New accounting rules for leases under FRS 102
On 27 March 2024, the Financial Reporting Council (FRC) issued its final amendments to UK and Ireland accounting standards arising from the periodic review. The amendments primarily affect FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, but there are consequential amendments to the other standards in the suite of UK and Ireland GAAP such as FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime.
Two of the most notable changes relate to lease accounting and revenue recognition. This article considers the new lease accounting treatments and a future article will consider the new revenue recognition treatments.
At the outset, it is worth emphasising that the new lease accounting treatments affect FRS 102 only. FRS 105 is unaffected by the new changes and hence micro-entities preparing financial statements under FRS 105 will continue to recognise finance leases on-balance sheet and operating leases off-balance sheet using the risks and rewards approach to lease classification.
The amendments arising from the FRC’s periodic review apply mandatorily for accounting periods commencing on or after 1 January 2026. Early adoption is permissible provided that all the periodic review amendments are applied at the same time.
On-balance sheet lease accounting
The FRC has aligned FRS 102, Section 20 Leases to IFRS® 16 Leases, albeit with additional simplifications and practical expedients to allow the new treatments to be proportionate to private entities.
Under the new recognition and measurement principles, a lessee will no longer distinguish between a finance lease and an operating lease. Most leases will be recognised on-balance sheet with two exceptions which apply to:
- Leases of assets of low-value; and
- Short-term leases.
Leases of assets of low value
In the Exposure Draft, the FRC included examples of assets that would be deemed to be low value (such as tablets and personal computers). Following stakeholder feedback, it has removed such examples and has only retained examples of underlying assets that would not be low value (FRS 102, para 20.11) such as:
- 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; and
- Production line equipment.
It should be noted that this is not a comprehensive list and professional judgement will, of course, be needed to assess what is, and what is not, low value.
The FRC has taken a more permissive approach to defining low-value assets. The term ‘low value’ is not specifically defined in the revised FRS 102, but paragraph 20.9 clarifies that the assessment of the value of an underlying asset is performed on an absolute basis. Leases of low-value assets qualify for off-balance sheet recognition regardless of whether those leases are material to the lessee. In addition, paragraph 20.9 clarifies that the value of lease payments has no bearing on the assessment of whether an underlying asset is of low value.
FRS 102, para 20.10 then states that an underlying asset can be of low value only if:
- the lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
- the underlying asset is not highly dependent on, or highly interrelated with, other assets.
There is a restriction in paragraph 20.12 whereby if a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify as a lease of a low-value asset.
The FRC are keen to emphasise that the assessment of low value is entity specific. It has chosen not to quantify a value for low value on the grounds of the permissive approach it has taken in contrast to IFRS 16 given the size of the task that the FRC has asked entities to take on in this respect.
Short-term leases
The FRC has included a new definition of ‘short-term lease’ which is:
A lease that, at the commencement date has a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease.
Accounting treatment
Effectively, the new lease accounting treatments will mean more leases will be recognised on-balance sheet. The principal difference is that, for lessees, there will no longer be a requirement to distinguish between an operating lease and a finance lease.
Paragraph 1.47 of FRS 102 states:
A lessee shall not restate comparative information. Instead, it shall recognise the cumulative effect of initially applying the Periodic Review 2024 amendments to Section 20 as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application.
Therefore, prior year adjustments will not be carried out. Paragraph 1.51(a) states that the lessee shall recognise a lease liability at the date of initial application at the present value of the remaining lease payments, discounted using:
- The lessee’s incremental borrowing rate; or
- The lessee’s obtainable borrowing rate.
The ‘lessee’s incremental borrowing rate’ is defined as:
The rate of interest a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.
The lessee’s ‘obtainable borrowing rate is defined as:
The rate of interest a lessee would have to pay to borrow, over a similar term, an amount similar to the total undiscounted value of lease payments to be included in the measurement of the lease liability.
| Example – Lease previously treated as an operating lease | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Sunnie Ltd signed a five-year lease on 22 December 2024 to lease a bonded warehouse facility. Lease rentals are £137,500 per annum payable monthly. The lease previously met the operating lease criteria in FRS 102 (January 2022). Sunnie Ltd has an accounting reference date of 31 March. No upfront fees were payable on inception of the lease and no lease incentives were granted. On 1 April 2026, the company could borrow money from a reputable high street lender at a rate of 7% per annum (see Transition to FRS 102 (2024) later in the example). The lease payments are profiled as follows:
VAT/equivalent sales taxes have been ignored for the purposes of this example. In the years to 31 March 2026 The following lease payments have been recognised in profit or loss as the lease was previously accounted for as an operating lease under FRS 102 (January 2022):
Lease rentals not paid at each reporting date are as follows:
Transition to FRS 102 (2024) The date of initial application of the new lease accounting rules is 1 April 2026. On this date, the committed lease rentals (i.e. unpaid lease rentals) amount to £515,625. Sunnie Ltd can borrow money at 7% on 1 April 2026, hence on initial application:
There is no retrospective restatement where a lease was previously classified as an operating lease (FRS 102, para 1.47). Keep in mind that paragraph 1.51(a) states that the lessee recognises a lease liability at the date of initial application at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate or the obtainable borrowing rate. Sunnie Ltd recognises the right-of-use asset at the amount of the lease liability (as calculated above) adjusted for any prepaid or accrued lease payments (although there are no prepaid or accrued lease payments in this example): Journal 1
Sunnie Ltd could choose to present this as a right-of-use asset rather than within property, plant and equipment. It could also recognise the asset within property, plant and equipment and disclose which line items include right-of-use assets. If the lease rentals have been posted to profit or loss during the year of transition to the new lease accounting requirements (which in many cases they will have been, hence in this case in the year to 31 March 2027), a journal to reallocate these will need to be made as follows: Journal 2
A further journal will also need to be recorded to include the year-end finance cost (interest) for the lease liability as at 31 March 2027 which will be calculated in the next step (see Journal 4). Subsequent measurement of right-of-use asset The right-of-use asset is then depreciated in accordance with FRS 102, Section 17 Property, Plant and Equipment. Where there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset is fully depreciated over the shorter of the lease term and its useful economic life. In addition, the lessee must carry out an assessment at each reporting date as to whether the right-of-use asset is impaired in accordance with FRS 102, Section 27 Impairment of Assets. For the purposes of this example, assuming a four-year useful economic life, the right-of-use asset is depreciated at an amount of £111,256 (£445,025 / 4): Journal 3
Subsequent measurement of the lease liability The lease liability is subsequently measured using the amortised cost method in accordance with FRS 102, Section 11 Basic Financial Instruments. This uses an effective interest rate and is accounted for as follows:
The above calculation results in a slightly lower effective interest rate (of 6.43% rather than 7%) as the payments have been apportioned over three years plus the final ending balance of nine months to ensure each period has an effective interest charge in profit or loss. At 31 March 2027, a journal will be required to allocate the finance cost of £28,607 as follows: Journal 4
Summary of impact of journals 1 to 4
Presentation of the lease liability at 31 March 2027 At 31 March 2027, the lease liability is split between the portion falling due within one year of £115,893 (£336,132 – £220,239) and the portion falling due after more than one year of £220,239 to comply with the statutory formats of the balance sheet. Impact on the financial statements The overall impact on the financial statements of moving the lease on-balance sheet is as follows:
If there are issues such as lease incentives (e.g. a rent-free period) then the calculations above may become a little more complex. For clarity, under FRS 102, lease incentives are amortised over the period of the lease. |
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Tax implications
HM Revenue and Customs will be issuing guidance on the corporation tax implications of the new lease accounting treatments in due course, so it is advisable to keep abreast of developments on the Gov.uk website in this respect.
Conclusion
In the year of initial application, there will be additional work involved in bringing leases on-balance sheet. However, once this has been completed, the subsequent accounting treatments should generally be straightforward.
Category: Accounting and standards
