Accounting for leases – proposals for a new approach

The UK's accounting for leases will change under proposals, FRED 82, recently issued by the Financial Reporting Council. Although only an exposure draft at this stage, the proposals, which align with international standards, are expected to come into force. The change to lease accounting will be substantial for lessees with significant operating leases. The impact will be greatest for businesses with significant property leases. Highlighted below are the key changes.

Overview of the changes

The biggest change is the proposed removal of the distinction between a finance lease and an operating lease for lessees. All leases, subject to certain limited exceptions, will be brought onto the balance sheet in a manner consistent with the current treatment for a finance lease.

Where a business has, for example, significant property leases, such as a retail company, these will need to be recognised on the balance sheet as a ‘right of use asset’ (ROUA) with a corresponding lease liability. Previously such leases would have been an operating lease accounted for on a ‘pay as you go’ basis.

The effect on reported profit will be to remove the rental charge and replace it with amortisation of the ROUA and an interest expensive on the lease liability. Although the total effect on profit for the duration of the lease is the same, the accounting will change the timing of the expense, it becoming front end loaded with a higher total expense recognised in the first third of the lease, but with a lower comparative expense in the final third.

As the expense is accounted for as amortisation and interest, rather than rent, this will change key performance measures such as earnings before interest, depreciation and amortisation (EBITDA) and the interest expense. Reported EBITDA will increase under the proposals, but with an increase in the interest expense.

In the cashflow statement, the rentals, previously treated as part of operating cashflows, will be replaced with an interest cashflow, and liability repayments, the latter being classified as financing cashflows. The net effect is that a business will report higher cash generated from operations, but with an increase in financing cashflows. The overall net cashflow will be the same.

Why does this matter?

The results and financial position of the business will change. Where these figures are used in assessing the business, either by management, lenders or investors, there can be real consequences arising from the change.

Is management remunerated on results? The change to the timing of the charge and the effect on EBITDA may impact both performance assessment and remuneration.

For entities with debt subject to covenants, how will the change impact compliance with these? For example, EBITDA would improve, but interest cover may not. Covenants based on reported debt would also be expected to deteriorate with the additional borrowings from the lease liability, possibly even leading to covenant breaches.

The increase in assets may even bring some companies into audit scope when previously they were exempt.

Management should review all arrangements in which these changes have an impact in order to determine the effect and consider whether any may need acting upon, possibly even renegotiation.

Making the changes

Implementing the changes will also present management with additional challenges in preparing accounts. Management will need to determine, for example, what is a lease, what is the lease term, what future payments to include and what discount rate to apply to the future payments.

What is a lease?

This is quite complex, but broadly, where the arrangement provides the lessee with the ability to control the use of a defined asset for a period of time it will be a lease. Where a retailer has an instore concession, this would need careful analysis to determine if the arrangement is a lease.

How are the ROUA and lease liability measured?

The ROUA is set as the amount of the lease liability together with any payments made before commencement of the lease and less any incentives received. The lease liability is the lease payments due to be made over the lease term. Where there are options to extend a lease, these will be included but only where it is reasonably certain that the extension will be taken. Reasonably certain is a high threshold.

The discount rate must be established, with a fall back to a rate based on gilts if an incremental rate cannot be readily determined. The payments include fixed amounts due under the lease. If the payments are variable, for example, they are linked to turnover, these are only accounted for when due. Where the lease includes amounts for other than the use of the asset, for example, service charges, these need to be identified, quantified and accounted for separately.

Where a business is concerned about the size of the liability being recognised, the use of shorter lease terms and variable payments can reduce this, but is this the right choice commercially, as this may expose the business to a future uncertainty as regards security over the property and the future cost.

Where the business has a number of leases, this will need to be done for each.

What exemptions are available?

There are two main exemptions. If the lease term is no more than 12 months, it may be accounted for as currently for an operating lease, on a straight line basis over the lease term, and without recognition of a lease liability on the balance sheet. Similarly, if the underlying asset if of low value it may also adopt this treatment. A low value asset is not defined by monetary amounts, but typically would include items such a laptops, mobile phones and small items of furniture. These are unlikely to provide much relief to retailers when applying the changes.

Lessors

The accounting for lessors remains broadly the same as existing requirements, with the distinction, and different accounting applying, depending upon whether the lease is an operating lease or a finance lease. The changes to lessee accounting will have consequences for lessors where they enter into back to back arrangements or sale and leasebacks.

Timing

We are expecting the proposals to be effective for accounting periods beginning on or after 1 January 2025. Under the transition rules, comparatives will not be required.

Where the impact is significant, the changes will not be cosmetic and management should plan in advance to determine how these changes will affect the business. If existing lease arrangements are due to be renewed, how the accounting will change may also be a factor in those negotiations, and we would advise understanding the effect in advance.

Please get in touch with Jeremy Cooper or Jamie Tomlin, if you would like to discuss this further.