Accounting for Subleases Under GAAP: the CORRECT Way

George Azih Lease Accounting, GAAP, Sublease Accounting

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. We are willing to bet that if you have a Sublease, YOU’RE ACCOUNTING FOR IT INCORRECTLY. In this blog, we will explain the correct accounting for subleases under the current GAAP, using a comprehensive example with actual numbers.

*editor's note 3/12/18. This post was published 12/7/2016. We have updated this post for consistency and accuracy based on the current lease accounting standards under FASB 840. We have also included a question from a reader discussing leasehold improvements to further clarify this topic. 

We write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but lease accounting experts. We understand the challenges faced by real estate professionals AND accounting departments. Our lease management software reflects our expertise.

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:

straightline-amortization-schedulestraight-line Amortization Schedule (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:

headlease-schedule-after-cease-use-dateHeadlease schedule after cease-use date

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:

sublease-amortization-schedule
Sublease amortization schedule

When you net the head lease amortization schedule against the sublease amortization schedule, you get the following net liability schedule:

net-liability-amortization-schedule
Net Liability Amortization Schedule

We now have everything we need to record our 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

Dr     Deferred Rent          6,000.00

Cr     Sublease Liability    17,062.44

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 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:

Dr   Accounts Receivable      9,000.00

Dr   Sublease Liability           4,000.00

Cr   Accounts Payable           13,000.00

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

Dr   Sublease Liability            4,000.00

Cr    Accounts Payable           13,000.00

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:

Dr   Accounts Receivable        9,000.00

Dr   Sublease Liability             3,585.63

Dr    Interest Expense             914.37

Cr    Accounts Payable            13,500

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:

Dr   Sublease Expense             9,000.00

Dr   Sublease Liability             3,585.63

Dr    Interest Expense             914.37

Cr    Accounts Payable            13,500

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:

differences-schedule
Difference in GAAP Sublease

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.

Once again, we write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but lease accounting experts. We understand the challenges faced by real estate professionals, equipment and fleet lease professionals, AND the accounting departments supporting both groups.

March 2018: One of our readers, a Director of Accounting, gave us an additional topic to clarify. They 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.  

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