12.2 Classification of a Sublease

ASC 842-10

25-6 When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset.

In a manner consistent with that in other leases, the lessee/intermediate lessor should classify the sublease on the basis of the criteria in ASC 842-10-25-1 through 25-3A (see Section 9.2). In applying these criteria, the lessee/intermediate lessor should look through the sublease to the underlying asset (i.e., the lessee/intermediate lessor should not classify the sublease by reference to the ROU asset that results from the head lease). Paragraph BC116 of ASU 2016-02 explains the FASB’s rationale for using the underlying asset in this assessment:

The Board decided that when classifying a sublease, an entity (that is, the intermediate lessor) should evaluate the sublease with reference to the underlying asset rather than the right-of-use asset arising from the head lease. The lessee in a sublease may not know the terms and conditions of the head lease, and, accordingly, referring to the item of property, plant, and equipment that is subject to the lease should be easier to apply than referring to the right-of-use asset arising from the head lease. In addition, the Board noted that it may be difficult to understand and explain why a lessor would account for similar leases differently. That could occur if an entity were required to refer to the right-of-use asset when classifying a sublease. For example, if subleases were classified with reference to the right-of-use asset, a lessor that leases two similar assets on similar terms for five years could account for those leases differently if the lessor owned one of the two assets and leased the other.

Bridging the GAAP

Classification of Sublease Different Under IFRS 16

Unlike ASC 842, IFRS 16 requires the lessee/intermediate lessor to determine the classification of the sublease with reference to the ROU asset arising from the head lease rather than to the underlying asset. Therefore, because the lease term of the ROU asset is typically less than the economic life of the underlying asset, we generally believe that the lessee/intermediate lessor may classify more subleases as a finance lease1 under IFRS Accounting Standards than as a sales-type lease under U.S. GAAP.

Example 12-1

Company A, a lessee, enters into a building lease with a third party. The term of the lease is 30 years, and the estimated economic life of the building is 40 years. Immediately after entering into the head lease arrangement, A subleases the building to SubCo. The term of the sublease is 25 years. As an accounting policy, A uses a 75 percent threshold when evaluating the “major part” of the economic life of the underlying asset in accordance with the classification criterion in ASC 842-10-25-2(c).

ASC 842 Evaluation

From the head lease perspective, A (as the head lessee) will classify the lease as a finance lease since the lease term is for a “major part” of the remaining economic life of the underlying asset (i.e., A is leasing the building for 30 years — or 75 percent — of the 40-year economic life). From the sublease perspective, A (as the intermediate lessor) will classify the sublease as an operating lease since the lease term does not represent a “major part” of the remaining economic life of the underlying asset (i.e., a sublease with a lease term of 25 years, when evaluated against the 40-year economic life of the underlying asset, does not meet the “major part” criterion). Remember that in evaluating the sublease classification under ASC 842, an entity considers the remaining economic life of the underlying asset (i.e., the building) that is subject to the lease.

IFRS 16 Evaluation

From the head lease perspective, A (as the head lessee) will account for the lease in a manner consistent with finance lease accounting under U.S. GAAP, since classification is not relevant for lessees under IFRS 16. From the sublease perspective, A (as the intermediate lessor) will classify the sublease as a finance lease since the lease term represents a “major part” of the remaining economic life of the ROU asset that was recorded as a result of the head lease (i.e., a sublease with a lease term of 25 years, when evaluated against the 30-year term of the ROU asset in the head lease, represents 83.3 percent of the overall term and meets the “major part” indicator). Remember that when evaluating the sublease classification under IFRS 16, an entity considers the term of the ROU asset that is subject to the lease (versus the economic life of the underlying asset itself).

12.2.1 Impact of Sublease Renewals on Head Lease Term

An entity must determine the lease term to perform lease classification and measurement. ASC 842-10-30-1 requires an entity to determine the lease term as follows:

An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following:

Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. [Emphasis added]

ASC 842-10-55-26 indicates that an entity should consider all economic factors in determining whether it is reasonably certain that a renewal option will be exercised. Further, an entity must consider a sublease in determining the lease term of the head lease.

At the FASB’s November 30, 2016, meeting, the Board indicated that the head lessee must determine whether the sublessee is reasonably certain to exercise its renewal options because the head lessee must determine the lease term for the head lease. If the exercise of the sublease renewal options by the sublessee is reasonably certain, the renewal of the head lease is also reasonably certain. However, if the head lessee determines that it is not reasonably certain that the sublessee will exercise its renewal options, the head lessee should not include additional renewal options that extend past the sublessee’s noncancelable term in the absence of other economic factors. That is, the sublease is one of many factors for an entity to consider in determining the lease term of the head lease.

Note that the head lessee would reassess its lease term in accordance with ASC 842-10-55-28 upon the occurrence of certain events, including “[s]ubleasing the underlying asset for a period beyond the exercise date of the option.” Therefore, upon notice by the sublessee that it is renewing or extending its sublease, the head lessee must reassess the lease term of the head lease, including whether the exercise of any remaining renewal options is reasonably certain.

Example 12-2

Under a lease agreement (the “head lease”), Company A leases equipment from Company B. Under another lease agreement (the “sublease”), A immediately leases the equipment to Company C. The noncancelable lease period of the head lease is 10 years, with two 5-year renewals at A’s option for a fixed amount. The sublease has a mirrored 10-year noncancelable period, with two 5-year renewals at C’s option. If C exercises its renewal option on the sublease, A will be forced to renew the head lease.

If it is not reasonably certain that C will exercise its renewal options, A could determine, in the absence of other contract-, asset-, entity-, or market-based factors, that the lease term of the head lease is limited to 10 years (i.e., the noncancelable period). If and when C renews its sublease, A must reassess the head lease term by including the first 5-year renewal and determining whether C’s exercise of the second 5-year renewal option is reasonably certain.

Footnotes

Unlike a lessor applying ASC 842, which can classify a lease as an operating, direct financing, or sales-type lease, a lessor applying IFRS 16 can classify a lease as either an operating or finance lease. A finance lease under IFRS 16 is classified in the same manner as a sales-type lease under ASC 842.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.