A lease agreement can have several types of payments including fixed payments, variable payments based on a particular index, or variable payments fixed in substance. A variable payment fixed in substance doesn’t create real variability, and because the lessee can predict the minimum payment amount, the payments lack true variability.
Consider a contract requiring a lease payment based on performance (such as a percentage of sales) or the usage of the underlying asset (such as machine hours or units produced) with a minimum fixed payment amount. Even if there is a high degree of uncertainty in estimates, accounting rules expense the amount over the minimum payment. That amount is not a part of the lease liability.
Example:
Suppose you enter into a lease agreement for the city. Your contract states a monthly payment of 10% of your utility revenue. Because performance determines the payment, it’s theoretically a variable payment. However, the lease also requires a minimum monthly payment of $2,500, regardless of your monthly revenue. You won’t know your exact monthly payment, but you will know it will be at least $2,500 per month.
Variable payments fixed in substance are treated the same way as fixed payments and must be included in the initial measurement of your lease liability or lease receivable. Even if a payment appears to be truly variable, a price floor or minimum amount can make the variable payment fixed in substance.