There are significant amendments to FRS 102 effective for periods beginning on or after 1 January 2026.
Lease accounting (Section 20) is one of the most impactful areas, particularly for businesses with significant leased property.
The removal of existing classifications and the introduction of a single on-balance-sheet model will reshape financial reporting, affect key performance metrics and influence commercial considerations such as profit distribution and banking arrangements.
In this article, we look to address some frequently asked questions.
Frequently asked questions
1. Do we need to recognise new assets or liabilities?
Businesses will now be required to recognise a right-of-use (ROU) asset alongside a corresponding lease liability.
2. Are all leases recognised on the balance sheet?
Practical expedients are available for:
- Short-term leases of less than 12 months
- Low-value assets.
Payments for these can continue to be expensed on a straight-line basis.
3. What does a 'low value asset' mean?
The low value exemption is not defined by a fixed amount. Instead, management must apply judgement. You can apply the low-value exemption on an asset-by-asset basis, even if the aggregate cost of the lease is not considered to be low value.
What is key is being able to apply a documented policy consistently across all leases – the exemption cannot be taken selectively to manage balance sheet outcomes.
4. Will serviced offices need to be recognised as a ROU asset?
There is potential that with serviced office leases, even those covering a period of less than 12 months following the balance sheet date, may still be subject to ROU asset recognition. What matters is the enforceable lease term and whether the lessee is reasonably certain to continue to occupy the premises based on there being an economic compulsion to stay.
Indicators will include the importance of the office to operations, whether there is fit out or branding specific to the premises, and whether the lease is below market pricing vs alternatives.
If the answer to the above is no, with evidenced consideration, the leases may well be appropriate to continue on existing treatment and be expensed directly to P&L. This is a highly judgemental area, so it would need a documented policy justifying the accounting treatment chosen.
5. How is the appropriate discount rate determined?
There are three rates that may be relevant.
- Interest Rate Implicit in the Lease (IRI): The rate that equates lease payments to the asset’s fair value.
- Incremental Borrowing Rate (IBR): The rate a business would pay to borrow funds for a similar asset over a similar term.
- Lessee’s Obtainable Borrowing Rate (LOB): A practical estimate of achievable borrowing under comparable conditions.
FRS 102, Section 20 requires that the IRI is used and only if that cannot be readily determined you can elect to use IBR or LOB. Therefore, selecting the appropriate rate requires judgement and should reflect the economic substance of the arrangement.
6. Does the interest rate matter?
This rate will impact the costs which are expensed to the P&L account and could impact distributable profits.
7. How are dilapidation costs treated?
If the lease includes a dilapidation obligation, the expected cost (discounted where appropriate) is:
- added to the ROU asset
- recognised as a separate provision liability.
Dilapidations can be a complex area, with the terms and conditions of dilapidation obligations requiring judgement. Early consideration is recommended. Dilapidation provisions should be reviewed separately for tax purposes.
8. How will this be reflected in the 'transition' financial statements?
A modified retrospective approach is permitted, meaning the comparatives are not restated. At transition, lease liabilities are measured at the present value of remaining payments, with ROU assets broadly aligned (adjusted for prepayments or accruals).
Any differences are recognised in opening retained earnings.
Disclosures will be included in the financial statements stating a change in accounting policy and a reconciliation of retained earnings at the date of transition.
9. How will this be accounted for on an ongoing basis?
Lease liabilities will unwind through finance costs and lease payments, and ROU assets are depreciated.
The changes in accounting treatment will give rise to a ‘weighted P&L’ impact relating to long-term leases. Whereby costs expensed through the P&L will likely be higher at the start of a lease than they will be toward the end of a lease arrangement, as the unwinding of the effective interest will not be on a ‘straight line’ basis.
10. What changes will I see in the financial statements?
The impact for many firms, particularly those with significant property leases, could be substantial.
Balance sheet growth will arise from recognising ROU assets and lease liabilities, potentially changing the perceived and statutory size of the entity.
There will also be a change in cash flow presentation, as lease payments move from operating to financing activities. While operating cash flows may appear stronger, underlying cash commitments remain unchanged, which could distort performance analysis if not clearly understood.
11. How does this impact LLPs?
The front-loaded expense profile may affect LLP profit allocations, particularly where members join or retire during lease terms. This may prompt a review of profit-sharing arrangements. Every firm will approach this differently depending on the internal appetite for running both statutory financial statements and distribution accounts.
12. Are there any specific tax considerations?
For tax purposes, the P&L charges arising from the ROU, typically depreciation of the asset and interest on the lease liability, should generally be deductible to the extent they represent revenue lease costs. However, tax adjustments may be required where amounts included in the ROU asset relate to capital or otherwise non-deductible items (such as lease premiums, SDLT or capitalised legal costs).
While overall taxable profits over the length of the lease will be unaffected, changes in when relief is received will impact the timing of tax payments. This will have an impact for LLPs when members join or leave during the lease term.
For companies specifically: Where a ROU asset would previously have been treated as an operating lease, the interest charged on that asset should not impact the Corporate Interest Restriction (CIR) rules.
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