LEASE ACCOUNTING OVERHAUL

Impact on the balance sheet:

The lessee will record a new asset under fixed assets, representing the ‘right of use’ of the property, along with a corresponding lease liability, divided into current and non-current liabilities. This liability will be measured at the present value of future lease payments, with adjustments for any incremental costs incurred in obtaining the lease. Each rental payment will decrease the lease liability.

Impact on the income statement:

The current operating lease expense (rent) will be replaced by depreciation (and any impairment) of the right of use asset, along with a finance cost for the unwinding of the lease liability.

Throughout the lease term, the total cost of the lease charged to the income statement will remain the same, but the timing will differ. This is because the finance cost will be higher in the earlier years of the lease as the lease liability is gradually reduced.

IMPACT ON KPIS:

• EBITDA will increase by the amount of the operating lease expense that is removed.
• Finance and depreciation costs will rise, potentially affecting lending covenants.
• Gross assets, used to determine company size thresholds*, may exceed limits due to the inclusion of right of use assets.
• Net current assets will decrease due to the current portion of the lease liability.
• Gearing ratios may increase, depending on how debt is defined.

The changes to FRS 102 kick in for periods starting on or after 1 January 2026 – but don’t wait until then to take action. Now’s the time to get ahead by understanding how these updates could affect your financial statements and any current or future contracts that rely on financial data or KPIs.

Practical hints and tips include:

• Identify your leases.
• Do you have access to lease documentation?
• Are there any embedded leases in other contracts?
• Understand the key terms in the lease contracts
• Consider how new double entries will be calculated and recorded:
  • Identify applicable nominal accounts for the right of use asset, lease liability and expenses
  • Consider whether lease accounting software is needed or whether the collation and calculation of the asset and liability can be managed in-house on spreadsheets.

• It is crucial to identify and assess any contractual arrangements, such as covenants, earn-out agreements, and performance related pay that refer to KPIs, such as EBITDA, to fully understand how they will be impacted. Early conversations and amendments can then be agreed in advance.
• Comparatives cannot be restated on initial application of the periodic review 2024, which means adjustments are taken to reserves at the start of the current year. While this may have some practical advantages, it creates a lack of comparability between the current and comparative periods. It is therefore advisable to plan how to explain the lack of comparability between the current and comparative periods to stakeholders, and the potential changes to KPIs, assets, liabilities, and profits, ideally before KPI targets and budgets are agreed.

• As a practical expedient, an entity is not required to reassess whether a contract is, or contains, a lease at the date of initial application.
• A number of other practical expedients are also available to lessees, such as for example applying a single discount rate to a portfolio of leases with reasonably similar characteristics and using hindsight in determining the lease term if a contract contains options to extend.
• For previous operating leases, a lessee is required to apply a modified retrospective approach (i.e. no restatement of comparative) by setting the ROU asset equal to the lease liability and adjusting the ROU asset for any previously recognised prepayment or accrual of lease payments, unless it chooses the option to use balances previously calculated for group reporting purposes under IFRS 16.
• For previous finance leases, a lessee recognises ROU asset and lease liability at the date of initial application equal to the carrying amount of the leased asset and finance lease liability immediately before that date, unless it chooses the option to use balances previously calculated for group reporting purposes under IFRS 16.
• If a lessor is not an intermediate lessor, it makes no adjustments on transition for its leases and accounts for those leases applying the revised Section 20 from the date of initial application.
• If a lessor is an intermediate lessor, it must reassess the classification of its operating leases at initial application of the revised Section 20 with reference to the remaining contractual terms and conditions of the head lease and sublease at that date. If the operating lease is reclassified as a finance lease as a result of this assessment, it is then accounted for as a finance lease from the date of initial application.
• In paragraphs 1.58 to 1.60, there are specific transition requirements for sale and leaseback arrangements.

HOW DO YOU IDENTIFY A LEASE?

At the contract’s inception, it should be determined if a contract conveys the right to control the use of an identified asset for a period in exchange for consideration. The control assessment is based on whether the customer can direct the asset’s use and obtain its economic benefits.

A contract is, or contains, a lease when the following is present:

• An asset is specified explicitly or implicitly. There is no identified asset if the supplier has a substantive right to substitute it throughout the period of use and can economically benefit from doing so.
• The customer has the right to obtain the economic benefits from using the asset throughout the lease period.
• The customer can direct the use of the asset or have designed it in a way that predetermines its use.

Lease Components:

• A contract may include multiple components, some lease-related and some not. Each lease component should be accounted for separately if they meet the separation criteria unless a practical expedient is applied to combine them.
• Lessees must allocate the contract’s consideration to each lease component based on their relative stand-alone prices. If stand-alone prices are not observable, they must be estimated maximising observable information.

WHAT IS THE “LEASE TERM?”

The lease term begins on the commencement date, including any rent-free periods.

• Components of lease term are;

– the non-cancellable period,

– periods covered by an extension option, if the lessee is reasonably certain to extend and

– periods with an option to terminate if the lessee is reasonably certain not to exercise it.

• If only the lessor has the right to terminate the lease, the non-cancellable period of the lease includes the period covered by the lessor’s option to terminate the lease.
• The lease term should be reassessed if significant events or changes occur that affect the likelihood of exercising options within the lessee’s control.

RECOGNITION IN FINANCIAL STATEMENTS

At commencement date, the lessee recognises both a right-of-use asset (ROU asset) and a lease liability on the balance sheet.

INITIAL MEASUREMENT

The ROU asset is initially measured at cost. The cost comprises the following:

• Initial lease liability measurement
• Lease payments made before or at commencement less incentives.
• Initial direct costs incurred by the lessee.
• Costs to dismantle, remove, or restore the asset/site per Section 21.

The lease liability is initially measured as the present value of the lease payments, discounted using the interest rate implicit in the lease or, if not determinable, the lessee’s incremental or obtainable borrowing rate.

Lease payments comprise:

• Fixed payments (less incentives).
• Variable payments dependent on an index or rate (measured initially at commencement).
• Expected payments under residual value guarantees.
• Exercise price of purchase options (if reasonably certain to exercise).
• Penalties for terminating the lease (if the term reflects this option).

Subsequent measurement

The ROU asset is subsequently measured at cost less accumulated depreciation and impairment losses, adjusted for lease liability remeasurements (this does not apply to investment property measured at fair value and property, plant and equipment that is revalued).

The lease liability is adjusted for:

• Interest on the lease liability.
• Lease payments made.
• Remeasurements due to reassessments, lease modifications or revised in-substance fixed lease payments

Reassessment and modifications

Reassessment: remeasure the lease liability for changes in lease term, purchase option assessments, expected residual value guarantees, and future lease payments from changes in an index or rate.

Lease modifications:

• Account for a lease modification as a separate lease if the modification increases the scope and consideration commensurately.
• For those lease modification that are not a separate lease, reallocate consideration, determine new lease term, and remeasure lease liability using a revised discount rate, with possible exceptions allowing for unchanged rates.

Presentation

ROU assets and lease liabilities can be presented separately or disclosed in notes, specifying which line items include them. Investment property right-of-use assets are presented as investment property.

What are the required disclosures?

The are several disclosures required for leases. At a high level, the following key disclosures are required:

• A description of the significant leasing arrangements, with certain minimum disclosures required in this respect.
• Specific disclosures required in respect of the lease liability, for example, the total interest expense, total cash outflows, variable lease payments not included in lease liabilities and the carrying amounts of remeasured lease liabilities.
• Specific disclosures in respect of the ROU-assets which include a reconciliation of the carrying amount at the beginning and end of the reporting period.
• Disclosure of lease commitments for short-term and low-value leases, disaggregated by maturity periods.