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Subleases Explained - Accounting Under IFRS 16

6/12/2025
IFRS
Table of Contents

Introduction

Subleasing, a common business practice, occurs when a lessee leases a leased asset (or part of it) to another party. Under IFRS 16 Leases, subleasing introduces accounting complexity, as entities must assess their roles as both intermediate lessors and lessees.

This article provides a comprehensive guide to the accounting treatment of subleases under IFRS 16, including classification, recognition, and measurement.

What is a Sublease?

A sublease occurs when a lessee (the intermediate lessor) grants a lease of the right-of-use (ROU) asset obtained under an original lease to another party (the sublessee). Importantly, the intermediate lessor continues to account for the original lease with the head lessor and also accounts for the sublease with the sublessee.

Definition: 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.

Accounting Overview

Under IFRS 16, when an entity subleases an asset, it must:

  • Continue to account for the head lease as a lessee.
    Note: If a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify as a lease of a low-value asset. The low-value exemption may therefore not be applied to such a head lease.

  • Account for the sublease as a lessor.
    The classification and measurement of the sublease depend on whether it is deemed a finance lease or an operating lease.

Step-by-Step Accounting for Subleases

1. Identify and Separate Lease Components

If the sublease involves only part of the original asset (e.g., subleasing one floor of a building), the intermediate lessor must determine whether the sublease constitutes a separate lease component.

2. Classify the Sublease

Unlike general lessor accounting, intermediate lessors classify the sublease by reference to the right-of-use asset, not the underlying asset. There is a key distinction to be made.

Intermediate lessors should classify the sublease as either a finance lease or an operating lease as follows:

  • If the head lease is a short-term lease that the entity, as a lessee, has accounted for applying paragraph 6, the sublease shall be classified as an operating lease.
  • Otherwise, the sublease shall be classified by reference to the right-of-use asset arising from the head lease, rather than by reference to the underlying asset (for example, the item of property, plant or equipment that is the subject of the lease).

Finance lease

A sublease is therefore classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the right-of-use asset. Indicators include:

  • The sublease term covers most of the head lease term.
  • The present value of lease payments amounts to substantially all the ROU asset’s carrying value.
  • The asset is of a specialised nature, only usable by the sublessee.

If these criteria are not met, the sublease is an operating lease.

As an illustration, land is usually leased in operating leases and not finance leases, due to its indefinite useful life. However, in a sublease, it is very possible for the land to be leased to the sublessee in a finance lease, as the focus on risks and rewards are on the right-of-use asset and not the land itself.

For a more detailed article on finance vs operating leases see: Finance Leases vs. Operating Leases - IFRS 16 Lessor Accounting

Head Lease & Sublease

A. Head Lease

The intermediate lessor (as lessee):

  • Recognises a ROU asset and a lease liability at commencement.
  • Depreciates the ROU asset (unless derecognised in a finance sub-lease) and accrues interest on the lease liability.
  • Continues this accounting regardless of the sublease classification.

B. Sublease

If the Sublease is a Finance Lease:

  • Derecognise the ROU asset (or portion of it).
  • Recognise a lease receivable equal to the net investment in the lease.
  • Recognise interest income over the lease term using the effective interest method.
    • If the interest rate implicit in the sublease cannot be readily determined, an intermediate lessor may use the discount rate used for the head lease (adjusted for any initial direct costs associated with the sublease) to measure the net investment in the sublease.

If the Sublease is an Operating Lease:

  • Continue to recognise the ROU asset.
  • Recognise lease income from the sublease on a straight-line basis over the lease term (or another systematic basis if more appropriate).

Practical Example

Scenario:

Company A leases a building for 10 years and recognises a ROU asset. After 2 years, it subleases the top floor for the remaining 8 years.

Step 1: Classify the Sublease

  • The sublease term covers the entire remaining term of the head lease.
  • Thus, it’s likely to be a finance lease.

Step 2: Account for the Sublease

  • Derecognise the portion of the ROU asset related to the top floor.
  • Recognise a lease receivable and interest income over time.

Special Considerations

Impairment

The ROU asset retained by the intermediate lessor is subject to impairment testing under IAS 36.

Modifications

If the terms of the head lease change (e.g., the lease is shortened), this may require remeasurement of both the head lease and sublease arrangements.

Head lease term

The inception of a sublease of the underlying asset for a period beyond the end of the previously determined lease term, is a situation that would require the lessee (intermediate lessor) to reassess the lease term of the head lease, specifically regarding whether the lessee is reasonably certain to exercise an option to renew the head lease, which was not previously included in its determination of the lease term.

Conclusion

Subleasing under IFRS 16 introduces nuanced accounting treatment. The key lies in correctly classifying the sublease and understanding that the ROU asset – not the underlying physical asset – is the focus for classification. A thorough understanding of these principles is essential for ensuring compliance and producing accurate financial statements.

For any clarification, guidance, or feedback on our article, please reach out to us on insight@leash.co.za.