Key changes to the FRS102 Series - Part 3

Week3: Lease Accounting - On Balance Sheet Recognition for Lessees

Building on Week 1’s overview and Week 2’s deep dive into revenue, this article walks through the amended FRS 102 lease model in a practical manner, breaking down key technical points so you can apply them with confidence. 

What is changing at a glance

• No more split between operating and finance leases for lessees.
• Most leases now hit the balance sheet via a Right of Use (ROU) asset and a lease liability (with a couple of practical exemptions noted below).
• The P&L moves from straight-line rent to depreciation (ROU asset) + interest (lease liability). Expect a front-loaded expense profile - more cost upfront, less later.
• EBITDA typically increases (rent drops out of EBITDA; depreciation and interest sit below the line), while reported assets and liabilities increase.
• Short-term and low value leases can be kept off balance sheet if you elect these policies and disclose accordingly. This aligns closely with the IFRS 16 exemptions.

Lessor accounting? Pretty much unchanged therefore this update focus on lessees

Recognition and measurement (lessees)

Think of the new model as two moving parts: a financing element (the liability) and a usage element (the ROU asset).

At commencement

• Lease liability = Present value of future lease payments, discounted at the implicit rate (if readily determinable) or your incremental borrowing rate.
• Payments usually include fixed (including in substance fixed), index-linked amounts (measured using the index/rate at commencement), expected sums under residual value guarantees, purchase options if reasonably certain to be exercised, and termination penalties if the assessed term includes them.
• Initial ROU asset equals the lease liability, adjusted for prepayments/accruals, initial direct costs, and restoration obligations.

Subsequently

• Lease liability accretes with interest and is reduced by cash payments; remeasured when the base changes (e.g., index reset, term reassessment, modifications).
• ROU asset is depreciated over the shorter of the useful life or the lease term (unless ownership transfers or a purchase is reasonably certain, in which case depreciation is over the useful life of the asset.). Test for impairment as you would other non-financial assets.

Why it matters: You’ll see a different expense shape in the P&L and bigger totals on the balance sheet. That’s not poor accounting – it’s being more transparent about how you’re financing the right of use assets. This increased transparency allows stakeholders to better understand a company’s financial obligations and how it manages its resources.

Illustrative example — Retail Co storefront lease

Facts: 3-year lease; £5,000 payable annually in arrears; incremental borrowing rate 5%.
Present value of payments: ≈ £13,600.

Day 1 journal

• Dr Right of Use Asset – Store Lease £13,600
• Cr Lease Liability £13,600

This is the initial recognition, where the ROU asset equals the lease liability at commencement (assuming no adjustments for prepaid rent, incentives, or direct costs).

End of Year 1 (payments in arrears)

• Dr Interest expense £680 (£13,600 x 5%)
• Dr Lease liability £4,320
• Cr Cash £5,000
• Dr Depreciation – ROU Store £4,533 (£13,600/3)
• Cr Accumulated depreciation – ROU Store £4,533

This reflects the payment split between interest and principal.

Straight-line depreciation over the lease term

Where you land after Year 1: Lease liability ≈ £9,280; ROU NBV ≈ £9,067.
Expense profile: Year 1 total ≈ £5,213 (interest + depreciation) vs £5,000 straight-line rent under old rules. Later years ease off as interest declines - the classic front-loaded curve.

Policy elections and practical exemptions

Consistent with IFRS 16, the new FRS 102 allows two notable exemptions.

• Short-term leases (12 months or less, no purchase option): policy choice to expense payments off balance sheet. You can apply this by class of underlying asset.
• Low-value assets (e.g., small office or IT equipment) can be expensed lease-by-lease if you elect the exemption. There’s no fixed monetary threshold in the standard, but you should:
  • Define a reasonable internal threshold (based on asset value when new)
  • Document your policy
  • Apply it consistently
  • Disclose the use of the exemption in your financial statements.
  • If the exemption is applied, no lease liability or ROU asset is recorded for those leases.

Tip: Decide these policies early and hardcode them into your close checklist so you don’t miss consistent application or disclosure.

Lessor accounting (for context)

Lessors keep the operating vs finance lease distinction. Income recognition and measurement are broadly unchanged. If you’re an intermediate lessor (sub-leasing), classification may reference the ROU asset of the head lease so this is worth a quick check

Transition to the new model

• No need to reassess existing contracts:
  There’s a “grandfathering” expedient:
  • If a contract wasn’t previously considered a lease, you don’t need to reassess it.
  • If it was a lease, continue treating it as such.
  • This saves time and avoids re-evaluating old contracts.
• Modified retrospective approach allowed:
  You can transition without restating prior periods:
  • Lease liability: Measured at the present value (PV) of remaining lease payments using the incremental borrowing rate at the transition date.
  • ROU asset: Usually equals the lease liability, adjusted for prepayments, accruals, or restoration costs.
• No need to restate comparatives:
  Just disclose:
  • Your transition approach
  • The impact on financials
  • A reconciliation from previously disclosed operating lease commitments to the opening lease liability.
• Short-term lease relief:
  Leases ending within 12 months of transition can be treated as short-term leases.

What to prepare now: a clean lease register, your discount rate methodology, and a transition paper that your board and auditors can sign off confidently.

Impacts, metrics & actions for 2025–2026

• Covenants & lenders: Model leverage and interest cover under the new rules; if tight, discuss resets/waivers before year end. E.g. A fiduciary firm with a St. Helier office lease of £250k/year now sees EBITDA up by £250k, but net debt rises by the PV of lease payments. Debt/EBITDA ratio deteriorates because the increase in debt from lease capitalisation outweighs the uplift in EBITDA.
• KPIs & remuneration: Expect higher EBITDA and shifts in EBIT/ROA — update scorecards and any target mechanics tied to these metrics. E.g. IT lease for servers (£60k/year, 3-year term) moves off P&L rent line into depreciation/interest. EBITDA bonus targets may need recalibration.
• Systems & controls: Build a complete lease register (payments, options, indices, residual guarantees, restoration). Put approval controls around new leases and modifications.
• Discount rate policy: Document how you set incremental borrowing rates (by currency/tenor/asset class) and how often you refresh them.
• Reassessment triggers: Lease liabilities and ROU assets must be remeasured when terms change. Track option exercise expectations, index changes, and modifications; remeasure promptly to avoid surprise adjustments at year end. If St. Helier office CPI jumps 0.5%, remeasure lease liability promptly.
• Low-value and short-term exemptions: Document which leases qualify for exemptions (short-term ≤12 months; low-value assets). Exempted leases can remain off-balance sheet but must still be disclosed, e.g. temporary office space for 6 months can apply short-term exemption.
• Disclosures: Plan to show ROU assets by class, current/non-current lease liabilities, maturity analysis, the expense split (depreciation/interest/short-term/low value), and any policy elections.
• Size tiers: Small entities (Section 1A) use the same recognition and measurement, with proportionate disclosure. Micro entities under FRS 105 sit outside this model.