We have known for some time that the changes to FRS102 are coming and there may be, for some businesses, quite an impact on KPIs, covenants and potentially remuneration schemes. Do you have a clear understanding of how these changes will impact your business? Have you calculated any downside or potential upside to your reporting?
This process can be really time consuming and complex. However, setting up a clear project plan and allocating appropriate resources is key to project success and low-stress adoption of new accounting standards.
What are the changes and when do they take affect?
On 27 March 2024 the Financial Reporting Council released amendments to FRS102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. The key amendments to the standard were the changes to make the standard more streamlined with IFRS15: Revenue from Contracts with Customers and IFRS16: Leases.
For the purposes of this post, we are going to concentrate on the key aspects of the alignment with IFRS16: Leases. In particular, the potential impact upon financial reporting.
The effective date of transition is for periods beginning on or after 1 January 2026, with early adoption permitted. At first glance, this adoption date appears to be quite away in the future. However, you will need to collect data, make accounting judgements and implement systems and tools ahead of this date.
A key aspect of this is to get ahead and manage the impacts on KPIs with external stakeholders such as funders and investors.
What are the changes to lease accounting?
At present, there is no requirement to recognise an operating lease on the balance sheet. At the moment the requirement is to disclose within the notes to the financial statements any operating leases and total future obligation.
Since the introduction of IFRS16: Leases a operating lease that met the standard requirements would be capitalised onto the balance sheet with an associated lease liability. The changes to UK GAAP will mirror the accounting approach under IFRS16: Leases.
Each key aspect of the above is detailed below;
Lease liability – A lease liability will be recognised as recognition of the obligation to make finance lease payments over the lease term. The liability is recognised at present value of future lease payments and will unwind as an interest expense. The currently expensed lease payment will change to reduce the lease liability.
Asset – A “Right of Use” asset will be recognised and depreciated over the term of the lease. This will be initially recognised and measured equal to the lease liability with some potential adjustments
Profit and Loss impact – The depreciation of each Right of Use asset is recognised as an expense and the lease liability will unwind as an interest expense over the lease term.
This all sounds very complex, what does this mean?
In the most basic explanation of the above – for a rental property, you now no longer recognise your rent payment as an expense. The building you are renting is capitalised as an addition on your balance sheet as a Right of Use assets and a lease liability is recognised for the remaining lease term.
The rental payment you used to recognise as an expense is then allocated as a lease payment on the liability and then an interest and depreciate expense is recognised instead of a rental charge.
Well that doesn’t seem any different, what’s the catch?
If you are a large business that relies on funding from banks or external investors and instead of reporting operating profit or net profit as a measure of business performance you report Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) or you are preparing a business valuation based on EBITDA and a multiplier – the impact on this KPI could be significant.
Previously your rental payment for the property would be included as a deduction from EBITDA and would make your KPI lower. However, now that you have removed this rental charge and are now accounting for extra Interest and Depreciation – now suddenly there could be a material increase in reported EBITDA.
On the flip side of this – if your business is heavily leveraged and you are reporting covenants each year that includes an interest cover. This KPI might be seriously affected by the above change as now you are accounting for additional interest in your profit and loss.
Where do I start?
If you haven’t already, we recommend that you perform an initial impact assessment to better understand how the changes will affect your business. To do this, you should ask yourself the following;
- What is my lease portfolio?
- Do I have copies of all the lease agreements? If not, how can you obtain them?
Can HSJ help?
Of course we can. It is important to note that, aside from our support, the Financial Reporting Council have included some optional simplifications within the revised FRS102 to ease the transition process, these being;
- Guidance on the application of the low value exemption
- Reduced modification triggers requiring a revised discount rate
- Simpler approach to recognising gains/losses for sale and leaseback arrangements
- Use of an ‘obtainable borrowing rate’ instead of ‘incremental borrowing rate’
Further to this HSJ, can provide training workshops to help understand the changes and how it make affect your business. Aid in the risk assessment and how the changes may have an impact on your reporting and we can also assist in developing systems and tools for accounting for leases in the future.
If you have any questions or if you wish to discuss these changes in more detail, please contact Alex on:
Tel: 01633 815800 – Email: alex.finch@hsj.uk.com
