How will the recent FRS 102 lease accounting changes affect borrowers?

Recent changes to FRS 102 will significantly alter the accounting treatment of leases for UK businesses, bringing most leases onto the balance sheet. This article examines the implications for borrowers, including the impact on financial covenants and loan agreements.

Understanding the changes to FRS 102 and their impact on financial reporting

FRS 102, the Financial Reporting Standard applicable in the UK and Republic of Ireland, is the main accounting standard for small and medium-sized enterprises (SMEs) that do not use International Financial Reporting Standards (IFRS). The Financial Reporting Council has introduced significant changes to FRS 102, particularly in respect of the treatment of leases for lessees, which may affect a company’s compliance with financial covenants under existing loan arrangements. The key changes relate to the way finance leases and operating leases are treated for accounting purposes.

Current treatment under FRS 102

Currently, finance leases are shown on a company’s balance sheet as both an asset (being the leased item) and a liability akin to a loan (being the obligation for future lease payments). Operating leases, in contrast, are accounted for off-balance sheet, with lease payments shown as an expense in the company’s income statement over time. An operating lease, therefore, has no effect on the company’s balance sheet figures. Whether a lease is classified as a finance or an operating lease can significantly impact a company’s financial statements, even though the economic obligations under each type of lease may be similar.

Changes to the treatment of leases under FRS 102

For accounting periods beginning on 1 January 2026 or later, there will no longer be any real distinction between the way operating leases and finance leases are treated. All leases will be treated similarly to the way finance leases are currently treated, aligning more closely with IFRS. The distinction between operating and finance leases will therefore become largely irrelevant for accounting purposes. Lessees will be required to recognise the majority of all leases on the balance sheet as:

• A right of use asset: the new asset will be shown within the company’s fixed assets on the balance sheet from commencement of the lease, measured at the initial lease liability amount.
• A lease liability: the lease will be shown as a new liability measured at the present value of future lease payments. This liability will be reduced by each payment of rent under the lease.

This change is likely to mostly impact sectors where leasing is very common, for example companies in the retail sector, or where leases of vehicle fleets or machinery are entered into. There is an exception to the new treatment for certain low-value leases and short-term leases of 12 months or less.

Impact on financial statements

The changes will increase both assets (by including the right-of-use asset) and liabilities (by including future lease payments) on a company’s balance sheet. In the profit and loss statement, where rental costs under operating leases are currently treated as an expense, this will be replaced with depreciation of the right of use asset and finance costs in respect of the lease liability. This will result in an increase in reported EBITDA, as depreciation and finance costs are added back when calculating EBITDA.

Implications for borrowers

The changes to FRS 102 will impact financial covenants under loan agreements, both in terms of compliance with financial covenants under existing financing arrangements and the setting of covenants in new transactions. The changes in lease accounting will affect the calculation of financial covenants, even though the business’s underlying performance may remain unchanged. Changes to the calculation of EBITDA and operating profit will affect financial covenants which are based on those metrics. In addition, where there are “baskets” of permitted items allowed for in certain covenants, these may need to be re-examined in light of the change to the treatment of operating leases going forward. Gearing ratios (i.e. debt:EBITDA) may also be impacted as a company’s total debt will increase with lease liabilities being added to the balance sheet, as well as an increase in EBITDA.

Borrowers may consider adopting the concept of “frozen GAAP” for the purposes of financial covenant calculations. Where frozen GAAP is used, financial covenants are calculated based on the accounting standards in force at the time the loan agreement was entered into, rather than such covenants being calculated by reference to subsequent changes in accounting standards (such as the changes to FRS 102). This approach can provide both the borrower and the lender with certainty as to how the financial covenants will be calculated for the term of the loan and alleviate concerns that any subsequent change in accounting standards could put the borrower into breach solely as a result of accounting changes.

However, the frozen GAAP approach can present significant challenges for smaller companies. A company would need to maintain and reconcile two sets of financial statements following a change in accounting standards (i.e. one prepared in accordance with the new regime and one prepared in accordance with the frozen GAAP for the purpose of the loan agreement). As well as the additional time and cost involved, smaller companies may lack the resources and technical expertise required to prepare and supply two sets of accounts. There may also be difficulties in ensuring accuracy and consistency between the two sets of accounts, increasing the risk of errors and potential disputes with lenders.

Borrowers affected by these accounting changes should consider the impact on their financial reporting and how their existing financing arrangements may be affected. The changes will affect accounting periods from 1 January 2026 and so it would be prudent for borrowers to explore the potential effects with lenders in advance of the changes to FRS 102 coming into force.