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Lease classification

How should Lessor Corp classify the lease?

Analysis
Lessor Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and
ASC 842-10-25-3.

Criteria Analysis

Transfer of ownership Ownership of the asset does not transfer to
Lessee Corp by the end of the lease term.
Purchase option which the lessee is reasonably The lease contains an option to purchase the
certain to exercise property for $3,000,000, which is below the
fair value of the real estate asset at lease
commencement and its expected value at the
date of exercise. Options to purchase real estate
at a price below commencement date fair value
are generally considered to be reasonably
certain of exercise since real estate generally
appreciates in value. Thus, a significant
economic incentive to exercise the purchase
option exists.

Lease term is for the major part of the remaining The lease term is 10 years; the five 5-year
economic life of the asset renewal options available to Lessee Corp are
not reasonably certain of exercise (determined
at lease commencement) because they require
rent to be reset to market rates at the time of
exercise.
Therefore, Lessee Corp is utilizing the asset for
25% of the economic life of the asset (10-year
lease / 40-year economic life), which is not
deemed to be a major part.

Sum of present value of lease payments and any The lease payments net of the incentive Lessor
residual value guarantee by the lessee amounts to Corp pays Lessee Corp are $5,531,940 (see
substantially all of the fair value of the underlying below for a schedule of payments). The present
asset value of the lease payments (discounted at the
rate Lessor Corp charges in the lease of
approximately 9.04%) is $3,737,510.
Because the purchase option is reasonably
certain of being exercised, it should be included
as a lease payment at the end of the lease term.
Using the rate Lessor Corp charges Lessee Corp
(approximately 9.04%), the present value of the
purchase option is $1,262,490.
Therefore, the present value of the lease
payments equals 100% of the fair value of the
leased asset (($3,737,510 + $1,262,490) /
$5,000,000).

Specialized nature Although the property is in a specific location, it
could be used by another party without major
modifications.

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