Lease accounting decides whether a lease shows up on the balance sheet or only as rent in the profit and loss account. Under the old FRS 102 Section 20, lessees split leases into finance leases (on balance sheet) and operating leases (expensed). The FRC’s periodic review replaced that for lessees with a single model close to IFRS 16, for accounting periods beginning on or after 1 January 2026.
Who applies which model
| Framework | Lessee accounting |
|---|---|
| FRS 102, including small companies using Section 1A | right-of-use asset and lease liability for most leases |
| FRS 102, lessors | still classify leases as finance or operating; largely unchanged |
| FRS 105 (micro-entities) | unchanged: finance leases capitalised, operating lease rentals expensed |
Hire purchase, where ownership passes to the business, was already on the balance sheet and stays there.
What counts as a lease
A contract contains a lease if it conveys the right to control the use of an identified asset for a period in exchange for payment. Property leases, vehicle contract hire and long equipment rentals usually qualify. A service contract where the supplier can swap the asset, or decides how it is used, usually does not.
Exemptions
Lessees can choose not to recognise:
- short-term leases, with a lease term of 12 months or less and no purchase option;
- leases of low-value assets, such as laptops, phones or small office furniture.
For these, payments are expensed on a straight-line basis as before. The choice for short-term leases is made by class of asset; document both in the accounting policies.
Initial measurement
At the commencement date the lessee recognises:
- a lease liability at the present value of the lease payments not yet paid, discounted at the rate implicit in the lease or, if that cannot be determined, the lessee’s incremental borrowing rate (FRS 102 also permits the lessee’s obtainable borrowing rate as a simpler alternative);
- a right-of-use asset at the amount of the liability, plus initial direct costs and payments made at or before commencement, less lease incentives received, plus any restoration costs provided for.
Worked example
A company leases equipment for four years with annual payments of £17,000 in arrears. The rate implicit in the lease is 6.5%.
| Year | Payment (£) | Discount factor (6.5%) | Present value (£) |
|---|---|---|---|
| 1 | 17,000 | 0.939 | 15,963 |
| 2 | 17,000 | 0.882 | 14,994 |
| 3 | 17,000 | 0.828 | 14,076 |
| 4 | 17,000 | 0.777 | 13,209 |
| Total | 58,242 |
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Right-of-use asset - equipment | 58,242 | |
| Lease liability | 58,242 |
Subsequent measurement
The right-of-use asset is depreciated, normally over the shorter of the lease term and the asset’s useful life. The lease liability accrues interest and is reduced by payments:
| Year | Opening liability (£) | Interest at 6.5% (£) | Payment (£) | Closing liability (£) |
|---|---|---|---|---|
| 1 | 58,242 | 3,786 | 17,000 | 45,028 |
| 2 | 45,028 | 2,927 | 17,000 | 30,955 |
| 3 | 30,955 | 2,012 | 17,000 | 15,967 |
| 4 | 15,967 | 1,033 | 17,000 | 0 |
Year 1 entries:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Depreciation of right-of-use assets | 14,561 | |
| Accumulated depreciation - right-of-use assets | 14,561 | |
| Lease liability | 13,214 | |
| Interest on lease liabilities | 3,786 | |
| Bank | 17,000 |
Compared with the old operating lease treatment, total cost over the lease is the same, but it is front-loaded because interest is highest early on. Operating profit rises (rent is replaced by depreciation), while assets, liabilities and gearing increase.
The liability is remeasured when the lease term changes (for example a break option will now be exercised), when payments change with an index or rate, or when the lease is modified.
Rent-free periods and incentives
Under the old model, rent-free periods were spread through accruals. Now an incentive received reduces the right-of-use asset, and the effect is spread through lower depreciation. Variable payments that do not depend on an index or rate, such as turnover rent, are expensed as they arise.
Transition
Most companies apply the change from the start of the first accounting period beginning on or after 1 January 2026, recognising the cumulative effect in opening retained earnings without restating comparatives. Practical reliefs allow, among other things, measuring the right-of-use asset equal to the lease liability and excluding leases ending within 12 months. Agree the approach with your accountant before the first set of accounts, because it affects covenants, the size thresholds and the corporation tax computation.
Lessor accounting
Lessors continue to classify each lease as a finance lease (substantially all risks and rewards transferred: recognise a receivable) or an operating lease (keep the asset and recognise rental income on a straight-line basis). Indicators include transfer of ownership, a bargain purchase option, a lease term covering most of the asset’s life, and payments with a present value close to the asset’s fair value.
Sale and leaseback
When a business sells an asset and leases it back, it first assesses whether the transfer is a sale under the revenue recognition requirements. If it is, the seller-lessee keeps a right-of-use asset for the part retained and recognises a gain or loss only on the rights transferred to the buyer. If it is not a sale, the asset stays on the balance sheet and the proceeds are a financial liability.
Disclosures
Lessees disclose, among other things, right-of-use assets by class, depreciation and interest for the period, a maturity analysis of lease liabilities, and the expense relating to short-term and low-value leases. Small companies applying Section 1A disclose less but must still give a true and fair view.
Tax
For corporation tax, leases accounted for on the balance sheet generally follow the accounting entries, with specific rules for long funding leases and for the transition adjustment. The accounting change does not alter VAT: each rental invoice is treated as before.
For the ledger accounts behind this, see leasing accounts in the chart of accounts; for the principle that drives lessor classification, substance over form.