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Lease classification

3.3.4.1 Fixed lease payments

Fixed lease payments are payments required under the lease. They can be either a fixed amount paid
at various intervals in a lease (e.g., a five-year equipment lease with annual lease payments of $2,000)
or they can be payments that change over time at known amounts (e.g., lease payments of $2,000 per
month at lease commencement that increase annually by $250 per month).

The exercise price of a purchase option should be included in the calculation of lease payments for
purposes of lease classification and measurement when exercise is reasonably certain. See LG 3.4 for
information on the application of the reasonably certain threshold.

ASC 842-10-30-5 requires lease incentives to be recorded as a reduction of fixed payments when
determining lease payments. See LG 3.3.4.2 for information on lease incentives.

Example 3-7 illustrates how to determine the fixed lease payments.
EXAMPLE 3-7

Lease payments – determining the fixed payments

Lessee Corp and Lessor Corp enter into a 10-year lease of an office building for fixed annual lease
payments of $100,000. Per the terms of the lease agreement, annual fixed lease payments comprise
$85,000 for rent and $15,000 for real estate taxes.

What are the fixed lease payments for purposes of classifying the lease?

Analysis

The fixed lease payments are $100,000. Although real estate taxes are explicitly stated in the lease
contract, they do not represent a separate nonlease component as they do not provide a separate good
or service. The right to use the office building is the only component. The annual lease payments of
$100,000 represent payments related to that single lease component.

See Example 3-9 for information on variable payments for real estate taxes. See LG 2.4 for additional
information on identifying lease and nonlease components in a contract.

Leasehold improvements

Payments made by lessees for improvements to the underlying asset (e.g., upgrades to lighting,
flooring, pantries) should be recorded as prepaid rent and included in fixed lease payments if the
payment relates to an asset of the lessor. Determining whether payments made by a lessee for
improvements to the underlying asset should be accounted for as lease payments to a lessor or as
leasehold improvements of the lessee requires judgment. There is significant diversity in practice and
there are a number of models in use to make the determination. While other models may be
acceptable, we believe the following model closely follows the economics.

Generally, if a lease does not specifically require a lessee to make an improvement, the improvement
should be considered an asset of the lessee. Payments for lessee assets should be excluded from lease
payments when evaluating lease classification and measuring the right-of-use asset and lease liability.
However, if the lease requires the lessee to make an improvement, the uniqueness of the improvement

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