Ask the Expert: Sub Leases

David Holland, Moore Stephens National Head of Technical Accounting, offers his advice on technical and compliance issues that impact businesses.

Issue
A Not-for-profit organisation provides services to remote communities in regional Australia.  In order to attract staff, they rent several houses (at market rates) for periods of 5-10 years from external parties.  Staff then rent these houses from the NFP organisation on a short term basis (normally 6 months at market rates). How is this dealt with under the new AASB 16?

Conclusion
The answer depends on the classification of the sub leases between the NFP and the staff member.  Based on the facts above it would appear the sub lease would be classified as an operating leases as it doesn’t transfer substantially all the risks and rewards of the head lease.  As such, the NFP will retain the lease liability and the right-of-use asset relating to the head lease with the external party for each property in its statement of financial position.  During the term of the sublease, the NFP will:

(a) recognises a depreciation charge for the right-of-use asset and interest on the lease liability; and

(b) recognises lease income from the sublease with the staff member.
 
Background - AASB 16
Example 20
Head lease—An intermediate lessor enters into a five-year lease for 5,000 square metres of office space (the head lease) with Entity A (the head lessor).

Sublease—At the beginning of Year 3, the intermediate lessor subleases the 5,000 square metres of office space for the remaining three years of the head lease to a sublessee.

The intermediate lessor classifies the sublease by reference to the right-of-use asset arising from the head lease. The intermediate lessor classifies the sublease as a finance lease, having considered the requirements in paragraphs 61–66 of IFRS 16.

When the intermediate lessor enters into the sublease, the intermediate lessor:

(a) derecognises the right-of-use asset relating to the head lease that it transfers to the sublessee and recognises the net investment in the sublease;

(b) recognises any difference between the right-of-use asset and the net investment in the sublease in profit or loss; and

(c) retains the lease liability relating to the head lease in its statement of financial position, which represents the lease payments owed to the head lessor.
During the term of the sublease, the intermediate lessor recognises both finance income on the sublease and interest expense on the head lease.
 
Example 21
Head lease—An intermediate lessor enters into a five-year lease for 5,000 square metres of office space (the head lease) with Entity A (the head lessor).

Sublease—At commencement of the head lease, the intermediate lessor subleases the 5,000 square metres of office space for two years to a sublessee.

The intermediate lessor classifies the sublease by reference to the right-of-use asset arising from the head lease. The intermediate lessor classifies the sublease as an operating lease, having considered the requirements in paragraphs 61–66 of IFRS 16.

When the intermediate lessor enters into the sublease, the intermediate lessor retains the lease liability and the right-of-use asset relating to the head lease in its statement of financial position.
During the term of the sublease, the intermediate lessor:

(c) recognises a depreciation charge for the right-of-use asset and interest on the lease liability; and

(d) recognises lease income from the sublease.
 
Classification of leases (paragraphs B53–B58)
61 A lessor shall classify each of its leases as either an operating lease or a finance lease.

62 A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

63 Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

(a) the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;

(b) the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;

(c) the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;

(d) at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and

(e) the underlying asset is of such a specialised nature that only the lessee can use it without major modifications.

64 Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:

(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;

(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equaling most of the sales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

65 The examples and indicators in paragraphs 63–64 are not always conclusive. If it is clear from other features that the lease does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset, the lease is classified as an operating lease. For example, this may be the case if ownership of the underlying asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are variable lease payments, as a result of which the lessor does not transfer substantially all such risks and rewards.

66 Lease classification is made at the inception date and is reassessed only if there is a lease modification. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the underlying asset), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.