Lease Classification, Considering Firm Guidance

Facts: On $1/1/20$X$3,$ Investor, Inc. $($Lessee$)$ signed a Lease Agreement with Developer Inc. $($Landlord$)$ to lease Landlords 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 Landlords option, to

extend the contract term for three additional five$-$year terms. No purchase option is present in the contract. Lessees monthly rental

payments are $$40,000$ per month, plus a monthly supplemental rental cost based on Lessees sales $(1\%$ of sales$).$ From experience,

Lessee estimates that $1\%$ of its sales should approximate an additional $$10,000$ per month. As of $1/1/20$X$3,$ 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 EYs most recent Lease accounting guide book.

Your answer to this case should be submitted as an Issues Memo