This post originally appeared on tBL Marketplace Partner LeaseQuery's blog Your Lease Queries, Answered and is republished with permission. Find out how to syndicate your content with theBrokerList.
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 current GAAP, using a comprehensive example with actual numbers.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 tell you the entry NOT to make. When a tenant ceases using a location, subleases it and continues making payments to the landlord, the incorrect thing to do 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 we see the VAST MAJORITY of companies doing, but it is NOT GAAP.
The correct treatment is to do the following:
- 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) 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 has to be marked to fair value.
Let’s use a comprehensive example to explain this.
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 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 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
When you net the Head lease amortization schedule against the sublease amortization schedule, you get the following net liability 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 Net Sublease Liability and write off deferred rent from 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:
Dr Accounts Receivable 9,000.00
Dr Sublease Liability 4,000.00
. Cr Accounts Payable 13,000.00
To record cash due to 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 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 AROwhen you sublease it. This is an over-simplification though because of the following significant differences:
- You do not capitalize the entire present value of the minimum lease payments, you 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:
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 intent to sublease the property (as some franchisors 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. Our lease management software reflects our expertise. Be sure to consider accounting for subleases when selecting your lease management software.
If you liked this post, consider reading the following:
Accounting for Tenant Improvement Allowances
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About LeaseQuery: LeaseQuery islease management softwarethat helpscompanies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to getalerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact ushere.
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