Subleases Explained (With Examples) - ASC 842 Accounting

Introduction

Subleasing is a frequent commercial arrangement in which a lessee (intermediate lessor) grants another party rights to use part or all of a leased asset. Under ASC 842 Leases, sublease accounting introduces additional considerations because the intermediate lessor must apply both lessee and lessor accounting models separately to the head lease and the sublease. The guidance and criteria for classification differ in key respects from IFRS 16.

What is a Sublease?

A sublease under ASC 842 (US GAAP) arises when the original lessee (intermediate lessor) leases the underlying asset to a third party (sublessee) while the original (head) lease with the lessor remains in effect. ASC 842 requires the intermediate lessor to account for the head lease as a lessee and the sublease as a lessor. This reflects the dual nature of the intermediate lessor’s role.

Accounting Overview

When an entity enters into a sublease under ASC 842:

• The intermediate lessor continues to account for the head lease in accordance with lessee accounting, recognising a right-of-use asset and lease liability at commencement unless relieved of primary obligation.
• The sublease is treated as a separate lease from the head lease and is accounted for using lessor accounting models under ASC 842.

The classification of the sublease is determined by reference to the underlying asset rather than the right-of-use asset arising from the head lease, which is a fundamental distinction from IFRS 16.

Step-by-Step Accounting for Subleases

1. Identify and Separate Lease Components

As with any lease assessment, the intermediate lessor must identify whether distinct lease components exist. For example, if only part of the leased asset is subleased, determine whether that portion constitutes a stand-alone lease.

2. Classify the Sublease

Under ASC 842, sublease classification is based on the underlying asset, not the right-of-use asset from the head lease. The sublease may be classified as:

• Finance lease
• Operating lease

Classification considers whether:

• ownership transfers to the sublessee;
• a purchase option is reasonably certain to be exercised;
• the lease term represents a major part of the remaining economic life of the asset;
• the present value of lease payments represents substantially all of the asset’s fair value; or
• the asset is highly specialised.

Head Lease and Sublease Accounting

Head Lease (Intermediate Lessor as Lessee)

The intermediate lessor:

• recognises a right-of-use asset and lease liability; and
• recognises lease expense depending on whether the head lease is operating or finance.

Sublease as Lessor

Finance sublease (direct-financing or sales-type)

The intermediate lessor (or original lessee):

• derecognises the portion of the underlying asset relating to the sublease;
• recognises a lease receivable equal to the net investment in the lease;
• recognises interest income over the lease term; and
• evaluate its investment in the sublease for impairment in accordance with paragraph 842-30-35-3.

Operating sublease

The intermediate lessor:

• retains the underlying asset; and
• recognises lease income on a straight-line basis.

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.

Practical Example

A company leases a warehouse for ten years. After two years, it subleases the entire warehouse to a third party for the remaining eight years.

Under ASC 842, the intermediate lessor:

1. assesses sublease classification by reference to the underlying warehouse asset;
2. determines whether the sublease is a finance or operating lease; and
3. applies the relevant lessor accounting model based on that classification.

Lessee Relieved of Its Primary Obligation Under the Head Lease

Before applying sublease accounting under ASC 842, the intermediate lessor must assess whether it has been relieved of its primary obligation under the head lease. This assessment is critical because it determines whether the arrangement is accounted for as a sublease or as a termination of the original lease.

An intermediate lessor is considered relieved of its primary obligation when the substance of the arrangement results in the sublessee assuming primary responsibility for the leased asset, and the original lessee no longer bears the main obligation to make lease payments to the head lessor.

Accounting Consequences

If the intermediate lessor is relieved of its primary obligation, ASC 842 treats the arrangement as a termination of the head lease, rather than as a continuing sublease. In this case, the intermediate lessor:

• derecognises the right-of-use asset and lease liability associated with the head lease; and
• recognises any resulting gain or loss in profit or loss.

Any consideration paid or received as part of the termination that was not already included in the measurement of the lease liability (for example, a termination payment or incentive) is included in determining the gain or loss on termination.

Secondary Liability

In some arrangements, the intermediate lessor may remain secondarily liable under the head lease, such as thright-of-usegh a guarantee to the original lessor. Where this occurs, the guarantee obligation is recognised separately in accordance with the applicable guidance for liabilities, even though the head lease itself is derecognised.

Distinction from a True Sublease

If the intermediate lessor continues to be responsible for lease payments under the head lease and remains the party with primary obligation to the head lessor, the arrangement does not represent a termination. In that case, the head lease continues to be accounted for as a lease, and the sublease is accounted for separately under the lessor guidance in ASC 842.

This distinction ensures that lease derecognition occurs only when the economic substance of the arrangement reflects a genuine transfer of the primary lease obligation.

Special Considerations

Impairment of subleases

Right-of-use assets or retained underlying assets must be assessed for impairment in accordance with ASC 360.

Modifications of subleases

Modifications to either the head lease or sublease may require remeasurement and reassessment, depending on the nature of the change.

Subsequent Measurement in subleases

Finance subleases recognise interest income over time, while operating subleases recognise income on a straight-line basis.

Conclusion

Subleasing under ASC 842 requires careful analysis and documentation. The critical distinction from IFRS 16 lies in the sublease classification criteria: ASC 842 looks to the underlying asset rather than the right-of-use asset when determining whether a sublease is a finance or operating lease. This can lead to different outcomes in classification and measurement compared with IFRS 16.

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