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Lease classification

Question 3-7

Is a lease with a fiscal funding clause (a clause included in some leases with federal, state, and local
government that gives the lessee the right to cancel if funds are not appropriated in future years)
considered noncancellable?

PwC response
Generally, yes. A fiscal funding clause should be evaluated to determine whether it is more than
remote that a lessee will exercise the clause. If it is determined that a lessee’s exercise of a fiscal
funding clause is more than remote, only the periods for which exercise is remote should be included
in the lease term. In evaluating these provisions, the factors to be considered may include (1) a lessor’s
experience relative to other similar leases with the same lessee and/or with similar lessees and
governmental agencies, (2) technological obsolescence, and (3) whether the leased asset is essential to
continued normal operation of the governmental unit.

Example 3-1, Example 3-2, Example 3-3, and Example 3-4 illustrate the effect of renewal options on
the lease term.

EXAMPLE 3-1
Lease term – ground lease with a renewal option

Lessee Corp enters into a 15-year ground lease agreement. The lease grants Lessee Corp an option to
renew the lease for an additional 15 years. The ground rents adjust to current market rates for
equivalent unimproved land upon exercise of the renewal option.

Lessee Corp plans to construct a building on the leased land. The cost of the building is significant and
its estimated life is 30 years.

What is the lease term?

Analysis

The lease term is 30 years. The loss of the building after year 15 as a result of non-renewal of the
ground lease provides Lessee Corp a significant incentive to renew the ground lease for another 15
years.

EXAMPLE 3-2

Lease term – building lease with a renewal option

Lessee Corp enters into an agreement to lease an office building for 10 years. The lease grants Lessee
Corp the option to renew the lease for an additional 10 years. The rental costs adjust to current market
rents for equivalent office space upon exercise of the renewal option.

What is the lease term?

3-13