Changes to UK financial reporting standards: Lease accounting

In the third of our 2025 Audit and Accounting updates we explore how the latest updates to the Financial Reporting Standards affect lease accounting in the financial statements.

So, what is changing?

Currently, UK GAAP has a different accounting treatment for leases that are classified as ‘operating’ to those that are classified as ‘finance’ leases, with operating leases being ‘off balance sheet’ and recognised in profit and loss only on payment of the lease rentals. 

New UK GAAP removes that distinction for lessee accounting and requires that virtually all leases are now accounted for ‘on balance sheet’, similar to international accounting standards (IFRS 16).  

Changes are effective for accounting periods beginning on or after 1 January 2026.

Identifying leases

You might think this is the simple part – you know what leases you have as you rent a building, or some equipment under a lease agreement and already capture the financial impact of these agreements for the lease commitment disclosures in the financial statements.

FRS 102 revised defines a lease as 

“A contract …………conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” 

An ‘identified asset’ may be one that is specifically referred to in a contract (“Floor 2 of Holing Tower”) or one that will be identified on delivery (stating a lorry will be leased, but the specific registration is not known until the lorry is delivered for use). There is some guidance in the new standard on how the accounting may be impacted if the lessor can substitute assets.

The ’right to control’ means directing the use of the asset and obtaining substantially all the economic benefits from that use, over the period of the lease. This could mean deciding how to use that floor of the building, and being able to choose to use, hold or sub-let it.

There is a chance that entities may have hidden leases in services contracts which have not been captured previously as the costs would be expenses as incurred, as with the current operating lease treatment. 

You may find a lease for a specific asset embedded within a service contract in areas such as transport and logistics (dedicated warehousing or transport services in branded trucks), or office supply contracts (coffee supplies with a ‘free’ machine supplied etc.). 

Companies should start reviewing recurring expenditure and reviewing contracts in place to identify potentially hidden leases. 

Lease terms

The lease term begins at the commencement date and includes any rent-free periods. Determining the length of the lease will be important for the appropriate accounting, as the lease term will take into consideration options to extend or terminate leases where these are ‘reasonably certain’ to be exercised. 

Lessee accounting

To account for the lease ‘on balance sheet’, entities will need to recognise a lease liability and a ‘right-of-use’ asset.

We start by calculating the lease liability, as the present value of the future, unpaid lease payments including:

• fixed payments (or payments that are in substance, fixed);
• variable payments that depend on an index or rate;
• payments under residual value guarantees;
• the exercise price of a purchase option where ‘reasonably certain’ to exercise; and
• any penalty for terminating lease where likely to be paid. 

The discount rate to be used is either the interest rate implicit in the lease, or where that is not available, an entity can apply either an incremental borrowing rate or an obtainable borrowing rate.

The ’right-of-use’ asset is recognised at:

• the amount of the lease liability; plus
• any lease payments made at or before the start date; and
• initial direct costs of obtaining the lease; and
• any amount for dismantling provisions; less
• any lease incentives received.

After initial measurement (as above), subsequent accounting will see the lease liability increase to reflect the interest charges expensed in the P&L, decrease for the cash lease payments made, and reflect any remeasurement adjustments (such as for variable payments when the market rates, or inflation, change). 

The ‘right-of-use’ asset will decrease over time by the annual depreciation charge and may also require remeasurement if the lease liability changes. The ‘right-of-use’ asset should also be reviewed for possible impairment each year, this effectively replacing the consideration of onerous leases. 

Exemptions from lessee accounting

There are two optional exemptions from the new lease accounting:

1. Leases of ‘low value’ assets – unlike IFRS, there is no monetary amount indicated as a suitable guide to determine if an asset is of low value. Instead, the revised standard includes an example list of assets that would NOT be considered low value (such as vehicles, land and buildings, production lines etc.). Judgment will be required in considering other assets.
2. Leases with a term of 12 months or less and which do not contain a purchase option. Care will be needed to consider whether a rolling-lease meets the criteria of such a short-term lease.

Accounting for changes

Care will be needed to determine how to account for changes and whether the change is in in effect a ‘reassessment’ of the lease (such as recalculating the lease liability when variable lease payments based on inflation change), or a lease ‘modification’, which may increase or decrease the scope of a lease (such as adding another floor to the lease of a building or halving the vehicle fleet you have leased from a haulier). 

Lessor accounting

The distinction between operating and finance leases remains for lessors and the accounting requirements are essentially unchanged under new UK GAAP.

Transition

On transition to the new standard, entities will not have to restate the comparative period, instead, any cumulative effect of recognising the revised standard will be accounted for in the opening reserves balance.

Leases previously identified as finance leases will see their presentation change under the new standard, but there is unlikely to be much change in the accounting.

Leases previously identified as operating leases will need to be accounted for using the present value of the remaining lease payments, discounted using a rate at the date of initial application. The ‘right-of-use’ asset will be recognised at an amount equal to the lease liability, adjusted by the amount of any prepaid or accrued lease payments for that lease in the balance sheet.

There are a number of practical expedients available to users, such as the option to use IFRS 16 accounting entries if these are available within the group, and to only consider leases that were identified as such to the date of initial application (the beginning of the first accounting period after 31 December 2025).

Further information

This is an ongoing series, and we'll continue looking at individual key changes in more depth throughout 2025. Check out our other articles in this series:

• Changes to UK financial reporting standards
• Changes to UK financial reporting standards: Revenue recognition

We’re here to help

We’ll dive deeper into the key changes throughout 2025. To learn more, reach out to your local Bishop Fleming team or email us with your enquiry.