Upcoming amendments to FRS102 Leases

Amendments to FRS102 regarding leases will come into effect for accounting periods ending on or after 1 January 2026. This will therefore first affect entities with a year end of December 2026 and entities with short periods. Early adoption is permissible provided all amendments are applied at the same time. 

The most significant change will be the removal of a distinction between a finance lease and operating lease. As a result, lessees will be required to bring all leased assets onto the balance sheet including those under an operating lease. The distinction being made is a move from “risk and rewards of ownership” under the old rules to a “right to use asset” under the amended rules. 

These amendments will bring some significant changes to financial statements of clients especially where leasing is concerned and will affect profit and loss and the balance sheet position. Where applicable, debt covenants may also need to be renegotiated due to additional assets and liabilities being recognised on-balance sheet.

HMRC is expected to issue guidance in the coming months on the tax treatment of the new lease accounting requirements.

Expected impact on financial statements

Balance sheet

On the balance sheet, the lessee recognises a new asset at the present value of the future lease payments together with any directly attributable costs of obtaining the lease (e.g. legal fees) and a corresponding lease liability. The entity then applies the cost or revaluation model as for other assets.

The lease liability is measured using the amortised cost method which uses an effective interest rate. The lease liability is split between current and non-current liabilities to comply with the statutory formats of the balance sheet.

Profit and loss account

The current operating lease rental expense is replaced with depreciation, any applicable impairment and a finance cost for the unwinding of the lease liability.

Impact on KPIs/key figures

The following KPIs/key figures are likely to be impacted under the new rules which could in turn affect existing debt covenants: 

• EBITDA will increase by the value of the operating lease expense that is removed.

• Finance and depreciation charges will be higher 

• Gross assets threshold regarding determination of company size may be breached due to additional right-of-use assets being recognised (although increases to company size thresholds are expected).

• Net current assets will be decreased due to the current lease liability.

• Gearing ratios could increase, depending on the definitions of debt.

Discount rate to be used

The lease payments contained in the lease agreement will be discounted to arrive at the value of the leased asset and corresponding finance lease liability. In other words, at initial recognition, the entity measures the lease liability at the present value of the lease payments that are not paid at that date.

The interest rate to be used in discounting the lease payments will be the interest rate implicit in the lease (where this can be readily determined), which is defined as the rate of interest that causes the present value of the lease payments; and the unguaranteed residual value to equal the sum of the fair value of the underlying asset; and any initial direct costs of the lessor. 

If the interest rate implicit in the lease cannot be determined reliably, the entity can choose (on a lease-by-lease basis) to apply either the lessee’s incremental borrowing rate or the lessee’s obtainable borrowing rate. The definition of these terms are also included in FRS102, however the FRC is keen to state that this should not be overly complicated. Getting the obtainable borrowing rate could be as easy as contacting the bank and asking them at what rate could the business borrow money.

Transitional provisions

The new operating lease rules will be applied under a modified retrospective approach meaning the comparatives are not restated but there may be a cumulative adjustment at the start of the current period to bring the relevant leases onto the balance sheet, with any difference between the assets and liabilities being recognised in retained earnings. The lease liability will be measured at the present value of any remaining lease payments, discounted at the date of initial application.

The right-of-use asset will be measured at the same value as the liability, with only adjustments for any prepayments or accruals on the balance sheet at the start of the current period. 

Exemptions from on-balance sheet recognition

There are two situations when a lease need not be recognised on-balance sheet:

Short-term lease

A short-term lease is a lease which, at the commencement date, has 12 months or less to run. Keep in mind that a lease which contains a purchase option is not a short- term lease.

Low-value assets

The standard provides a list of assets that would NOT be low value, as follows:

• Cars, vans, buses, coaches, trams, trucks and lorries

• Cranes, excavators, loaders and bulldozers

• Telehandlers and forklifts

• Tractors, harvesters and related attachments

• Boats and ships

• Railway rolling stock

• Aircraft and aero engines

• Land and buildings

• Production line equipment

In developing the revised FRS 102, Section 20, the FRC deliberately did not include monetary amounts for low value. Preparers should ensure that for leases of assets that are not low value, these should be recognised on-balance sheet. If the entity has smaller things, the standard is happy to leave the treatment to professional judgment.