Part 1: FRS 102 On-Balance-Sheet Leases

Understanding the revised lease accounting requirements in FRS 102

Periods beginning on or after 1 January 2026 are subject to significant changes to lease accounting under FRS 102. The revised requirements remove the previous distinction between finance leases and operating leases and bring nearly all leases onto the balance sheet.

Under the revised Section 20, a lessee is generally required to recognise a “right-of-use” asset and a corresponding lease liability at the commencement date of a lease. This represents a substantial change from the previous approach, under which many operating leases were recognised through the profit and loss account without a related asset or liability being recorded on the balance sheet. Instead of seeing a rental charge in the profit and loss account, we’ll see depreciation and interest charges under the new standard.

These changes could have a significant impact on some companies beyond the obvious changes outlined above.

Replacing a rent charge with depreciation and interest will mean companies showing a higher EBITDA, which could be relevant for companies with loan covenants, for example.

Bringing leases onto the balance sheet will also increase gross assets, which could push some small companies into being medium companies (and medium into large).

Scope of the requirements

The revised requirements apply to nearly all leases, with a small number of specific exclusions for specialist areas set out within Section 20.

A contract contains a lease when it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. In assessing whether a contract contains a lease, entities are required to consider whether the customer has both:

• the right to obtain substantially all of the economic benefits from use of the identified asset; and

• the right to direct the use of that asset during the period of use.

  
  

Recognition exemptions

FRS 102 includes two optional recognition exemptions for lessees.

A lessee may elect not to apply the recognition and measurement requirements for:

• short-term leases (12 months or less); and

• leases for which the underlying asset is of low value.

Where these exemptions are applied, lease payments are generally recognised as an expense over the lease term.

The standard provides guidance on assets that would not normally be regarded as low-value assets, including land and buildings, motor vehicles, aircraft, ships and production-line equipment.

Low value is defined in absolute terms, rather than whether or not it is material to the lessee – so, for example, a car lease would always need to go on the balance sheet, regardless of the size of the company.

IFRS (cited in FRS 102 B20.10 as additional guidance) states that examples of low value assets can include tablet and personal computers, small items of office furniture, and telephones.

Initial recognition

At the commencement date of a lease, a lessee is required to recognise:

• a right-of-use asset; and

• a lease liability.

  
  

The right-of-use asset is initially measured at cost. Cost includes the initial measurement of the lease liability together with specified additional items such as lease payments made before commencement, initial direct costs and certain restoration obligations.

The lease liability is initially measured at the present value of future lease payments that have not been paid at the commencement date. Lease payments included in the calculation may include fixed payments, payments linked to an index or rate, residual value guarantees and certain purchase or termination options.

To calculate the present value of future lease payments, companies will have to determine a suitable interest rate to use. FRS 102 gives guidance on the steps to take on this.

FRS 102 lease term considerations

Determining the lease term is an important aspect of the revised model.

The lease term includes:

• the non-cancellable period of the lease;

• periods covered by extension options where the lessee is reasonably certain to exercise those options; and

• periods covered by termination options where the lessee is reasonably certain not to exercise those options.

Entities are required to consider relevant facts and circumstances when assessing whether extension, purchase or termination options are reasonably certain to be exercised.

Conclusion

The revised lease accounting requirements introduce a single lessee accounting model based on recognition of a right-of-use asset and lease liability. The changes require careful assessment of lease arrangements, including identification of leases, determination of lease terms and application of any available recognition exemptions.

Companies will need to restate their comparatives using the new model when they first prepare accounts under the new standard, so early preparation is key.

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Sources

FRS 102 (September 2024), Section 20 – Leases, paragraphs 20.1–20.54.

Disclaimer

This article provides a general overview of the relevant FRS102 requirements and should be read alongside the full standard and any applicable guidance. The application of the requirements will depend on an entity's specific facts and circumstances.

Author

This article was reviewed by David Fletcher FCA, Associate Director at Just Audit. David is also an IPC ICAEW Practice Committee Member.