Accounting for Sublease

A lease is an agreement between two parties for using an asset. The party that owns the asset is the lessor, while the other party is the lessee. The lessee uses the leased asset and pays a regular fee to the lessor. Before the transaction, both parties enter into an agreement that defines each party’s responsibilities. These terms may cover the risks and rewards for each party, the time period of the lease, etc. It also includes whether the lessee can sublease the asset.

What is a Sublease?

A sublease is an arrangement in which a lessee lets out an asset to another party. Usually, it involves offering a leased property for rent to another tenant. The original tenant stays in an agreement with the property owner, while the new tenant stays in contact with the lessee. Another name used for sublease agreements is sublet arrangements. Subleases are common in the real estate industry.

Whether a lessee can sublease an asset depends on their lease arrangement with the lessor. If the lessor does not allow subleasing their leased asset, the lessee cannot sublet it legally. On top of that, some jurisdictions may also include restrictions related to subleases. Therefore, tenants have to consider all their limitations before entering into a sublease agreement.

How Does a Sublease Work?

A lease agreement starts from a contract between a lessee and a lessor. The lessee is the party that uses the lessor’s asset. In exchange, they make regular payments to the lessor. They also enter into a lease agreement that defines the terms related to the lease arrangement. This agreement also includes the terms associated with subleasing.

If allowed by the agreement, the lessee will have the option to offer the leased asset for subleasing. Through this process, the lessee can find a tenant for the leased property. In this transaction, the lessee collects payments from the new tenant and provides them to the lessor. Sometimes, the lessee may make a profit or loss in sublease agreements, which they can keep.

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For a sublease agreement to be considered legal, the lease agreement must allow it. If there are any restrictions around subleasing, the lessee must also include them in the sublease agreement. Furthermore, when the lessee provides the leased asset for sublease, they must notify the lessor. Some leases may also allow the owner to have control over the sublease agreements.

A sublease does not release tenants from the original arrangement between the lessor and lessee. Therefore, any terms that apply to the lessee in the original agreement are also applicable to the tenant. However, the tenant is only obligated to the lessee. The lessor cannot hold the tenant accountable for a breach of contract as the contract only exists between the lessee and the tenant.

What is the Accounting for Subleases?

IFRS 16 deals with accounting for subleases and requires lessors to classify the leased asset as finance or operating lease. Based on this classification, the accounting for sublease will differ. There are specific requirements that separate finance subleases from operating subleases.

Finance Sublease

For a finance sublease, the terms of the lease must cover the entire potential life of the asset. Or, the net present value of the total payment for lease installments must equal the current fair market value of the leased asset. In any of these circumstances, the lessor must account for the leased asset as a finance sublease.

When accounting for finance subleases, the lessor must derecognize the asset and recognize a receivable for the net investment in the lease. The net investment amount may include fixed or variable lease payments, the exercise price for the purchase option, fees for penalties or termination, etc. The lessor must use the implicit interest rate to measure this net investment in the lease.

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Once recognized, the lessor must recognize finance income over the lease term. On top of that, the lessor must re-measure the lease receivable amount at regular intervals. They must account for any impairments in the amount promptly.

Operating Sublease

If a sublease agreement does not meet the requirement for finance subleases, it will be an operating sublease. Therefore, a sublease agreement that does not cover the entire potential life of the asset is an operating sublease. Alternatively, if the net present value of total payments for lease installments does not equal the current fair market value of the leased asset, it will be an operating sublease.

In operating subleases, the lessor does not derecognize the asset. Instead, they must recognize the income received on a straight-line basis over the lease term. The lessor must also record costs related to earning the lease income. Furthermore, the lessor must depreciate the asset consistent with their standard depreciation policies. The provisions of IAS 36 will also apply to the impaired asset.

Example

A company, ABC Co., leases the property from another company for five years. In exchange for the leased property, ABC Co. will pay regular lease payments. For ABC Co. and the lessor, the lease contract will be a finance lease. Therefore, ABC Co. will recognize a right-of-use asset and a lease liability in its financial statements. After one year of using the property, ABC Co. found a new building and shifted its business.

However, ABC Co. could not leave the lease contract. Therefore, it decided to sublease the property to XYZ Co. The lease contract allows for subletting the property. ABC Co. subleased the property for the rest of the four years of the contract. In this case, the sublease arrangement is a finance sublease. Therefore, ABC Co. must derecognize the right-of-use asset. Instead, it must recognize a net investment in the sublease.

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At this point, the remaining value of the right-of-use asset is $100,000. However, the net investment in sublease is $120,000. ABC Co. must recognize the difference in both as a profit in the profit or loss account. Therefore, the double-entry for it will be as follows.

AccountDebitCredit
Net investment in sublease$120,000
Right-of-use asset $100,000
Profit or Loss a/c $20,000

However, ABC Co. must not derecognize the lease liability related to the head lease. Therefore, the lease liability will remain at the same amount. On top of that, ABC Co. will also recognize finance income from the sublease when received. Assuming the finance income is $5,000, the accounting entry will be as follows.

AccountDebitCredit
Cash$5,000
Finance Income $5,000

Lastly, ABC Co. must also recognize an interest expense on the head lease. Assuming the interest expense on the head lease is $4,000, the journal entry will be as follows.

AccountDebitCredit
Interest expense$4,000
Cash $4,000

Since ABC Co. derecognized the right-of-use asset in its financial statements, it can no longer record any depreciation expense related to the asset. However, that would not apply if the sublease were an operating sublease.

Conclusion

A sublease is an agreement in which a lessee sublets an asset or property to a new tenant. These arrangements are prevalent in various industries. The accounting for subleases requires lessors to differentiate between finance and operating subleases based on some criteria. The process for accounting for finance leases differs from operating leases, as mentioned above.

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