How to treat percentage-of-sales rentals

The new lease accounting rules (ASC 842) require lessees to capitalize operating leases. The capitalized amount is based on the present value of future rental payments. But are all rental payments capitalized? (hint, the answer is no)

Many restaurants and retailers pay at least some portion of their rents based on a percentage-of-sales. Sales or other performance-based provisions allow the lessee and lessor to share some of the tenant’s business risk. In the wake of pandemic-fueled vacancies, the negotiating power has shifted more towards tenants, and these types of risk-sharing provisions are likely to see a comeback.

So how should percentage-of-sales rents be treated under the new accounting rules? Answer - these are variable rents that should be expensed as incurred. Do not include them in your right of use asset or your lease liability.

Percentage of sales rentals are inherently variable. The FASB specifically excluded variable rents because “variable [lease] payments contingent on future events (for example, performance or use) do not represent a present obligation of the lessee or a right of the lessor and, therefore, do not meet the definition of an asset or a liability.”

The FASB got this part right. Those of us operating within real businesses know that unexpected things happen. When I was the controller for a popular restaurant chain we saw sales at one of our top 5 locations collapse almost overnight when the highway exit ramp was moved a hundred yards beyond our parking lot entrance. That is one example to remind us that you don’t need a pandemic to create uncertainty for businesses.

Even if you believe a contingent rent is highly certain, it is still contingent, and therefore, even “virtually certain” variable rents should be excluded from your capitalized lease payments. (search “Virtually Certain Variable Lease Payments” in Deloitte’s ASC 842 Guide).

So that should be a relief that you do not have to try and estimate your percentage of sales rents. The downside to this is that now you will have a series of new accounting processes and controls surrounding only your base rents. During your reviews, you may find yourself having to back out variable rents from your P&L line item. You might consider coding variable rents to a separate P&L account so the you can clearly see your base and variable expenses separately without having to do any manual calculations.

Stan Bimmerle, CPA, CMA

Founder of Lease Ledger