Countdown to FRS 102 - lease renewals, extensions and breaks

New FRS 102 Accounting rules introduce changes to how lease liabilities are reported in a business' annual accounts. This episode considers the impact of lease length in those calculations, where breaks, options to extend, reversionary renewals and Minutes of Variation might have a substantial impact but protected renewals under the 1954 L&T Act might not.  

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Transcript

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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. This is 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 is now just a few weeks away as we publish this episode. These changes are the biggest upheaval in accounting compliance in a really long time. It's a game changer and it's complicated, and it impacts all retailers with leased assets. So are you ready? In this episode, we'll discuss the implications of back to Back leases, whether this is a renewal under the 1954 Landlord and Tenant Act, or a renewal triggered by a lease option to renew or a mutually negotiated reversionary extension. We'll delve into each of these in a moment, but first, let's just wind back a bit and remind ourselves what is FRS 1 0 2? The new rules set out how businesses, and for our purposes here we're talking about retailers report their lease obligations in their annual accounts. These leases could be for anything that the business holds on a lease rather than actually owns outright. So it could include distribution and delivery vehicles or warehouse equipment. Refrigeration equipment, data, servers, office equipment, and much more. But here at that retail property guy, our obvious focus is buildings shops. Under current UK accounting rules, a retailer doesn't have to indicate how many leases they have. What they're for or how much their cumulative rental commitment is. Whatever the rental payment, they just pass it through the books is an operating expense, just like buying fuel or a sandwich, as we mentioned in other episodes on this specific challenge. This means that anyone looking at the annual accounts from the outside might not be able to see if the retailer has overstretched itself in terms of lease costs compared to its earning potential. The basic question as always, can its income service, its lease contract obligations, or is it in too deep? Is it weighed down by obligations which could possibly sink it? And the obvious comparables are always Woolworths and Debenhams and so many more. So the newly amended rules state that a business must report these lease contracts in the annual accounts. Well, there are some exceptions. Maybe really short leases or low value leases or leases with rent based only on sales turnover. But otherwise, retailers should now be well down the road to being able to calculate the present value of their business leases, which will then sit on the balance sheet in clear black and white for anyone who's interested. We've discussed in other episodes some of the practical considerations of calculating the value of the lease cost liability. A simplistic approach might 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. These calculations use complex discounted cash flows, otherwise known as dcfs to calculate the present value of a future payment. We recognize that just like inflation eats away at the present value of a pound, we must anticipate that a pound in the future just won't buy as much as it does today. But clearly the underlying core of the calculation is effectively rent multiplied by lease length. A lease for 10 years at 50,000 a year will have a liability in the general region of half a million pounds. But the same rent for only five years will show a liability in the region of just 250,000 pounds. Ah, so we can see that shorter leases drive lower liabilities, which might have a different impact or perception in the accounts. This factor alone is a key driver in retailers looking for shorter leases rather than longer ones. Of course, there are other drivers for shorter leases, such as the ability to avoid upward only rent reviews and to have a lower contractual obligation, so more flexibility. But for retailers who want to remain trading in their established location, this also means frequently negotiating to renew the lease, possibly to modernize the terms and conditions, and then having to pay legal costs for that new document. Nobody said that being a tenant was cheap or easy, so if we're considering flexibility, one way to avoid so many renewals of short-term leases is to seek a longer lease with a break option. Now this is a trade off. It has pros and cons. The longer lease requires a big tax in the form of SDLT, stamp duty land tax, but it means one set of lawyers fees every 10 years, not two sets. Breaks can offer a tenant that desired flexibility may be subject to some conditions. Maybe the landlord will require a penalty fee, maybe certain terms must be complied with. Breaks aren't all plain sailing. Tread carefully. Don't miss a deadline or a condition and end up stuck with a surplus lease for another five years. Trust me, it happens. It's an expensive mistake to make. But we're discussing FRS 1 0 2, the new, or at least newly amended accounting rules. And what does that have to do with breaks? Well, the main purpose of FRS 1 0 2 is to require the calculation of a liability to pay future rents. So we are back to that approximate guide of rent multiplied by lease length. A short lease produces a lower liability for the balance sheet than a longer lease does, but if the lease has a break clause in the tenant's favor, well, is this a game changer? Well, yes and no. The critical point is the likelihood that the tenant will exercise that break option if they're truly likely to use it. They'd calculate the least liability for FRS only up to the date of the break, not to the full contractual expiry date. So they'd calculate five years, not 10. But this assumes that the tenant is robust in their intention to use it. They shouldn't just assume to exercise all of their breaks in order to reduce the impact of their FRS calculations on the balance sheet. If they then don't follow through by breaking all their leases, it could look like they were just fudging the numbers. So a tenant should look at the leases, which contain break options in their favor and make a robust declaration perhaps evidenced by their previous history of actually breaking leases. And if on the other hand, their history shows that generally they let breaks slip by without action, then they should probably assume that future breaks will also be skipped and calculate the whole lease length for FRS purposes. But hey, not all lease options relate to breaks. Some leases contain options for the tenant to demand a renewal. Okay, so experiences teach it us that renewal options are not ENT in UK business leases, at least not in England and Wales, where those leases are generally protected By the 1954 Landlord and Tenant Act, a tenant doesn't really need a renewal option written into the lease if they have the full power of the law behind them to demand a new lease. Let's come back to the andels and tenant renewals in a moment and focus right now on options, just like break options. The lease might provide that certain conditions will apply, may be including some upfront costs or the payments of fees. An option based renewal might also be quite restrictive, literally a renewal on exactly the same terms, except maybe the rent. Everything else gets rolled forward into the new lease. Warts and all. There's no chance to modernize. There's no chance to change the defective clauses or to recognize new legislation or changing business practices. But in some markets, an option to renew is the best chance a tenant gets to protect the goodwill of their established business, at least expiry without the risk of simply handing that goodwill to the landlord who can then offer it to the highest bidder. Or maybe the tenant getting fleeced for a new deal because they feel that the landlord holds all the cards. But like break options. The presumption for FFR S 1 0 2 reporting would be, is the tenant actually likely to utilize this option or not? If their operational history shows that each renewal option probably would be exercised. Then from an FFR S 1 0 2 perspective, the calculation should be the initial term of the initial lease plus the renewal or extension, which could be offered by that option. And possibly even a subsequent renewal if the option gets renewed and each additional period of years could add a marked increase in the calculated total liability for the balance sheet. Longer leases. Bigger liabilities. One critical factor, of course could be if the future rent of that future lease under the As yet, unexercised option isn't known. FRS 1 0 2 relies on known values, whereas unknown factors which have to be negotiated in the future are generally ignored. So if the renewal option sets out the new lease length and the new rent, then it's a known element, which can be calculated now, but if the rent will remain unknown until the new lease starts, well, it's like an unknown future rent review. It would be ignored for FRS until it gets fixed, settled, documented in black and white. And in the meanwhile, the current rent would be assumed to extend for the option period. The same thought process applies to many leases under the 1954 Act. If the existing lease expires and the legally protected tenant simply holds over while negotiating terms for a new lease, which is eventually signed well after the old lease run out. Then for FRS purposes, those two leases are not connected, so you have one calculation for the first lease and a subsequent unconnected calculation later for the renewed lease. This avoids an assumption of a much longer term IE, the original plus the renewal. So it avoids acting as a big multiplier for the rent when calculating the liability and the right of use asset. And as we mentioned earlier, generally retailers prefer the shorter, smaller calculations. So keeping these two leases separate seems a really good idea. Except if a retailer anticipating an upcoming expiry has an operational reason to open negotiations early, they might end up with what's known as a reversionary lease. This is a new lease signed separately from the original one and legally completed while the existing one is still in force and intended to kick in seamlessly the day after the original one expires. From the retailer's perspective, business is guaranteed and uninterrupted, but from an FRS 1 0 2 point of view, this Reversionary lease acts as an extension of the original lease term. So at the point of legal completion, the retailer would have to recalculate their liability and asset to cover the total period of the remainder of the original term, plus the extended term. This is a bit of a complication. It's something to have to remember to do. It's messy and it impacts the balance sheet. The same could be said of a minute of variation. That's an agreement between the tenant and the landlord to vary the terms of the existing lease. Sometimes these are used just to relax a restrictive term or a condition, like a change of use, or maybe to allow an alteration to the building, but sometimes they are used to change the rent and maybe the lease term. Maybe rather than negotiate a separate reversionary lease to kick in the day after the current lease expires. The tenant and the landlord just agree to legally amend that current lease by agreeing that the original expiry date would be deleted and be replaced with a newer date five years later on, and maybe changing the rent from that date too, or maybe even from this date. But bingo, the action of changing the rent and or the lease term triggers the need to recalculate the lease liability and the right of use assets. Okay, hands up. Nobody said that compliance with FRS 1 0 2 would be easy. It's a comprehensive change to reporting practice, and the technical demands are substantial. If a retailer holds more than a handful of leases, they probably need software to help with the heavy and repetitive lifting. And transitioning into new software isn't child's play. Applications exist, but they're not plug and play like a video game. They have to be configured to the retailer's needs. And the retailer's data must be migrated in and verified, and lots of decisions have to be made. A non-compliance isn't an. Now, as always, bear in mind that this podcast isn't advice. We are just having a discussion maybe to prompt you to ask pertinent questions of your trusted advisor. But 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. So seek out a reliable and experienced practitioner with relevant experience in this sector. Maybe learned from supporting international businesses who've 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.