IASB’s International Accounting Standard IAS 17 defines contingent rent as follows:
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (eg percentage of future sales, amount of future use, future price indices, future market rates of interest).
US-based FASB’s FAS 29 defines contingent rent as following:
The increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors (other than the passage of time) on which lease payments are based…
In simple words contingent rent is such amount that is paid as part of lease payments but is not fixed or agreed in advance at the inception of lease rather the amount to be paid is dependent on some future event. However, it is not an interest payment as it is not connected with the passage of time therefore time value of money is not under consideration while discussing contingent rent. Contingent rentals are mostly connected with the increase or decrease in future sales by the lessee or increase or decrease in the use of asset or inflation or deflation. In other words contingent rentals are rentals linked to an inflation index or consumer price index, rentals based on the sales the lessee achieves from the leased premises, and usage based rentals (for example, rentals based on the miles driven in a leased car or the hours for which the leased machinery has been used).
Under both the accounting frameworks the contingent rent or rentals are defined in almost the same way.
Types of contingent rental agreements
Although the use of contingent rent in lease agreements is not so common in equipment leasing but it has been observed that contingent rentals are mostly used in estate leasing. Following are the three major types of contingent rentals arrangements in leasing contracts. Lease agreements can have either one type or combination of the three types of contingent rental arrangements.
- Contingent rentals based on price changes or inflation index
- Contingent rentals based on lessee’s financial or operating performance
- Contingent rentals based on lessee’s use of leased asset
Contingent rentals based on price changes or inflation index
This is the most commonly found arrangement in all three types. In this arrangement lease rentals are adjusted at specified dates according to the changes in price, indexes such as consumer price index, inflation index, LIBOR or any other suitable variable
The advantage for lessee for having such arrangement is that the rentals will increase only when inflation will rise and if inflation is going to increase so does the prices therefore lessee get the benefit of having a balanced match of outflows in the form of rentals and inflows in the form of sales both of which are linked with the same variable i.e. inflation.
On other hand lessor is also happy of such arrangement as his rentals are “inflation free” and the rising prices will not hurt the economic or real value of his income as with the increases inflation will result in increased rentals.
Contingent rentals based on lessee’s financial or operating performance
In this arrangement rentals are based on benefits derived by the lessee out of leased asset. For example fixed amount of minimum rentals is decided and in addition to that percentage of sales made by the lessee will be paid to lessor as part of the rentals.
This is advantageous to lessee as they can get assets on lease under such agreement if their business is booming and also they can bargain for lower fixed portion of rentals where contingent rent is based on inflows which is usually not a pain to agree on.
For lessor’s this arrangement is fruitful as they can bargain for lower fixed rentals with higher contingent rentals based on the financial and operating performance of the lessee and thus have more logical sight of their vested interest with lessee and the risk attached to it.
Contingent rentals based on lessee’s use of leased asset
This kind of contingent rent arrangement connects the lease rentals with the use of the asset. Most often a fixed amount of rentals is agreed with the conditional rentals for use of the asset above the certain limit. For example a machine leased out for Rs. 10,000 a year with a contingent rent of Rs. 50 for every additional hours used above 5,000 hours.
Such arrangement is good for lessee where use of the asset is seasonal based and thus cannot estimate the usage rate in advance. Therefore, it provides cushion for uncertain increase or decrease in demand. More of a just-in-time strategy.
For lessor’s it is an obvious choice if they want to save the asset’s running life and thus residual value as they are getting equal benefits for any usage above the agreed limit where the charges for excess use is often compensated at higher rate of rentals.
Accounting treatment for contingent rent
Under currently applicable IASB’s accounting standard the contingent rent are excluded from minimum lease payments and are accounted as expense/income in the period in which they are incurred/earned. There are no particular instructions regarding determination and measurement of contingent rent and definition alone is being used for accounting purposes.
Under FASB’s accounting standards the contingent rent is accounted for in two ways. Under FASB contingent rent is either connected with the use of the asset or consumer price index CPI or rate i.e. LIBOR
Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety.
However, lease payments that depend on an existing index or rate, such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at the inception of the lease; any
increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable.
So we observe that even accounting treatment of contingent rent is also almost the same.
But since IASB and FASB is involved in producing a unified and global accounting framework, therefore, things are changing. And one of the most discussed standards after Financial Instruments have been the standard on Leases. By looking at the exposure draft that is expected to be finalized soon gives an impression that the accounting for leases is going to be a complex task. Also IASB and FASB has decided to re-expose the proposed standard for more commentary by the stakeholders around the world. After which a revised exposure draft will be released which will lead to another fresh IFRS ready to replace old IAS 17.