12.3 Accounting for a Sublease by the Lessee/Intermediate Lessor

A lessee/intermediate lessor should generally account for the head lease and sublease as separate contracts. Paragraph BC115 of ASU 2016-02 summarizes the rationale for accounting for the head lease and sublease separately:

In addition, the Board decided that an entity should account for a head lease and a sublease as two separate contracts unless those contracts meet the contract combinations guidance. Even if entered into at close to the same date, each contract is generally negotiated separately, with the counterparty to the sublease being a different entity from the counterparty to the head lease. Because of this, the obligations that arise from the head lease for the lessee are generally not extinguished by the terms and conditions of the sublease. Therefore, it is appropriate to account for a head lease and sublease separately, and the head lease right-of-use asset is not considered to be held for sale.

A lessee/intermediate lessor’s accounting depends on whether the lessee/intermediate lessor is relieved of its primary obligation under the head lease as a result of the sublease.

12.3.1 Lessee/Intermediate Lessor Is Not Relieved of Its Primary Obligation Under the Head Lease

ASC 842-20

35-14 If the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original lease, the original lessee (as sublessor) shall continue to account for the original lease in one of the following ways:

If the sublease is classified as an operating lease, the original lessee shall continue to account for the original lease as it did before commencement of the sublease. If the lease cost for the term of the sublease exceeds the anticipated sublease income for that same period, the original lessee shall treat that circumstance as an indicator that the carrying amount of the right-of-use asset associated with the original lease may not be recoverable in accordance with paragraph 360-10-35-21.
If the original lease is classified as a finance lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph 842-30-40-1 and continue to account for the original lease liability as it did before commencement of the sublease. The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph 842-30-35-3.
If the original lease is classified as an operating lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph 842-30-40-1 and, from the sublease commencement date, account for the original lease liability in accordance with paragraphs 842-20-35-1 through 35-2. The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph 842-30-35-3.

35-15 The original lessee (as sublessor) in a sublease shall use the rate implicit in the lease to determine the classification of the sublease and to measure the net investment in the sublease if the sublease is classified as a sales-type or a direct financing lease unless that rate cannot be readily determined. If the rate implicit in the lease cannot be readily determined, the original lessee may use the discount rate for the lease established for the original (or head) lease.

ASC 842-20-35-14 indicates that if the lessee/intermediate lessor is not relieved of its primary obligation under the head lease, its accounting for the lease depends on the classification of both the sublease and the head lease, as depicted in the decision tree below.

Example 12-3

Accounting for a Lease Assignment

Entity B has opted to exit a particular retail location and will assign the rights and obligations of the existing lease arrangement (the “original lease”) to the new tenant (the “sublessee”) through an agreement with the sublessee (the “lease assignment”).

The lease assignment is a contract between B and the sublessee (i.e., the lessor is not a party to the lease assignment). There is no alteration or termination to the original lease that takes place at the time of the lease assignment. Therefore, the terms in the original lease are in full effect notwithstanding execution of the lease assignment. In addition, the terms in the original lease do not state that B’s obligations would change if B enters into a lease assignment with a sublessee.

From an operational perspective, once the original lease has been assigned to the sublessee, B no longer has use of, or operational oversight over, the underlying property subject to the original lease. The sublessee and head lessor will transact directly with each other regarding lease payments and operational oversight of the leased property, and B is not involved in the management of the leased property or in the relationship between the head lessor and the sublessee.

It would not be appropriate for B to account for the lease assignment as a lease termination because B has not legally been released as the primary obligor for the original lease. Rather, the lease assignment should be accounted for as a sublease in accordance with ASC 842-20-35-14 and 35-15. In accordance with ASC 842-20-35-14 and as discussed above, B’s accounting will depend on the classification of both the original lease and the lease assignment (i.e., the sublease).

Connecting the Dots

Lease Assignment Contract Involving Original Lessor

Certain lease assignment contracts are structured as a three-party agreement between the original lessor, the lessee/intermediate lessor, and the sublessee, since the original head lease requires the approval of the original lessor before the lease assignment takes effect. The terms and conditions of this type of assignment contract should be carefully evaluated to determine whether the lessee/intermediate lessor is relieved of its primary obligation under the head lease. In many cases, even though the lessor is a party to the assignment contract, there are no changes to the head lease that would relieve the lessee/intermediate lessor of its primary obligation under the lease. An entity should use judgment in evaluating the terms and conditions of the assignment contract and, in some cases, may need to consult its legal counsel.

12.3.2 Lessee/Intermediate Lessor Is Relieved of Its Primary Obligation Under the Head Lease

If the nature of the sublease is such that the lessee/intermediate lessor is legally relieved of its primary obligation under the head lease, the transaction would be considered a termination of the head lease. As a result, the lessee/intermediate lessor would derecognize the ROU asset and lease liability arising from the head lease and would recognize any difference in profit or loss. If the lessee/intermediate lessor remains secondarily liable under the head lease, then it is a guarantor in accordance with ASC 405-20-40-2 and its guarantee is accounted for in accordance with ASC 460.

See Section 8.7.4 for additional discussion about when the lessee/intermediate lessor is relieved of its primary obligation under the head lease.

12.3.3 Classifying an ROU Asset as Held for Sale

As with other PP&E, ROU assets for both operating leases and finance leases are subject to the requirements in ASC 360, including the “held for sale” requirements. In a manner consistent with paragraph BC115 of ASU 2016-02, we generally believe that when a head lease and sublease exist, the head lease ROU asset is not considered held for sale. However, we think that a lessee should classify an ROU asset as held for sale in certain circumstances.

An ROU asset would be considered held for sale when (1) the lease is part of a disposal group for which it is expected that the purchaser will assume the lease as part of the purchase of the group or (2) the entity has initiated a “plan” under which it is identifying a third party to assume (acquire) the related lease so that the entity can be relieved of being the primary obligor under the lease. An ROU asset is not considered held for sale when the entity intends to sublease the underlying property or when the entity remains the primary obligor under the lease.

In addition, since an ROU asset is considered part of a long-lived asset (or disposal group), when a long-lived asset (or disposal group) is characterized as held for sale, the amortization of the ROU asset should cease in accordance with ASC 360-10-35-43, which states:

A long-lived asset (disposal group) classified as held for sale shall be measured at the lower of its carrying amount or fair value less cost to sell. If the asset (disposal group) is newly acquired, the carrying amount of the asset (disposal group) shall be established based on its fair value less cost to sell at the acquisition date. A long-lived asset shall not be depreciated (amortized) while it is classified as held for sale. Interest and other expenses attributable to the liabilities of a disposal group classified as held for sale shall continue to be accrued.

If an entity subsequently changes its plans to dispose of the long-lived asset (or disposal group), the asset would be reclassified from “held for sale” back to “held and used” in accordance with ASC 360-10-45-6. Accordingly, ASC 360-10-35-44 requires the entity to adjust the carrying amount of the long-lived asset that is reclassified as “held and used” to the lower of (1) the asset’s fair value as of the date of the decision not to sell or (2) the asset’s carrying amount before it was classified as held for sale, adjusted for any amortization that would have been recorded while the asset was classified as held for sale.

See Section 8.4.4.4.1 for more information about the amortization considerations related to ROU assets that are classified as held for sale.

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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.