5.8 Lease Classification, Considering Firm Guidance (Issues Memo)

Facts:On 1/1/20X1, Investor, Inc. ("Lessee") signed a Lease Agreement with Developer Inc. ("Landlord") to lease Landlord's newly constructed hotel located at 15 Main St. in San Francisco, CA.The lease term is 20 years, and the estimated life of the building is 40 years.Lessee will occupy all 4 floors of the building.The lease includes renewal options, exercisable at the Landlord's option, to extend the contract term for three additional five-year terms.No purchase option is present in the contract.Lessee's monthly rental payments are $40,000 per month, plus a monthly supplemental rental cost based on Lessee's sales (1% of sales).From experience, Lessee estimates that 1% of its sales should approximate an additional $10,000 per month.As of 1/1/20X1, the appraised value of the building is $15 million.For simplicity, please ignore discounting in this example (use of present value calculations, rates implicit in the lease, etc.).There are no residual value guarantees present.

Required:You are a corporate accountant for Lessee and have been asked to prepare an accounting issues memo to address the following issue:Should the lease arrangement be classified as an operating lease or as a finance lease?

Assume that this arrangement is within the scope of lease accounting guidance.As needed to clarify areas of judgment, support your response with guidance from both the Codification and from EY's most recent Lease accounting guide book.

Please include the Codifications.