FRS 102: Lease accounting – commercial implications and practical challenges

In this second instalment, continuing the theme from our first article around why should we care and how hard can it be, we are not going to delve into the detail of the accounting standard, we can get into that at a later date. Instead, the focus here is on the commercial impact the changes are likely to have, including tax implications, alongside some of the key judgements and other complexities that may arise when accounting for lease arrangements.

By now, the high-level accounting concepts are well publicised. For accounting periods commencing on or after 1 January 2026 (primarily 31 December 2026 year-ends), most leases will be recognised on-balance sheet, subject to limited exemptions.

If we were to walk through a simple, textbook example of a typical lease arrangement – the type often used in accounting updates on this topic – you could be forgiven for assuming that the accounting treatment will be relatively straightforward. The general principles for recognising right-of-use (‘ROU’) assets and the corresponding lease liabilities are already familiar to those responsible for financial reporting.

However, the commercial implications and technical accounting complexities can be far-reaching and should not be underestimated – or overlooked.

Commercial impact (including tax implications)

There remains a degree of uncertainty around the commercial impact of adopting the new rules, with different stakeholders across a business often at different stages of preparation. To help frame internal discussions and support early planning, we have set out below some of the key themes we regularly explore with clients that have a significant volume of lease arrangements:

KPIs / financial ratios

The changes to lease accounting will affect a number of metrics that warrant a direct commercial consideration:

• EBITDA ↑ – Operating lease expenses are replaced by depreciation and interest charges, which typically improves EBITDA. This is particularly important where EBITDA underpins loan covenants, financing arrangements or business valuations. Early discussions with lenders are strongly advised, as initial indications suggest approaches may vary. In some cases, lenders may continue to require covenant calculations under the existing lease accounting rules, potentially resulting in duplicated reporting.
• Gross assets ↑ – Recognising ROU assets on the balance sheet may push businesses closer to – or beyond – key thresholds, including those linked to company size, audit and disclosure requirements, and the availability of certain tax reliefs (for example, EIS and SEIS relief, which we’ll cover in a future article). For larger companies, gross assets can also affect exemptions from mandatory transfer pricing rules and the Senior Accounting Officer (SAO) regime.
• Net current assets ↓ – The recognition of lease liabilities due within one year is expected to reduce net current assets. This is particularly relevant where liquidity ratios are used for financing, covenant compliance or tendering for new contracts.
• Net assets / (liabilities) ↓ – A reduction is the most likely outcome, particularly where lease liabilities exceed the carrying value of ROU assets after inception. This arises due to the front-loading of interest on lease liabilities compared to the typically straight-line depreciation of ROU assets. The result is a temporary erosion of balance sheet strength, which can affect valuations, financial headroom and investor reporting.
• Gearing ratios ↑ – Gearing is expected to increase, depending on how debt is defined. This is another key metric to monitor where gearing is relevant to any of the commercial considerations already noted.

Tax implications

We’ll explore tax in more detail in a later article, alongside company size considerations and the availability of reliefs and exemptions. For now, some of the key tax implications to be aware of include:

• Allowable tax deductions for depreciation and finance costs (with finance costs typically higher in the earlier years of a lease);
• Transition adjustments to opening retained earnings, which are expected to be spread over the average lease term for tax purposes, giving rise to deferred tax considerations;
• Capital elements included within ROU assets (such as stamp duty land tax) should be monitored separately, as any associated depreciation remains non-deductible;
• Finance costs that may be excluded from Corporate Interest Restriction (CIR) calculations.

Accounting complexities

It’s easy to overlook specific features within lease agreements that can significantly affect the accounting treatment. These are often absent from simplified examples, despite being common in real-world commercial arrangements. Identifying these features early – and reflecting them appropriately in lease schedules – is critical. At a minimum, consideration should be given to:

• Lease incentives paid or received;
• Variable lease payments (for example, those linked to an index or rate);
• Option to purchase (exercise price), options to extend and break clauses;
• Penalties for early termination;
• Amounts payable under residual value guarantees;
• Payments made before lease commencement;
• Initial direct costs of obtaining the lease;
• Dismantling or restoration costs of the underlying asset (which often require estimation);
• Lease modifications, including changes in scope, assets or payment terms.

An additional layer of complexity arises on transition, particularly for leases that are mid-term at the date of initial application. A simplified transition approach is available on first time adoption and will be the focus of our next article.

This can still involve different accounting treatments depending on whether leases were previously classified as operating or finance leases, or where the reporting entity has prepared lease accounting postings in the past due to being included with an IFRS consolidation.

Key judgements

Beyond the accounting complexities, there continues to be uncertainty and areas of subjectivity to contend with, including:

• Initial identification of a lease, including whether there is an identifiable asset in the contract, the right to control that asset in terms of its economic benefits, and the right to direct its use;
• Determining the discount rate, particularly where the implicit rate is not stated in the lease agreement and an incremental / obtainable borrowing rate must be estimated;
• Applying low-value exemptions, which are assessed based on the absolute value of the underlying asset rather than the value of the lease payments and whether these are material to the entity. While the standard lists asset types that are not considered low-value, judgement is still required beyond this.

Disclosure requirements

Given the potential scale of impact, the changes inevitably bring additional disclosure requirements, including:

• Descriptions of significant leasing arrangements;
• Clear distinction over the presentation of ROU assets from other assets and lease liabilities from other liabilities;
• The carrying value of ROU assets / lease liabilities, depreciation charges and finance costs, alongside cash outflows;
• Expenses relating to short-term and low-value leases where exemptions are applied.

It’s also worth noting that FRS 102 includes disclosure requirements beyond those in IFRS 16, such as:

• A full reconciliation of ROU assets from opening to closing values;
• Maturity analyses for exempt leases, alongside the expense recognised;
• Additional disclosures around lease modifications, where relevant.

Where do I start? 

Start by understanding the volume and scope of lease arrangements across your business and identifying key features that may require specialist input when preparing accounting schedules. From there, consider the potential commercial impact to support early conversations with lenders, investors, auditors (we can help), and other stakeholders affected by the changes.

UNW’s team includes experts who have supported clients during their adoption of IFRS 16 in 2018–2019 and have experience with current IFRS clients who are effectively already adopting the lease accounting approaches set out by the changes to be reflected in FRS 102. Whether you need (commercial) impact assessments, guidance papers, or practical implementation support, we can tailor our approach to your needs.

If you’d like to discuss how the new FRS 102 requirements apply to your organisation, or want support preparing for the transition, please get in touch with your usual UNW contact – who will refer you to one of our Audit and Accounting specialists – or email enquiries@unw.co.uk.