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Lease classification

For example, consider a 10-year lease that provides for an increase in rent beginning in year six, which
is calculated as five times the change in the CPI over the prior five-year period, with any increase in
rent capped at 5%. It is reasonable to conclude a 5% rent increase commencing in the sixth year of the
lease term is unavoidable; therefore, the 5% rent increase should be included in lease payments by the
lessee and lessor.

There is often some portion of a contingent lease payment that is highly probable of being paid (e.g.,
some level of payment will generally be required in a lease that provides for percentage rent based on
sales derived from the output of the leased asset). However, because the payment provision creates
genuine variability, the total payment should be considered a variable lease payment and excluded
from the lease payments.

A lease may include protective rights that impact the amount of lease payments due. Protective rights
are generally rights that protect a lessee from the requirement to make payments during periods when
the underlying asset is not available for use. For example, lease payments due may be substantially
reduced during periods of excessive downtime for maintenance or inspection, when a lessor defaults
on its obligations, or when weather conditions render the underlying asset unavailable to the lessee.
The effect of protective rights should be disregarded when determining lease payments for purposes of
classification and measurement.

Example 3-11, Example 3-12, Example 3-13, and Example 3-14 illustrate how to determine if variable
lease payments are considered in substance fixed lease payments.
EXAMPLE 3-11

Lease payments – payments tied to sales

Lessee Corp enters into a 10-year lease for retail office space with Lessor Corp. The annual lease
payments are $20,000 plus an amount equal to 5% of Lessee Corp’s sales. Lessee Corp’s annual sales
have exceeded $200,000 since it began operations and are projected to grow at a rate of 10% annually.

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

Analysis

The lease payments for purposes of classifying the lease are the fixed annual lease payments of
$20,000.

Although there is a high probability of some variable lease payments being made in light of Lessee
Corp’s historical results and projections, the variable lease payments are based exclusively on, and
vary with, the performance of the underlying asset and do not represent in substance fixed lease
payments.

EXAMPLE 3-12

Lease payments – in substance fixed lease payments

Lessee Corp enters into a five-year lease for office space with Lessor Corp. The initial base rent is
$10,000 per month. Rents increase by the greater of 1% of Lessee Corp’s generated sales or 3% of the
previous rental rate on each anniversary of the lease commencement date.

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