Key Takeaways
- An intermediate lessor classifies subleases by reference to the right-of-use asset, not the underlying asset
- This classification approach often results in more subleases being classified as finance leases
- The head lease remains on the balance sheet even when the sublease is a finance lease
- Finance lease subleases result in derecognition of the ROU asset and recognition of a lease receivable
- Operating lease subleases retain the ROU asset and recognise rental income on a straight-line basis
What is a Sublease?
A sublease occurs when a lessee (the intermediate lessor) grants the right to use an underlying asset to a third party (the sublessee), while retaining the original lease obligation to the head lessor.
In a sublease arrangement, there are three parties:
- Head Lessor: The original owner or lessor of the asset
- Intermediate Lessor: The entity that is both lessee (under the head lease) and lessor (under the sublease)
- Sublessee: The third party that obtains the right to use the asset
IFRS 16 Definition
"A sublease is a transaction for which an underlying asset is re-leased by a lessee ('intermediate lessor') to a third party, and the lease ('head lease') between the head lessor and lessee remains in effect."
- IFRS 16 Appendix A
Classifying Subleases
A critical change under IFRS 16 is how subleases are classified. The intermediate lessor must classify the sublease as a finance lease or operating lease by reference to the right-of-use asset arising from the head lease, not the underlying asset itself.
Key Change from IAS 17
Under IAS 17, subleases were classified by reference to the underlying asset. Under IFRS 16, classification is by reference to the ROU asset. This change often results in subleases being classified as finance leases when they would have been operating leases under IAS 17.
Why This Matters
Consider a 10-year head lease for office space. If the intermediate lessor subleases the space for the remaining 8 years:
- Under IAS 17: Classified against the building's economic life (e.g., 50 years). The 8-year sublease would likely be an operating lease.
- Under IFRS 16: Classified against the ROU asset's remaining life (8 years out of 10). The sublease transfers substantially all the ROU asset, making it a finance lease.
Classification Indicators
Apply the standard IFRS 16 lessor classification tests, but reference the ROU asset:
| Indicator | Finance Lease | Operating Lease |
|---|---|---|
| Transfer of ownership | Ownership of ROU asset transfers to sublessee | No transfer |
| Bargain purchase option | Sublessee has option to purchase at below FV | No option or at FV |
| Lease term | Major part of ROU asset's remaining life | Minor part |
| Present value of payments | Substantially all of ROU asset's fair value | Less than substantially all |
| Specialised nature | Asset only usable by sublessee | General use asset |
Finance Lease Sublease Accounting
When the sublease is classified as a finance lease, the intermediate lessor:
Derecognise the ROU Asset
Remove the right-of-use asset (or portion thereof) from the balance sheet.
Recognise Net Investment in Sublease
Recognise a lease receivable measured at the net investment in the sublease (present value of sublease payments plus any unguaranteed residual value).
Recognise Any Gain or Loss
The difference between the ROU asset carrying amount and the net investment is recognised in profit or loss.
Retain the Head Lease Liability
The lease liability for the head lease remains on the balance sheet and continues to be accounted for normally.
Worked Example: Finance Lease Sublease
Scenario
Company A has a head lease for office space with the following details:
- Original head lease term: 10 years
- Remaining head lease term: 8 years
- Current ROU asset carrying amount: $400,000
- Current lease liability: $420,000
- Head lease annual payment: $60,000
Company A subleases the entire space to Company B:
- Sublease term: 8 years (full remaining term)
- Sublease annual payment: $65,000
- Interest rate implicit in sublease: 5%
Classification Assessment
The sublease term (8 years) equals the remaining life of the ROU asset (8 years). This transfers substantially all the economic benefits, so the sublease is a finance lease.
Calculate Net Investment in Sublease
Journal Entry at Sublease Commencement
Subsequent Measurement
The intermediate lessor will:
- Recognise interest income on the net investment using the effective interest method
- Receive sublease payments, reducing the net investment
- Continue to recognise interest expense on the head lease liability
- Make head lease payments, reducing the lease liability
Operating Lease Sublease Accounting
When the sublease is classified as an operating lease, the intermediate lessor:
- Retains the ROU asset on the balance sheet and continues to depreciate it
- Retains the lease liability for the head lease
- Recognises rental income from the sublease on a straight-line basis (unless another systematic basis better represents the benefit pattern)
Worked Example: Operating Lease Sublease
Scenario
Using the same head lease details, Company A subleases to Company C:
- Sublease term: 3 years (out of 8 remaining)
- Sublease annual payment: $55,000
Classification Assessment
The sublease term (3 years) is only 37.5% of the ROU asset's remaining life (8 years). This is not a "major part", so the sublease is an operating lease.
Journal Entries
Operating Sublease Results
With an operating sublease, the intermediate lessor reports: (1) depreciation expense on the ROU asset, (2) interest expense on the head lease liability, and (3) rental income from the sublease. The net effect depends on the relative amounts, but this can result in a loss even when sublease income exceeds cash payments.
Head Lease and Sublease Interaction
A critical point is that the head lease accounting continues regardless of the sublease classification:
| Item | Finance Sublease | Operating Sublease |
|---|---|---|
| ROU Asset | Derecognised | Retained and depreciated |
| Head Lease Liability | Retained | Retained |
| Sublease Asset | Net investment (receivable) | None |
| Income Statement | Interest income + Interest expense | Rental income + Depreciation + Interest expense |
Balance Sheet Impact
For a finance sublease, the balance sheet shows both:
- A lease liability (head lease obligation)
- A net investment in sublease (receivable)
These do not offset because they are separate contractual arrangements with different counterparties.
No Offsetting
Even when the head lease liability and sublease receivable have similar amounts and timing, they cannot be offset on the balance sheet. This "gross" presentation reflects the distinct credit risks and contractual obligations.
Back-to-Back Lease Arrangements
A back-to-back lease occurs when an entity enters into a head lease and immediately subleases the asset on identical or similar terms. These arrangements are common in real estate and equipment leasing.
Accounting Considerations
Even in back-to-back arrangements:
- Both the head lease and sublease must be accounted for separately
- Classification is still determined by reference to the ROU asset
- Full back-to-back subleases are typically finance leases (transferring substantially all the ROU)
Example: Full Back-to-Back
Scenario
Company A signs a 5-year lease for equipment at $100,000 per year, then immediately subleases to Company B for 5 years at $110,000 per year.
At commencement, Company A recognises:
- ROU Asset: PV of $100,000 x 5 years (immediately derecognised)
- Lease Liability: PV of $100,000 x 5 years (retained)
- Net Investment in Sublease: PV of $110,000 x 5 years
- Day-one gain: Difference between ROU asset and net investment
Over the lease term, Company A earns a spread between the interest income on the sublease and interest expense on the head lease, plus the initial gain.
Practical Expedients and Subleases
Short-term Lease Exemption
If the head lease qualifies for and the intermediate lessor elects the short-term lease exemption:
- No ROU asset is recognised for the head lease
- The sublease classification is made by reference to the underlying asset (not the ROU asset, which doesn't exist)
Low-value Asset Exemption
Similarly, if the intermediate lessor elects the low-value asset exemption for the head lease, the sublease is classified by reference to the underlying asset.
Practical Impact
When the short-term or low-value exemption is applied to the head lease, subleases are more likely to be classified as operating leases because the reference asset is the underlying asset with its full economic life, not a short-lived ROU asset.
Disclosure Requirements for Subleases
Intermediate lessors must provide disclosures as both a lessee (for the head lease) and a lessor (for the sublease).
Lessee Disclosures (Head Lease)
Lessor Disclosures (Sublease)
Sublease Income Disclosure
IFRS 16.90(b) specifically requires disclosure of income from subleasing right-of-use assets. This must be presented separately from other lease income.
Summary: Finance vs Operating Sublease
| Aspect | Finance Sublease | Operating Sublease |
|---|---|---|
| ROU asset | Derecognised | Continue to depreciate |
| Sublease asset | Net investment (receivable) | None |
| Day-one impact | Gain or loss possible | No day-one impact |
| Income recognition | Interest income (effective interest method) | Rental income (straight-line) |
| Head lease liability | Continues | Continues |
| Classification basis | Reference to ROU asset remaining life/value | |
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.