The issue of accounting for contingent rentals was a big part of the recent research brainstorming session on leasing.  I think that academics may have something to offer the FASB and others related to accounting for contingent rentals.  In particular, what can economic/finance theory tell us about the desirability of capitalizing expected contingent rentals?

One of the main concerns is that operating lease accounting understates the company’s debt, which can lead to underestimation of financial leverage.  For that reason, many (most?) commentators want to record a liability for the company’s future mimimum rentals.

The finance theory relating to leverage that I am familiar with (Modigliani and Miller, 1958, Hamada, 1969) addresses how a company with an expected return on its operating activities of, say, 20% can finance its operations with half debt (paying a fixed 9%) and half equity.  The equity holders end up making more than 20% on their investment.  However, the risk to the equity holders per dollar invested is magnified, because they owe 9% on the debt whether business is booming or going down the tubes.

The FASB/IASB leasing proposal suggests that estimated contingent rental be included in the present value of payments that is recorded as a liability.   Consider the typical lease for retail space in which the lessee agrees to pay X% of monthly gross receipts.  In good times, the company owes more and in bad times, the contingent rental can be zero.  This type of payout does not increase equity risk in the same way as fixed-rate debt.  Thus, I doubt if traditional leverage-based arguments for capitalizing minimum rental payments can be easily extended to contingent rentals.  That raises the question – what sort of finance/economic theories would support capitalizing contingent rentals?

Of course, contingent rentals can come in other flavors.  For example, the contingent rent can vary with some macro economic variable like LIBOR interest rates.   If the contingent rental does not vary with the operating risk of the company, then perhaps capitalizing the expected contingent rentals makes more sense.  The challenge to researchers, especially those who are experts at computing cost of capital, is to help us understand how contingent rentals should affect valuation, and then consider what sort of accounting might provide the most useful information to investors.