Countdown to FRS 102 - recognizing rent frees and other lease incentives

Newly amended UK domestic accounting standard FRS 102 kicks in 1st January 2026. This episode compares the old & new rules for recognizing lease incentives such as rent free or landlord’s contributions. Tune in to gain valuable insights, and ensure your business is prepared.

00:00 Introduction to FRS 102 and Podcast Overview

00:49 Understanding FRS 102: Basics and Implications

01:34 Lease Obligations and Financial Reporting

03:24 Calculating Lease Liabilities and Incentives

05:30 Rent-Free Periods and Break Options

08:35 Complexities of FRS and IFRS Reporting

09:14 Stamp Duty and Its Impact on Lease Accounting

10:45 Conclusion and Final Thoughts

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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. Welcome to another episode in our miniseries on FRS 1 0 2, the newly amended UK domestic accounting standard, which kicks in on the 1st of January, 2026, which right now is just a few weeks away. It impacts all retailers with leased assets. Are you ready in this episode, let's recognize the ease or perhaps the complications. Of recognizing incentives or rent-free periods. But hang on, before we launch in at that deep end, let's just catch up on the basics. What is FRS 1 0 2? Regular listeners should already be aware that these mandatory accounting changes are coming soon, and the amended rules will apply to domestic retailers and other businesses, just like IFRS 16 impacted their international counterparts a few years ago. So it'll mean everyone is on the same page for accounting purposes. The newly amended rules set out how a retailer must report its lease obligations in its annual accounts. These leases could be for anything a business holds on a lease rather than owns outright. And it could include distribution and delivery vehicles or warehouse equipment. It could include data service, refrigeration, equipment, office equipment, and so much more. And here at that retail property guy, our obvious focus is buildings or shops a. Under current UK accounting rules, a retailer doesn't have to indicate how many leases they have or what their cumulative commitment to lease rental is. Whatever the rental payment, they can just pass it through the books as an operating expense, just the same as buying fuel or a sandwich. So anyone looking at those annual accounts, and that could be potential investors or existing shareholders, banks, and other lenders, or even the business's own staff, might not be able to see if the retailer has overstretched itself on the lease cost front compared to its earning potential. It's a basic question, can its income service, its lease contract obligations, or is it in too deep? Is it over its head? Is it weighed down by obligations which could possibly sink it? And at this point, as always, I ask you, does anyone remember Woolworths or Debenhams? And so many more? So the newly amended rules state that a business must report those lease contracts in the annual accounts. While there are some exceptions, maybe really short leases and low value leases and leases with a rent based only on sales turnover. But otherwise, retailers should be well down the road. To being able to calculate the present value of their business leases, which will sit on both sides of the balance sheet. And if that sounds a bit odd, like how can something be an asset and a liability at the same time? Consider that it's an asset that you get to use, but a liability you have to keep paying for. If you'd purchased it outright, then that expense would've been reported a long time ago, and the asset would sit just on the asset side of the balance sheet. But you didn't. You have to keep paying rent. So the rent sits on the liability side. We've discussed in other episodes some of the practical considerations of calculating the value of the lease cost liability. A simplistic approach could be that a five year lease for 10,000 pounds a year equals a liability of 50,000 pounds. But this is accounting, so it isn't that simple. The calculations use complex dcfs discounted cash flows to calculate the present value of a future payment. Just like inflation eating away at the present value of a pound, we anticipate that a pound in the future just won't buy as much as it does today. Now another aspect to throw into the calculation is incentives, and this could get complicated for the novice, but we can consider lessons learned from the implementation of IFRS for international businesses. A few years ago, an incentive could be a capital payment from the landlord, which could be a contribution towards doing some necessary works, maybe installing toilets or removing walls, or remedying a state of disrepair. Or it could be a simple inducement to take the lease, often referred to as a sweetener or a bung. I mentioned these separately because they might have different income tax implications completely. Aside from the FRS reporting. A simple bung taken as a cash incentive to take a lease might be treated for tax as a form of income, like a spike in sales. Whereas a contribution to works could be treated as a refund of the tenant's own expenditure. So a repayment rather than income for tax purposes. But for the purposes of FRS 1 0 2, that distinction could be an inducement, might be treated as a credit or a reduction against the rent liability to be spread over the whole of the lease term. And in doing so, it reduces the overall calculation. But a contribution to works might, and I emphasize, might be disregarded for that calculation because the works themselves are something that the tenant is doing on behalf of the landlord. This area is complex, so take good advice. A more common incentive could be a rent-free period. For example, the tenant and the landlord agree a 10 year lease at a hundred thousand pounds a year, but for whatever reason, they agree that no rent will be payable for the first year. Now at face value, you might think this means exactly what it says, that for the first year, the rent is zero, followed by nine more years at a hundred grand. This would be the physical cash flow outta the bank, but not for the purposes of FRS 1 0 2. Under these new rules, the total of rent and rent free must be averaged out over the length of the lease. So for FRS reporting, it looks like 10 years at 90,000 a year. It's the same total, just spread over the whole term of the lease, not lumped into the first year. Some leases have multiple rent-free periods. Landlords sometimes offer a follow on rent-free period as a reward for the tenant not using a break option. So a 10 year lease might allow the tenant a possibility of a break, say at the end of the fifth year, and then say that if the tenant doesn't use the break, they'll benefit from a rent-free period, like a reward, say for the first six months of the sixth year. Now consider this as it might play out. If the tenant serves the break. The lease will come to an end, so no more rent will be payable. That's the end of the lease and the calculation. But if they don't serve it, then the lease and the calculation continue. But by default, they get an extra six months rent free. This expectation is known at the start of the lease, so it has to be reflected on the FRS calculation. We don't have to wait until the break date has passed before we recognize it. We should compute it now as part of the overall future liability. The pivot point is the break option. Is the tenant likely to use it? And if so, they should calculate the lease liability only up to that date, not to the full contractual expiry date. So they'd calculate five years, not 10, but this assumes that the intended use of the break is likely the tenant needs to be robust in this they shouldn't state. We'll assume to exercise all our breaks in order to reduce the impact of FRS calculations on our balance sheet. If in fact they then don't use any of the breaks and it looks like they were just fudging the numbers. Okay, fine. If the tenant has a proven history of using break options, this might support the assumption that future breaks will also be used. But if their history indicates that they don't usually serve breaks, then they probably shouldn't assume a different approach for those future ones. So if the tenant must assume that there is a break, but it's likely they won't use it. Then they could also assume that by default they will reap the benefit of that future reward, the follow-up rent-free period. And then just the same as with an initial rent free at the start of the lease. FRS reporting requires the calculation to be based on the average rent spreading that future rent free across the whole of the lease term. And of course, none of this assumed averaging and spreading reflects the actual payments that'll be going out each rent day. That's why FRS and IFRS reporting is so complicated. The more leases a tenant has, the more they might need specialist software to help. And of course there's no application off the shelf, which will just work from day one, like plug and play on a video game. They need configuring to suit the user's needs and they need loading with the user's data and they need testing for glitches and the results need to be reviewed by whoever will be responsible for signing them off. No surprises. Oh yeah, and one more thing. Stamp duty SDLT or stamp duty land tax to give it its full name is a tax payable by the tenant on legal completion of a new lease. It's a tax to the government. It's calculated as a percentage of the total rent payable under the terms of the lease without any discounted reductions like FRS offers. And annoyingly, the SDLT calculation also includes any VAT payable on the rent. So yes, you have to calculate tax on a tax. So the tenant must pay this tax and then consider how to apply it in the consideration of FRS 1 0 2. Does it impact the lease liability on one side of the balance sheet or the asset to which it has the right of use, which is the other side of the balance sheet, or both? Well, FRS defines the lease liability of the present value of the lease payments that are not paid at the commencement date. SDLT is a one-off tax payment and doesn't fall within the definition of lease payments. So SDLT doesn't feature on the liability side of the balance sheet, but the other side of the balance sheet is the right of use asset, which is measured or calculated as the amount of the lease liability plus any initial direct costs. SDLT is a direct cost of taking the lease and therefore should be capitalized as part of the right of views asset. The basis for reporting lease liabilities and the asset to balance it is complex stuff. Now, as always, bear in mind that this podcast isn't advice. It's just a discussion maybe to prompt you to ask questions of your trusted advisor. The upcoming changes in FRS standards are the biggest changes in accounting. In absolutely ages and non-compliance isn't an option. So wherever you are on this journey to FRS compliance, always bear in mind that the value of good advice often outweighs the cost of it, and that generally you get what you pay for. Seek out a reliable and experienced practitioner with relevant experience in this sector may be learned from supporting international businesses who have already adopted the international IFRS standard. There are more episodes in this miniseries about the transition to FRS. Tune in and join the discussion. Thanks for tuning in to that retail property guy. I hope you enjoyed the discussion and found the subject both entertaining and insightful. Check out more podcast episodes and please consider leaving a review. Thanks for listening.