Store leases, renewals and variable rent

Almost every store premise in Saudi retail - mall units, street stores, kiosks, and warehouses - is leased rather than owned, making IFRS 16 one of the most balance-sheet-transformative standards for the sector: operating leases that were once off-balance-sheet footnote disclosures now generate a right-of-use asset and a lease liability at commencement for nearly every store. Getting the lease term wrong (particularly the assessment of renewal options as 'reasonably certain') or misclassifying variable, turnover-based rent can materially misstate total assets, total liabilities, EBITDA (since lease expense shifts from a single operating line to depreciation and interest), and key retail metrics such as occupancy cost ratios. Because Saudi mall leases commonly combine a fixed minimum rent with a percentage-of-sales turnover component, correctly separating the two is a recurring and material judgment area.

Is renewal reasonably certain given the store's performance history and the amount of unrecovered fit-out investment? Does the lease include turnover/percentage rent, and is any portion index-linked (in-substance fixed) versus purely volume-based (variable, excluded from the lease liability)? Are there lease incentives, rent-free periods, or landlord contributions that should reduce the initial right-of-use asset?

1. At commencement, identify the lease term: the non-cancellable period plus any renewal option periods the retailer is reasonably certain to exercise (and any termination option periods it is reasonably certain not to exercise), considering economic incentives such as the cost/disruption of relocating a fitted-out store, sunk fit-out costs, and store performance.
2. Recognize a lease liability at commencement measured at the present value of fixed lease payments (including in-substance fixed payments and any minimum guaranteed turnover rent) not yet paid, discounted using the rate implicit in the lease or, if not readily determinable, the retailer's incremental borrowing rate.
3. Recognize a right-of-use asset at commencement, initially measured at the amount of the lease liability, plus any lease payments made at or before commencement, initial direct costs, and an estimate of dismantling/restoration costs, less any lease incentives received (e.g., a rent-free fit-out period or a cash contribution from the landlord).
4. Exclude variable lease payments that depend on an index, rate, or on sales performance (turnover rent above the fixed minimum) from the initial measurement of the lease liability; these are recognized as an expense in the period incurred.
5. Subsequently measure the lease liability using the effective interest method (unwinding the discount as interest expense) and reduce it for lease payments made; depreciate the right-of-use asset, typically on a straight-line basis over the shorter of the lease term and the asset's useful life.
6. Reassess the lease term (and remeasure the lease liability and right-of-use asset) on a significant change in circumstances affecting whether renewal is reasonably certain, such as a decision to refit the store or a change in store profitability.

Use an appropriate incremental borrowing rate reflecting the retailer's credit standing, the currency, the lease term, and the economic environment of the specific market (rates can differ meaningfully between a prime Riyadh mall lease and a secondary-city street lease). Measure the lease liability initially at the present value of the fixed minimum payments over the full lease term (including reasonably certain renewal periods), and subsequently amortize using the effective interest method, splitting each cash payment between interest expense and principal reduction. Measure the right-of-use asset at cost less accumulated depreciation and any impairment, testing for impairment when a store underperforms or closure is being considered. Turnover/percentage rent above the fixed minimum is measured and expensed as incurred, based on actual sales achieved, and is not included in the discounted lease liability. On a lease modification (e.g., a mid-term renegotiation of the minimum rent or an early renewal), remeasure the lease liability using a revised discount rate and adjust the right-of-use asset.

Present right-of-use assets either as a separate line item on the statement of financial position or disclosed separately in the notes with the class of underlying asset they relate to; present lease liabilities separately from other financial liabilities, split between current and non-current; present interest expense on lease liabilities within finance costs, separate from depreciation of right-of-use assets within operating expenses; disclose a maturity analysis of lease liabilities; disclose the amount of variable lease payments (turnover rent) expensed during the period, separate from fixed payments; disclose significant judgments in determining the lease term, including renewal and termination options; disclose the total cash outflow for leases during the period; disclose additions to right-of-use assets during the period

• Including turnover/percentage rent above the fixed minimum in the initial measurement of the lease liability instead of expensing it as incurred
• failing to include reasonably certain renewal option periods in the lease term, understating the right-of-use asset and lease liability
• conversely, including renewal periods that are not genuinely reasonably certain, overstating the balance sheet
• using a single company-wide incremental borrowing rate for stores in very different cities or lease durations instead of tailoring the rate
• failing to reassess the lease term when circumstances change (e.g., a major store refit signaling renewal intent, or a loss-making store where closure at first break option is likely)
• netting lease incentives (fit-out contributions, rent-free periods) incorrectly against expense rather than reducing the right-of-use asset at commencement
• forgetting to split each lease payment between interest expense and principal repayment in the cash flow statement and income statement