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
Derecognise the portion of the right-of-use asset that relates to the rights transferred to the sublessee. For a sublease covering the full remaining head-lease term, this is typically the entire ROU asset. For a partial sublease, allocate the carrying amount between the rights retained and the rights transferred.
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). The net investment is subsequently subject to IFRS 9 impairment requirements, including expected credit loss assessment.
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 head lease liability continues to accrete interest and be reduced by payments under normal lessee accounting. 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 is classified as an operating lease
Low-value Asset Exemption
A head lease does not qualify as a low-value lease if the lessee subleases, or expects to sublease, the underlying asset. This means the low-value exemption cannot be used on the head lease when a sublease exists.
Common Mistake
Entities sometimes apply the low-value exemption to a head lease and then sublease the asset. IFRS 16 specifically prevents this. If the asset is subleased or expected to be subleased, the head lease must be accounted for in full (ROU asset and lease liability).
Modifications and Terminations
Modifications are the most technical part of sublease accounting because two contracts can change independently, and a change in either can affect the sublease's classification.
Modifying the Sublease
The intermediate lessor applies the IFRS 16 lessor modification rules. Treatment depends on the original classification:
- Operating sublease. If the modification adds scope and the consideration increases by an amount commensurate with the standalone price for that scope, treat it as a separate lease. Otherwise, account for the modified sublease as a new lease from the effective date, with any prepaid or accrued lease payments from the original sublease included in the new lease payments.
- Finance sublease. If the modification adds scope at standalone pricing, treat it as a separate lease. If not, and the new terms would have resulted in operating lease classification at inception, derecognise the net investment, recognise an ROU asset based on the rights retained, and account for the modified sublease as a new operating lease. Other finance lease modifications follow IFRS 9.
Head Lease Modification: Reassess the Sublease
When the head lease is modified, the intermediate lessor must reassess the sublease classification. A change in the remaining ROU asset's life or value can flip a sublease between operating and finance, even when the sublease itself is unchanged.
Common Trap
Extending the head lease lengthens the remaining life of the ROU asset, which can move a sublease from finance to operating classification. Shortening the head lease does the opposite. The sublease's measurement does not change unless the sublease itself is also modified, but the classification reassessment can require derecognition of the net investment, or recognition of a new ROU asset.
Early Termination
If the sublease ends before the head lease, derecognise any remaining net investment (finance sublease) or stop recognising rental income (operating sublease). The head lease continues, and the intermediate lessor returns to standard lessee accounting on the retained ROU asset. If the head lease ends, the sublease typically ends with it, because the intermediate lessor no longer holds the right to grant.
The mechanics for the underlying modification accounting (separate lease test, decrease in scope, other modifications, terminations) are covered in the Modifications and Terminations guide.
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 16.53(f) requires lessees to disclose income from subleasing right-of-use assets as part of their lessee disclosures.
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 | |
Examples in this guide are simplified and ignore items such as initial direct costs, variable lease payments, lease incentives, and tax effects. This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.