For many small to medium sized businesses, leasing is considered a more favourable option compared to owning an asset out right. This particularly happens with high value items such as properties and motor vehicles, where a business will enter a lease over a specific period and pay a monthly or quarterly amount to the owner.
For leases that does not transfer substantially all the risks and rewards incidental to ownership to the lessee, the costs would be directly attributed to the profit and loss account as a leasing expense, reducing accounting and taxable profit. These are called “operating leases”. However, for accounting period starting from 1 January 2026, the treatment of these leases has now changed which can have a significant effect on a business’ profit and balance sheet. Instead of allocating the lease payment to the profit and loss, FRS102 now dictates that small and medium sized businesses must recognised a Right of Use (ROU) asset and a lease liability.
On initial recognition, the lease liability is measured at the present value of the lease payments that have not been paid at the recognition date, discounted by the business’ incremental borrowing rate with a corresponding ROU asset initially reflecting the lease liability in fixed assets. Over the length of the lease, the ROU asset is depreciated to the profit and loss while the lease liability discount is unwound to the profit and loss as interest paid, with the payments allocated against the liability. This will initially have a negative impact on the profit as in the earlier years of the lease the depreciation and interest will outweigh the lease payments.
For ease, here is an example for a company entering a five-year property lease starting at 1 January 2026 with fixed lease payments of £2,000 per month, totalling £120,000 over the period of the lease, with an incremental borrowing rate of 6% per annum:
The lease liability and ROU asset at commencement would be £103,450 (rounded), being the present value of the 60 monthly payments. Below is a comparison between old rules and new rules:
| Old rules | New rules | Profit difference | |||
|---|---|---|---|---|---|
| Lease payments | Interest | Depreciation | Total | Increase/(decrease) | |
| £ | £ | £ | £ | £ | |
| Year 1 | 24,000 | 5,710 | 20,690 | 26,400 | (2,400) |
| Year 2 | 24,000 | 4,581 | 20,690 | 25,272 | (1,272) |
| Year 3 | 24,000 | 3,384 | 20,690 | 24,074 | (74) |
| Year 4 | 24,000 | 2,112 | 20,690 | 22,802 | 1,198 |
| Year 5 | 24,000 | 762 | 20,690 | 21,452 | 2,548 |
| Total | 120,000 | 16,549 | 103,451 | 120,000 | |
In years 1 to 3, the profit is lower under the new rules, the impact reversing in years 4 and 5, the result is that the same amount is recognised in the profit and loss account over the length of the lease. The company can however benefit from an accelerated corporation tax reduction as the interest and depreciation on ROU assets are allowable for tax.
Balance Sheet ImpactThe recognition of the asset could affect the company size, which may result in the company requiring an audit. The recognition of the liability will affect gearing ratios which could impact credit scores and stakeholders’ confidence. This is more apparent with the liability requiring to be split between within one year (£18,290 (£24,000 lease payments less £5,910 interest to be changed in year 1) in our example) and more than one year (£85,160 on inception in our example). As an illustration, below shows an example of the balance sheet impact at the transition date:
| Old rules | New rules | Difference | |
|---|---|---|---|
| £ | £ | £ | |
| Fixed assets | 25,000 | 128,450 | 103,450 |
| Stock | 10,000 | 10,000 | – |
| Debtors | 50,000 | 50,000 | – |
| Cash at bank | 35,000 | 35,000 | – |
| Current assets | 95,000 | 95,000 | – |
| Trade creditors | (35,000) | (35,000) | – |
| Lease liability within 1 year | – | (18,290) | (18,290) |
| Net current assets/liabilities | 60,000 | 41,710 | (18,290) |
| Lease liabilities more than 1 year | – | (85,160) | (85,160) |
| Net assets | 85,000 | 85,000 | – |
Businesses are not permitted to restate comparative figures under these rules. Instead, any leases entered prior to accounting periods beginning 1 January 2026 will need to be transitioned into the financial statements as if they were entered on the first day of the accounting period. For example, a business with a 31 March 2027 year end would transition the lease on 1 April 2026. There are exemptions for short-term leases (12 months or less at commencement, with no purchase option) and low-value leases such as small IT and office equipment.
Overall, with such a significant change in accounting treatment, finance teams should now review their lease contracts and potential borrowing rates to understand the likely impact and budget for any changes accordingly.
Alternatively, businesses should consider whether using FRS105 micro entity accounts would be more appropriate, as the lease accounting changes do not apply under FRS105.
If you would like to discuss this further, please contact us and one of our accounting team will be very happy to help.
Call 0115 955 5500 or email enquiries@pagekirk.co.uk.
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The Page Kirk team ensures all content is accurate, fact-checked, and aligned with current financial standards.
