Changes to the accounting rules for operating leases will come into force in January 2026, giving affected businesses a matter of months to review and update their reporting practices.
Under amendments to the FRS102 financial reporting standard announced last year, the distinction between operating and finance leases will be abolished, bringing UK practices in line with the International Accounting Standard IFRS 16.
Under the current rules, operating leases are considered an ‘off-balance sheet’ asset, meaning they do not have to be recorded as a liability on the company balance sheet. This reflects the fact that, unlike with a finance lease, the lessee doesn’t take on legal ownership of the asset with the lease agreement, just the right to use it. Under an operating lease, the lessor remains recognised as the legal owner for the duration of the lease period.
However, regardless of the ownership status of an asset subject to an operating lease agreement, the convention internationally has become for lessees to include such assets on the company balance sheet. From 1st January 2026, UK businesses will have to do the same.
Who is affected?
The biggest impact of the changes will be felt in real estate and property rentals, where it is commonplace for leaseholds to carry no ownership rights. Other examples include vehicle, machinery and equipment rentals.
However, short-term leases of 12 months or less and leases for low-value assets such as laptops or office equipment are exempt from the changes. Lessees can elect to apply the existing operating lease treatment for these categories.
What is the impact on accounting?
The change will mean that operating leases will have to be accounted for on the balance sheet as a right-of-use asset (RoA) with a recognition of the corresponding liability. The initial liability will be measured at the present value of the future lease payments, adjusted for any payments made at or before the commencement date; any lease incentives received, any initial direct costs incurred and any dismantling or restoration costs.
Following initial recognition, the asset will be depreciated and tested for impairment, while the liability will be remeasured and adjusted over time as lease payments are made
These changes to on-balance sheet recognition of operating leases will also have a knock-on effect for profit and loss accounts, which will have to reflect depreciation of the RoU asset and interest on the lease liability. This replaces the straight-line lease expense traditionally recognised for operating leases. While total expense over the lease term remains broadly similar, classification and timing will shift.
What will the impact on company finances be?
These shifts will subsequently have a knock-on effect on a number of key financial metrics. For any business with significant exposure to operating leases, these could in turn have a wider impact on company finances, on everything from borrowing to company classification.
For example, as operating lease costs will no longer be classified as operating expenses, EBITDA calculations will increase. On the other hand, so will interest and depreciation charges, affecting net profit.
At the same time, net current assets may decrease, with the current portion of lease liabilities now recognised, and gearing ratios may rise, potentially impacting perceived financial stability. These shifts could influence debt covenants, while companies that link EBITDA to employee bonuses could find themselves facing higher remuneration costs.
Importantly, the inclusion of RoU assets on the balance sheet will inflate measurement ot gross assets, one of the thresholds used to determine company size for audit exemption purposes. Businesses currently qualifying as small may find themselves reassessed, triggering new audit obligations.
With the January 2026 effective date approaching, businesses should begin assessing their lease portfolios and modelling the financial statement impact now. Early engagement with finance teams, lenders, and auditors will be key to a smooth transition. For more advice, please contact the Xeinadin team today.
