Exploring the accounting and tax implications of these changes
The new lease accounting requirements will mean more leases will be recognised on balance sheets as Right-of-Use (ROU) and lease liability. The principal difference is that, for lessees, there will no longer be a requirement to distinguish between an operating lease and a finance lease.
Accounting treatment
Para 1.47 of revised FRS 102 states that ‘a lessee shall not restate comparative information. Instead, it shall recognise the cumulative effect of initially applying the Periodic Review 2024 amendments to Section 20 as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application.’
Prior-year adjustments must not be carried out on initial application of the new lease accounting provisions. FRS 102, para 1.51(a) states that the lessee shall recognise a 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
- the lessee’s obtainable borrowing rate.
As highlighted within this ACCA technical factsheet:
Under the new recognition and measurement principles, a lessee does not distinguish between a finance lease and an operating lease. Most leases will be recognised on-balance sheet with two exceptions which relate to:
- leases of assets of low value
- short-term leases.
Leases of low value
FRS 102, para 20.11 provides a list of underlying assets whose value would not be considered low value as follows:
- cars, vans, buses, coaches, trams, trucks and lorries
- cranes, excavators, loaders and bulldozers
- telehandlers and forklifts
- tractors, harvesters and related attachments
- boats and ships
- railway rolling stock
- aircraft and aero engines
- land and buildings
- production line equipment.
The above is not a comprehensive list and professional judgement will, of course, be needed to assess what is, and what is not, low value. Effectively, if the leased asset is something like the list in paragraph 20.11 above, the asset will not be considered to be low value. Examples of assets which would be considered low value would be:
- laptop computers
- desktop computers
- tablets
- small items of office furniture
- mobile telephone (on, perhaps, a two-year contract).
FRS 102, para 20.5 provides an exemption from on-balance-sheet recognition for leases that are short-term. ‘Short-term leases’ are defined as: ‘A lease that, at the commencement date, has a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease.’ Potentially, short-term leases include evergreen leases which are those on a day-to-day, week-to-week or month-to-month basis.
Section 20 requires that at the inception date, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
A contract conveys the right to control the use of an identified asset when, throughout the period of use, the customer has both the right to direct the use of the identified asset, and the right to obtain substantially all the economic benefits from that use. If the customer has the right to control the use of the identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term.
A reassessment of the ROU and lease liability may be required when there is modification of the terms and conditions of the contract.
Lease for serviced office
Normally a serviced office agreement may be accounted for as a licence to occupy (service agreement) rather than a lease under FRS 102, depending on the specific terms of the contract and when the accounting standard amendments are applied.
The key factor is whether the agreement conveys the right to control the use of an identified asset. The key assessment of whether the supplier has a substantive right to substitute the asset remains critical. If the serviced office provider retains the practical ability and economic benefit to move the occupant to a different space, it remains a service contract and does not go on the balance sheet.
Depreciation and finance cost
The ROU asset will initially be measured at the present value and depreciated on a straight-line basis over the length of the lease. In the profit and loss account, lessees will recognise both a depreciation charge on the ROU asset and a finance cost on the lease liability.
The finance cost is calculated using the effective interest rate applied to the remaining lease liability. Because the liability is higher at the start of the lease, the finance expense will usually be greater in the early years and gradually decrease as the liability is repaid.
Tax implications
The revised lease accounting model requires lessees to recognise most leases on the balance sheet, bringing FRS 102 broadly into line with IFRS 16. The distinction between finance leases and operating leases for lessees has been removed, with most leases now recognised as a right-of-use (RoU) asset together with a corresponding lease liability. Exemptions are available for certain short-term leases and leases of low-value assets.
Following initial recognition, the RoU asset is depreciated over the appropriate period and interest is recognised on the lease liability, with both charges recognised in the profit and loss account. On first-time adoption of the revised requirements, comparative information is not restated. Instead, the cumulative effect of applying the new lease accounting model is recognised as an adjustment to opening retained earnings (or another appropriate component of equity). For tax purposes, legislation provides spreading rules so that any one-off taxable adjustment arising on transition does not crystallise immediately. Instead, the adjustment is brought into account over a spreading period, broadly based on the weighted average remaining lease term of the affected leases.
Where these spreading provisions apply, deferred tax should be considered, as timing differences may arise between the accounting recognition of the transitional adjustment and the period in which the corresponding income or expenditure is recognised for corporation tax purposes.
The tax treatment of RoU assets must be considered on a lease-by-lease basis. Although the accounting treatment has changed, the underlying tax legislation has not. In some cases, the depreciation of the RoU asset and the interest expense on the lease liability may be deductible for corporation tax. In other cases, such as where the lease was previously accounted for as a finance lease under UK GAAP and qualified for capital allowances, the existing tax treatment will continue to apply. The appropriate tax treatment will therefore depend on the nature of the lease and the applicable tax rules.
Care is also required where the carrying amount of the RoU asset includes costs that are capital in nature. Examples include lease premiums, Stamp Duty Land Tax, property fit-out costs, payments made to a previous tenant to secure the lease, and provisions for dilapidation or restoration obligations. These elements should be identified and considered separately to determine the appropriate tax treatment, as they may not follow the same tax treatment as the RoU asset itself.
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