In March 2024, the Financial Reporting Council (FRC) introduced key changes to UK GAAP which will be mandatory from 1 January 2026. Businesses can choose to adopt the changes early, potentially benefiting financially if they have a rent-free period on a current lease.

The new regime

The updates to UK GAAP will make lease accounting consistent with international standards by aligning with IFRS 16. This means that operating leases will now appear on the balance sheet as both a right-of-use asset and a lease liability.

Typically, the initial liability is calculated based on the present value of the future payments under the lease measured at the effective interest rate at the inception of the lease. If there is no interest rate inherent in the lease, you can choose to use the incremental borrowing rate or the obtainable rate. The right-of-use asset will match the lease liability initially, subject to prepayments or estimated costs to exit a lease, but will diverge in time.

The interest rates

The interest rates allowable represents the sole area with divergence from the international standards. In international standards, if there is no rate inherent in the lease, you can only use the incremental borrowing rate.

The incremental borrowing rate is the interest rate you would need to pay if you were to borrow the funds to acquire a similar asset at a similar location.

Experience has shown this is not an easily estimated rate and practice has diverged, hence a third alternative has been introduced to UK GAAP:

The obtainable rate is the interest rate a lessee would need to pay in order to borrow an amount equal to the undiscounted total lease payments over the same length of time as the lease.

How will things change?

Under the old UK GAAP, lease payments were recorded as expenses evenly over the lease term. If there were no upfront payments or rent-free periods, the balance sheet was not impacted since expenses matched cash payments. During rent-free periods, expenses were still recorded, creating a rent-free accrual that would unwind over the lease term once payments began.

Under the new system, for any lease with a rent-free-period, you would initially recognise the lease liability and a matching right-of-use asset, resulting in no overall impact on the balance sheet. Similarly to the old system, as the rent- free period progressed, an expense is recognised whilst no payments are made leading to a net liability position arising. However instead of recognising rental expense, this is replaced with depreciation of the asset and a finance cost from the liability. The combined new expenses will probably be higher initially than under old GAAP as interest is front loaded in line with the size of the liability, but the total expenses will decrease towards the end of the lease. Over the length of a lease, the total expenditure will be the same under both methods.

Transitioning to the new standards

The main difference between the old and new GAAP is the gross-up of the balance sheet under the updated standard. However, the transitional rules create significant differences when first adopting the new standards.

The date of transition is the first day in the financial year in which the updated GAAP is adopted, and there is no requirement to restate any comparative figures. If on the date of transition an existing lease has less than 1 year remaining, you can continue with the old GAAP treatment.

Otherwise, for any existing lease at transition, a right-of-use asset and lease liability should be calculated at the point of transition based on the remaining payments under the lease and the interest rate applicable at the point of transition.

Fundamentally, this transition approach means that any historic terms in an existing lease, such as a rent-free period, will be ignored. This means that on transition, you would recognise the benefit for any historic rent-free period directly into retained earnings and you would effectively move to a position where the asset matches the liability.

In effect this means that on first transition, the rent-free accrual recognised under the old standard can be effectively released directly to retained earnings, resulting in an uplift in net assets.

What’s the catch?

Unfortunately, the impact is only temporary. At the end of any lease, under any methodology, the lessee will be at the same financial position. For an existing lease at transition, this will result in higher expenditure being recognised than previously. For those that track EBITDA, it is worth noting that the expenditure under new GAAP fall below the EBITDA line, leading to a higher EBITDA.