FRS 102: changes to lease accounting rules

FRS 102 is changing for periods starting on or after 1 January 2026. The main accounting changes are around small company disclosures; revenue; and leases. Beyond the accounting, the changes have potentially significant implications for tax that are important for businesses to be aware of.

Background and lease accounting

Currently, leases are classified as either finance leases or operating leases.

• For finance leases, where the lessee effectively owns the asset, their balance sheet includes both the right to use the asset, and a liability (loan) for the future lease payments. Over time they recognise interest on the loan and depreciation on the asset
• For operating leases, where the lessee effectively rents the asset, they recognise a straight-line lease expense over time. Together with accruals and prepayments if the lease payments are not on a straight-line basis

One of the key changes is that lessees will need to move to treat most of their leases like finance leases, bringing operating leases onto the balance sheet by recognising both the right of use asset and the lease payments liability. This brings the accounting closer to international financial reporting standards (IFRS).

Where these changes bring a lease onto the balance sheet for the first time, this will be accounted for on a forward-looking basis only. In the first period starting on or after 1 January 2026, the prior year figures will be left unchanged, while the current year figures will follow the new rules, with the difference going to brought forward reserves.

The accounting for lessors, who receive payment for renting out their assets, is largely unchanged. This article is directed at lessees.

Exceptions, choices, KPIs and covenants

Lessees will need to treat most of their leases like finance leases, but there are two exceptions. In the following cases you can choose which approach to take:

• Low value leases where the leased asset, when new, was worth less than a small car (so cars cannot qualify as low value, but laptops can)
• Short-term leases where the lease term, including periods with options to extend that the lessee is reasonably certain to exercise, is 12 months or less (and where the lessee does not have an option to purchase the asset).

For low-value leases, you can choose what approach to take on a lease-by-lease basis. You do not need to be consistent.

For short-term leases, you can choose what approach to take for each class of leased asset, but should be consistent within each class. (The classes are the headings you use in your accounts’ fixed asset notes.)

Businesses should be intentional about this choice. How you treat a lease of 200 laptops (each a low value item) can have a major impact on your accounts.

Bringing a lease onto the balance sheet like a finance lease:

• Increases your total assets, which might change your company size
• Increases your current liabilities (to reflect the first year of payments), reducing your current asset ratio, which might impact bank covenants
• Replaces the lease expense with depreciation on the right of use asset, and interest on the lease payment liability… both of which are added back in calculating EBITDA
• By increasing EBITDA, could impact bonus targets, share options, or contingent consideration.

It is likely ‘simpler’ to take advantage of these exemptions wherever possible to maintain your previous treatment, but in many cases it will be more important to consider how you want your results to be presented.

For micro-sized businesses, it is possible to avoid the lease changes by adopting FRS 105. In FRS 105, the revenue rules are changing, but the lease rules stay the same as before. See this article for more detail on company size thresholds.

It is also possible to adopt the changes early. You might do this if you were planning a transaction in 2027 and wanted to present figures for 2026 and 2025 on a consistent basis. You need to adopt all the FRS 102 changes in one go.

If you are evaluating the accounts of a customer, supplier, or competitor, you should be aware of the basis on which their accounts are prepared.

If you are negotiating a sale agreement, bonus agreement or new bank loan, you should consider whether the impact of these changes will make it easier or harder to meet targets. Be ready to present your (potentially changing) figures in the best possible light.

Information gathering for lease accounting changes

The first step in preparing for these changes is to assemble a complete list of leases. In theory you should already have this list, but there are many corners of the business that might have signed such an agreement. Areas to consider include

• Building and facility leases
• Vehicle leases
• Leases of specific, identifiable parking spaces
• Leases of IT equipment such as laptops
• Leases of office equipment such as printers and coffee machines
• Leases “built into” other contracts – eg a canteen or catering contract that gives you the right to direct the use of specific kitchen equipment

Once you have a complete list of these leases, you will want to consider whether they qualify for either the short-term or low-value lease exemption, and whether you wish to use those exemptions or not.

Forecasts

These new rules apply to periods starting on or after 1 January 2026.

If you are preparing internal forecasts for one of these periods – eg the calendar year 2026 – these should include figures on both a comparable basis to previous years, and the ‘statutory’ basis that will be shown in the accounts under the new rules.

When preparing covenant or bonus forecasts, you should carefully read the underlying agreements and determine whether these are based on figures under the new rules or old.

Tax implications of lease accounting rules

On a basic level, it would seem that there isn’t too much to think about in terms of the tax implications of this change, as the tax will follow the accounts. Operating leases will move from having a rental expense that is deductible for corporation tax, to having an amortization cost and an interest expense, both of which will be deductible.

As corporation tax follows the accounts here, there will not normally be any change to deferred tax either.

This simple picture does not, though, tell the whole story.

Capital allowances

Although operating leases are being moved to being recognised on the balance sheet as ROU assets within tangible fixed assets, this does not change the treatment in relation to capital allowances. For the most part, as detailed, leases will be deductible for tax via the amortization and interest expenses. Leased assets will only qualify for capital allowances where they are acquired on hire purchase leases or other similar leases that provide for a transfer of ownership and where there is a capital element to the lease payments.

Companies will therefore need to be careful to ensure that they can separately track leased assets from other tangible fixed assets, to ensure that the correct tax treatment is applied.

We recommend that where ‘right of use’ assets arising from leases are included within tangible fixed assets in the accounts, the internal register supporting this category should separate these out from other assets and should detail whether each lease is considered to be an ‘operating’ or ‘finance’ lease under the old rules.

Corporate interest restriction

Moving leases to the balance sheet, with the future payment liability unwinding through the profit and loss as an interest expense, means that companies are likely to see a significant increase in their interest expense each period.

Although the interest expense is initially deductible, companies and groups may run into trouble if their total net interest expense exceeds the £2m de minimis for the corporate interest restriction.

In order to avoid a disallowance arising on what are essentially notional interest charges, rather than genuine interest costs, the legislation operates in such a way that it excludes the interest debits on leases that would previously have been classified as operating leases from being considered for corporate interest restriction purposes. Interest charges arising from operating leases will therefore not cause the corporate interest restriction to bite.

Interest charges arising on leases that would have been classified as finance leases are not, though, excluded for corporate interest restriction purposes, so potentially could cause an interest restriction to apply.

The main practical implication of this is that although companies will no longer have to separate operating leases and finance leases for accounting purposes, they will still have to track them separately for tax purposes. Maintaining separate nominal codes within the company’s accounting system for interest on operating leases liabilities and finance lease liabilities would be sensible.

Venture capital investment schemes –
EIS and SEIS

The enterprise investment scheme and seed-enterprise investment scheme are vital schemes for helping businesses to attract investment. Under both schemes, there is a hard cap on the maximum gross assets a company can have immediately before the issue of any EIS or SEIS shares being £15m for EIS and £350,000 for SEIS.

With the move to leases being recognised on the balance sheet as ROU assets, companies could see a significant increase in their gross asset position with no real change to the underlying business. This means that companies could be pushed out of qualifying for these valuable schemes, which could significantly reduce their ability to obtain investment.

Companies wanting to obtain EIS or SEIS investment will need to consider the impact of the change in the rules on the recognition of leases on their gross asset position and may need to consider accelerating any such plans to ensure that they qualify.

Employee incentives – enterprise management incentives (EMI)

Another area that the increase in gross assets could have an impact on is a business’s ability reward its staff with EMI share options. EMI share options are only available to companies / groups with gross assets of £30m or less prior to the grant of the share options, so businesses will need to consider the impact that this change in accounting rules may have on their gross asset position.