Transition provisions in FRS 102’s new lease accounting model: the pros and cons

Overview of the changes

Section 20 (Leases) of FRS 102 has been substantially re-written leading to fundamental changes to the accounting for leases by lessees. For lessees, the distinction between operating leases and finance leases has been removed, and most leases will now be recognised on the balance sheet as a right-of-use asset with a corresponding lease liability. The amendments largely align with IFRS 16, with some simplifications.

Accounting by lessors has not been significantly changed.

These amendments are effective for accounting periods beginning on or after 1 January 2026.

The transition provisions available under the new lease accounting model offers both opportunities and challenges. This article spotlights the practical implications of these transition provisions.

What are the pros and cons of the leases transition provisions?

Mandatory requirement

Modified retrospective approach:

Lessees are required to apply a modified retrospective approach on transition to revised Section 20. Under this approach, the lessee measures the lease liability at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate or obtainable borrowing rate.

The lessee recognises a right-of-use asset equal to the current lease liability (adjusted for any previously recognised prepayment or accrual of lease payments) unless the entity applies the IFRS 16 expedient discussed below. A lessee must not restate its comparative figures and, instead, it recognises the cumulative effect of initially applying the amendments as an adjustment to the opening balance of retained earnings on the date of initial application.

Pros

• Simplified transition: When compared to a fully retrospective approach, which is more commonly applied when standards change, this method offers a simpler approach to transition. The lessee recognises a right-of-use asset equal to the current lease liability (adjusted for any previously-recognised prepayment or accrual of lease payments) unless the entity applies the IFRS 16 expedient discussed below. In addition, this method reduces the time and cost of restating prior period financial statements.

Cons

• Lack of comparability: Whilst this may have practical implementation advantages, it creates lack of comparability between the current and prior periods. Entities should proactively engage with their stakeholders to explain the lack of comparability of the financial statements between the current and prior years.

Entities with previously recognised items such as lease incentives, rent free periods etc should ensure these items are adjusted from the right of use assets to avoid double counting as this is a common pitfall in initial application of the new lease model.

Practical expedients

Use of IFRS 16 carrying amount at the date of initial application

As a practical expedient, a lessee that is already preparing IFRS 16 information for the purpose of consolidated financial statements is permitted to transition to revised Section 20 by recognising the IFRS 16 carrying amounts of its right-of-use assets and lease liabilities at the date of initial application.

Pros

• Consistency within group who report under IFRS and FRS 102: This method also minimises differences between the lease accounting requirements in statutory financial statements (FRS 102) and group reporting purposes (IFRS 16), thereby avoiding any need to maintain parallel lease records when the underlying accounting standards are substantially aligned. As entities can use IFRS 16 numbers that are already available for group reporting purposes, this practical expedient reduces transition cost and effort.

Cons

• Lack of flexibility in applying the IFRS 16 practical expedient: Entities who apply the IFRS 16 practical expedient lose flexibility in applying the expedient as the IFRS 16 exemption is required to be applied to all leases at the date of initial application.

Recognition exemptions for short term leases and low value leases

As an exception to the general on-balance sheet accounting model, FRS 102 provides recognition exemptions for short-term leases (leases for which the lease term ends within 12 months of the date of initial application) and leases of low-value assets. These exemptions permit lessees to recognise such leases in a manner similar to operating leases in the previous version of Section 20.

Note: It is not possible to keep a lease off-balance sheet simply by breaking the leased asset down into low-value components.

Pros

• Time and cost efficiency: This exemption provides practical implementation advantages by saving time and cost that could have been incurred in accounting for low value assets and short-term leases.
• Flexibility in determining which assets are low value assets: The exemption on low value assets focuses on ensuring that the most significant leased assets (for example, properties, vehicles and large equipment) are recognised on-balance sheet, but it allows some flexibility for preparers to determine whether or not other assets are of low value.

Cons

• Lack of flexibility in applying the exemption to certain assets: The exemption for low value assets cannot be applied if the lessee subleases or expects to sublease the assets.

Use of single discount rare

A lessee may apply a single discount rate to a portfolio of similar leases at the date of initial application. This exemption can be taken on a lease-by-lease basis.

Pros

• Time and cost efficiency: For entities with a large portfolio of leases, the ability to group similar leases together can save considerable time and administrative costs in the initial measurement process.
• Consistency and Comparability: The use of a uniform discount rate across similar leases ensures consistent treatment and comparability of financial information, simplifying internal reporting and external analysis of lease liabilities.

Cons

• Application of judgement in determining which leases have similar characteristics:Entities would need to apply judgement in determining leases which have similar characteristics as each lease’s specific characteristics (such as its term, market conditions, and credit risk) may differ. This may require applying different discount rates to multiple portfolios of leases rather than applying a single discount rate across the entity.

Use of hindsight in assessing terms of the lease:

Hindsight may be used in assessing the terms of a lease, such as in assessing whether an extension or termination option is likely to be exercised when determining the lease term.

Pros

• Simplified transition: Using hindsight simplifies the initial application of the lease accounting standard, as lessees do not need to make judgments about future lease options that may not yet be clear. It also allows businesses to apply a more realistic lease term based on current realities.

Cons

• Possible misalignment with original intentions: Applying hindsight may lead to situations where the revised lease term differs significantly from what was originally intended when the lease was entered into, potentially creating challenges in aligning lease accounting with the original business strategy.
• Complexity in documentation: Entities may need to provide additional explanations or disclosures to justify their use of hindsight when determining lease terms, which could increase the level of disclosure required in the financial statements.

Exemption from reassessment whether contracts which existed prior to the date of initial application is a lease or contains a lease.

An entity may choose not to reassess whether contracts that exist at the date of initial application are, or contain, leases. Instead, the new lease accounting requirements are applied to contracts that were previously identified as containing a lease and not applied to contracts that were not previously identified as containing a lease.

Pros

• Reduced implementation costs and effort: Entities save time and resources that would otherwise be spent reviewing each contract in detail. This is particularly beneficial for businesses with numerous lease agreements.
• Minimized risk of judgment errors: Since prior assessments of lease contracts were conducted under an established framework, entities reduce the risk of subjective judgments that could arise from reassessing contracts under the new standard.

Cons

• Lack of flexibility on application of the exemption: If an entity elects to apply the practical expedient, it must do so for all contracts, without exception. This removes flexibility and may force the entity to retain past classifications that are not optimal under the new standard.
• Potential misclassification of contracts: In rare cases, if certain contracts previously qualify as leases under the old model and such contracts do not meet the definition of lease under the new model, these will be accounted for under the new lease model, potentially leading to inconsistencies and non-compliance with the economic substance of the contracts.

The transition provisions provide lessees with various options to ease the adoption of the new lease accounting model. Each provision offers distinct advantages, such as cost savings, simplified implementation, and enhanced consistency with IFRS 16. However, they also present challenges, including potential comparability issues and increased judgment in application amongst others. Entities must carefully assess these provisions to determine the most suitable approach based on their financial reporting needs, stakeholder expectations, and operational realities. Thoughtful and early planning as well as clear communication will be crucial in navigating this transition effectively.

If you would like to discuss how the amendments might impact your business and how BDO can help support your business through the transition to the new standard, please get in touch with Laura Jackson, Nigel Harra or a member of our audit team.