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Lease classification

EXAMPLE 3-10

Lease payments – variable lease payments tied to fair market value

Lessee Corp enters into a five-year noncancellable office lease with Lessor Corp. The lease contains a
5-year renewal option that Lessee Corp is reasonably certain to exercise. The lease payments are fixed
at $600k annually for each of the first five years. The annual lease payments for the renewal option
will be set at the beginning of the renewal period based upon the fair market rent at the beginning of
the renewal period.

Should the lease liability include amounts related to the renewal period even though the amount of the
annual lease payments for that period is unknown at the lease commencement date?

Analysis

Yes. Similar to variable lease payments that depend on an index or rate, lease payments during the
renewal period should be included in lease payments when classifying and measuring the lease at lease
commencement. The renewal period rents should be based on the market rental rate at lease
commencement (i.e., $600k per year), not the estimated market rental rate at the beginning of the
renewal period.

In substance fixed lease payments

Variable lease payments that are considered in substance fixed lease payments should be included in
the calculation of lease payments for classification and measurement. ASC 842-10-55-31 provides
guidance on in substance fixed lease payments.

Excerpt from ASC 842-10-55-31
In substance fixed payments are payments that may, in form, appear to contain variability but are, in
effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any
of the following:

a. Payments that do not create genuine variability (such as those that result from clauses that do not
have economic substance)

b. The lower of the payments to be made when a lessee has a choice about which set of payments it
makes, although it must make at least one set of payments.

Variable lease payments based on performance or use are excluded from the calculation of lease
payments for classification and measurement. This is true even if there is a high probability of some
payment for usage during the lease term. Accordingly, a reporting entity would not include payments
that vary solely on the basis of future use or performance in lease payments, regardless of the
probability of occurrence (except in cases where the arrangement contains a guaranteed minimum
payment or penalty that effectively amounts to a floor for lease payments).

Some lease payments are contingent in form, but are in effect, unavoidable; for example, payments
due to clauses that lack economic substance or that provide a choice of payment type, but no ability to
avoid a payment.

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