One of the most significant changes arising from the Financial Reporting Council’s (FRC) periodic review of UK GAAP is the removal of the distinction between operating and finance leases by lessees in FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. Instead, for accounting periods beginning on or after 1 January 2026 (or earlier if the amendments are adopted early), Section 20 Leases will require lessees to capture most leases on the balance sheet. These changes do not apply to FRS 105 The Financial Reporting Standard applicable to the Micro‑entities Regime. Recognising significant concerns about potential costs of the change for the smallest entities, the FRC decided those applying FRS 105 should continue to differentiate between on-balance sheet finance leases and off-balance sheet operating leases. 

Do all leases need to go on the balance sheet?

In short, no. There are two exemptions available that might be relevant; short-term leases (leases with a term of less than 12 months) and leases of low value assets. 

The assessment of whether a lease is of a low value asset is based on the underlying asset, ie, the subject of the lease, rather than the value of the lease payments. It’s also worth noting that the low value assessment is irrespective of whether the lease is material to the lessee; it’s assessed on an absolute basis. An underlying asset is deemed to be low value only if the lessee can benefit from use of the asset (either on its own or with other readily available resources) and the asset is not highly dependent on other assets. Section 20 provides examples of assets that would not be considered low value, including land and buildings, production line equipment and vehicles. Besides this list, judgement will be required.

Unlike IFRS 16 Leases, the international counterpart of FRS 102 Section 20, the FRS 102 amendments do not refer to a threshold for low value assets; IFRS 16’s Basis of Conclusions indicates an asset worth $5,000 or less would be considered low value. Instead, the intention is for FRS 102 to enable a more proportionate approach to recognising leases on-balance sheet.

Where a lease is not exempt on the basis of being either short-term or for a low value asset, it will be necessary to first confirm that the contract contains a lease before then recognising a right of use asset and corresponding lease liability.

Assessment of whether a contract is, or contains, a lease

As a first step, entities will need to assess whether a contract is, or contains, a lease. A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. The decision tree below illustrates the approach required.

Where it’s concluded that the contract is (or contains) a lease, the lessee recognises the lease on the balance sheet by recording both an asset and a liability; the asset reflecting the right to use the asset over the lease term and the liability reflecting the obligation to make lease payments. By contrast, where a contract does not contain a lease, the lease payments will be accounted for as an expense in the statement of profit or loss on a straight-line basis (or other systematic basis) over the term of the lease.

Measurement of the lease liability and right-of-use asset

As noted above, the lease liability represents the lessee’s obligation to make lease payments over the term of the lease. The lease liability is initially measured at the present value of the future lease payments unpaid at the commencement date. The lease payments are discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, either the lessee’s incremental borrowing rate or obtainable borrowing rate.

Subsequently, the lease liability is adjusted by:

• increasing the carrying amount to reflect interest on the lease liability;
• reducing the carrying amount to reflect the lease payments made; 
• remeasuring the carrying amount to reflect any lease modifications, reassessments (eg, due to changes in lease payments), or revised in-substance fixed lease payments.

The right-of-use asset (ROU asset) reflects the lessee’s right to use the asset throughout the lease term. The ROU asset is initially measured at cost, made up of:

• the initial measurement of the lease liability;
• any lease payments made at or before the commencement date;
• less any lease incentives received; 
• any initial direct costs incurred by the lessee; and
• any provision recognised for dismantling or restoring the underlying asset.

After the commencement date, in most circumstances, a lessee measures the ROU asset applying the cost model. The initial cost is reduced by any accumulated depreciation and accumulated impairment losses. Adjustments for any remeasurement of the lease liability may also be necessary. 

Simplified transition approach

When it comes to transition, the FRC has opted for a simplified transition approach compared with the approaches used when IFRS 16 was introduced. While the amendments are to be applied retrospectively, comparative figures are not to be restated; instead, an adjustment is to be made to the opening balance of retained earnings at the date of initial application (being the beginning of the reporting period in which an entity first applies the amendments). 

For leases previously classified as operating leases, ROU assets and lease liabilities are to be recognised based on the outstanding lease payments and remaining lease term at the date of initial application. For leases previously classified as finance leases, the ROU asset and lease liability are recognised at the carrying amounts immediately prior to the transition. A simplification has also been included whereby entities included in consolidated accounts prepared under IFRS Accounting Standards can use balances that have been calculated under IFRS 16 for the purpose of group reporting. 

Greater transparency

Overall, the new requirements of Section 20 Leases will better reflect the financial impact and commitment of leases on an entities’ financial performance and position. This will provide greater transparency and comparability for the users of financial statements, which will, in turn, facilitate more informed decisions.

Fahad Asgar, Technical Manager, Corporate Reporting Faculty, ICAEW