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Lease classification

To determine whether a payment from the lessor to the lessee represents a lease incentive, a reporting
entity must determine whether it represents a lessee or a lessor asset. See LG 3.3.4.1 for additional
information about making that determination. If an improvement represents a lessee asset, the lessor
payment is a lease incentive that should be recorded as a reduction to fixed lease payments. On the
other hand, when a lessee pays for an improvement that is a lessor asset, the expenditure is prepaid
rent rather than a lease incentive; the reimbursement is a reduction to prepaid rent. If a lessee was not
fully reimbursed, the difference between the costs incurred and the reimbursements received would be
included in lease payments.

If a lessor agrees to pay a fixed or formula-based amount to the lessee once the lessee provides
evidence of the expenditures and the contract does not specify the nature of the improvements to be
completed, it is reasonable to conclude that the improvements represent lessee assets. However, if the
amount a lessee will receive is based on the actual costs incurred on improvements that are specified
in the contract, judgment will be required to determine whether the improvements represent lessee or
lessor assets.

When lessor reimbursement for lessee assets (i.e., a lease incentive) occurs subsequent to lease
commencement, the lessee and lessor must determine whether the lease incentive is considered fixed
or variable. If the incentive is subject to a cap and it is reasonably certain the lessee will use some or all
of the amount available for reimbursement by the lessor, we believe the portion of the incentive that is
reasonably certain of use should be treated as an in substance fixed lease payment (i.e., reduction to
lease payments). A leasehold improvement allowance that is negotiated between a lessee and lessor
creates an economic incentive for the lessee to use the full amount of the allowance. Therefore,
negotiated lease incentives are generally considered reasonably certain of use because a lessee is
economically incentivized to use the entire incentive that it negotiated.

For lessees, at lease commencement, if an allowance for lessee assets represents an in substance fixed
lease payment, we believe a lessee should estimate the timing and amount of the payments not yet
received and include them in lease payments when classifying the lease and measuring the lease
liability, which in turn would get reflected in the right-0f-use asset.

Similarly, a lessor should estimate the timing and amount of the payments not yet paid when
classifying the lease and measuring the net investment in the lease if classified as a sales-type or direct
finance lease. If classified as an operating lease, although there is no impact to any amounts recorded
at lease commencement, the reduction to lease payments is included in the calculation of lease income
that will be recorded on a straight-line basis over the lease term.

See LG 5.3.2 for information on the subsequent accounting for estimated lease incentives.

If an incentive is determined to be variable at lease commencement, we believe both a lessee and
lessor should account for the lease incentive as a period item when the contingency is resolved.

3.3.4.3 Variable lease payments

Variable lease payments, or contingent payments, are defined in the ASC 842 Glossary and further
discussed in the Basis for Conclusions in ASU 2016-02.

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