Changes coming to the accounting for leases
The Financial Reporting Council (FRC) has issued new proposals for lease accounting in the UK under Financial Reporting Exposure Draft (FRED) 82. These changes are set to have a very significant impact on the way that companies report their lease obligations in their financial statements. In this blog, we will provide an overview of the changes, explain why they matter and what exemptions are available.
Overview of the changes
Under the new proposals, UK companies will be required to recognise most leases on their balance sheet as a right-of-use asset and a corresponding lease liability. This represents a major shift from the current accounting standard. It presently allows companies to keep ”operating leases” off their balance sheets.
The new standard will require companies to recognise the right-of-use asset and lease liability at the commencement date of the lease, based on the present value of lease payments over the lease term. The right-of-use asset will be depreciated over the lease term, while the lease liability will be reduced as payments are made.
The new standard will apply to all leases, except for those with a lease term of 12 months or less and leases of low-value assets (such as office equipment or computers).
Why it matters
The main reason for the change is to align FRS 102 with the IFRS on-balance sheet model for lease accounting. This model provides investors and stakeholders with a more complete picture of a company’s financial position. Currently, many companies are able to keep significant lease obligations off their balance sheets, which can make their financial position appear stronger than it really is. The new standard will make it easier for investors and stakeholders to compare companies’ financial statements and make more informed investment decisions.
In addition, the change may impact a company’s key financial metrics, such as debt-to-equity ratio, interest coverage ratio, and return on assets. It may also impact how lenders and creditors view a company’s creditworthiness, potentially impacting borrowing costs and existing banking covenants as they haven’t been drafted to accommodate this change.
While most leases will be subject to the new accounting standard, there are some exemptions available. Leases of 12 months or less will be exempt, as well as leases of low-value assets. In addition, leases for exploration and evaluation assets in the oil and gas industry will be exempt, as will leases of biological assets.
One of the key changes for lessors is that they will need to classify leases into two categories: finance leases and operating leases. Finance leases are those that transfer substantially all of the risks and rewards of ownership to the lessee, while operating leases are all other leases. Finance leases will be accounted for using the principles that apply to the lessee, while operating leases will be accounted for using a straight-line rental expense approach.
Additionally, under the new lease accounting standards, lessors will need to provide more detailed disclosures in their financial statements, including information about the nature and terms of leases, the carrying amount of lease assets and liabilities, and the risks and uncertainties associated with leasing activities.
When does this come into effect?
It’s predicted that proposals will be effective for accounts beginning on or after 1st January 2025. Comparative periods will not requirement restatement however there will be an option to voluntarily do so.
The new lease accounting standard represents a significant change for UK companies, requiring them to recognise most leases on their balance sheets. While the change will require additional work which can be complex to carry out and may impact financial metrics, it is hoped it will ultimately provide investors and stakeholders with a more complete picture of a company’s financial position. Companies should carefully consider the new requirements and take steps to ensure compliance before the standard comes into effect, especially where covenants are in place to ensure that these changes do not have any unintended covenant breaches.
It’s important to plan in advance and determine how these changes may affect your business in the future. For more information around these new changes or anything else tax related, contact our Business Services Team on 01903 234094.