FRED82, IFRS16 & FRS102: How New Regulations on Lease Reporting Impact Retailers' Balance Sheets

The Major Acounting Changes Coming with FRS 102 and Their Impact on Retail Leases

Host Gary Marshall delves into the intersection of estate management and accounts payable, focusing on the impending changes to the UK's Financial Reporting Standard with FRS 102. Gary introduces 'FRED', the Financial Reporting Exposure Draft, and outlines the proposed alignment of FRS 102 with the international IFRS 16 standard. These changes will require most lease obligations to be accounted for on the balance sheet starting January 2026. The episode covers the shift from old to new accounting methodologies, the implications for retailers with leased properties, and the importance of preparing for the significant impact on financial reporting.

00:00 Introduction 

00:24 Meet Fred: Financial Reporting Exposure Draft

00:49 Understanding FRS 102 and GAAP

01:59 Impact of IFRS 16 on Big Corporations

03:00 Upcoming Changes to FRS 102

04:09 Implications for Retailers and Property Leases

04.36 Tweedy's Aircraft Question

07:18 Calculating Lease Liabilities

09:01 Effects on Retailers' Balance Sheets

10:46 Preparing for the New Standards

16:10 Conclusion and Final Thoughts

Other useful episodes:

The Landlord and Tenant Act 1954

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Transcript

0:00

Welcome to that Retail Property guy with your host, Gary Marshall. In each podcast episode, we delve into topics relating to the particular overlap between estate management and accounts payable from the perspective of a retailer as tenant sharing stories and insights through Gary's unique lens. We hope you'll be entertained, enlightened, and may be a little inspired. In this episode, let's introduce Fred to be precise. Fred 82, but that's not a Twitter handle or a Hotmail id Fred, was the financial reporting exposure draft. Basically a document inviting feedback from the accounting community on a draft of some new accounting legislation. It was inviting feedback before the draft evolved into full on accounting rules. Fred proposed changes to FRS 1 0 2, which is a long established accounting practice part of UK Gap. Generally accepted accounting principles. There's a similar version in the US known as US gaap. They're pretty similar, but not exactly the same. Gap is the basic platform for corporate accounting, ensuring that all companies and businesses do their end of year reporting on the same basis, not making it up as they go along. But that's all about to change. After extensive feedback to Fred's suggestions, the Financial Reporting Council issued its list of amendments to FRS 1 0 2. Now the FRC is the UK's independent regulator. It's responsible for promoting high quality corporate governance, financial reporting, and so on. And if you are not an accountant and you are wondering what Fred FRS 1 0 2, gap and FRC have got to do with your business and especially your property leases. Well for us property people with our retailer occupier leases. This is major buckle up. I say, again, this is major. In other episodes we discuss another accounting standard called IFRS 16. Now, unlike UK or US Gap, which are kind of specific to the country they operate in, IFRS is an international standard. It's already been adopted by big corporations who have international dealings. IFRS 16 came in a few years back. Those bigger corporations have already embedded it into their accounting architecture. It was costly, complex, confusing, unfamiliar, and daunting. It was a time consuming and brain challenging minefield, a sea change of established accounting methodology. Everything shifted. Everything was impacted, but smaller organizations, particularly those which deal in a domestic rather than an international marketplace, didn't have to adopt it. They could keep their heads down, keep doing the old stuff like. Treating lease expenses as revenue costs of doing business. Basically with no impact on the balance sheet. Fred and the FRC now propose to align that old familiar accounting closer to the IFRS model. And for us, with our retail Occupy property hats on, we must be aware of and ready for the massive impact. Massive, enormous, huge, costly, no upside, potentially. Lots of downside. So we get to the point. What's the deal with these changes to FRS 1 0 2? Here goes with the biggest impact that all the big corporations with their IFRS reporting standards have already sweated through. Coming up from the 1st of January, 2026, the majority of lease obligations must be accounted for on the balance sheet. This includes leased buildings, of course, but also leased equipment like trucks or airplanes. And this is where IFRS 16 plays its part. The intention of the amended FRS 1 0 2 is that it'll mimic the steps that IFRS 16 already imposed on the bigger players, but now for the smaller players. A key aspect of IFRS 16 was to recognize when a business has liabilities in its leases, contractual obligations to pay rent for many years. To show these on the balance sheet like it would otherwise show debt to make it clear to all interested parties, just how bogged down in financial commitments a company might be. Basically, don't just look at the turnover, look at the millstone hanging round its neck. The idea for IFRS 16 is largely and anecdotally accredited to Sir David Tweedy, a former chairman of the International Accounting Standards Board. He joked that one day he'd like to fly in an aircraft that actually existed on the airline's balance sheet. What he meant was that although airlines operate large fleets of aircraft and sometimes also operate, the airports they flew from these large and expensive assets usually didn't appear on the corporate balance sheet. Instead, the airlines took leases from companies like Boeing, effectively paying them a rent to use the aircraft, but without actually seeming to own them. Nevermind that the aircraft were decked out in the airline's corporate colors under the previous reporting standards. These rental arrangements were treated as operating leases where the rent, et cetera could be deducted from incoming revenue. And the airline claimed to own no assets and have no liabilities. But Tweedy clearly recognized that this was bonkers. The airlines had exclusive use of those aircraft for long periods under binding contracts. They weren't hired by the hour. The airlines had large numbers of these contracts shelling out millions in rent, and they had legal obligations to make those payments for years to come. But anyone looking at the company balance sheet, perhaps an investor looking to do a health check to establish if the company was solvent, would see nothing. The long reaching leasehold obligations were to all intents and purposes invisible. So Tweedy and the other setters of standards proposed a new model where the majority of leasehold commitments to pay rent would be recognized as a right of use asset or a liability on the balance sheet. And the amended FRS 1 0 2 leans heavily on those changes that Tweed and co introduced in IFRS 16. We can see the comparison, the same logic, the same conditions in simple brutal terms. Big corp accounting is coming to the little guy, and we can learn lessons from what the introduction of IFRS 16 taught those big guys. So let's dig a bit deeper. As IFRS 16 was launched, many companies were obliged to add millions or billions or trillions to their balance sheet. This represented that millstone of contractual liability, and in some cases, this completely changed the perception of how solvent there were. When your real time obligations are aired in public, you might suddenly seem more of a weekend millionaire, not a real one. The new standard defined a lease as a contract or part of a contract that conveys the right to use an asset for a period of time in exchange for a consideration. It isn't necessary for the consideration to be labeled rent, but that is the implication. The standard ignored deals less than 12 months, but anything greater was included in the mix. The lease liability initially measured. All of the rent for the length of the lease, but using a practice known as discounted cash flow to calculate the present value, this assumes that the worth of a pound in your hand today is different to a promise of a pound in say 10 years. And of course, the standard didn't impact just airlines with aircraft. It swept up any businesses that were running operating leases, deducting rental expenses from revenue income while showing an empty balance sheet. And here we get to property. Retailers with leases are big players here. Many retail occupiers had long since got outta the business of owning the freeholds of the shops they traded from. Instead, they ran their shops through operating leases where the rent was a deductible cost not seen on the balance sheet, but a property portfolio of long leases at high rents presents a substantial burden, a millstone, an obligation, which investors should be aware of. Back in the olden days when retailers owned their freeholds, these showed as assets on the balance sheet, making them appear stable, robust, financially responsible. By comparison, a staggering amount of legal obligation to pay rent. Shouldn't be overlooked. So the new IFRS 16 standard meant that these obligations, or the discounted cashflow version of them appears on the balance sheet as a liability. And the amended FRS 1 0 2 coming your way, we'll work the same way. So if you operate from leases, and those leases have contractual terms measured in years, you need to be getting your house in order. Pronto. I don't want to unduly alarm anyone, but it is critical to be ready. The whole point of a balance sheet is that it should well balance the debt side, shouldn't exceed the asset side. The ratio of asset to debt or vice versa is critical. The ratio of debt to turnover is also critical. This is the leverage by which business is measured. As bigger corporations transitioned into reporting their lease liabilities through IFRS 16, many found that their leverage, their debt to turnover ratio. Suddenly swung wildly in the wrong direction. What might have previously seemed a profitable business suddenly looked, weighed down, over leveraged, unstable, possibly on the brink of bankruptcy. And of course, this sounds dire, but in essence, the position hadn't changed. It's just that those companies had previously been concealing their millstone liabilities from public view. Let's make a comparison. If someone owns a hundred houses and is mortgage free, we can consider them stable and robust. If they then reveal that they actually have full mortgages on all those houses, and the rental income only just covers the monthly payments, they seem less robust and possibly at risk if the interest rate changes. Smaller retailers using FRS 1 0 2 need to be thinking about adding those liabilities to the balance sheet and figuring the consequences. But how to do that arithmetic. What is the sum of the obligation to pay rent to lease expiry? Well, it's never simple for starters. It's not just a sum of all the rent for all the lease for all the leases. Many retailers will have leases that started before this new amendment comes into effect. The same occurred with IFRS. It wasn't reasonable to throw in the past value of rents already paid, so they were allowed to transition in, meaning they summed up only the remaining obligation of rents. Due from the date of the new legislation, not the who lease obligation from some historic day one and a pound in your hand now is worth more than the promise of a pound next year or in 10 years. This combines the effect of inflation and of having to wait to get paid. So the arithmetic of the liabilities relies on complex discounted cash flows. Most people need software to work these out. The DCF discounted cashflow also demonstrates that each payment of rent under the lease diminishes the remaining liability of future rent. Eventually whittling the liability down to zero, at least expiry. So as leases age and therefore becomes shorter in remaining term, the remaining millstone shrinks, which has a positive effect on leverage against turnover, and these dcfs can be even more complex. Many leases have future rent reviews, and maybe the new rent isn't known yet. But as soon as that review is settled and the new rent becomes known, the calculation must be rerun to provide the newly calculated liability for the balance sheets and lease expires. Present some interesting scenarios. Technically, when a lease comes to an end at the end of the contract, the balance has whittled down to zero. But in England and Wales at least, where business tenants are usually protected by the 1954 Landlord and Tenant Act, the tenant might be able to remain in occupation, still paying rent under a process known as holding over. We discussed this 54 act and its security of 10 year provisions. In other episodes, check the show notes for links. So holding over isn't a new lease. It's a periodic tenancy, maybe month by month or quarter by quarter, so generally coming under the threshold to be ignored as it's less than 12 months. So still paying the same rent, but while holding over on a periodic tenancy, the tenant could be reaping the benefits of the leased asset, but not be required to do a liability calculation, interestingly well, until they get to negotiate to renew the lease. If the new lease is agreed after the old lease expires, it gets treated as a new standalone lease with a new calculation for the balance sheet. But if the commitment is signed before the original lease runs out, then the assumption is that this is now one single but much longer lease and the new calculation must rework the remaining liability of the old lease, plus the new liability of the renewal lease. Again, interesting, eh, and what about break options? The calculation should also pick up if there is any break option where the tenant or the landlord could effectively break the lease before its contractual expiry. But the reporting standard treats breaks with a degree of skepticism. It requires that the break is likely to be used. It's not acceptable for a tenant to program their calculations as if all breaks are certain, and therefore, to curtail the calculation of all their leases. This could massively reduce the debt obligation for the balance sheet. So there must be a degree of realism, an indication that the breaks are actually likely to be used. This could be evidenced by a genuine track record where the tenant can demonstrate the common use of brakes to exit from leases. If this evidence doesn't exist, the tenant might be stuck with the greater calculated liability. I. And of course, not all discounted cash flows are created equal. Not all properties and leases and locations are equal discounted cash flows. User percentage return, like the borrowing or interest rate In any investment model, it must be realistic. It'll often be based on yields, which investors might expect from that specific property or location. Classes of location can vary. For example, prime high street or secondary high street or prime retail park or secondary retail park. The differing rates of return for differing expectations of better or worse yields can have a marked impact on the sum produced by the calculation. One consequence of this new approach, of course, has been the drive towards shorter leases, whereas in the eighties and nineties, a 25 year lease meant stability and practicality. It now also means a massive balance sheet liability. So IFRS 16 and FRS 1 0 2 are driving shorter leases. Fewer years on the lease reduces the sum of the overall calculation for the balance sheet and gives flexibility at renewal of course. So in conclusion, a lot of retailers previously owned their stores and had healthy balance sheets with large asset values. Then they sold them all and took back leases. I. Certainly the lease model is now the most common method to operate a retail store, but now the lease liabilities must be calculated and those sums must appear on the balance sheets hanging like a debt, a millstone, reflecting the extent to which the retailer has committed themselves to all those leases. Retailers, accounts are transparent and investors and shareholders should know where they stand. As we discussed before, if a retailer operates from leased property or leases their trucks or other equipment, and if they haven't already adopted international standard IFRS 16, then now is the time to get on board with the changes coming soon, very soon in FRS 1 0 2, seek professional advice. Consider your software. Be prepared. Thank you for listening to that Retail Property guy. I hope you enjoyed today's discussion Be sure to like, share and subscribe so you can never miss an episode. For more information, visit that retail property guy.com. Thanks again for tuning in.