How will the FRS 102 lease changes affect professional services firms?

The revised lease rules apply to accounting periods beginning on or after 1 January 2026 and so a firm with a 31 March 2027 year end, will transition on 1 April 2026. Early adoption is available if wider amendments from the periodic review are applied at the same time.

Transition will take place using a modified retrospective approach, meaning:

• The impact is reflected at the start of the accounting period
• Opening balances are restated
• Comparative figures are not restated

Gross assets within the first balance sheet prepared under the new rules are likely to be significantly larger than in previous years, with net assets initially being unaffected on transition date, and instead impacted as the lease liability is unwound and right of use asset depreciated.

Some leases remain outside the scope of the revised rules. These include short-term leases, defined as those of 12 months or less, and leases for which the underlying asset is of low value.

However, low value is not determined by materiality and remains judgemental.

In the revised FRS 102, no absolute value is provided for what constitutes a low value asset, and no guidance is provided for what underlying assets qualify. Guidance is provided however in the standard for what assets do not qualify, and these include:

• 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

We can also draw on guidance accompanying IFRS16, which whilst falling short of prescribing a threshold, suggested that $5,000 might be appropriate.

Most leases held by professional services firms are expected to be affected.

Professional services firms are one of the sectors most exposed to the changes. This is largely due to business models that rely on:

• Large office premises
• Longer lease terms
• Higher value town or city centre locations

The longer the lease term and the higher the discount rate applied, the greater the impact on the timing of costs recognised in the profit and loss account.

Lease costs will no longer appear as rental expenses within operating costs. Instead, firms will recognise:

• Depreciation of the right-of-use asset
• A finance cost arising from the lease liability

This change is expected to increase EBITDA, as rental costs are removed from administrative expenses (or ‘Other operating charges’ in a format 2 profit and loss). However, profits may be lower in the early years of a lease due to the front-loading of interest costs, with higher profits in later years.

One practical consideration is the effect on gross assets, which form part of the audit exemption thresholds.

Bringing leases onto the balance sheet may:

• Increase gross assets above the audit threshold
• Result in firms entering audit for the first time

This is particularly relevant for firms close to the thresholds and highlights the importance of assessing the impact in advance. Audit thresholds do need to be breached for two consecutive years for an audit to be required, but particularly firms with over 50 employees, need to be conscious of both the gross asset and turnover thresholds.

The first year of adoption is expected to result in a noticeable shift in balance sheet presentation.

In particular:

• Both assets and liabilities will increase significantly
• The portion of the lease liability due within one year will reduce net current assets
• The balance sheet may appear more highly geared

Although these changes are accounting driven, they may impact how third parties interpret a firm’s financial position.

Under the revised FRS 102:

• Leases are recognised on the balance sheet increasing assets and liabilities.
• Lease expenses are recognised as:
  • Depreciation of the ROU asset; and
  • Interest expense on the lease liability.
• Neither depreciation nor interest is included in EBITDA.

The move to recognising ROU assets and lease liabilities means:

• EBITDA will increase.
• Total debt will rise due to the inclusion of lease liabilities.

There is a risk of inadvertent covenant breaches if the impact is not considered early. Whilst banks may be willing to adjust covenant definitions or apply frozen GAAP clauses, this cannot be assumed and will vary by lender.

Early discussions with relationship managers are strongly recommended to ensure that any foreseen issues are adjusted in good time, as covenant breaches at year end, even if waived after the year end, mean that any non-current bank loans are reclassified to current liabilities.

The revised lease model introduces several areas of judgement that will require careful consideration and documentation. These include:

• Determining the lease term where break clauses or extension options exist and assessing whether it is reasonably certain that breaks will not be exercised
• Selecting an appropriate discount rate
• Deciding how to account for dilapidations and end-of-lease obligations
• Factoring in lease incentives, such as rent-free periods

These judgements increase both the complexity of accounts preparation and the level of audit scrutiny on management assessments.

Yes. Firms will need to provide more detailed disclosures around:

• Key judgements made and discount rates used
• Practical expedients that have been applied
• Interest expense for leases recognised as assets and liabilities
• Expenses and commitments relating to short term and low value leases