Changes to lease accounting – how will this impact your financial statements? 

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Businesses will soon be required to capitalise operating leases as a ‘right of use’ asset following a significant change under FRS 102, the Financial Reporting Standard applicable in the UK and the Republic of Ireland.

This is a considerable amendment in accounting treatment for businesses that use assets that are held under an operating lease agreement. The changes do not impact companies under the FRS105 micro regime, but if you are a small, medium or large business, it is important to be aware of what is changing and how to prepare for the transition.

What are the changes?

Currently, all operating leases are ‘off balance sheet,’ but for periods commencing on or after 1 January 2026, businesses will need to change the way they account for operating leases. To put it simply, they will need to bring operating leased assets onto the balance sheet as a ‘right of use’ asset with a corresponding lease liability. Examples of such assets could include property, motor vehicles or plant and equipment.

There are some exemptions available for low-value assets, such as small office furniture and mobile phones, and short-life leases of less than 12 months, which can continue to be accounted for as they are now under the old treatment, whereby payments are expensed through the profit and loss account.

How to prepare for leases accounting changes

To get ready for the new lease accounting standards, businesses will need to:

1. Identify all operating leases

Review the lease terms and calculate the remaining payments due on that lease from the first day of the accounting period impacted. This will form the basis of the lease calculation. Be mindful here of optional lease extensions or variations in lease agreements that might impact on the calculation.

2. Determine an appropriate discount rate to use when calculating the present value of future operating lease payments

Calculate the ‘right of use’ asset value and lease liability that will arise from the new lease accounting.

Key considerations

• If there are any bank covenants in place, this change could impact certain ratios and EBITDA. Be mindful of any impact this accounting adjustment could have on agreed covenants with your bank.
• Do you pay EBITDA-linked bonuses to your staff? Again, this accounting adjustment may have an impact on this year-end calculation.
• An increase in gross assets may breach the audit threshold (relevant if the business or organisation has already breached the revenue or employee metrics).
• Businesses will need to consider how easy it is to obtain a borrowing rate to use as the discount rate in the calculation if they do not have any external debt.
• Judgement is required on a list of low-value assets that don’t need to be considered, and documentation on the decision-making process to exclude such assets.
• If your company needs to process IFRS transition journals for international group reporting, you may want to consider early adoption.

Significant change

For a business with a number of operating leases – offices, warehouses, retail spaces, cars and other high-value equipment - there will be some work to do to identify operating leases and prepare to bring them onto the balance sheet, as well as updating systems and processes to comply with the new FRS 102 requirements.

While accounting for new lease changes won’t be mandatory until accounting periods commencing on or after 1 January 2026, businesses need to be thinking about it now to ensure they are aware of any impacts it may have on the business, and to determine the implicit interest rate that will be needed to calculate the change on the implementation date.