Lease accounting is changing for UK SMEs: FRS 102, Section 1A and FRS 105 compared

For decades, the rent on your office, warehouse or van fleet has sat quietly in the profit and loss account, with the future commitment tucked away in a note. That era is ending. The Financial Reporting Council's Periodic Review 2024 amendments to FRS 102 take effect for accounting periods beginning on or after 1 January 2026, and they bring most leases onto the balance sheet for lessees — a UK GAAP version of the international standard IFRS 16.

We covered the headline change when the amendments were finalised in our earlier article on the FRS 102 lease accounting changes. This guide goes deeper for the SME audience: what the new lessee model actually involves, how to measure the numbers, how transition works, and — crucially — what it means depending on whether you prepare accounts under full FRS 102, FRS 102 Section 1A (small companies) or FRS 105 (micro-entities). We finish with a worked example and a practical preparation checklist.

Key takeaways

• From periods beginning on or after 1 January 2026, FRS 102 brings most leases on balance sheet for lessees.
• Section 1A does not exempt small companies — only disclosure is reduced; recognition follows full FRS 102.
• Micro-entities on FRS 105 are unaffected: operating leases stay off balance sheet.
• Short-term and low-value leases can stay off balance sheet, and the obtainable borrowing rate makes discounting practical for SMEs.
• Transition is modified retrospective: comparatives are not restated and opening-reserves impact is usually minimal.

Why the rules are changing

Under the current rules, lessees classify each lease as either a finance lease (on balance sheet, because it transfers substantially all the risks and rewards of ownership) or an operating lease (off balance sheet — the rent is simply expensed, usually straight-line, with future commitments disclosed in the notes). Most SME leases — offices, shops, warehouses, vehicles, equipment — are operating leases, so a company can be committed to years of payments with nothing showing on its balance sheet.

International standards fixed this in 2019 with IFRS 16, which requires lessees to recognise almost all leases on balance sheet. The FRC's periodic review of UK GAAP concluded that FRS 102 should follow suit, on a simplified basis. The result is a rewritten Section 20 of FRS 102: for lessees, the operating/finance lease distinction disappears and a single on-balance-sheet model applies.

The new lessee model in a nutshell

For each lease in scope, at the start of the lease you recognise:

• A lease liability — the present value of the lease payments you are committed to, discounted at an appropriate rate; and
• A right-of-use asset — broadly the same amount, plus initial direct costs and any restoration obligations, less incentives received.

Then, each year:

• The right-of-use asset is depreciated, normally straight-line over the lease term; and
• Interest is charged on the lease liability, which unwinds as payments are made.

The familiar single rent expense is replaced by depreciation plus interest. The total cost over the life of the lease is unchanged, but it is front-loaded — more expense in the early years, less later — because interest is highest when the liability is largest.

Which discount rate?

The liability is discounted using the interest rate implicit in the lease where that can be readily determined. In practice it usually can't — landlords don't tell tenants their internal rate of return — so FRS 102 offers two alternatives:

• The incremental borrowing rate — the rate you would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value; or
• A genuinely useful simplification unique to FRS 102: the obtainable borrowing rate — the rate at which the company could borrow an amount similar to the total lease payments, over a similar term, in the same currency. For most SMEs this can be evidenced from an existing loan facility or a quote from the bank, which makes the calculation far more practical than the full IFRS 16 exercise.

The exemptions: short-term and low-value leases

Two categories of lease can stay off the balance sheet, with payments simply expensed as now:

• Short-term leases — a lease term of 12 months or less at commencement, with no purchase option; and
• Leases of low-value assets — judged on the asset's value when new, irrespective of the size of your business. Think laptops, phones, printers and small items of office furniture. Cars, vans and property never qualify, however small the rent.

For many smaller businesses these exemptions strip out most of the admin, leaving only the property and vehicle leases to bring on balance sheet.

Framework by framework: what do you need to do?

Full FRS 102

The new Section 20 applies in full. All non-exempt leases come on balance sheet from the first period beginning on or after 1 January 2026 (early adoption was permitted, but only of the amendments as a whole). Lessee disclosure requirements are more extensive than before — carrying amounts of right-of-use assets, interest expense, short-term and low-value lease expense, and a maturity analysis of lease liabilities.

FRS 102 Section 1A (small companies)

This is the point many small company directors miss: Section 1A does not exempt you from the new lease accounting. Section 1A only reduces disclosure — the recognition and measurement rules are exactly the same as full FRS 102. A small company renting premises will recognise the same right-of-use asset and lease liability as a large one; it will simply give fewer notes about it. If your accountant files "small company accounts" for you under Section 1A, expect your balance sheet to change in 2026.

FRS 105 (micro-entities)

Micro-entities are the exception. The FRC deliberately kept FRS 105 simple: operating leases stay off balance sheet, expensed as before, with lease commitments forming part of the total financial commitments disclosed at the foot of the balance sheet. If your company qualifies as a micro-entity and uses FRS 105, nothing changes on leases.

That said, staying on (or moving to) FRS 105 purely to avoid the lease rules is a trade-off worth thinking through. FRS 105 accounts are extremely stripped back — no fair values, minimal notes, no flexibility on presentation — and lenders, credit agencies and potential buyers often find them uninformative. A growing company will also outgrow the micro thresholds eventually, and the transition later can be more painful than adopting the fuller framework earlier. Don't let the lease tail wag the framework dog.

Lessors: largely unchanged

If you grant leases — for example a property company letting units, or a group company leasing equipment to another — lessor accounting is largely untouched. Lessors still classify leases as operating or finance and account for them broadly as before. The heavy lifting falls on lessees.

A worked example: a small company's office lease

Suppose Brampton Design Ltd signs a five-year lease on a studio at £20,000 a year, payable annually in arrears, from 1 January 2026. There is no purchase option and no rent-free period. The interest rate implicit in the lease isn't determinable, and the company's bank confirms it could borrow a similar amount over five years at 6% — its obtainable borrowing rate.

Day one: the present value of five payments of £20,000 discounted at 6% is roughly £84,250. Brampton recognises a lease liability of £84,250 and a right-of-use asset of the same amount.

Year one:

• Depreciation: £84,250 ÷ 5 = £16,850
• Interest: 6% × £84,250 = £5,055
• Total profit and loss charge: £21,905 — compared with the £20,000 straight rent charge under the old rules.

The £20,000 payment reduces the liability, which ends year one at about £69,305. By year five the interest charge has shrunk to around £1,130 and the total annual charge is below £18,000 — the same £100,000 of cost overall, just front-loaded. Meanwhile the balance sheet carries an asset and a liability that never appeared before, and because depreciation and interest both sit below operating profit differently from rent, reported EBITDA rises by the full £20,000.

Transition: how the switch actually happens

FRS 102 mandates a modified retrospective approach — simpler than it sounds:

• Comparatives are not restated. The prior-year column in your first affected accounts stays on the old basis.
• On the date of initial application (the first day of the first period beginning on or after 1 January 2026), each former operating lease gets a lease liability equal to the present value of the remaining payments, discounted at your incremental or obtainable borrowing rate at that date.
• The right-of-use asset is set equal to the liability, adjusted for any rent prepayments or accruals already on the books — so for most SMEs there is little or no hit to opening reserves.
• Existing finance leases simply carry over at their previous carrying amounts.

Helpful practical expedients are available on transition: you need not reassess whether existing contracts contain a lease; leases ending within 12 months of the transition date can be treated as short-term; a previously recognised onerous lease provision can be used instead of a fresh impairment review; and subsidiaries of IFRS groups can simply reuse the IFRS 16 numbers already prepared for group reporting.

The knock-on effects SMEs actually care about

• Gearing and net debt. Lease liabilities count as debt on the balance sheet. A company with significant property leases can see reported borrowings jump overnight, with no change in the underlying business.
• Bank covenants. Loan agreements referencing gearing, net assets, interest cover or EBITDA may be mechanically affected. Many facility agreements have "frozen GAAP" clauses; many don't. Talk to your lender before the first affected accounts are filed, not after a covenant test fails on paper.
• EBITDA and profit profile. EBITDA improves (rent moves out of operating costs), but profit before tax dips in the early years of each lease because of front-loading. Anyone valuing the business on an EBITDA multiple needs to understand the change.
• Company size thresholds. Size tests are based partly on balance sheet total — gross assets. Adding right-of-use assets can nudge a company over the small or medium thresholds, potentially affecting audit exemption and filing requirements, although the substantial uplift in the size thresholds from April 2025 gives most companies more headroom.
• Tax. For most trading leases, corporation tax relief follows the accounts — so instead of deducting rent, you will deduct the depreciation and interest charges, and where relief tracks the accounts in this way no deferred tax arises from the lease itself. Timing differences can still crop up in specific situations — for example the treatment of transitional adjustments on the change of accounting basis, or leases where tax relief does not follow the accounting entries — so the tax position is worth confirming for your circumstances rather than assumed.
• Dividends. Front-loaded costs can trim early-year distributable profits — worth modelling if you rely on dividends for income.

How to prepare now: a checklist

• Build a complete lease register. Property, vehicles, plant, equipment, software-with-hardware bundles — terms, payments, break clauses, renewal options and rent reviews. This is the single biggest time-saver.
• Confirm which framework you report under — full FRS 102, Section 1A or FRS 105 — and whether staying put still makes sense.
• Apply the exemptions to shrink the population: park short-term and low-value leases.
• Agree a discount rate. A letter or quote from your bank evidencing an obtainable borrowing rate makes the whole exercise defensible.
• Model the impact on the balance sheet, EBITDA, profit, size thresholds and any covenants before the year-end — surprises are cheaper on a spreadsheet than in filed accounts.
• Brief your lender and stakeholders if the numbers move materially.
• Consider timing of new leases. Lease terms, break options and incentives signed now will be measured under the new rules — factor that into negotiations.

The 2026 lease changes are the biggest shift in SME accounting for a generation, but handled early they are entirely manageable — and for many businesses the work is mostly a one-off data-gathering exercise. If you'd like us to review your leases, model the impact on your accounts and covenants, or advise on whether FRS 105 or Section 1A is still the right home for your company, book a free consultation and we'll walk you through it. We do this work for SMEs across Medway and Kent from our Rochester office — see our accountants in Medway page.