Countdown to FRS 102 - Discount Rates for calculations

Preparing for FRS 102:  Discount Rates when calculating Lease Liabilities

This episode is part of a mini-series focusing on the challenges faced by retailers as tenants, for the upcoming mandatory changes to domestic accounting standard, FRS 102, set to take effect on January 1, 2026. 

Host Gary Marshall explains the complexities of discounted cash flow calculations, and the importance of choosing the appropriate discount rate for accurate financial reporting

He suggests practical steps for small businesses, and some potential pitfalls for low-cost reporting solutions. Listeners are encouraged to consult with experienced accountants or FRS specialists!

00:00 Introduction to FRS 102 Changes

00:55 Understanding Lease Liabilities

03:01 Calculating Discount Rates

06:24 Discount Rate Options and Implications

10:05 Practical Considerations for Small Businesses

11:46 Conclusion and Final Thoughts

Link to excellent article: https://www.linkedin.com/pulse/whats-new-frs-102-discount-rates-lease-accounting-harpreet-kaur-0ncte/

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Transcript

0:00

Hello, and 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. Retailers, are you ready for FRS 1 0 2? Regular listeners should already be aware that these mandatory changes are coming soon as changes to domestic accounting standard known as FRS 1 0 2. Kick in on the 1st of January, 2026. At today's date of dropping this podcast, that's just a few weeks away. So we have this mini series of countdown episodes focusing on some of the challenges that retailers are facing as they transition into the new standard. It's a big change not to be overlooked until the last minute. So I ask again, are you ready? In this countdown, let's talk about discount rates in the calculations of lease liability for FRS reporting. Oh, okay. Hang on. Are we already a step too far? Shall we rewind with a quick reminder of what this is all about? These new accounting rules will apply to retailers in the UK and the Republic of Ireland, aligning domestic reporting rules with the rules already in place for international retailers. Under IFRS 16, the rules set out how a business with leases reports those lease obligations in its annual accounts. And the leases could be for trucks or warehouse machinery, data servers, refrigeration equipment, and so much more. But our obvious focus is on buildings, and the business will be a retailer occupying those buildings as a tenant. Under the current version of domestic FRS accounting rules, a retailer doesn't have to show any numbers in their accounts in relation to their leasehold rent obligations. Even if these amount of. Thousands or even millions of pounds a year, they can just pass the cost through the books as an operating expense, just the same as buying fuel or a sandwich. So, investors, shareholders, lenders, bankers, city analysts, and the business' own employees might not be aware. Of that rental obligation, they'd be unable to see clearly if the retailers overstretched itself on the property lease front compared to its earning potential. And if anyone remembers Woolworths or Debenhams and so many more, that's the point under new FRS 1 0 2 rules. This will substantially change. Lease holders, especially property tenants, must calculate the value of their rental obligations and show that on the balance sheet it's complicated. One side of the balance sheet will show the benefit. That's the upside of having a lease as a right of use asset, while the other side will show the burden, the obligation of all that rent to the expiry of the longest running lease. They kind of balance each other out, but the info makes it very clear whether the tenant is comfortable or overstretched. Okay, so back to the plot. We need to calculate the total of our rental liabilities, and if it was simple, we could just multiply all the rents by the number of payments left on the leases. But of course it isn't that simple. This is accounting and accountants recognize that the value of one pound today will diminish over the coming years. Factors like inflation will eat away at it. A pound at today's value might only be worth, I dunno, 85 p in a few years time. It just won't buy you what it used to. So to avoid overstating the calculations, we need to be able to work out what a pound of value today will be worth at the point in future when we actually pay it out. And because leases usually have obligations to make many payments over fairly long periods, maybe three years or five or maybe 25, we need to do this calculation for every single future payment under each lease, assuming that as time reaches away into the future, each quarter or month, contractual rent will effectively diminish in value against today's perceived value of a pound. As a thumbnail version of this, you might say that the simple version of a 10 year lease at 50,000 pounds a year is 10 times 50,000, so 500,000 pounds. But the accounting method might work this out as a lower figure, say 450,000. Hmm. So how does it do this? Well, it uses complex discount, cash flow calculations, often known as dcfs. And if you recall that we have to do a DCF for each and every lease and each and every payment. You can recognize why software to help with this is a really good idea. Now before we jump in at the deep end, bear in mind that the FRS rules allow some exemptions. So for example, it might not be necessary to do these complex DCF calculations for leases with a really low rent or for leases that are really short, or for leases that pay rent based only on turnover values, not a fixed value. But you might want to check with your accountants or your FRR specialist before making any rash assumptions. How would you define a really low rent? Is it a token, one pound per annum or a peppercorn that never actually gets collected or anything up to a grand a year or more? Your assumption about low value must be robust, and it's the same with really short leases. How to define short. Less than a month, less than a year, less than 18 months. And bear in mind that when these rules kick in on the 1st of January, 2026, the initial calculations will probably be looking at how long remains on your existing leases rather than what the whole original term was. So you might have a 10 year lease from the 1st of January, 2017, meaning it only has one year left as at the 1st of January 26th when the rules kick in. So you might consider that that remaining one year, well, you might call it a short lease term and choose to not report it, but when you renew the lease in 2027, well, at that point, you'd most likely have to recognize the full liability of the whole new lease. So you'd see a big jump in values on your balance sheet. So for all the leases that are neither really short or really low value or purely turnover based, what next? How to assess those discounted cash flows? The first and obvious step is to decide on an appropriate discount rate, discounted cash flows, DS user discount rate. Now, a simple analogy could be the interest on a loan where the interest rate gets added to the original sum, meaning that you pay back more than you borrow. But of course, you chop around for a loan with a reasonable interest rate. A DCF works the other way. The interest rate gets deducted or discounted, meaning that the end value is less than the original amount. It actually winds down to zero, but you need to use a reasonable discount rate. Luckily, the FRS rule itself helps us out here. It defines how to assume or set the discount rate. It starts with the obvious question, what does the lease say? If an interest rate is specified in the lease, then probably use it, but if it isn't clear or perhaps doesn't seem appropriate, then the tenant can choose from two other options. Their incremental borrowing rate or their obtainable borrowing rate. These sounds similar but are quite different. The incremental version is the interest rate that a tenant would pay to borrow funds for a similar asset, so it compares apples with apples, shops with shops, trucks with trucks. By comparison, the obtainable version is the interest rate that a tenant would pay for a general loan that isn't tied to any type of assets. You can imagine that maybe a tenant could get a lower interest rate on a mortgage linked to a building. This will be similar to the incremental version than on an unsecured general loan, and this will be similar to the obtainable version. The shift in actual interest rate can make a substantial and material difference to the calculation. Just like a hike in your mortgage rate could make a difference to your domestic situation. Many small businesses will probably opt for the obtainable version. Quite simply because it's simpler to research and requires less auditable evidence, it's just easier to implement, but beware the potential impact if the incremental version could be more advantageous, like choosing a loan based on its offered interest rate. Luckily, FRS allows tenants to pick and choose which method to apply on a lease by lease basis. They don't have to apply one method for all leases, and this can help if some assets are buildings and some are trucks, apples with apples, and all that. A business making a choice about the appropriate discount rate should bear in mind any material factors which could impact the assumed rate. It might not be appropriate to assume the Bank of England interest rate on the day. Some businesses might get advantageous terms at their banks, while others could be in a weaker position and might have to pay a special rate. This borrower status might be a material factor reflecting the credit rating of the actual business. I know the material factor might be in the length of the leases. Interest rates on loans might vary for shorter or longer loan loans, or the quality of the asset to which the loan relates. Even if it isn't a secure loan, and the same applies to the discount rate on your dcfs, but a notable outcome of which rate do I use could be that the higher the rate being applied as the discount factor, the lower the overall outcome of the liability. Just like a higher interest rate on a loan creates a higher overall payable value. A higher discount rate means a lower overall calculation as at today's present value, and this variable might have a material impact as the total liability would look lower on the balance sheet. And maybe that's what you want. Hmm. So now if we wrap up this into a mission statement for retailers and other businesses, of course, who haven't yet resolved their method of calculating and reporting their lease cost liabilities, we could say, figure out which leases you need to report and figure out what discount rate to. And start calculating. But of course it's not that simple. A DCF on a simple lease with no rent changes in the future is one thing, but it becomes more complicated if the lease has future rent changes, and then it becomes more complicated if some of these are known and therefore fixed now, and others are open to negotiation perhaps years into the future for many small businesses, perhaps with just a handful of leases, but nevertheless with a need to calculate liabilities and report them. The entry cost for software might just seem huge. Like many other statutory initiatives such as making tax digital, also known as making tax difficult, the technical challenges of getting some software, applying the skill in using the software, having competence in setting the configurations for the software, it's all just a massive headache and perhaps overly expensive for smaller retailers. So some accountancy firms will be offering a low cost solution, but savvy retailers will be wary to recognize that you generally get what you pay for. The lower the offered cost, the more likely that the service will be like a factory, one size fits non, not tailored to your needs, and maybe taking ages for the churn of caseload to get around to you. So choose wisely and remember as always that the value of good advice often outweighs the cost of it. PS. There's an interesting link to a LinkedIn article in the show notes. Take a look. Follow it through. Good luck. Thanks for tuning in to that retail property guy check out more podcast episodes and if you have a suggestion for a future topic, please leave a suggestion or send us a message. If you liked what you heard, please consider leaving a review.