From 1 January 2026, the UK Financial Reporting Council (FRC) is introducing significant changes to FRS 102 lease accounting, aligning it more closely with IFRS 16.

These changes will impact how businesses account for leases, particularly for lessees who previously classified leases as operating leases.

What’s changing?

Currently, leases are classified as either finance leases, where the lessee recognises both an asset and a liability, or operating leases, where lease payments are expensed over time.

Under the new FRS 102 rules, lessees will need to recognise most leases on their balance sheet, treating them similarly to finance leases. This means:

• A Right-of-Use (RoU) asset will be recorded.
• A lease liability will be recognised for future lease payments.
• Lease expenses will be presented as depreciation and interest, rather than a straight-line rental expense.

Tax relief will no longer apply to straight-line rental expenses, although the corresponding RoU depreciation and lease liability interest expenses will remain deductible for corporation tax purposes.

Impact on gross assets and company size thresholds

One of the most significant implications of these changes is their effect on company size classification.

Since leased assets will now be recognised on the balance sheet, businesses may see an increase in their total assets, which could push them into a higher company size category.

The UK Government has increased company size thresholds since 6 April 2025, meaning businesses will need to assess whether the new lease accounting rules will affect their classification.
Since RoU assets will now be included in total assets, businesses close to the small or medium thresholds should carefully assess whether they will exceed the new limits due to lease recognition.
See our related article ‘Upcoming Changes to UK Audit Thresholds’ summarising the transitional and “two-year” rules.

Transitional adjustments

The adoption of the revised FRS 102 lease accounting rules may require transitional adjustments, particularly for businesses that previously accounted for leases as operating expenses.

Companies will need to carefully assess whether retrospective application of the new rules affects historical financial statements. In some cases, businesses may opt for a modified retrospective approach to simplify implementation.

Key transitional considerations include:

• Reassessment of existing lease contracts – Businesses must review current lease agreements to determine how they should be accounted for under the new standard.
• Initial recognition of RoU – Companies transitioning from off-balance-sheet treatment will need to determine how to measure their RoU assets.
• Restatement of financial statements – Depending on the transition approach selected, businesses may need to adjust prior-year financial statements to reflect the new lease accounting model.
• Deferred tax adjustments – The recognition of lease liabilities and RoU assets may create temporary differences requiring deferred tax adjustments.

Short-term and low-value leases

The updated FRS 102 will continue to provide exemptions for short-term leases (leases with a term of 12 months or less) and low-value assets, which helps reduce the administrative burden on businesses with minimal lease commitments.

For short-term and low-value leases:

• Lease expense recognition – Businesses can opt to continue expensing lease payments on a straight-line basis, rather than recognising lease assets and liabilities.
• No balance sheet recognition – These leases do not need to be recorded as RoU assets, simplifying financial reporting.
• Industry impact – This exemption is particularly beneficial for businesses that rely on leasing office and IT equipment, or other small-value assets.

By leveraging these exemptions, companies can minimise the complexity of lease accounting while maintaining compliance with the new regulations.

Worked example: How the changes affect businesses

Let’s consider an owner-managed business, XYZ Ltd, which currently leases office space under an operating lease:

Annual lease payments: £400,000
Lease term: 10 years
Discount rate: 6%
Current total assets: £4.8 million

For the ease of providing a simple worked example, no rent incentives have been considered below which would impact the caluclation further.

Under the previous accounting rules, businesses simply deducted the full lease payment each year.

Under the new accounting rules, lease payments are split into interest expense and depreciation (both tax-deductible).

The interest expense declines over time as the lease liability reduces.

Using the Present Value of an Annuity formula, the lease liability is £2.94 million.

Under the previous and new accounting rules, the total tax deduction over 10 years: £4 million.

Current Accounting (Before 2026)

XYZ Ltd expenses £400,000 annually as a lease cost.

Total assets remain at £4.8 million, meaning XYZ Ltd qualifies as a small business.

New Accounting (From 2026)

Under the new FRS 102 rules, XYZ Ltd will recognize:

A Right-of-Use (RoU) asset valued at £2.94 million (present value of future lease payments discounted at 6%).

A lease liability of £2.94 million, split into:

• £223k due within one year
• £2.72 million due after one year

Depreciation expense of £294k per year (assuming straight-line depreciation over 10 years).

Interest expense starting at £177k in year one, reducing as the liability is repaid.

Following an increase in total assets to £7.7 million, XYZ Ltd now meets the criteria for classification as a medium-sized business under the new thresholds. This applies unless the company is eligible for any exemptions under the transitional provisions or the ‘two-year’ rule.

Potential hurdles for businesses

While the new lease accounting rules bring greater transparency, they also introduce challenges that businesses should prepare for, including:

• Determining a reliable discount rate – Businesses will need to estimate a discount rate to calculate the present value of lease liabilities. This can be complex, especially for private companies with no readily available borrowing rate.
• Impact on financial ratios – EBITDA will increase, but gearing ratios may rise due to the recognition of lease liabilities.
• Transition adjustments – Companies must carefully evaluate whether retrospective application of the new rules will affect historical financial statements. See our related article ‘Upcoming Changes to UK Audit Thresholds’
• Tax implications – With these changes affecting tax deductions, profits, and deferred tax, it’s essential that businesses review their lease agreements and assess the impact on tax planning.

Key deferred tax implications

These changes will not affect Corporation Tax over the life of the lease.

Although tax relief will no longer apply to straight-line rental expenses, the corresponding RoU depreciation and lease liability interest expenses will remain deductible for Corporation Tax purposes.

1) Interest expense deductibility

Previously, lease payments were fully deductible as an operating expense.

Under the new accounting rules, the interest portion of the lease liability remains deductible under the loan relationship rules.

Businesses may need to consider restrictions on interest deductibility, such as the Corporate Interest Restriction (CIR) rules for large businesses.

2) Capital allowances considerations

Businesses will recognise an RoU asset, but this does not automatically qualify for capital allowances as ownership remains with the lessor.

Tax relief is now obtained through deducting depreciation instead of rental costs. Depreciation itself is not tax-deductible, however there is special concession for ROU depreciation to be allowable for corporation tax purposes.

3) Impact on taxable profits

Companies may see a change in taxable profits due to differences between the old and new accounting treatments.

While rental payments were evenly deducted before, interest expense will decline over time, affecting profit fluctuations.

Tax planning may be required, especially for leasing-heavy businesses where deductions could be lower in early years.

4) Deferred tax adjustments

Bringing leases onto the balance sheet could lead to temporary differences between accounting and tax treatment, requiring a deferred tax adjustment.

Businesses should assess whether these differences impact financial statement disclosures and future corporation tax liabilities.

Key takeaways

• Higher tax deductions in early years: Businesses used to deduct the rental expense per year. Now, the interest portion and depreciation is deductible, with interest declining over time.
• Lower taxable profits initially: Since deductions are higher in the first few years, businesses may see lower taxable profits.
• Deferred tax adjustments: The difference between accounting and tax treatment may require adjustments.

Final thoughts

The FRS 102 lease accounting changes will bring greater transparency but may require adjustments in financial reporting. Businesses should review their lease agreements, assess the impact on financial ratios, and consider whether early adoption is beneficial.

If you have any questions about how these changes impact your business or would like access to our TWP factsheet, don’t hesitate to contact TWP Accounting LLP for expert guidance.

Our factsheet is designed to support businesses with lease assessments, providing insights into discount rate selection and financial reporting.

If you’d prefer not to navigate these changes alone, our team is here to provide clear guidance and tailored support on the FRS 102 lease accounting updates.