19 November 2020
Coronavirus could impact both lessors and lessees on a practical level, as businesses or individuals may not have the liquid cash to pay their rent when it falls due.
What does FRS 102 say?
There are potentially two key issues:
- Onerous lease agreements – some lease agreements may now meet the definition of an onerous lease agreement given that some properties (eg restaurants) have been closed and are no longer generating revenue; and
- Lease modifications - where lessors and lessees have agreed to modify the terms of their lease (on a temporary or permanent basis) so that the lessee is able to continue to trade (and pay the rent) in the longer term once restrictions have been lifted.
Onerous lease agreements
Leases in general are discussed in Section 20 ‘Leases’ of FRS 102, but where an operating lease becomes onerous, an entity shall also apply Section 21 ‘Provisions and Contingencies’.
The definition of an onerous contract is:“A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.”
The first question to be addressed is whether a lease has become onerous. This may be a simpler exercise where the asset itself represents core infrastructure of a cash generating unit (for example, a restaurant premises or high street shops) but more difficult for cost centres which do not generate their own cash (for example, the back-office location for shops).
In order to assess whether a lease is onerous it is necessary to determine whether:
- the building will be closed permanently; or
- the rent is above market rate as it is part of a loss-making cash generating unit (CGU).
It is important to note that the requirements of Section 32 ‘Events after the End of the Reporting Period’ apply to this consideration, so the judgements made should reflect only information available at the reporting date together with any ‘adjusting events’ after the reporting date. For a full discussion on this topic, please see our separate article.
It is important to check that the requirements for recognising a provision have been met ie that an obligation exists at the reporting date because of a past event and will result in a measurable transfer of economic benefits to settle the obligation. Lease agreements normally cover this point as they should set out clearly the rent payment requirements and oblige a lessee to make payment to the lessor.
Once you are satisfied that the contract is onerous and meets the conditions for recognising a provision, the provision is measured at the discounted value of the best estimate of the future cash outflows associated with a contract excluding:
- gains from the expected disposal of assets;
- potential reimbursement (recognised as a separate asset should requirements be met); and
- future operating losses.
In the interests of both the lessor and the lessee, lease contracts are being modified either permanently or temporarily.
Other than in the specific circumstances covered by the October 2020 amendment to FRS 102 as set out below, FRS 102 is silent on the explicit treatment of a modification of the lease and the accounting should follow the normal guidance that:
“A lessee shall recognise lease payments under operating leases (excluding costs for services such as insurance and maintenance) as an expense over the lease term on a straight-line basis unless either:
a) another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis; or
b) the payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor’s expected inflationary cost increases. If payments to the lessor vary because of factors other than general inflation, then this condition (b) is not met.”
The October 2020 amendment to FRS 102 requires that for accounting periods commencing on or after 1 January 2020, temporary rent concessions occurring as a direct consequence of Coronavirus are accounted for on a systematic basis over the periods that the change in lease payments is intended to compensate, if and only if the following three conditions are met:
a) the change in lease payments results in revised consideration for the lease that is less than the consideration for the lease immediately preceding the change;
b) any reduction in lease payments affects only payments originally due on or before 30 June 2021; and
c) there is no significant change to other terms and conditions of the lease.
These changes also apply to lessors as the amendment requires any change in lease income meeting the criteria a – c above to be booked on a systematic basis over the periods that the change in lease payments is intended to compensate.
Practical impact and interpretation for preparers
Onerous lease agreements
Entities will need to assess whether contracts including lease agreements have become onerous, either as at the reporting date (for adjustment) or after the reporting date (for disclosure). Key issues include:
- the difficulty in assessing whether a lease has become onerous;
- entities may never have undertaken these sorts of calculations and may not have the expertise in-house; and
- the consideration of timing to determine if the onerous lease provision is an adjusting or non-adjusting event after the reporting date.
Management should be aware that because this is a valuation exercise, the ethical standards for auditors preclude the entity’s auditor from assisting in performing the calculation of the provision. Therefore, it is even more imperative that these items are dealt with as soon as practically possible to be able to source any assistance.
The October 2020 amendment to FRS 102 brings clarity and consistency for temporary rent concessions that are within its scope as the rules in FRS 102.20.15C and 20.15D must be followed.
Whilst this will bring consistency for short term concessions for payments due on or before 30 June 2021, for those outside of scope it means the entity will require to choose an appropriate accounting policy for any slightly longer term rent negotiations (eg a rent reduction for 12 months to September 2021) or rent deferrals (with no reduction in rentals payable) which would be on a straight line basis over the remaining period of the lease or another systematic basis if that is more representative of the entity’s use of the asset.
An example of ‘another systematic basis’ is: if a landlord agrees to a suspension of the lease for three months as a result of coronavirus (so the term is extended by three months, and a three month rent free period is granted), meaning that the entity is not able to access their office for those same three months, it may be appropriate to recognise no rental costs. This is different to the usual treatment of rent-free periods that are provided as a lease incentive when entering into a lease where cost would be accrued to facilitate spreading the overall costs evenly over the entire term of the agreement.
Care should be taken by those who are only out of scope of the amendments due to the start of the accounting period being before the effective date of 1 January 2020, as it will require to be applied in the next accounting period, and if material, this could necessitate a prior period adjustment if the accounting chosen was not consistent with the amendment.
Other changes to lease arrangements may have different accounting treatments and each one should be considered on their own merits.
We would always recommend that management seek professional advice concerning valuations where significant amounts of judgement are required. When considering whether or not a lease meets the definition of an onerous contract, it may be necessary to consult a valuation specialist.
Similarly, before entering into a lease or an amendment to a lease such as a rent concession, management should seek to understand the accounting and tax consequences especially with specific rules being introduced by the time limited amendment to FRS 102 in October 2020 for Coronavirus related temporary rent concessions.