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Lease classification

to the lessee’s intended use should be considered. Improvements that are not specialized and for
which it is probable they could be utilized by a subsequent tenant would likely be considered assets of
the lessor. Other factors to consider include whether the improvement increases the fair value of the
underlying asset from the standpoint of the lessor and the economic life of the improvement relative to
the lease term.

If a lessee is required to complete a lessor asset improvement, but the improvement has not been
completed as of the lease commencement date, an estimate of the costs to construct the asset, net of
any funding to be provided by the lessor, should be included in lease payments for purposes of
classification and measurement. Any subsequent difference between the estimated and actual cost of
the improvement should be accounted for as variable lease payments. See LG 3.3.4.3.

See LG 3.3.4.2 for information on lessor reimbursement for leasehold improvements.

3.3.4.2 Lease incentives

As discussed in ASC 842-10-55-30, a lease agreement may include incentives to encourage a lessee to
sign the lease, such as an up-front cash payment to a lessee, payment of lessee costs (such as moving
expenses), or the assumption by a lessor of a lessee’s preexisting lease. When a lessor assumes a
lessee’s preexisting lease with a third party, the lessee and lessor should independently estimate any
loss associated with the assumption as illustrated in ASC 842-10-55-30(b).

Excerpt from ASC 842-10-55-30(b)

For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new
lease with the market rental rate available for similar underlying assets or the market rental rate from
the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the
total remaining costs reduced by the expected benefits from the sublease of use of the assumed
underlying asset.

Like other amounts included in lease payments, lease incentives are included in the calculation of
consideration in the contract, which must be allocated when multiple components exist (e.g., lease and
nonlease components). However, irrespective of the allocation, lease incentives always reduce the
consideration in the contract for a lessee and lessor.

For a lessee, the reduction to fixed lease payments will affect lease classification and the initial
measurement of the right-of-use asset and lease liability. For a lessor, the reduction will affect lease
classification and the measurement of lease income on a straight-line basis (if classified as an
operating lease) or the net investment in the lease (if classified as a sales-type or direct financing
lease).

Reimbursement for leasehold improvements

Lessor reimbursement for some (or all) of the costs a lessee incurs to complete leasehold
improvements is a common example of a lease incentive. These payments may be calculated as a
certain amount per square foot or a fixed amount regardless of the level of improvements undertaken
by a lessee.

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