News
FRS 102 Changes Effective from 1 January 2026: Capitalisation of Operating Leases
18 Jun 2025
Overview of the FRS 102 Amendments
Effective from 1 January 2026, significant changes to FRS 102 – The Financial Reporting Standard applicable in the UK and Republic of Ireland will bring the treatment of operating leases more in line with international financial reporting standards, notably IFRS 16. These revisions are designed to improve transparency and comparability of financial statements by ensuring that all leases are appropriately recognised on the balance sheet.
The headline change is the capitalisation of operating leases, meaning that leasee’s will now be required to recognise most leases as right-of-use assets and corresponding lease liabilities, rather than expensing lease payments on a straight-line basis through profit or loss.
Key Accounting Changes
From 1 January 2026, the revised FRS 102 will require:
- Recognition of a right-of-use asset and a lease liability at the commencement of the lease.
- Right-of-use asset will be amortised over the lease term.
- Lease liability will be measured using the present value of lease payments, discounted at the interest rate implicit in the lease or the lessee’s incremental borrowing rate.
- Profit and loss impact will now be split between:
- Amortisation expense (straight-line or another systematic basis).
- Interest expense on the lease liability (declining over time).
This approach replaces the current method where operating lease rentals are typically treated as an operating expense.
Implications for Financial Reporting
1. Improved EBITDA
Under the new treatment:
- EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) will increase, as lease expenses will no longer be included in operating expenses.
- Instead, expenses are split between depreciation and interest, which are excluded from EBITDA.
- This may lead to more favourable earnings metrics and could be viewed positively by analysts and investors.
2. Negative Impact on Net Current Assets
- Lease liabilities will be split into current and non-current portions.
- The current portion of lease liabilities will increase current liabilities without a corresponding increase in current assets.
- This results in a deterioration of the net current asset position, potentially affecting liquidity ratios such as the current ratio and quick ratio.
Practical Considerations for Companies
Impact on Bank Covenants
- Many companies have bank covenants tied to EBITDA, net debt, interest cover, or current ratios.
- While EBITDA may improve, current liabilities increase, potentially breaching net current asset or liquidity covenants.
- Action Points for Directors:
- Review existing loan agreements and identify any sensitive covenants.
- Engage early with lenders to renegotiate covenants if necessary.
- Model the impact of lease capitalisation on financial statements and covenant ratios.
Impact on Stakeholder Communication
- Lenders, investors, and internal management may require education and explanation of the effects of the change.
- Transitional disclosures should clarify the reasons behind changes in key financial metrics post-implementation.
Systems and Process Updates
- Businesses will need to review lease contracts and ensure all qualifying leases are captured.
- Accounting systems must be updated to:
- Track right-of-use assets.
- Manage lease liabilities.
- Automate amortisation and interest calculations.
Transitional Provisions and Next Steps
The new standard allows for transitional reliefs, which may include:
- Applying the changes prospectively.
- Simplifying the treatment of short-term and low-value leases.
Companies are advised to:
- Conduct an impact assessment in 2025.
- Engage advisors and auditors early to understand compliance requirements.
- Communicate with key stakeholders regarding the changes.
- Prepare updated financial projections incorporating the new lease treatment.
Advice & Recommendations
The 2026 changes to FRS 102 represent a significant shift in lease accounting, with clear benefits in terms of improved transparency and EBITDA performance. However, the knock-on effects on net current assets and bank covenants require careful consideration.
Directors and finance teams should act now to assess, plan, and communicate the impacts of these changes to ensure smooth adoption and avoid unintended financial or regulatory consequences.
