by Lucas Russell 2021-08-26
One of the most time-consuming aspects of compliance with the new lease accounting standard ASC 842 is when a lessee under ASC 842 leases their right of use asset and becomes an intermediate lessor.
So what is a sublease? in the ASC 842 glossary, a sublease is defined as:
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.
In other words, after entering into a sublease, the lessee will account for two roles, which is now the intermediate lessor and its original role as a lessee. Subleases make a lot of sense from a commercial perspective, but an accountant might not be jumping for joy when the sublease is executed.
From an accounting standpoint, there will be no netting of the two leases. Netting of any account balance is frowned upon, and the new lease accounting example and subleases are no exception to this. The treatment of sublease accounting and accounting for each lease separately is further discussed in Paragraph BC115 of ASU 2016-02
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.
So there's no debate that it's two separate leases. So what's an example of sublease accounting? Let's say a company entered into a lease for three floors of office space. Given the change over the last year and the ability for employees to work from home, the company only requires two floors of office space. It's not uncommon for a lease to have expensive termination clauses, even for partial terminations. Because of this, the lessee decides to lease the unused floor of office space rather than cancel the lease.
Sublease accounting is depicted in the following diagram:
So we now know what a sublease is. The lessee becomes an intermediate lessor and continues as a lessee. So now we’re going to cover how accounting works for a sublease. The first step is to determine if:
Once determined, the accounting for each scenario is materially different.
The first step to determine how to account for the sublease under ASC 842 is to determine if the intermediate lessor is relieved of its primary obligation under the head lease.
ASC 842-20-40-3 states the following when determining if the intermediate lessor is removed of its primary obligation:
If the nature of a sublease is such that the original lessee is relieved of the primary obligation under the original lease, the transaction shall be considered a termination of the original lease. Any consideration paid or received upon termination that was not already included in the lease payments (for example, a termination payment that was not included in the lease payments based on the lease term) shall be included in the determination of profit or loss to be recognized in accordance with paragraph 842-20-40-1. If a sublease is a termination of the original lease and the original lessee is secondarily liable, the guarantee obligation shall be recognized by the lessee in accordance with paragraph 405-20-40-2.
In this scenario, the intermediate lessor essentially passes on the lease, as the subsequent lessee will take primary responsibility for the leased asset. When this occurs, the intermediate lessor would derecognize the ROU asset and lease liability arising from the head lease and would recognize any difference in profit or loss.
Any additional consideration received or paid on termination that was not already included in the lease payments would generally be included in calculating the gain or loss resulting from the termination (e.g., a termination penalty not included in the determination of the original lease liability).
This is akin to terminating the lease. If the intermediate lessor still has obligations under the head lease and is responsible for lease payments, it would not have been relieved of its primary obligations under the lease.
This is the alternative scenario for sublease accounting. The standard states the following:
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:
a. 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.
b. 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.
c. 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.
Below is a summary ASC 842’s guidance in a diagram:
Entering into a sublease agreement triggers both roles within the lease accounting standard, being lessee and lessor accounting. Both roles' overall accounting principles do not change from either the lessor or lessee for sublease accounting. The most significant step for the intermediate lessor is to determine if relieved of its primary obligation under the head lease.