Preparing for change: Leases

The FRC has issued its amendments to FRS 102 via the periodic review 2024, which will move UK GAAP to an ‘on balance sheet’ lease accounting model for most leases. The new approach is based on IFRS 16 and is similar to current finance lease accounting. Despite the similarities in concept to the current finance lease model, virtually all material leases which are currently classified as operating leases will move onto balance sheet too, and the distinction between operating and finance leases will no longer be relevant to the accounting treatment.

As a result, for most lessees, the new model will increase the assets and liabilities recognised on the balance sheet, and there will also be changes to the presentation of the lease expenses in the income statement. Only short-term leases and leases of low-value assets will remain ‘off balance sheet’.

While the revisions to FRS 102 are effective for periods commencing on or after 1 January 2026, we recommend using the intervening time to prepare and understand the impact on your accounts, and on any contracts which currently exist, or are being considered, that refer to financial information or KPIs. 

How will the new lease accounting model impact the financial information of a lessee?

Using an existing property operating lease as an example, at a high level, you should expect impacts in several areas: 

On the balance sheet

The lessee will recognise a new asset within fixed assets, which represents the ‘right of use’ of the property, and a corresponding lease liability, split between current and non-current liabilities, at the present value of the future lease payments, with adjustments made for the incremental costs of obtaining the lease. Each rental payment will reduce the lease liability.

In the income statement 

The current operating lease expense (rent) will be replaced with depreciation (and any impairment) of the right of use asset, and a finance cost for the unwinding of the lease liability.

Over the length of the lease, the amount charged to the income statement will still be the total cost of the lease, it’s just that the timing will change, due to a higher finance cost in earlier years of the lease as the lease liability is unwound.

On key figures and KPIs, such as: 

• EBITDA increasing by the value of the operating lease expense that is removed;
• finance and depreciation costs being higher, which may impact lending covenants;
• gross assets used for the company size thresholds*, which may be breached by the inclusion of right of use assets;
• net current assets being decreased by the current element of the lease liability; and
• gearing ratios increasing, depending on the definitions of debt. 

The impact on any finance leases will be far less, as they are already shown 'on balance sheet'. However, you will need to assess whether the amounts already recognised as assets and liabilities meet the new requirements.

*The government has announced that it will bring forward legislation in the summer of 2024 to increase the turnover and gross asset thresholds by approximately 50% which may alleviate some of these concerns.

What should the finance team be doing first?

While your first financial reports that apply the new lease accounting model may be over two years away, we recommend using this time to identify all your leases, including those that are embedded in other contracts, and to understand the key terms in your lease agreements. As a practical starting point, you may wish to review leases included in your operating lease commitment calculations, together with any finance leases, to gauge the number of leases that will need to be revisited. 

What impact will changes to FRS 102 have on the management information systems?

Andy Ka, partner at RSM UK, advised: ‘At a practical level, various accounting system decisions will be required, including when to adopt the standard in the management accounts, identifying applicable nominal accounts for the right of use asset, lease liability and expenses in the income statement, and mapping these through to the management and financial reporting systems. A decision will also be needed as to whether to manage the collation and calculation of lease liabilities through lease accounting software, or inhouse solutions, such as spreadsheets.’

Other considerations include whether the new categories can be added to the fixed asset register to record each right of use asset and the relevant depreciation (and any impairment) calculation over time.

What are the wider considerations for implementing the new lease accounting model?

It is crucial to identify and assess any contractual arrangements, such as covenants, earn-out agreements, and performance related pay that refer to KPIs, such as EBITDA, to fully understand how they will be impacted. 

Comparatives cannot be restated on initial application of the periodic review 2024, which means adjustments are taken to reserves at the start of the current year. While this may have some practical advantages, it creates a lack of comparability between the current and comparative periods.

Head of financial reporting at RSM UK, Danielle Stewart OBE, said: ‘Having a plan to explain the lack of comparability between the current and comparative periods to stakeholders, and the potential changes to KPIs, assets, liabilities, and profits is vital, ideally before KPI targets and budgets are agreed.’ 

If you would like to discuss how the amendments to lease accounting under UK GAAP might impact your business, please get in touch with Danielle Stewart OBE, Andy Ka, or your usual RSM contact.