The accounting landscape is poised for substantial transformation with the latest amendments to the Financial Reporting Standards (FRS) 102 and 105, set to take effect in March 2024. These changes primarily focus on lease accounting for lessees and mandate that virtually all lease contracts be recorded on the balance sheet as assets and liabilities, signifying a departure from traditional operating leases accounting.
In Amendments to FRS 102 and 105 Update (March 2024),Robert Kirk delves into the pivotal changes and their implications for financial reporting.
Abolition of Operating Leases
The foremost change heralded by the amendments is the abolition of operating leases for lessees, aligning the treatment of all leases under a single framework. Traditionally, operating leases were off-balance-sheet items, recorded simply as rental expenses over the lease term. The new standard eliminates this distinction, requiring that all leases be recognised on the balance sheet. This change stems from the acknowledgment that leases, in essence, create assets (the right to use the leased asset) and liabilities (the obligation to make lease payments), which should be reflected in financial statements.
Right-of-Use Asset and Lease Liability
Under the revised FRS 102, at the inception of a lease, lessees must recognise a right-of-use asset and a corresponding lease liability. The lease liability is calculated as the present value of all unavoidable future lease payments, discounted using either the rate implicit in the lease or an incremental borrowing rate. Consequently, the right-of-use asset is typically equal to the lease liability at inception, adjusted for any lease prepayments, initial direct costs, or restoration obligations.
Lease Term Considerations
One of the intricate aspects of the new model is determining the lease term, which includes non-cancellable periods and optional extension periods that are reasonably certain to be exercised. This implies that lessees must continually reassess their leases, particularly around significant events or changes in circumstances, to ensure that the financial statements reflect the current lease terms accurately.
Amortisation and Interest
The right-of-use asset is subject to amortisation over the shorter of the asset's useful life or the lease term, and the lease liability is adjusted to reflect lease payments and interest. Interest expense on the lease liability accrues over time, reflecting the unwinding of the discount. This treatment results in a front-loaded expense pattern, where higher interest costs are recognised in the earlier periods of the lease term.
Cash Flow Presentation
In the statement of cash flows, the changes significantly impact the classification of cash flows. Lease payments previously recorded as operating outflows under operating leases will now be split between principal repayments, classified as financing outflows, and interest payments, classified as either operating or financing outflows, depending on the entity’s policy.
Exceptions and Exemptions
While the default position is that all leases should be on the balance sheet, the standard does provide for some exceptions. Notably, heritage assets, certain agriculture and biological assets, and some Public Finance Initiative (PFI) or Public-Private Partnership (PPP) contracts are treated separately under other sections of FRS 102. Additionally, lessees have the option not to capitalise short-term leases (with a term of less than 12 months) and leases of low-value items, a practical expedient aimed at reducing the administrative burden for entities with numerous low-value leases.
Differentiating Lease Contracts from Service Contracts
An essential aspect of the amendments is the clear distinction between lease contracts and service contracts. A lease exists if the customer has the right to control the use of the identified asset for a period of time in exchange for consideration. This includes obtaining substantially all the economic benefits and having the authority to direct the use of the asset.
In contrast, a service contract often implies that the supplier retains control over the asset's use. Mixed contracts—those combining lease and service components, such as a vehicle lease with a maintenance service agreement—pose a significant challenge. The standard permits lessees to account for the entire contract as a lease when the service component is not easily separable or is insignificant, thereby simplifying the accounting process.
Practical Implementation Challenges
Implementing these changes involves several practical challenges. Entities must update their systems to handle the new calculations and disclosures, train staff on the new requirements, and potentially renegotiate lease terms to reflect the new accounting treatment. The necessity of continuously monitoring lease agreements to account for changes in terms, like extensions or modifications, adds another layer of complexity.
Tax and Capital Allowance Implications
While the primary focus here is accounting, it's crucial to recognise that these changes will also affect tax reporting and capital allowances. Historically, payments under operating leases were fully deductible for tax purposes. With the new model, the deductions will shift towards depreciation and interest, requiring alignment between accounting policies and tax treatments. However, as noted in discussions within the UK, the definitive tax implications are yet to be fully clarified by tax authorities like HMRC.
Conclusion
The amendments to FRS 102 and 105 mark a significant shift in lease accounting, promoting greater transparency by recognising lease obligations on the balance sheet. This change enhances comparability and provides users of financial statements with a more accurate representation of an entity’s financial position. However, it also brings challenges that entities must meticulously address over the next 18 months. As businesses embark on this transition, thorough preparation and understanding of the new requirements will be pivotal in ensuring compliance and minimising disruptions.
For the full session, please click here. Robert Kirk covers the following topics during this course:
- Brief introduction to the publication of the amendments to FRS 100-105
- Summary of key changes to lessee accounting
- Summary of the key changes to reporting revenue
- Quick review of the changes to the definition of an asset, liability and the different recognition and derecognition of both
- Brief discussion of changes to FRS 102 Section 1A and FRS 105
The contents of this article are meant as a guide only and are not a substitute for professional advice. The author/s accept no responsibility for any action taken, or refrained from, as a result of the material contained in this document. Specific advice should be obtained before acting or refraining from acting, in connection with the matters dealt with in this article.
