Original content provided by BDO United Kingdom
January 2025 could see Generally Accepted Accounting Practice in the UK ("UK GAAP") adopt new lease accounting as previously seen under International Financial Reporting Standard (IFRS). The changes proposed in Financial Reporting Exposure Draft ("FRED") 82 will impact FRS 102 users and specifically concerns the way lease payments are treated for accounting purposes.
In 2016, IFRS users saw a complete overhaul of lease accounting in this direction through the introduction of IFRS 16, and now UK GAAP look to do the same.
That sounds like a change to a small area of the rules, and January 2025 is a long way off. So why worry about it now? The reason is that for construction and real estate businesses particularly, the changes could have a material impact on your bottom line. And you don’t want to find out too late.
Under current rules, companies that rent real estate - so most businesses - can treat rental payments as a business expense in their profit and loss accounts, with limited disclosure requirements.
This overlooks the fact that holding a 20 or 30-year lease on a property allows a business to benefit from the property as if it was an asset of its own, as well as tying the business in to a long-term liability - something which the proposed changes to FRS 102 seeks to address.
FRED 82 sets out the proposed changes for FRS 102 users, which would align UK GAAP with the key principles of IFRS 16, where a lessee is required to recognise any lease with a term of more than 12 months ‘on balance-sheet’ through corresponding assets and liabilities.
Practical impacts
In practice, the asset will be the right of use to the space being leased and the liability will be the discounted amount of future payments, which could be viewed in a similar way to a long-term loan. While total cash flows will remain unchanged, there will be changes in the cash flow statement.
Depreciation of the right-of-use asset will be included in operating cash flows and interest payments may be included in operating or financing cash flows. This is an amendment to Section 7 of FRS 102, where leases were included entirely in operating cash flows.
It is clear this could have an impact on all businesses, but the effects will be most keenly felt by companies that lease a lot of space!
Business risks
Here, the proposed changes may have a significant impact on the balance sheet and key performance indicators, especially commonly used earnings before interest, taxes, depreciation and amortisation (EBITDA) and debt ratios. Companies with big leases may see an improvements in their EBITDA profile that has nothing to do with trading conditions, but simultaneously see worsening of debt ratios.
The proposed changes may also affect agreements such as earn-outs, bonus agreements and bank covenants that are linked to reported numbers.
These agreements may need to be reviewed and amended and companies could be caught-out by breaching their covenants as a result of reporting changes if they do not consider the impact of the new rules and commence appropriate discussions in good time.
Complying with the proposed amendments may also require changes to systems and processes, so you can obtain the information you need for accounting and disclosure requirements. Things become more complex when considering the relationship between parent companies and subsidiaries.
The bottom line is that if you lease real estate there is a good chance FRED 82 could influence your financial position - and with it, your ability to trade - even if your trading remains consistent.
As with most things in accounting, behind the rule change there is mass of detail, some of which is still being worked out.
But the headline news is that FRS 102 is changing and companies that prepare for it sooner rather than later will be best positioned to take advantage of the changes, rather than being caught out by them.
Find out now how you can get ahead of the new rules by contacting our team: Nigel Harra, Laura Jackson, Sam Howard, Breandan Lundy.
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