Chapter 12 — Sublease Accounting
Chapter 12 — Sublease Accounting
12.1 Overview
ASC 842-10 — Glossary
Sublease
A transaction in which an underlying asset
is re-leased by the lessee (or intermediate lessor) to a
third party (the sublessee) and the original (or head) lease
between the lessor and the lessee remains in effect.
For information on subleases that are part of a sale-and-leaseback transaction, see Section 10.2.3.3.
For information on required disclosures for sublease transactions, see Section 15.2.4.5.
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 842-10-25-2 (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 sales-type or direct financing under IFRS
Accounting Standards than 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 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 asset- 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 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.
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).
12.3.2 Lessee/Intermediate Lessor Is Relieved of Its Primary Obligation Under the Head Lease
In a manner consistent with ASC 840-10-40-2, 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.
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 or (2) the asset’s carrying amount before it was classified as held
for sale, adjusted for any depreciation that would have been recorded while the
asset was classified as held for sale.
See Section 8.4.4.3.1 for
more information about the amortization considerations related to ROU assets
that are classified as held for sale.
12.4 Lessor’s Accounting for a Sublease
ASC 842-30
35-7 If the original lessee enters into a sublease or the original lease agreement is sold or transferred by the original lessee to a third party, the original lessor shall continue to account for the lease as it did before.
40-3 If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease as provided in paragraph 842-30-40-2 and shall classify and account for the new lease as a separate transaction.
In a manner consistent with ASC 840-10-35-10, the lessor should continue to account for the head lease as it did before the execution of the sublease. See Chapter 9 for additional information about the lessor’s accounting model.
In addition, if the original lease is replaced by a new agreement with a new lessee, the lessor should account for the replacement as a termination of the original lease. The lessor should classify and account for the new lease as a separate transaction from the termination of the original lease.
12.5 Sublessee’s Accounting for a Sublease
A sublessee’s accounting for a sublease is consistent with its accounting for other leases in which it is the lessee. The existence of the head lease does not affect the sublessee’s accounting for the sublease. See Chapter 8 for additional information on the lessee’s accounting model.