Have you ever leased a space, decided you no longer require it, then subleased the space to a third party? Did you continue making payments to the Landlord under the initial lease while collecting payments from the third party under the sublease? Did you account for this transaction correctly under GAAP? Are you willing to bet on it? Better yet, are you willing to bet your job on it?
We are. Chances are that if you have a sublease, you’re accounting for it incorrectly.
This blog contains two sections. The first explains the correct accounting for subleases under current GAAP and provides a comprehensive example with actual numbers. In the second section, we answer two questions we received regarding the treatment of loss in sublease accounting.
Accounting for subleases under GAAP the correct way
Let us begin by telling you the entry not to make. When a tenant ceases using a location, subleases it and continues making payments to the landlord, the incorrect practice is to continue the straight-line amortization of the initial lease and then start a new lease for the sublease (as a landlord) and amortize it straight-line as a separate lease. This is what the vast majority of companies are doing, but it is not GAAP.
These are the correct procedures to follow:
- Record a liability, calculated as the present value of the remaining minimum lease payments due under the original (head) lease, reduced by the present value of any estimated sublease income,
- Write off the deferred rent from the original lease, and
- Record a loss on the income statement for the difference.
Note the following:
- This entry should be made at the “cease use date”.
- The liability (present value of the remaining minimum lease payments under the initial lease) should always be reduced by (netted against) the estimated sublease income, even if the company does not intend to sublease the property, or if the company intends to sublease the property but does not have a sub lessee as of the cease use date. This adjustment is necessary because the liability must be marked to fair value.
Let’s use a comprehensive example to explain sublease accounting under current GAAP in further detail.
Assume Company A signs a 10-year lease with payments of $10,000 annually with $500 escalations each year, paid in advance. At the end of Year 6, Company A decides that it no longer needs the space, and estimates it could sublease it to a third party for the remaining 4 years on the lease at 9,000 annually. Assume the company’s discount rate is 7%.
The following is the straight-line amortization schedule for the initial lease:
At the end of Year 6, the total remaining payments Company A owes the Landlord under the head lease is $55,000, which using a discount rate of 7% gives us a present value of $49,681.28, as shown in the amortization schedule below:
The company estimates it can receive $9,000 annually from a sublease over 4 years, which using the same discount rate of 7% gives us a present value of $32,618.84, as shown in the amortization schedule below:
When you net the head lease amortization schedule against the sublease amortization schedule, you get the following net liability schedule:
We now have everything we need to record our journal entries.
At the end of Year 6 (or beginning of Year 7), the journal entry Company A needs to make is as follows:
|DR||Loss on Sublease||11,062.44|
To record the Net Sublease Liability and write-off deferred rent from the head lease.
Note that the $6,000 comes from the initial straight-line schedule, while the 17,062.44 comes from the net liability schedule. The loss on sublease is the plug.
Once again, note that the entry above would always be made, regardless of if there is a sublease or not. Company A would also make the following entry in the beginning of Year 7 if there is a sublease to reflect the payment of cash to the Landlord and receipt of cash from Company B for the sublease:
To record cash due to the Landlord and cash due from Company B for sublease in Year 7
Note that if there is no Sublease, then the cash entry in Year 7 is as follows:
|DR||Loss on Sublease||9,000.00|
To record cash due to Landlord and record additional loss because no sublease in Year 7.
In Year 8, if there is indeed a sublease, Company A would make the following entry to reflect the payment of cash to the Landlord and receipt of cash from the sublease to Company B:
To record cash due to the Landlord and cash due from Company B for sublease in Year 8
In Year 8, if there is no sublease, Company A would make the following entry to reflect the payment of cash to the Landlord and receipt of cash from the sublease to Company B:
To record cash due to Landlord and record additional loss because no sublease in Year 8.
This seems a little complex, but believe it or not it is actually very simple. Remember that we are simply calculating the present value of the minimum lease payments and adjusting for sublease receipts.
Based on that previous remark, you should be having an “aha!” moment right about now. The “aha” moment you should be having is this: When you cease using a location, the lease now becomes treated much like an asset retirement obligation (ARO). That’s it folks, plain and simple. An operating lease becomes treated as an ARO when you sublease it. This is an over-simplification though because of the following significant differences:
- Do not capitalize the entire present value of the minimum lease payments, only capitalize the amounts in excess of any estimated sublease income.
- Unlike AROs, the offset to the liability is not to an asset.
Now you may be thinking that it is much easier to simply continue the straight-line amortization of the head lease and also straight-line the sublease as a Landlord would, and you would be correct, except for 2 important points:
- It is not GAAP.
- The differences could be significant.
Let us use the following table to illustrate how material the differences could be:
Note that when you account for subleases the correct way, the income statement expense on the “cease use” date will be greater than if you incorrectly keep straight-line amortizing the lease, but the expense in subsequent years will be less.
Also note that your liability balances will be greater when you make this entry correctly.
Finally, I should stress that this accounting is appropriate only for those subleases that are not entered into or contemplated at the beginning of the head lease. If a tenant enters into a lease with the intent to sublease the property (as some franchisers do), then straight-line accounting for both the head lease and the sublease will apply.
Accounting for leasehold improvements after subleasing out a facility
The following is a question from one of our readers, a Director of Accounting, on an additional topic that needed clarification. The reader asked:
How do you account for the leasehold improvements you paid for originally and capitalized once you have decided to vacate a facility and have a sub-lessee in place? Initially I think you’d write them off… but is there a reason to argue that it would remain on your books as it’s still your lease?
Answer: No, you cannot keep this on your books if you have ceased use because GAAP requires you to write it off at that time. If you are subleasing at a gain, you would not write anything off because you are not effectively ceasing use.
Treatment of loss in sublease accounting
We received the following two questions from our readers regarding the treatment of a loss in sublease accounting:
Question 1: Properly accounting for the income received from a sublease
“We lease 2 floors of a commercial building. One floor we occupy ourselves and the other we sub-let to another organization. There is escalation written into both the head lease and the sublease. The term of the sublease is not the same as the term of the head lease. On our balance sheet we have a deferred rent liability and on our income statement we recognize rent expense on a straight-line basis.
We recognize sublease revenue as received but do not show an asset on our balance sheet corresponding to future sublease payments receivable. We are subleasing at a loss and the head lease was signed twenty-one months before the sublease, so I do not believe we anticipated subleasing the floor. How should we properly reflect this income stream in both the income statement and balance sheet?”
Because you are subleasing at a loss, the first thing that needs to be done is to calculate the present value of the remaining lease payments and the present value of the expected receipts from subleasing (this will mark your liability to market).
To do so, the journal entry will be:
- A debit to a receivable account for the present value of the sublease.
- A credit to a liability account for the present value of your remaining lease payments and a debit to a loss account for the difference.
The liability will be reduced as you make payments via the effective yield method (a portion of the payment will go to interest while the other to liability reduction) and the asset will be reduced as you receive payments.
Question 2: Partially subleased office space
“We have an office space where we subleased 50% of the rent-able square footage to another entity.
Under our original lease,
- we received incentives for leasehold improvements,
- dollars to pay off the early buyout from a previous lease, and
- free rent up front on the new lease.
Under the new 50% sublease agreement, the net cash flows show a loss over the life of the lease.
Should we offset this loss by writing off 50% of the deferred liability for straight-line rent, 50% for the deferred liability for the previous lease termination cash payout, and 50% of the deferred liability established for the tenant improvement allowance?
Also, if we write off 50% of the deferred liability for the tenant improvement allowance, would we write off 50% of the net book value of the leasehold improvement asset? Finally, why would we account for this under ASC 420 vs. just accounting for it under ASC 840-20-25-14-15?”
Yes, as you indicated, the loss would be offset by reducing 50% of the deferred rent liability and 50% of the previous lease termination payout incentive, and 50% of the tenant improvement allowance. In addition, since you are reducing the TIA liability by 50% you would also write off 50% of the NBV of the leasehold improvement.
Additionally, ASC 840-20-25-15 specifies that if the costs under the head lease exceeds the revenues under the sublease, then a loss would be recognized. ASC 420-10 then tells you how to calculate that loss so rather than using one or the other you will use both parts of the standard for various reason.
Hopefully, these clarifications will close the brackets on the treatment of a loss for sublease accounting, but if not, feel free to contact us by completing the form below. This doesn’t only apply to this topic, but to any lease accounting inquiry. We are happy to provide answers from our lease accounting experts for your tenacious questions.