With the new ASC 842 lease accounting standards in place, companies are required to report leases through the balance sheet, providing increased visibility into leasing obligations. Recognizing leases as assets and liabilities increases accuracy and efficiency when determining a company’s indebtedness. However, subleases may also be a part of a company’s lease portfolio and need to be accounted for to ensure compliance with the new standards. So, how does a company sublease under ASC 842?
What is a Sublease?
Before determining how to account for a sublease, it is important to understand what a sublease is. According to the ASC 842 glossary, a sublease refers to “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.” What this means is that in a sublease, the lessee will have two roles: that of an intermediate lessor and the original role as the lessee. However, depending on the sublease, the lessee, or intermediate lessor, may or may not be relieved of the primary obligation under the head lease. Here is what each scenario means and how to account for them.
Lessee IS Relieved of Primary Obligation
A lessee, or intermediate lessor, being relieved of the primary obligation under the head lease means that the lease is passed on to the sublessee, or subsequent lessee, who will take full responsibility for the leased asset. It can be considered similar to terminating a lease in the sense that the lessee would cover all obligations, responsibilities and payments under the head lease. The lessee will then derecognize the ROU asset and lease liability and calculate the profits or losses resulting from the termination. The company that was the initial lessee would have to account for the termination of the lease through a gain or loss listed in the income statement.
Lessee is NOT Relieved of Primary Obligation
In case of a lessee not being relieved of the primary obligation under the head lease, they, now as the sublessor, still have to account for the original lease. However, there are different ways of accounting for such a lease depending on how the sublease is classified.
Sublease IS Classified as Operating Lease
The lessee, or intermediate lessor, will continue to account for the sublease as they did before if it is classified as an operating lease. An operating lease refers to the partnership between a lessor and a lessee, in which the lessee is given access to an asset. In other words, the sublessee can use the asset from the lessee, or intermediate lessor, for a given period of time. In this case, the period must be less than the economic life of the asset and the sublessee must pay for using the asset for the agreed-upon time period. Furthermore, if the costs of the lease exceed the expected income from the sublease, the lessee must assess the head lease ROU asset for impairment.
Sublease NOT Classified as Operating Lease
In case of a sublease not being classified as an operating lease, accounting depends on how the original head lease is classified. If the original lease, or head lease, is classified as an operating lease, the original right-of-use asset must be derecognized according to ASC 842 guidance (ASC 842-30-40-1) and the lease liability of the original lease should be accounted for based on the leasing guidelines for a lease liability in a finance lease. The intermediate lessor is also responsible for evaluating the original assumptions relating to the head lease to determine if they have changed based on the conditions of the sublease. Finally, once the right-of-use asset is derecognized, the net investment in the sublease is to be considered based on the impairment guidance (ASC 842-30-35-3).
When the original lease is a finance lease and the sublease is classified as either a sales-type or direct financing lease, the original right-of-use asset still needs to be derecognized per the sales-type/direct financing lease derecognition guidelines, with the original lease liability being accounted for the same as before the commencement of the sublease. Furthermore, the intermediate lessor must evaluate the net investment in the sublease for impairment according to ASC 842 guidance.
Subleasing is a complicated process with intricate accounting implications. With the main lessee becoming an intermediate lessor, both assets must be accounted for to ensure ASC 842 compliance. While the accounting principles of each role are unchanged, it’s extremely important to determine all aspects of a sublease, how it impacts the main lease and whether or not the intermediate lessor is relieved of the primary obligations listed under the head lease. Fortunately, with the help of lease accounting software, the accounting process for any scenario can be managed accurately and efficiently without giving your accounting team too much trouble.
Yardi Corom is a simple and comprehensive accounting, lease and workplace management solution for CRE tenants. Our cloud-based software solution allows employers to activate hybrid workplaces and desk hoteling, increases efficiency and accuracy across your entire lease portfolio: manage leases and subleases, track key lease data, centralize transactions and become FASB/GASB/IFRS compliant. To learn more, you can visit our website or schedule a meeting with our team.
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