Sublease that ends earlier than head lease

How to account for a sublease that is classified as finance lease and ends earlier than head lease? How residual period is determined and accounted at the inception?

An intermediate lessor classifies a sublease by reference to the right‑of‑use (ROU) asset arising from the head lease, not the underlying asset itself (IFRS 16.B58, IFRS 16.63–65).

The fact that the sublease ends before the head lease is common and does not itself prevent finance‑lease classification — what matters is whether the sublease transfers substantially all the risks and rewards of that ROU asset, tested through indicators such as:

• The sublease term covers the major part of the remaining useful life of the head‑lease ROU asset (not the underlying asset's total economic life).

• The present value of the sublease payments is substantially all of the fair value of the ROU asset at sublease inception.

• The subleased space/asset is specialised, usable in practice only by the sublessee.

If these are met, the sublease is a finance lease even though a residual period of the head lease remains unsublet after it ends.

Measurement at Inception

When the sublease is a finance lease, the intermediate lessor:

• Derecognises the head‑lease ROU asset (or the relevant portion of it) and recognises a net investment in the sublease (lease receivable) instead.

• Measures that net investment as the present value of (a) the sublease payments receivable, plus (b) the unguaranteed residual value accruing to the lessor at the end of the sublease term — discounted at the interest rate implicit in the sublease, or, if that isn't readily determinable, the rate used for the head lease (adjusted for any initial direct costs).

• Recognises the difference between the net investment recognised and the ROU carrying amount derecognised immediately in profit or loss.

Crucially, the "residual period" — the stretch of the head lease remaining after the sublease expires — is not accounted for as a separate retained asset at inception. It is captured inside the unguaranteed residual value component of the net investment: an independent estimate of what the lessor's remaining rights in the ROU asset will be worth once the sublease ends (e.g., the fair rental value it could earn re‑subleasing, or the value of reoccupying itself). That estimate is then discounted back to the sublease start date and added to the PV of the sublease rentals to build the receivable.

Worked Example

A 10‑year office head lease has annual payments of €120,000 (arrears), discount rate 5%, giving a ROU asset at commencement of about €926,608, straight‑line depreciated over the lease term.

Three years in, the head lease has 7 years left. The lessor subleases the whole space for 5 years (a finance lease, since the PV of sublease rentals is substantially all of the ROU's fair value) at €140,000/year arrears, leaving a 2‑year residual period it expects to re‑let at ~€115,000/year, giving an estimated unguaranteed residual value of €214,000 at the end of the sublease.

Item	Amount
ROU carrying amount at sublease inception	€648,626
PV of 5 sublease payments (€140,000 arrears, 5%)	€606,127
PV of unguaranteed residual value (€214,000 in 5 yrs)	€167,675
Net investment in sublease (receivable) recognised	€773,801
Gain recognised in P/L at inception	€125,176

Over the sublease term the receivable amortises with interest income and cash receipts, and — by construction — its closing balance after the last payment lands exactly on the €214,000 residual value estimate:

Year	Opening NI	Interest income	Cash received	Closing NI
1	773,801	38,690	140,000	672,491
2	672,491	33,625	140,000	566,116
3	566,116	28,306	140,000	454,422
4	454,422	22,721	140,000	337,143
5	337,143	16,857	140,000	214,000

Accounting at End of the Sublease Term

At the point the sublease ends, the remaining net investment balance (€214,000 here) is exactly the estimated residual value — it is settled not in cash but by the lessor recovering its residual rights in the ROU asset for the leftover head‑lease period.

Two outcomes follow, per IFRS 16.77 and market practice discussed by practitioners:

• If the lessor can reoccupy or re‑sublease the space: the receivable is derecognised and a new ROU asset (or a new sublease receivable, if re‑let) is recognised at the amount realised. If actual fair value differs from the €214,000 estimate, the difference hits P/L immediately — this can also happen earlier, since the unguaranteed residual value must be reviewed regularly, not just at expiry, with any reduction adjusting the net investment and hitting P/L at once.

• If the residual right turns out to have no value (e.g., the lessor has no further use and cannot re‑let it), the outstanding balance is written off as an impairment loss to P/L — practitioners note this loss effectively must be recognised either at sublease inception (if residual value is excluded/understated) or at sublease-end (if it later proves unrecoverable), but it cannot be avoided altogether.

So the "residual period" is never a separate line item at inception. It is embedded as the unguaranteed residual value inside the net investment, and it crystallises into either a reinstated ROU asset or a write-off once the sublease actually ends.