On-balance sheet lease accounting under FRS 102
The move to on-balance sheet lease accounting for most leases for lessees will begin this year. Since the Financial Reporting Council (FRC) finalised its amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, Section 20 Leases, there have been several questions concerning the issue. This article seeks to resolve those commonly asked queries where the new accounting treatments are concerned (although further articles will be published over the course of the year addressing other queries).
At the outset, it is worth noting that the new on-balance sheet accounting treatments do not apply to micro-entities preparing financial statements under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime.
It should also be emphasised that while the lease accounting treatments in FRS 102 are based on the principles in IFRS® 16 Leases, they are not completely aligned. The FRC has included some simplifications to ensure that the requirements remain proportionate and cost-effective to apply.
Impact on lessees’ financial statements
Under FRS 102 (September 2024), Section 20, there is no distinction between a ‘finance lease’ and an ‘operating lease’ for lessees (though there continues to be for lessors). This is because most leases for lessees will be recognised on-balance sheet. Under a typical lease agreement, a lessee will recognise a right-of-use asset with a corresponding lease liability. Hence, the balance sheet will recognise more assets and more liabilities.
Consequently, the previous operating lease expense that was recognised in profit or loss will be replaced with the depreciation charge for the right-of-use asset and an interest expense on the lease liability. The depreciation charge itself will usually be on a straight-line basis over the lease term (although not in every case). However, the interest expense will be higher in the earlier years of the lease as it will be based on a higher liability.
There are some limited exceptions to on-balance sheet recognition of leases for lessees, which are discussed below.
Another issue to consider is audit exemption. The company size thresholds were increased for accounting years commencing on or after 6 April 2025. The revised total assets threshold is now £7.5 million compared to £5.1 million and so this may help shield some entities from audit. However, some entities may require an audit if they breach the total assets threshold as well as either the turnover threshold (up from £10.2 million to £15 million) or the average number of employee headcount (which remains the same at an average of 50).
Keep in mind that on first-time application of the new on-balance sheet lease accounting rules, no prior year adjustments are carried out to move previous operating leases on-balance sheet. A modified retrospective approach is used instead, meaning the adjustments are made to the opening balance sheet at the date of initial application (ie, adjust opening balances on 1 January 2026 for a 31 December 2026 year end).
Exemptions from on-balance sheet lease accounting
There are two exemptions from the requirement to bring leases for lessees on-balance sheet which relate to:
- Short-term leases; and
- Leases of assets of low value.
Short-term leases
A lease is a ‘short-term lease’ when it has 12 months or less to run from the date of inception of the lease. If the lease agreement contains a purchase option, it cannot be classed as a short-term lease.
The short-term lease exemption is applied (or not applied) on a class-by-class basis (ie, by class of underlying leased asset).
Leases of assets of low value
A low-value asset is not defined in FRS 102 and will require judgement. An entity assesses the value of an underlying asset on an absolute basis. This means the assessment is performed independently of materiality or the value of lease payments.
An underlying asset can be determined to be of low value if the following recognition exemptions are applied:
- The lessee can benefit from use of the underlying asset on its own or together with other, readily available resources; and
- The underlying asset is not highly dependent on, or highly interrelated with, other assets.
| Example – Laptop computers
An entity enters into a lease agreement to lease a batch of laptop computers for use by its staff and directors. If the entity can demonstrate that it can benefit from use of the laptop on its own and the laptops are not highly dependent on, or highly interrelated with, other assets, then the entity can apply the low-value recognition exemption. This would apply even if the lease liability in aggregate would be material. |
The Basis for Conclusions in FRS 102 notes that IFRS 16 does provide examples of low-value assets which would include tablets and PCs, small items of office furniture and telephones. The Basis for Conclusions acknowledges that it would be acceptable to apply the low-value recognition exemption to such items.
A point worthy of note is that if a lessee sub-leases (or expects to sub-lease) an asset, the head lease cannot qualify as a lease of a low-value asset.
The focus of FRS 102, Section 20 is on those assets which are not considered to be low value and there is a list of such assets in FRS 102, para 20.11 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
The list above is not conclusive. The idea behind this list is that the entity must judge whether a leased asset is similar in value to those listed above. If it is, the leased asset is not low value.
Measuring the lease liability
The lease liability is measured at the present value of the committed lease payments that remain unpaid. On first-time adoption of FRS 102 (September 2024), any pre-existing leases that were previously treated as operating leases are discounted using either:
- The lessee’s obtainable borrowing rate (OBR); or
- The lessee’s incremental borrowing rate (IBR).
Do not use the interest rate implicit in the lease for a lease previously treated as an operating lease being transitioned on-balance sheet. The interest rate implicit in the lease should be used for any leases entered into after first-time application of FRS 102 (September 2024). If the interest rate implicit in the lease cannot be readily determined, then use either OBR or IBR.
It is likely that OBR is going to be widely used as this is the easiest rate to get. However, if the entity cannot identify an observable OBR (eg, because it has no existing borrowings), it will be necessary for the entity to determine OBR based on the entity’s individual facts and circumstances.
Keep in mind that the decision to use either OBR or IBR is made on a lease-by-lease basis (ie, it is not an accounting policy choice that is followed for all similar leases).
Cost of a right-of-use asset and lease incentives
In a lot of cases, the lease liability calculation (see above) will also arrive at the value to be recognised as the right-of-use asset. Hence, once the lease liability has been calculated, the double entry is:
- Dr Right-of-use asset
- Cr Lease liability
FRS 102, para 20.47 states that the cost of a right-of-use asset comprises:
| a) the amount of the initial measurement of the lease liability, as described in paragraph 20.49;
b) any lease payments made at or before the commencement date, less any lease incentives received; c) any initial direct costs incurred by the lessee; d) any amount recognised in accordance with Section 21 Provisions and Contingencies at the commencement date as an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period; and e) any amount recognised at the commencement date in accordance with Section 24 or, for a public benefit entity, paragraphs PBE34.64 to PBE34.74, when a lease component contains a government grant or non-exchange transaction as described in paragraph 20.35 |
In b) the right-of-use asset is presented net of any lease incentives received. Hence, any lease incentives are not included in the calculation.
| Example – Lease incentive
Sunnie Ltd enters into a five-year lease for a small office on 1 January 2026. Annual lease payments are £50,000 paid in advance. The landlord gives Sunnie a six-month rent-free cash incentive which is received at the start of the lease. The lease payments to be included in the initial calculation of the lease liability (ie at present value (in a) above) and thus included in the right-of-use asset are:
The £25,000 lease incentive is not included in the calculation of the lease liability. It is deducted from the cost of the right-of-use asset. (Assuming a 7% discount rate, the present value of these lease payments would be £181,645). |
| Example – Lease incentive on first-time adoption of FRS 102 (September 2024)
Morley Ltd enters into a five-year lease on 1 January 2025 to lease a warehouse. Lease rentals are £137,500 per annum payable monthly. The lease was previously treated as an operating lease. Morley Ltd has a 31 March accounting reference date. At the commencement of the lease, there was a six-month rent-free period granted by the landlord. On 1 April 2026, Morley could borrow money from a reputable high street lender at a rate of 7% per annum and the value of lease payments outstanding on this date was £515,625. On initial application of FRS 102 (September 2024), the present value of the committed lease payments (£515,625) is calculated as follows:
This figure is used as the value of the lease liability at the date of initial application and the corresponding right-of-use asset (ie, Dr RoU asset, Cr Lease liability). At 1 April 2026, the balance on the lease incentive accrual was £51,568. This is credited against the cost of the right-of-use asset as follows:
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Conclusion
Over the remaining few months, there will be other technical issues that will be covered in similar articles. However, the key is for preparers to have a thorough understanding of FRS 102, Section 20 and to determine the impact that the new on-balance sheet treatments will have on entities’ financial statements.
Category: Accounting and standards
