FRS12 - a change to accounting regulations that may have implications for the property industry

FRS12 - time to own up about your liabilities as tenant

Caroline Potter details a change to accounting regulations that may have implications for the property industry

Does a tenant need to show in its accounts that it is losing out following the closure of a retail store? If, for example, the rent on a vacant shop was reviewed in the early 1990s on an upwards-only basis to such a level that it is way above the current open market rent and there are only 4 more years left to run on the lease, it is unlikely that a tenant will find an assignee or underlessee for this period, let alone one who will pay the rent that you are having to pay. If this liability needs to be shown in the accounts how would it be shown?

As from 23rd March 1999 this liability will be treated, under the Financial Reporting Standard 12, as an onerous contract and an appropriate provision will have to be made in the accounts for the future costs to which a tenant is committed in relation to the premises. The good news is that the High Court have recently held that tax relief will be available for the whole amount of the provision for the tax year in which the provision is made (see Herbert Smith (a firm) v Honour (1999)). An onerous contract under FRS12 is a contract where the unavoidable costs of meeting the obligations under it exceed the benefits expected to be received. In order for a provision to be made the company has to show that, as a result of past events, it is under an obligation to make payment. This past event is something that has happened prior to the balance sheet date which could give rise to a liability.

Where a company tenant, prior to the end of the lease, decides to close a leasehold store (without assigning or underletting) or underlets such store at a rent less than that being paid by it the company must, under FRS12, make provision for the total rent that it is committed to pay to the end of the lease and deduct from this any rent it expects to be able to recover. These liabilities will be high where the property is over-rented. Once made, provisions would need to be reviewed and adjusted as necessary each year. For example, the company may find an undertenant or achieve a higher rent than originally anticipated because the prevailing open market rent has risen.

What happens if the tenant does not close or underlet the store but is running at a loss at these particular premises? In this case FRS12 does not require a provision to be made so long as the tenant is in occupation and earning monies from its use of the building.

The focus is not just, however on leasehold stores that have been closed or underlet. For occupied leasehold premises, the lease itself may create the need for a provision to be made as soon as the tenant starts occupying. Under the lease it is likely that the tenant will have covenanted to repair the premises and make good any dilapidations at the end of the term. FRS12 makes it clear that it does not preclude the recognition of liabilities to make good dilapidations once the event giving rise to the obligation under the lease has occurred. It is certainly conceivable that FRS12 requires a provision to be made as soon as that liability comes into play, ie on occupation. The appropriate provision will be the best estimate of the total expenditure required to make good any dilapidations as at the balance sheet date - it is easy to anticipate that there will be problems in assessing this figure in the early years of a lease.

Quite what impact these changes will have on the property industry, and how property balance sheets will be affected, remains to be seen. Some believe it will affect tenants' willingness to accept long terms for fear of exposing losses incurred by vacant property. What is clear is that tenant companies will be unable to make a single provision for all possible future losses relating to vacant property. Instead annual provision needs to be made for future costs to which the company is committed at the balance sheet date.