FRS 102 Lease Accounting is Changing: What You Need to Know

The Financial Reporting Council (FRC) has updated FRS 102 to bring lease accounting in line with the international standard, IFRS 16. These mandatory changes take effect for accounting periods starting on or after 1 January 2026 (early adoption is allowed from 2025).

The Big Shift: On-Balance Sheet Leases

The most important change is that most leases, which were previously treated as “operating leases” and kept off the balance sheet, must now be capitalized.

• Old Way: Lease payments (for operating leases) were simply recorded as an expense on the Income Statement (Profit and Loss account).
• New Way: At the start of a lease, you must recognize two items on the Balance Sheet:
  1. A Right-of-Use (ROU) Asset
  2. A Lease Liability

How the New Items Are Measured

1. The Lease Liability (Debt)

The Lease Liability is the present value of the future lease payments. This liability is:

• Reduced over time as you make payments.
• Increased by an interest charge each period, calculated using the interest rate implicit in the lease (or your incremental borrowing rate).

2. The Right-of-Use (ROU) Asset (Fixed Asset)

The ROU Asset is measured at cost, which includes the initial Lease Liability plus any initial direct costs. This asset is subsequently:

• Depreciated over the lease term (like a standard fixed asset).
• Adjusted for any remeasurement of the liability.

In summary: Lease costs are no longer a single rental expense. Instead, they are split into Depreciation (on the ROU Asset) and Interest Expense (on the Lease Liability).

Key Exceptions (Still Off-Balance Sheet)

Not all leases are capitalised. You can still treat the payments as a straight-line expense for:

• Short-Term Leases: Leases that are for 12 months or less at the start date.
• Low-Value Assets: Leases for assets that are inherently low value (e.g., typically a new computer or small office equipment).

Commercial Impact and Next Steps

These accounting changes will significantly impact your company’s key financial metrics:

Crucial Advice: The changes to metrics like EBITDA and Interest Cover can affect your banking covenants (the financial promises you made to your lenders). It is essential to engage with your bank or key stakeholders now to discuss necessary adjustments.

How to Prepare

1. System Assessment: Ensure your systems can accurately track all necessary lease data (lease payments, commencement dates, borrowing rates, etc.).
2. Covenant Check: Review all loan agreements and recalculate your covenants based on the new FRS 102 rules.
3. Lender Engagement: Talk to your bank now to agree on adjustments or the use of ‘frozen GAAP’ (an agreement to use the old rules solely for covenant calculation purposes).

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