FRS 102 amendments - lease accounting initial application

This helpsheet has been issued by ICAEW’s Technical Advisory Service to help ICAEW members with initial application of the lease accounting requirements introduced by the Periodic Review 2024 amendments to FRS 102 as reflected in the published FRS 102 (September 2024).

The majority of the amendments introduced, including those relating to lease accounting, are mandatorily effective for accounting periods beginning on or after 1 January 2026, with early application permitted provided all amendments are applied at the same time (FRS 102 (September 2024) para 1.37).

Please note that this helpsheet does not cover the accounting within revised Section 20 Leases but instead primarily focuses on the approach to initial application for entities already applying FRS 102, as set out in paragraphs 1.44 to 1.60 of FRS 102 (September 2024). This helpsheet also does not detail the disclosures required on initial application of FRS 102 (September 2024).

Detailed guidance on the requirements of lease accounting in the revised Section 20 Leases is set out in a separate Corporate Reporting Faculty factsheet, FRS 102 Leases (effective 2026).

Where an entity currently applies another accounting standard (such as FRS 105 or IFRS® Accounting Standards) it would need to apply Section 35 when transitioning to FRS 102. Application of Section 35 is not covered within this helpsheet.

Members may also wish to refer to the guidance written on specific areas of change introduced by the Periodic Review 2024 amendments to FRS 102,  which can be found via the links below:

• Helpsheet: Implementation of the changes to FRS 102
• Corporate Reporting Faculty Hub page: Changes to UK GAAP
• Corporate Reporting Faculty factsheet: FRS 102 Periodic Review 2024 Amendments

Previously FRS 102 (January 2022) Section 20 required lessees to differentiate between finance and operating leases, with the former being recognised on balance sheet, and the latter being disclosed as financial commitments.

Following introduction of the amendments, lessees will no longer need to differentiate between operating and finance leases and must instead recognise all non-exempt leases on balance sheet as a right-of-use asset with a corresponding lease liability.

Recognition exemptions are available for leases of low value assets and short-term leases.

It is worth noting that lease accounting for lessors is largely unchanged, with entities still required to determine whether leases are operating or finance, and account for them in a manner largely consistent with that of the previous edition of FRS 102 (January 2022). Therefore, the remainder of this factsheet focuses on initial application for lessees.

Unlike initial application of the Periodic Review 2024 amendments to revenue recognition, FRS 102 does not allow a choice of transition approaches for leases and instead mandates the modified retrospective approach. A lessee may choose to use carrying amounts of right-of-use assets and lease liabilities prepared for group reporting purposes under IFRS 16 Leases (see further information about the IFRS 16 practical expedient later in this helpsheet).

Under the modified retrospective approach comparatives are not restated, and as such, the comparative period will continue to present operating and finance leases separately. On the first day of the current period, we then apply the updated accounting requirements (or, if taking the practical expedient, IFRS 16 balances), with an adjustment recognised against opening reserves if applicable, to bring the starting position as at the date of initial application in line with the new accounting requirements.

The date of initial application, per FRS 102 (September 2024) para 1.40, is the beginning of the reporting period in which the entity first applies the Periodic Review 2024 amendments. For example, assuming no early application is applied, for a December year end, the date of initial application would be 1 January 2026. Similarly, assuming no early application, for a March year end, the date of initial application would be 1 April 2026.

As a practical expedient, entities are not required to reassess whether a contract is or contains a lease at the date of initial application. Instead, an entity can choose to apply the updated lease accounting requirements to contracts that had previously been identified as containing a lease, and not apply the requirements to those which had not previously been identified as containing a lease. Where this expedient is applied it would need to be applied to all lease arrangements in place as at the date of initial application (FRS 102 (September 2024) para 1.45). However, in the event that this practical expedient is not applied, all contracts in existence at the date of initial application would need to be reassessed as to whether they contain a lease and all such leases would need to be recognised (subject to the available recognition exemptions for leases of low-value assets and short-term leases).

Leases previously classified as finance leases

Unless a lessee takes the IFRS 16 practical expedient (see below), it shall recognise a lease liability and a right-of-use asset equal to the carrying amount of the leased asset and finance lease liability immediately prior to the date of initial application, using pre-existing FRS 102 (January 2022) requirements (per FRS 102 (September 2024) para 1.55). There will therefore be no adjustment to retained earnings at the date of initial application in respect of leases previously classified as finance leases. However, as after the date of initial application, an entity must use FRS 102 (September 2024), depending on the circumstances of the lease, the subsequent measurement may differ from that which would have been measured using the old lease accounting model, for example if there are lease modifications after the date of initial application.

Leases previously classified as operating leases

A lessee shall recognise a lease liability and a right-of-use asset at the date of initial application, unless applying one of the recognition exemptions.

Unless a lessee takes the IFRS 16 practical expedient (see below), the lease liability is initially measured at an amount equal to the present value of remaining lease payments, discounted using the lessee’s incremental borrowing rate or lessee’s obtainable borrowing rate (FRS 102 (September 2024) para 1.51) (or, for a public benefit entity, a deposit rate in accordance with FRS 102 (September 2024) para PBE20.50) for each lease at the date of initial application.

The right-of-use asset is initially measured at an amount equal to the lease liability, adjusted for any accrued or prepaid lease payments recognised immediately before the date of initial application (FRS 102 (September 2024) para 1.51). We must also consider the right-of-use asset for impairment at the date of initial application, unless the practical expedient relating to onerous leases (covered later in this helpsheet) is applied.

While any new lease under Section 20 of the amended FRS 102 (September 2024) initially recognised as a right-of-use asset will be adjusted for any provisions for dismantling and restoration costs in accordance with FRS 102 (September 2024) para 20.47(d), any existing leases being recognised on initial application of the amended FRS 102 in accordance with paras 1.51-1.54 will not initially be adjusted for such costs.

Where lessees had previously recognised assets or liabilities relating to favourable or unfavourable terms of operating leases acquired as part of a business combination, on the date of initial application those assets and liabilities are required to be derecognised by adjusting the carrying amount of the right-of-use assets recognised (FRS 102 (September 2024) para 1.54).

IFRS 16 practical expedient

Alternatively, if calculations have been prepared for a lessee for group reporting purposes under IFRS 16, the lessee may use the carrying amounts of the lease liabilities and right-of-use assets calculated for that purpose to measure its lease liabilities and right-of-use assets under FRS 102 at the date of initial application (FRS 102 (September 2024) para 1.48). If taken, this option applies to leases previously classified as finance leases or as operating leases. It should be noted that this expedient is available only on the date of initial application, and not on an ongoing basis.

FRS 102 paragraph 1.52 allows entities to apply exceptions to certain leases which were previously classified as operating leases. Note that these exceptions are not available to leases which were previously classified as finance leases. The exceptions available are as follows:

• Leases of low value assets - If a lease relates to an underlying asset which is of low value, as set out in paragraphs 20.9 to 20.11 of FRS 102 (September 2024), a lessee may apply the recognition exemption in paragraph 20.6 in respect of that lease and hence not recognise it on the balance sheet; in this case it is not required to make any adjustment for the lease on initial application. FRS 102 doesn’t explicitly clarify whether the assessment of whether or not the underlying asset is of low value should be made at the date of initial application or looking back to the commencement of the lease. In the absence of specific guidance within FRS 102 (September 2024), entities may instead look to the requirements of IFRS 16, which requires the assessment to be made based on whether the underlying asset would have been low value when it was new, however other approaches could also be justified.
• Investment property - Leases previously accounted for as investment property, applying the fair value model as set out in Section 16 Investment Property, do not require any adjustment on initial application. This may apply if, for example, an entity generates rental income from a property that it is itself leasing. The lessee shall account for the right-of-use asset and the lease liability arising from those leases applying Section 16 and the revised Section 20, respectively, from the date of initial application. For leases previously accounted for as operating leases, but which will be accounted for as investment property from the date of initial application, the right-of-use asset shall be measured at that date at fair value. Where there is a difference on initial application between the fair value of the right-of-use asset and the present value of the remaining lease payments, we would generally expect that this difference is recognised as an adjustment to opening retained earnings, in accordance with paragraph 1.47.

There are also a number of practical expedients provided by paragraph 1.53, which can be applied to simplify the requirements on initial application for leases previously classified as operating leases. These expedients are as follows:

• A lessee may apply a single discount rate to a portfolio of similar leases at the date of initial application.
• Short-term leases – if a lease ends within 12 months of the date of initial application, even if the full lease term was longer, a lessee may choose to account for it in the same way as a short-term lease in accordance with paragraph 20.6, avoiding the need to recognise the lease on balance sheet.
• A lessee may rely on its previous assessments of whether leases are onerous under Section 21 Provisions of FRS 102 (September 2024), as an alternative to applying Section 27 Impairment to the right-of-use assets at the date of initial application. If this expedient is applied, the lessee adjusts the right-of-use asset by the amount of any provision for onerous leases recognised on the balance sheet immediately before the date of initial application.
• Hindsight may be used in assessing the terms of a lease, such as in determining the lease term if the contract contains options to extend or terminate the lease.

Both the short-term lease practical expedient and the leases of low value assets exception can be applied on a lease-by-lease basis on initial application. Note that this is not necessarily the case for new leases recognised following initial application (see FRS 102 (September 2024) para 20.7).

Key facts

Company A entered into a lease on 1 January 2021 and classified this under the previous version of FRS 102 (January 2022) as an operating lease. The reporting date is 31 December, and the first accounting period that the entity will adopt the amendments will be the year ending 31 December 2026.

The primary terms included in the lease agreement are as follows:

Lease liability

The lessee is required to measure the lease liability at the date of initial application at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate or obtainable borrowing rate. In this example, there are 5 remaining annual lease payments of £25,000, with the first payable immediately on the date of initial application and discounted at the lessee’s obtainable borrowing rate of 6%.

Right-of-use (ROU) asset

The lessee is required to measure the ROU asset at an amount equal to the lease liability, adjusted by the amount of any prepaid or accrued lease payments relating to the lease recognised in the balance sheet immediately prior to the date of initial application.

Immediately prior to the date of initial application, Company A had accrued lease payments recognised on the balance sheet of £5,000, as a result of the lease incentive received at the start of the lease being spread on a straight line basis over the lease term.

As a result, the ROU asset at the date of initial application would be £111,628 – £5,000 = £106,628.

Journals on initial application

On 1 January 2026, Company A would recognise the ROU asset and lease liability calculated earlier on its balance sheet, and derecognise the lease incentive accrual which had been recognised under the previous lease accounting requirements:

Dr ROU Asset £106,628
Dr Lease incentive accrual £5,000
Cr Lease liability £111,628

Subsequent accounting

Following initial application, Company A would depreciate the ROU asset over its useful life. Separately, it would increase the carrying amount of the lease liability to reflect interest charged, and reduce the carrying amount for lease payments made, as calculated in the lease liability table shown earlier.

If we assume a 5-year straight line depreciation method, Company A would be recognising a depreciation charge on the ROU asset of £106,628/5 = £21,326.

The journals to be recognised for the accounting period ended 31 December 2026 would therefore be:

Depreciation Expense: Dr P&L Depreciation £21,326
Cr ROU Asset £21,326

Lease Payment: Dr Lease liability £25,000
Cr Bank £25,000

Lease Interest: Dr P&L Finance costs £5,198
Cr Lease liability £5,198

FRS 102 Appendix 1 Glossary contains the following relevant definitions:

Lease payments

Payments made by a lessee to a lessor relating to the right to use an underlying asset during the lease term, comprising the following:

1. fixed payments (including in-substance fixed payments), less any lease incentives;
2. variable lease payments that depend on an index or a rate;
3. the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
4. payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

For the lessee, lease payments also include amounts expected to be payable by the lessee under residual value guarantees. Lease payments do not include payments allocated to non-lease components of a contract, unless the lessee elects to combine non-lease components with a lease component and to account for them as a single lease component.

(Section referring to lessors has not been included in this helpsheet).

Lessee’s incremental borrowing rate

The rate of interest a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

Lessee’s obtainable borrowing rate

The rate of interest a lessee would have to pay to borrow, over a similar term, an amount similar to the total undiscounted value of lease payments to be included in the measurement of the lease liability.

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.