an operating lease should be included in the total lease consideration to be recognised on a straight-line basis over the lease term.

Applying paragraphs 23 and 40 of AS -19, the view reflects the notion that if there was no rent-free period, the parties to the lease agreement would have revised the annual rent payable to be based on a lower percentage of a performance indicator (i.e., in the fact pattern above, less than 18% of sales). The recognition of the rent-free benefit or cost over the lease term results in a pattern of expense or income recognition that is similar to a lease that has no rent-free period.

Accordingly, the benefit of such an incentive should be quantified, and recognised over the lease term on a straight-line basis (unless another systematic basis is more appropriate).

Author’s view

The author favour’s View 1, because it is rather improbable that the intention of the standard was to require straightlining of lease rentals that were contingent in nature. Straightlining requires knowing in advance the rentals for all the years covered by the operating lease arrangement. In an arrangement that is fully contingent, and there are no fixed or minimum or guaranteed payments, straightlining may not be appropriate.

View 2 may be possible under Ind-AS and IFRS. For example, in IFRS for operating leases, paragraph 5 of SIC 15 Operating Leases — Incentives states that: “All incentives for the agreement of a new…. operating lease shall be recognised as an integral part of the net consideration for the use of the leased asset, irrespective of the incentive’s nature or form or the timing of payments.”

The incentives in the paragraph above include a rent-free period, as reflected in paragraph 1 of SIC 15: “In negotiating a new or renewed operating lease, a lessor may provide incentives for the lessee to enter into the agreement. Examples of such incentives are…..

Alternatively, initial periods of the lease term may be agreed to be rent-free or at a reduced rent.”

Under SIC 15, the lessee and the lessor recognise the aggregate benefits of incentives in the following manner: “The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, on a straight-line basis, unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset.” (SIC 15.5).

“The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term, on a straight-line basis, unless another systematic basis is representative of the time pattern over which the benefit of the leased asset is diminished.” (SIC 15.4).

It may be noted that Ind-AS also contains similar requirements.

ICAI may consider addressing this issue both under Indian GAAP and Ind-AS.