The change to lease accounting will be substantial for lessees with significant operating leases. The impact will be greatest for businesses with significant property leases.
Highlighted below are the key changes.
The biggest change is the removal of the distinction between a finance lease and an operating lease. All leases, subject to certain limited exceptions, must be brought onto the balance sheet in a manner consistent with the treatment for an existing finance lease.
Where a business has, for example, significant property leases, such as a retail company, these must be recognised on the balance sheet as a ‘right of use asset’ (ROUA) with a corresponding lease liability. Prior to the change, such leases would have been an operating lease and accounted for on a ‘pay as you go’ basis. For leases with significant time remaining, the impact will be much greater.
The changes will affect reported profit in two ways:
Changing the classification of the lease expense from rent to amortisation and interest will also change key performance measures such as earnings before interest, depreciation and amortisation (EBITDA) and interest cover. Reported EBITDA, for example, will increase under the proposals, but with an increase in the amortisation and interest expense.
In the cashflow statement, the rentals, previously treated as part of operating cashflows, will be replaced with an interest cashflow, and liability repayments, the latter being classified as financing cashflows. The net effect is that a business will report higher cash generated from operations, but with an increase in financing cashflows. The overall net cash flow will be the same.
Accounting requirements are rarely static, and often the changes are minimal. For lessees with significant operating lease portfolios, especially property leases, the effect could be highly significant.
The reported results and financial position of the business will change. Where these figures are used in assessing the business, either by management, lenders or investors, there can be real consequences arising from the change.
Is management remunerated on results? The change to the timing of the charge and the effect on EBITDA may impact both performance assessment and remuneration.
For entities with debt subject to covenants, how will the change impact compliance with these? For example, EBITDA would improve, but interest cover may not. Covenants based on reported debt would also be expected to deteriorate with the additional borrowings from the lease liability, possibly leading to covenant breaches.
The increase in assets may even bring some companies, previously exempt, into audit scope.
When planning the implementation of the changes, management should not restrict themselves to the accounting requirements but review arrangements in which these changes have an impact. An early understanding of the impact will enable management to determine what actions they may need to take because of the changes.
The changes apply to accounting periods which commence on or after 1 January 2026. To ease the implementation, the comparative figures are not restated.
Management needs to identify all leases which are within the scope of the changes. Determining what is a lease is potentially complex, but the standard assists with this by permitting those arrangements identified as a lease under the old rules to also be covered by the new rules on transition.
Leases previously classified as finance leases will continue to be accounted for on the same basis. For leases previously classified as operating leases, these will need to be brought onto the balance sheet together with the related lease liability. The ROUA will be adjusted for any lease incentives on the balance sheet.
After this, new leases must be identified and brought onto the balance sheet.
The ROUA is set as the amount of the lease liability together with any payments made before the commencement of the lease, less any incentives received. The lease liability is the lease payments due to be made over the lease term. Where there are options to extend a lease, these will be included but only where it is reasonably certain that the extension will be taken. 'Reasonably certain' is a high threshold.
The discount rate must be established, being the interest rate implicit in the lease. If this is not available, which is often the case, an incremental borrowing rate, or obtainable borrowing rate, must be used. This will involve judgment as such rates are rarely readily available.
The payments include fixed amounts due under the lease. If the payments are variable, for example, they are linked to turnover, these are only accounted for when due. Where the lease includes amounts other than the use of the asset, for example, service charges, these should be identified, quantified and accounted for separately.
Where a business is concerned about the size of the liability being recognised, the use of shorter lease terms and variable payments can reduce this, but decision-makers should consider whether this is the right choice commercially, as this may expose the business to future uncertainty as regards security over the property and the future cost.
Where the business has a number of leases, this will need to be done for each.
There are two main exemptions. If the lease term is no more than 12 months, it may be accounted for as rent on a straight-line basis over the lease term, and without recognition of a lease liability on the balance sheet. Similarly, if the underlying asset is of low value, it may also adopt this treatment. A low-value asset is not defined by monetary amounts but typically would include items such as laptops, mobile phones and small items of furniture.
The accounting for lessors remains broadly the same as existing requirements, with the distinction and different accounting applying depending upon whether the lease is an operating lease or a finance lease. The changes to lessee accounting will have consequences for lessors where they enter back-to-back arrangements or sale and leasebacks.
The new requirements introduce significantly more disclosures. In addition to the existing disclosures, a lessee should give:
Where the impact is significant, the changes will not be cosmetic, and management should plan in advance to determine how these changes will affect the business. If existing lease arrangements are due to be renewed, how the accounting will change may also be a factor in those negotiations, and we would advise understanding the effect in advance.
The above is a high-level overview. Early preparation will be key to ensuring a smooth transition to the new requirements and understanding how the changes could impact the business.
Please get in touch with Jeremy Cooper or Jamie Tomlin, if you would like to discuss this further.
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