Is Your Business Ready for the New FRS 102 Lease Accounting Changes?

In our previous article, What You Need to Know About the Major FRS 102 Changes, we introduced the upcoming amendments to FRS 102, which take effect from 1 January 2026, bringing significant changes across multiple areas of financial reporting. One of the most substantial changes relates to lease accounting, aligning more closely with IFRS 16.

These changes represent one of the most significant updates to FRS 102 in recent years and Hall Morrice is ready to support businesses through every step of the transition. Whether you are a growing SME or a larger organisation, our experienced team can guide you through impact assessments, system changes and strategic planning. These changes matter to finance teams, business owners, lenders and investors, with potential effects on borrowing, financial reporting and tax. Early preparation with expert advice can help you avoid misstatements and stay ahead of compliance risks.

What’s Changing in Lease Accounting?

Under the revised FRS 102 framework, lessees will be required to recognise most leases as both an asset and a liability. This change will fundamentally alter how lease obligations are recorded and presented in financial statements.
Our team can help you identify which leases will be affected and calculate the right-of-use (ROU) asset and lease liability correctly, providing tailored advice for your business structure.

Key Changes:

• Recognition of Right-of-Use Assets and Lease Liabilities
• Lessees must now recognise a ROU asset and a lease liability for most lease agreements.
• The ROU asset will be measured at the present value of future lease payments, adjusted for directly attributable costs.
• Examples of directly attributable costs include legal fees, initial lease negotiations, site preparation costs, and costs related to moving or installing leased assets.
• The lease liability will be split into current and non-current portions, reflecting future payment obligations.

• Exceptions for Short-Term and Low-Value Leases
• Short-term leases (12 or less months at inception) and leases of low-value assets (such as IT equipment) are exempt from capitalisation.
• These leases can continue to be expensed on a straight-line basis over the lease term.

Key Considerations in Lease Calculations

Calculating lease liabilities under the revised FRS 102 framework involves several complexities. Businesses must determine both the lease liability and the discount rate, each of which presents unique challenges. Accurately assessing these components is crucial to avoiding misstated financial statements.

Hall Morrice can support you by reviewing your lease portfolio, advising on assumptions, and helping you apply appropriate methodologies.

Determining the Lease Liability

• The lease liability is calculated based on the present value of lease payments over the lease term.
• The lease term includes the non-cancellable period of the lease plus any extension options that are reasonably certain to be exercised.
• Lease payments included in the calculation typically comprise:
• Fixed lease payments.
• Variable lease payments that depend on an index or rate.
• Payments related to purchase options if the lessee is reasonably certain to exercise the option.
• Termination penalties if the lease term reflects the expectation of early termination.

Determining the Discount Rate

Determining the appropriate discount rate is a critical step in calculating the present value of the lease payments, as it directly affects the lease liability and ROU asset measurements. There are three primary methods to determine the discount rate:

• Implicit Rate of the Lease: This is the interest rate that reflects the cost built into the lease itself. It’s the rate that makes the present value of the lease payments (plus any expected residual value at the end) equal to the fair value of the leased asset at the beginning, along with any costs the lessor incurred to set up the lease.
• Practical challenges: This rate is often difficult for the lessee to determine, as it relies on detailed financial information that only the lessor typically holds. Without access to those figures, lessees may not be able to calculate it reliably.

• Incremental Borrowing Rate (IBR): This is the rate the lessee would pay if they were to borrow the money needed to purchase a similar asset, over a similar term, with comparable security.
• Practical challenges: Determining the IBR involves several factors, including the company’s credit standing, current market interest rates, and specific lease features such as the duration and any collateral. As these factors vary between businesses and market conditions, estimating the IBR can be complex and may require judgement.

• Obtainable Borrowing Rate (OBR): This is the rate the lessee could reasonably expect to get from a lender for financing a similar asset under comparable lease conditions.
• Practical challenges: Estimating the OBR involves reviewing available financing options, taking into account current economic conditions, and making adjustments for lease-specific risks like asset type, lease term, and security provided. Because market conditions can shift quickly, arriving at a suitable OBR may require external benchmarking and careful evaluation.

Our team can support your business in selecting and documenting a suitable discount rate, helping reduce the risk of audit challenge or regulatory scrutiny.

Justifying the Discount Rate

Lessees must carefully justify and document their chosen discount rate methodology to ensure compliance and financial accuracy. Incorrect estimations may lead to misstated liabilities and financial position distortions. Consulting external advisors or benchmarking against market rates may be necessary to ensure compliance and accuracy.

Impact on Financial Statements

The new approach to lease accounting will significantly impact key financial metrics, with the following expected changes:

Balance Sheet:

• An increase in total assets (due to the ROU asset).
• An increase in liabilities (due to the recognition of lease obligations).
• Potential shifts in leverage ratios, which could affect debt covenants.

Profit & Loss Account:

• Operating lease expenses will be replaced with depreciation and interest costs.
• EBITDA will improve as a result of removing lease expenses from operating costs.
• Interest expenses will be front-loaded, leading to higher initial costs compared to straight-line lease expense recognition.

How does the New FRS 102 Lease Accounting Changes actually impact your financial statements?

Let’s bring this to life with a simple example. Imagine your business enters into a five-year property lease on 1 January 2026, at £400,000 per year, paid quarterly in advance.

Under the current FRS 102 standard:

The lease is treated as an operating lease, and the full £400,000 annual payment is charged directly to the Profit and Loss Account each year:

Under the amended FRS 102 standard:

The lease is brought onto the balance sheet as a Right of Use (ROU) asset and a lease liability. For this example, assume a discount rate of 8%.

Profit & Loss Account:

Balance Sheet:

What's the difference?

At the start of the lease, the full ROU asset and lease liability of £1,676,300 are recorded on the balance sheet.

Instead of a straight-line lease expense, the new model separates the cost into depreciation and finance charges. This results in higher charges to the Profit & Loss in the earlier years, due to the front-loaded nature of the finance cost. The finance cost gradually decreases as the lease liability is paid down over time.

Key Business Considerations

1. Impact on Key Performance Indicators (KPIs)

Businesses relying on EBITDA as a performance metric may see an artificial improvement due to the removal of lease costs from operating expenses. Comparatively, with interest costs higher earlier in the lease, net profit will be adversely affected early in leases.

2. Banking and Financial Covenants

Changes in reported debt levels and interest costs may affect compliance with banking covenants. Early engagement with lenders is advisable to discuss potential adjustments to covenant calculations.

3. Company Size Thresholds

In conjunction with company size thresholds increasing in 2025, businesses should assess whether lease capitalisation might push them into a higher reporting category, leading to additional compliance obligations.

4. Financial Systems and Internal Controls

Companies will need to ensure their financial reporting systems can accommodate the new lease accounting requirements. This may involve system upgrades or modifications to capture lease data accurately.

5. Tax Considerations

Changes in lease accounting could impact taxable profits and deferred tax calculations. Our tax specialists can help you assess how these changes affect your tax position and guide your planning strategy.

How to Prepare for the Transition

The implementation date of 1 January 2026 may seem distant, but businesses should take action now to ensure a smooth transition. Steps to take include:

• Review Existing Lease Agreements: Identify all leases and assess which will need to be capitalised.
• Evaluate System Readiness: Ensure accounting systems can handle lease capitalisation and associated calculations.
• Communicate with Stakeholders: Engage with lenders, investors, and auditors early to discuss the impact of changes.
• Assess Financial Impact: Conduct a financial impact assessment to understand how KPIs, profitability, and compliance obligations may be affected.

How We Can Help

Navigating the changes in FRS 102 lease accounting requires careful planning and expert guidance. Our team is ready to support your business with:

• Impact assessments tailored to your lease portfolio
• Training sessions for finance teams on the new standard
• System reviews to ensure compliance with the updated requirements
• Strategic advice on covenant negotiations and tax planning

If you’d like to discuss how these changes will affect your business, please reach out to Paul Archibald (p.archibald@hall-morrice.co.uk).

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