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Lease classification

Analysis

Since the rents at the beginning of the renewal period will adjust to market rents, the renewal option
does not create an economic incentive for Lessee Corp to exercise its option. Therefore, assuming the
asset is neither unique nor specialized and no other economic incentives exist, Lessee Corp will likely
conclude, at the lease commencement date, that the option is not reasonably certain of exercise.
Accordingly, the lease term would be 10 years.

EXAMPLE 3-3

Lease term – third party is not reasonably certain to exercise a renewal option

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the
“head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a
noncancellable period of 10 years with two 5-year renewal options. Lessee Corp (as sublessor)
determines Sublessee is not reasonably certain to exercise its options to extend the sublease. Lessee
Corp also determines it is not reasonably certain that it will exercise any renewal options in the head
lease.

How should Lessee Corp (as sublessor) determine the term of the head lease?

Analysis

The definition of lease term only requires options controlled by the lessor to be included in the lease
term. Therefore, the term of the head lease would be 10 years because Lessor Corp cannot control
whether Lessee Corp will exercise the extension option and because Lessee Corp concluded it is not
reasonably certain that it will exercise any renewal options in the head lease.

Subsequent to lease commencement, in accordance with the lessor guidance on reassessment, Lessee
Corp (as sublessor) would not reassess whether Sublessee is reasonably certain to renew the sublease.
It would only need to determine the impact when the sublessee actually exercises the renewal option.

EXAMPLE 3-4

Lease term –third party is reasonably certain to exercise a renewal option

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the
“head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a
noncancellable period of 10 years with two 5-year renewal options. At lease commencement, Lessee
Corp (as sublessor) determines Sublessee is reasonably certain to exercise its options to extend the
sublease.

How should Lessee Corp (as sublessor) determine the term of the head lease?

Analysis

The term of the head lease would be 20 years because Lessee Corp (as sublessor) concluded Sublessee
is reasonably certain to exercise its options to extend the sublease, which in turn results in Lessee Corp
similarly concluding the renewal options in the head lease are reasonably certain of exercise.

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