Countdown to FRS 102 - Turnover Rents

New FRS 102 accounting rules: Retailers, Are You Ready?

In this episode of 'That Retail Property Guy,' host Gary Marshall reminds retailers of the upcoming changes in Accounting Standard FRS 102, which takes effect on January 1, 2026.  He discusses the impact retailers' leased assets, the complexities of calculating lease liabilities for the Balance Sheet, and specifically this episode addresses Turnover Rents! 

00:00 Introduction to the Podcast

00:27 Overview of FRS 102 (and IFRS 16)

01:25 Current UK Accounting Rules and Lease Obligations

02:31 Complexities in Lease Calculations

04:36 Turnover Rent and Its Implications

07:23 Transitioning to New FRS 102 rules

09:53 Preparing for the New Standards

12:27 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 sharing stories and insights through Gary's unique lens. We hope you'll be entertained, enlightened, and maybe a little inspired. FRS 1 0 2. The new UK Domestic Accounting Standard kicks in on the 1st of January, 2026. At today's date, that's less than six weeks away. Now it impacts all retailers with leased assets. Are you ready? We discuss FRS 1 0 2 and its international forerunner IFRS 16. In other episodes, regular listeners should already be aware that these mandatory changes are coming. Soon. But as a quick reminder, new rules will apply to domestic retailers following their international counterparts who already have to follow the same kind of reporting under IFRS 16. The FRS 1 0 2 rules set out how a retailer must report its lease obligations in its annual accounts. These leases could be for trucks and airplanes, plant and machinery, data servers, refrigeration equipment, and much more. Our obvious focus is buildings. Under current UK accounting rules, a retailer doesn't have to indicate if they hold a hundred leases for 10 years at a hundred grand a year each, so have a technical obligation to pay out a hundred million pounds over the next 10 years. They can just pass that rent cost through the books as an operating expense, just like buying fuel or sandwiches. So investors, shareholders, lenders, bankers, city analysts, and the staff might not be aware of that massive leasehold obligation. They wouldn't be able to compare that obligation against the potential income of the retailer. They'd be unable to see if the retailer has overstretched itself on the property lease front compared to its earning potential. Now, bear in mind these liabilities are not debt, but they do sit on the balance sheet and they make it pretty obvious to anyone researching the retailer just how comfortable or overstretched that retailer is with its least cost obligations. Anyone remember Woolworths or Debenhams or so many more? Of course, the calculation of a lease liability for FRS purposes isn't simply an arithmetical. Rent times lease length inflation and other factors affect the likely value of today's pound in the future. So these calculations are actually. Complex discounted cash flows, and if a lease has rent reviews, then the changes can make a difference too, depending whether those future rent changes are already known now or have to be determined in the future, or even if they're somehow dependent on another factor that can or cannot be determined now. So depending how many leases a retailer holds the best solution for all of this might be specialized software that can work this all out rather than perhaps an unstable model in Excel or on a sheet of a four. So what's about to change? Let's delve a little deeper. A retailer has to make some robust and consistent assumptions. For example, it might conclude that it won't report any leases which have less than 18 months remaining. Maybe they're just too short to bother with. Though, bear in mind if these are all the tail end of longer leases, which will be renewed at their expiry. Well, the new leases will be reported once they're completed, and at that point, the balance sheet could see a notable jump from zero to hundreds of thousands of pounds. If a retailer holds a lease with a fixed rent, the calculation is simpler than for a lease with five yearly rent reviews if the rent reviews are fixed steps agreed in advance, so known now, the calculation is simpler and unchanging through the course of the lease compared to a lease with open market rent reviews that won't be negotiated until some point in the future. And at that point, the calculation would have to be refreshed again, prompting a notable jump on the balance sheet. But as a rule of thumb, the requirement is to report known and fixed rental commitments. Unknowns don't get reported, and for some retailers, a particular unknown is turnover, rent, and again, as a quick catchup, a turnover rent is a common practice in retail leases where the tenant pays a rent based on their sales figures. Their turnover, the building's value isn't really a factor. The rent is tied to the tenant's business activity, so the landlord could get more rent or less rent, depending on how successful the tenant's activity is. Many factors can impact turnover. Imagine how sales might spike at Black Friday or in the Runup to Christmas, or how they might. Downturn during a week of awful weather when nobody goes out. Imagine what occurred during the COVID Lockdowns when many retailers operating from physical stores were unable to generate any turnover. But what if the retailer was able to generate online turnover? Should that count towards turnover for the calculation of rent on the shop? What does the lease say? Turnover might not be applied as a single assessment. A tenant might point out that one product or category has a bigger profit margin than another, so maybe they need to split those categories so they can calculate a different turnover percentage for each of them. Maybe the lease stipulates that turnover rent will be applied across different bands, maybe 20% on the first, a hundred thousand, 10% on the next 50,000, 5% on anything above that. And just to get really complicated, maybe the lease provides for a minimum base rent, irrespective of sales or turnover or profits, plus a top up of turnover rent for sales above a specific value, say above 200,000. But the issue, the complication about turnover rent, is that it remains an unknown until the sales figures are retrospectively computed. So at best it might be assessed quarterly in arrears, or maybe even annually in arrears. So how does this impact our FRS or IFRS if we're international mandate to calculate our lease liabilities? If we don't know the future rent, how can we calculate the total liability at the moment with the current regulations before the new accounting amendments kick in? It doesn't matter. The turnover, rent element of a lease, whether that's all of the rent or just a top-up element, is treated as a contingent rent. It just goes through the books as an expense when it's occurred, so it's kind of invisible to shareholders and investors. Which is partly what the new standard is trying to fix, but will it fix the issue of turnover? Rents. The new FRS 1 0 2 rules are effective for accounting periods from the 1st of January, 2026. Retailers will have to bring onto their balance sheet the calculations of their lease rent liabilities. Most retailers will probably transition in their liabilities based on the remaining term of their leases on the 1st of January. Maybe not doing the full backdated lease calculation from its original day one. So already transitioning in these initial liabilities will be a headache, and turnover based leases might drive the need for a corporate statement in the same way that a retailer might state that it's ignoring remaining lease terms of less than 18 months. It might also state what it's doing about turnover based lease costs. Under the new rules at face value, unknown liabilities such as turnover, rent should generally continue to be excluded from any initial liability calculation. They can still just be expensed in the p and l as and when they are incurred. This differs from variable rents that can be accurately forecasted, like stepped rents, which are known now, or perhaps a base rent that will be adjusted by relation to an index like RPI. On the face of it, if the rent or part of the rent is an unknown factor based on future sales turnover, then the new rules also say to ignore it. But is that a fair representation of the retailer's exposure to lease costs? If a retailer has a history of trading from multiple leased outlets, all of which could be on a turnover basis, and the historic turnover, rents are consistently measurable. Then shouldn't they form a platform, a basis point for advising the shareholders and other interested parties about the probable extent of future liabilities? Okay. The rules say that the variable should be ignored. It isn't fixed, it isn't guaranteed. So a retailer would probably not include it in the technical calculations, but at the same time, it could make a corporate statement in its accounts about those historical costs and their impact on the future likelihood. So it's not a technical number on the balance sheet, but it is an advisory note on the accounts pack. In the aim of transparency, not mandatory. Perhaps applaudable, it's up to the retailer. But a thought, we've spoken about the initial liabilities being transitioned in from the 1st of January. We've spoken about including fixed and known values, but ignoring unknowns. We recognize that turnover is an unknown, but what if that unknown variable then becomes a known fixed costs? Bear with me. A scenario could be that's an end of year calculation of turnover based rent. Then gets converted into a base rent for the following year, a fixed rent. Maybe the lease provides that after each turnover rent calculation, 80% of that sum becomes payable the following year as a fixed base rent, perhaps even on an upward only basis, like a ratchet. So it can never come down again, even if future turnover subsequently slumps. So now we'd have a lease with a partly known rental value. It might only be 80% of the total rent paid to the landlord. But as a known factor, it needs to be reported under the new FRS rules and be sitting on the balance sheet. But again, in the pursuit of transparency, if this is a common occurrence for the retailer, should they add a corporate statement into the accounts pack, explaining that additional rent might also be payable once the next turnover calculations are completed at the following year end. All of this makes for some pretty complex accounting forethought, and for retailers who are considering software to help deliver those calculations, it makes for some pretty complex configuration choices. What scenarios do the various leases require? Are we looking for a single uniform percentage calculation across all leases or different regimes for different leases with different landlords with different percentages or different bans and categories? And what impact if the landlord's accounting years don't align with the retailer's year? Can your chosen software handle multiple configuration structures to accommodate all of these possibilities? Or depending on your actual volume of leases with a turnover basis and no obligation to report this element, could it be simpler to just calculate these offline purely for management purposes? So as the clock ticks forward towards the 1st of January, 2026, I ask again, are you ready? Have you already implemented your new software, calculated your transition in values, made your assumptions and drafted your corporate statements? Are you braced and ready for the potential shift in the apparent health of your balance sheet? Remember that this podcast isn't legal or accounting advice. It's just a discussion perhaps to inspire you. If you are in any way unsure, please take sound advice from an expert with specialist experience in this niche sector, perhaps having learned lessons in the implementation of international IFRS as always, bear in mind that the value of good advice can often outweigh the cost of it. 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 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. Thanks for listening.