Lease accounting – The new regime

The new regime

The updated FRS 102 (September 2024 version) comes into effect for accounting periods commencing on or after 1 January 2026. One of the main changes in the updated FRS 102 is the new lease accounting requirements.

Previously, leases were categorised as finance leases or operating leases. Only finance leases were brought onto the Balance Sheet with operating leases being charged to the profit and loss account as the lease payments fell due. Under the new regime, all leases, with the exception of low value leases and short term leases (see definitions below) must be brought onto the Balance Sheet. The most significant impact is likely to be in relation to property leases which previously would have been treated as operating leases.

The standard gives a clear definition of a lease which is ‘the use of an identified asset for a period of time in exchange for consideration’. If the supplier has the right to substitute one asset for another (at their discretion) it is likely that they are providing a service rather than the use of an asset.

As noted above, there are two categories of lease which are exempt from the new regime and which can, effectively, carry on being treated as operating leases. These are:

Short Term Leases: These are leases with a term period of less than 1 year as at the commencement of the lease and with no purchase option. Under the transition provisions, leases with a remaining term of less than 1 year at the date of transition are also exempt even if the original lease was for a longer period.
Low Value Leases: These are leases where the asset has a low value. There is no figure provided in the standard and it is a case of judgment. The standard simply includes a list of assets which would not qualify as low value, such as land and buildings, cars and heavy equipment. It is important to note that the definition of a low value asset is the same for all entities and the asset’s materiality for an entity is not relevant. The asset being considered must also be self-contained and not part of a larger asset.

Transition provisions in first year of application

The opening balances of existing finance leases are not affected, as they will remain unchanged. Existing operating leases (unless they are exempt) will be brought into account as follows:

In the first year of application, a prior year adjustment is not required and the comparatives do not need to be amended. Instead the opening balances of the leased assets and leased liabilities are brought into account onto the Balance Sheet as at the start of the accounting period which is applying the new regime for the first time. There shouldn’t be any effect on the brought forward reserves but, if there were to be, the brought forward reserves would simply be amended.
Lease liabilities: The lease liabilities would be brought into account onto the Balance Sheet and would be equal to the net present value of the unpaid lease payments as at the start of the accounting period. The discount rate used in the calculation (if it is not implicit in the lease agreement) would be the entity’s cost of borrowing. The standard gives two alternative methods to calculate the cost of borrowing. The lease term would be equal to the non-cancellable period of the lease plus any period beyond an option to cancel or an option to extend where it is reasonably certain that the entity will extend the lease. Where lease payments increase periodically by inflation or market rates, a best estimate will be required of these future increases.
Assets (Right of Use Assets): The Right of Use Assets would be brought into account onto the Balance Sheet and would be equal to the lease liabilities subject to an adjustment to the extent that there are any brought forward accruals or prepayments relating to the lease payments. If there was a brought forward accrual it would be netted off the cost of the Right of Use of Asset. If there was a brought forward payment in advance, it would be added to the cost of the Right of Use Asset.

Accounting Treatment of leases in first year of application and thereafter

Once the new lease accounting regime comes into effect, the new methodology for accounting for leases applies equally to existing finance leases as well as to the operating leases brought onto the Balance Sheet for the first time. The accounting requirements are broadly the same as for existing finance leases but there are a number of specific requirements. In simple terms:

The Right of Use asset should be depreciated over the lease term.
The ‘effective interest rate method’ should be used to calculate the annual interest applicable to the lease liability.

When a new lease is entered into, after the new regime has come into force, the Right of Use Asset will be capitalised at an amount equal not only to the lease liability but also to:

Direct costs associated with entering the lease, such as legal costs.
Any advance payments made to the lessor before the lease was signed, less any lease incentives received from the lessor.
Any provision for dismantling or removing the asset at the end of the lease term.

Where an entity receives a grant to enter into a lease (which could be the case for a charity or a housing association) the value of the grant should be added to the cost of the Right of Use Asset and the grant itself should be accounted for, as usual, in accordance with the relevant SORP.

Presentation and disclosure

The Right of Use Assets should be shown either as a separate category of asset or, if included with owned assets, a note is required to identify where the Right of Use assets are included and their carrying value.
Lease liabilities should be disclosed either as a separate category of liability or, if included with other liabilities, a note is required to identify where the liability is included. The liability should be split between short term and long term.
There is a requirement to provide narrative information about the nature of the leases including;
- Details of any options, variable terms etc.
- The method used to calculate the discount rate.
- Any remeasurements during the year.
- The total interest cost and the total cash outflow on leases.
The lease costs and future lease commitments of low value and short term leases have to be separately disclosed in a similar way to how operating leases are currently disclosed under the existing regime.

Below market rate leases held by charities

Charities may enter into lease arrangements which are below market value where the lessor wishes to provide a social benefit. In these cases, the charity must determine the non-exchange component of the lease. The Charity SORP refers to three possible scenarios:

1. Peppercorn or nominal arrangements

Even where a charity has a formal lease agreement, where the lease payments are purely nominal, the arrangement is unlikely to meet the definition of a lease. In this case, the asset should be capitalised at the charity’s estimate of its value to its own operations (equivalent to the price it would have paid for a similar asset) and this value should be treated as a donation. Usually the donation will be accounted for annually over the term of the arrangement as it represents, in effect, donated facilities.

2. Social donation leases

Social donation leases are arrangements where the lease payments are below the market rate because the lessor wishes to provide a benefit to the charity, perhaps as part of its social responsibility objectives. In this case, there is a non-exchange component to the arrangements and the asset should be capitalised at the charity’s estimate of its value to its own operations. The difference between the capitalised asset and the lease liability should be treated as a donation. The donation element will usually be accounted for in full at the commencement of the lease.

3. Leases with conditions

The lessor may stipulate specific conditions setting out how the asset must be used and as a result the lease payments may be below the market rate. An example may be a building which must only be used for certain purposes. In this case, the charity should determine whether the reduced lease payments fairly reflect the conditions imposed, in which case normal lease accounting applies. If the lease payments are lower than the market rate, even taking into account the conditions, the lease would be classified as a social donation lease.

Practical Considerations: Specific lease terms

Non-Lease elements included in the monthly payments, such as maintenance and insurance

It is very common for the monthly payments for car and equipment leases to include elements which are distinct from the actual asset, for example, maintenance and insurance. How should these elements be accounted for?

These non-lease elements should strictly be separated out and accounted for separately from the leased asset. However, para 20.33 of FRS 102, as a practical expedient, allows lessees to elect (by class of leased asset) ‘not to separate non-lease components from lease components, and instead account for each lease component and any associated non-lease components as a single lease component’. In other words, the lessee can elect to treat the whole payment as a lease payment.

This concession would make the calculations much simpler without materially affecting the financial results and so we should consider recommending this approach to our clients.

Determining lease terms when there are options to extend and terminate the lease

These type of terms are very common in property leases. Usually there will be an initial fixed term following which there will be options to extend or terminate the lease either by the lessee or both the lessee and lessor. When calculating the net present value of the lease liability, how should the lease term be determined?

FRS 102 states that, at the commencement of the lease, an assessment must be made to determine whether it is ‘reasonably certain’ that the lease will be extended or terminated. Matters to consider are past practice, the operational importance of the property asset to the lessee and plans to significantly modify or improve the property asset. If it is reasonably certain that the lease will be extended, the lease liability should be calculated based on the extended term.

Licences to occupy properties

Some organisations do not have a formal lease but, instead, occupy properties under licence agreements. These licence agreements may be formal or informal and may or may not have notice periods to cancel the agreement. These types of agreement are very common in group situations where subsidiary companies occupy premises under formal or informal licence arrangements. How should these licence agreements be accounted for?

The first consideration is whether there is a lease agreement in place. If there is no contractual liability to make payments over a period of time into the future, which can be legally enforced, there is unlikely to be a lease. If there is a formal agreement in place with a notice period, the notice period is likely to be less than 1 year with the result that the lease agreement would be exempt from the new lease accounting requirements as it would be classified as a short term lease with a period of less than 1 year.

The above would apply equally to ‘rolling leases’ which have no fixed term but are cancellable at the discretion of the lessee and lessor. The key consideration is whether there is a contractual period over which future rental payments are unavoidable. If the lessee can terminate the lease at its discretion the lease term is less than 1 year.

Property Leases with rent review dates

Most property leases have rent review dates during the term of the lease when the rent may be increased to align with market rates. How should this be taken into account when calculating the net present value of lease liabilities?

In accordance with para 20.54 of FRS 102, at the commencement of the lease, no assumption should be made about potential increases in the rent payable, following a future rent review. The initial calculation should be based on the current rent. A reassessment (i.e. a recalculation) of the lease liability should be carried out in the year the rent is revised and a corresponding adjustment should be made to the leased asset at that point.

Dilapidation Provisions

In accordance with the terms of most property leases, there is a requirement to reinstate a dilapidated property to a good condition when the lease terminates. Provision should be made for the dilapidation of leased assets in the normal way, usually over the term of the lease. However, the dilapidation amount should not be charged to expenditure but should instead be added to the cost of the leased property.