Lease Classification, Considering Firm Guidance (Issues Memo)

Facts: Tech Startup Inc. ("Lessee") is entering into a contract with Developer Inc. ("Landlord") to rent Landlord's newly constructed office building located at 15 Tech Drive in San Francisco, CA. The lease term is 10 years, and the estimated life of the building is 40 years. Lessee will occupy all 12 floors of the building. At the end of the Lease term, Lessee has the option to purchase the property for $16.25 million. The fair value of the building at that time, expected to be $17 million.

Monthly, Lessee will be required to pay $50,000 to occupy the building, plus a monthly supplemental total cost based on Lessee's sales (1% of sales). From experience, Lessee estimates that 1% of its sales should approximate an additional $20,000 per month. For simplicity, please ignore discounting (use of present value calculations, rates implicit in the lease, etc.) for purposes of this example. There are no residual value guarantees present in this example.

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 he classified as an operating lease or as a capital low?

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.