Sublease refers to the arrangement where a person, known as lessee, leases out the property which is taken on lease from the lessor to a third party in exchange of periodic rentals and is generally done by the lessee when the asset cannot be used up to its full potential and lessee decides to sub-let that un-utilized portion but the terms of agreement between the lessor and the lessee remains the same.
It simply means an arrangement in which one party (lessee), which has taken the lease, leases out the same asset or property to a third party in full or partial. It is the same as subletting, and sometimes when the lessee is unable to use the leased property to its full potential, they sublease that un-utilized part to a third party. There is no change in the original contract between the first two parties, and the lessee is still responsible for honoring the terms of the contract, even in case of default from the third party. Here let’s understand the parties involved –
- Lessor – Is the person who gives his property or asset on lease.
- Lessee – Is the person who has taken the property or asset on lease from the lessor.
- Third-Party – Is the person to whom the lessee has leased out the property, so here lessee and a third party have the same relationship of lessor and lessee, respectively.
Accounting for Sublease
With increasing globalization and IFRS (International Financial Reporting Standards) being implemented, we have to understand here what IFRS needs disclosure from the parties. IFRS 16 deals with accounting for sublease and requires a lessor to classify whether it is operating or a finance lease –
#1 – Finance SubLease Accounting
When the terms of lease cover the full potential life of the asset or the net present value of total payment for lease installments is equal to the current fair market value of the leased asset, this lease is called finance lease. However, when it comes to the categorization of the sublease, the basis becomes the terms of the sublease and not the original lease.
Let’s understand this with the following example –
A Ltd. has leased a real estate property from B Ltd for 5 years. At the end of the 2nd year, A Ltd for certain reasons has to move to some other place, so they sublease it to C Ltd for the next three years. What is the category here?
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Now we know that real state leases are usually operating lease as the lease does not cover the full life of the asset, but for only a certain period of time, so the original lease between A & B Ltd is Operating lease. However, in the case of the lease between B & C Ltd, the remaining useful life of the asset in the hand of B Ltd is 3 years, and it is leased out to C Ltd for its remaining useful life. So, the lease between B & C Ltd is categorized as Finance Lease.
#2 – Operating SubLease Accounting
If the lease does not cover the full potential life of the asset or the net present value of total payment for lease installments is not equal to the current fair market value of the leased asset, this lease is called an operating lease. If we consider the same example as above and assume that B Ltd leases out only for 1 year to C Ltd, in this case, the lease between B & C Ltd is categorized as Operating Lease.
#1 – Cargo Shipment
There is company X Ltd which takes Trucks on lease from a Truck company X Ltd works as movers and packers and any kind of cargo shipment. Now Mr. D asks the company to lease him a truck for 2 months, and they enter into a contract for 2 months with truck, speed, distance, and other conditions specified. Now Mr. D has exclusive rights for 2 months to use the truck as per contract, and this is an example of an operating sublease X Ltd remains responsible for honoring their original contract with the truck company.
#2 – Cab Services
We know that nowadays there are companies providing cab services without owning a single cab. The ca belongs to the driver or the actual owner. Recently few big cab providers entered into an arrangement where if a person wants to drive a cab with them but does not have funds, the cab company will give them the vehicle on lease. So, the cab company has an original lease agreement with the vehicle company. The cab company then leases out the vehicle to the drivers. It is a classic case of subleasing, and the cab company remains responsible to vehicle company in regard to the original lease.
This type of subleasing falls under the category of finance sublease as the contract between driver and cab company is usually for the fair market value of the vehicle, and if the driver hours the lease contract in full, the vehicle at the end of a lease is handed over to the driver.
- Both parties are benefitted on revenue and expense front.
- Optimum utilization of resources.
- Sublease helps the parties to experiment with new business in the short run.
- Eases out the burden on lessee in the original contract;
- It helps the small parties to own the assets which are difficult for them to buy in the short run.
- The ethical and legal way of utilizing a leased property as subleasing is a globally accepted practice.
- A lessee in the original lease remains responsible even in case of default from the party to whom the asset was subleased.
- Extra paperwork and legal expenses.
- Compliance requirement as per IFRS 16 – The parties have to categorize and submit the details as required by statutory bodies in that country.
Points to Note about Changes
Every time a sublease is renewed or there is any change in terms and conditions, period, or underlying asset – It should be analyzed carefully to assess if there is any change in a category and need to update in statutory documents.
Subleasing is a fantastic system of optimum utilization of resources and bailing out the organizations from a financial crisis in the short run. The organizations or individuals should analyze carefully and use it for their benefit in the best way possible and approved by law.
This article has been a guide to what is Sublease and its meaning. Here we discuss accounting for sublease along with examples, advantages, and disadvantages. You can learn more about accounting from following articles –