Understanding the end of off-balance sheet lease accounting: A quick guide for brokers

In September 2024, the Financial Reporting Council published new lease accounting rules that many UK companies are required to implement, similar to the international accounting rules that listed companies, and some others have been required to follow since 2019.

The new lease accounting rules must be followed by eligible companies for reporting periods from January 2026, but companies can switch to apply them ealier for reporting periods starting this year, and many are expected to do this.  

I'm beginning to hear from brokers whose customers are either becoming aware of this or may need to be made aware. Here’s a few points that may assist.

Which companies are affected?

Many companies, and probably the majority of companies that lease equipment or vehicles are likely to be impacted as they must report using the UK’s Financial Reporting Standard 102 that includes the new lease accounting rules (FRS 102).

Apart from companies that report using international accounting standards, the only other companies out of scope are ‘micro-entities’ if they follow another accounting standard called FRS 105.

From April 2025, ‘micro-entities’ include will have at least two of the following: Turnover of £1m or less, £500,000 or less on the balance sheet, and 10 employees or less. Exceptions include charitable companies and companies that are subsidiaries of entities required to produce consolidated accounts.

Note however that some ‘micro-entities’ choose voluntarily to follow FRS 102 rather than FRS 105.

A good way of working out if a company is affected is to look at their accounts at Companies House, as they will normally state which accounting standard has been followed.

What’s the big change?

There’s quite a lot of detail, but one change tends to dominate any discussion of FRS 102 in the pub: Leases that would have been reported as operating leases under the old rules, meaning they were ‘off-balance sheet’ of the lessee, have disappeared as a category. Now all asset finance agreements are ‘on-balance sheet’ (with some exceptions for low value assets).

What exactly is (or was) ‘off-balance sheet’ accounting?

For an operating lease in accounting terms (what meany in the industry simply call a ‘lease’ - which is guaranteed to totally confuse any accountant*, because any asset finance agreement is a lease in accounting, including hire purchase, full payout, etc.) under the old rules, the lessee did not report the lease as an asset on its balance sheet. Hence the term ‘off-balance sheet’.

The term ‘off-balance sheet’ might have exciting connotations of somehow hiding or obscuring information. Hugely disappointingly for anyone hoping to make lease accounting interesting, elsewhere in the financial accounts there was a note setting out details of the operating leases if they were material.

Is information about operating leases being hidden? If only accounting was that interesting!

So the information was in the accounts, just not showing in the summary of financial position (for very good reasons, as it happens, but let’s not get into that here, as unfortunately it’s water under the bridge as far as the UK is concerned).

So (former) operating leases are now on-balance sheet?

Yes, that’s it. Not the full value of the asset, but the present value of the minimum lease payments (following various detailed rules).

Are there reasons why this doesn’t matter?

Yes, plenty. Try these:

1. Most leases are already on-balance sheet, because they were classified as finance rather than operating leases in the ‘old world’.
   

2. Information about operating leases was already published in the accounts where material (as noted above)

   
   

3. For many companies, their use of (former) operating leases is limited, so the overall impact on their balance sheet will be minor
   

4. For small companies, there’s plenty of research suggesting that limited use is made of published financial accounts (not least because by the time they are published, they are so out of date)
   

5. This doesn’t change the basics of how leases are taxed

So what’s the problem?

Unfortunately, this can still cause some concerns, as I am starting to hear about.

Here are some examples:

1.       Subsidiary companies that don’t have authorisation to use leases other than operating leases

2.       Companies worried that the new accounting rules might cause them to breach restrictions on borrowing built into banking covenants

3.       Companies worried that their financial ratios (such as debt to equity) will 'deteriorate', causing users of their accounts to take a less favourable view of the business

4.       Companies worried about the extra accounting work involved for the new rules

What can we say about these problems?

Whilst it’s not the role of the broker to provide detailed accounting advice, it might be helpful to note that when the new rules were introduced for large companies under the international rules, most of the the effects seem to have been very minor.  

Parent companies amended restrictions on subsidiaries, banks waived through changes to covenants, and changes to financial ratios were explained to users of accounts, who quickly moved on to find more interesting things to worry about that aren't just about obscure changes to accounting rules (and kudos to readers who spotted that EBITDA actually increases!).

The preparation work involved for large companies was considerable, and this was the real problem, not the effects of changes to the balance sheet. We can only hope that smaller companies in the UK will mostly have quite limited use of (former) operating leases, making their transition easier, but if there's a major concern to look out for with customers and maybe offer support, this is the one.

Just out of interest, what are the implications for lessors?

None - oddly, lessor accounting hasn’t changed. So former operating leases are reported as assets by both the lessee and the lessor. Try to explain that to anyone in your firm thinking of starting to study for their accountancy exams!

As a broker, where can I get support with this at low cost?

That’s one accounting question I hope you already know the answer to 😊 As well as any advice on particular lease accounting matters, I can run in-house training on use of accounting information by brokers.

* Footnote: Unless they are in possession of the new 3rd edition of the A to Z of Leasing and Asset Finance, available from Amazon or other booksellers, or direct from me for a special offer price of £25 including P&P until the end of February as recognition for making it to the end of a lease accounting article!

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