What is changing under FRS 102 for leases?
The distinction between operating and finance leases is being removed. All leases will now be recognized on the balance sheet as:
- Right-of-use assets
- Lease liabilities
Previously, operating leases were only recorded in the profit and loss account as lease payments (rent), with no asset on the balance sheet. The new approach provides a more accurate picture of a company’s commitments and aligns reporting with international standards.
When recognising the lease on the balance sheet the payments are discounted using a net present value calculation to account for the time value of money. Meaning that the amount you would pay in the future is recognised at today’s value, giving a more accurate representation of the future costs.
When do these changes take effect?
- Mandatory adoption: Accounting periods starting 1 January 2026
- Early adoption: Allowed if applied to all assets
Are all leases affected?
Most leases are affected, but there are exceptions:
- Short-term leases: Less than 12 months and with no purchase option
- Low-value leases: No strict monetary threshold; guidance provides examples
Which leases are most impacted in manufacturing?
Manufacturers can hold large and numerous leases, such as:
- Factory and warehouse space
- Plant and machinery
- Office buildings
The changes will affect how these are reported on the balance sheet and profit and loss statement.
How will this impact EBITDA?
- Lease expenses will be split into depreciation and interest rather than recorded as rent.
- Depreciation and interest are added back to EBITDA, potentially increasing reported EBITDA.
- Year-on-year comparisons may be distorted due to these accounting changes.
How will this affect interest cover?
- Lease payments now generate an interest component, increasing total interest charges.
- As a result, interest cover (EBIT/Interest) may decrease.
- Companies may need to manage stakeholder expectations if covenant ratios appear worse despite no actual cash flow change.
What are the key challenges in applying the new standard?
Identifying a lease
- A lease is a contract that conveys the right to use and control an asset for a period of time in exchange for consideration.
- Ensure the contract genuinely meets the definition of a lease
- Check for restrictions that could affect the accounting treatmen
Determining an appropriate discount factor
- Use the rate implicit in the lease if readily available
- Otherwise, use either:
- The lessee’s incremental borrowing rate
- The lessee’s obtainable borrowing rate (typically easier to determine)
Measuring the lease
- Consider lease length, rent-free periods, and options to extend or terminate
- Use prior experience to assess the likelihood of extensions
- Update calculations if lease terms change
What steps can companies take to prepare?
- Review current contracts to confirm they meet the definition of a lease
- Understand lease terms, renewal options, and likely extensions
- Assess the impact on reports, EBITDA, and debt covenants
- Communicate with key stakeholders about potential changes in reported figures
What is the overall impact?
- Improved financial reporting and transparency
- Greater alignment with international accounting standards
- Challenges exist, but they can be managed through careful contract review, accurate measurement, and proactive stakeholder communication
Contact us below for expert support and guidance in assessing your leases and ensuring compliance with the upcoming changes
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