Introduction
The revised FRS 102 Section 20 on lease accounting has introduced significant changes that affect how businesses account for their leases. For small entities using Section 1A of FRS 102, understanding these changes and their practical application is crucial for compliance and accurate financial reporting.
Key Changes Under Revised Section 20
The main change is the move towards a single lease accounting model where most leases are brought onto the balance sheet as:
- Right-of-use asset (what you have the right to use)
- Lease liability (what you owe in future payments)
What This Means for Small Entities
Previously, many leases were treated as operating leases and kept off the balance sheet. Now, most leases over 12 months must be capitalised, significantly impacting your financial statements.
Practical Application for Section 1A Entities
Recognition Criteria
You must recognise a lease on your balance sheet unless it meets specific exemptions:
Exemptions available:
- Short-term leases (12 months or less)
- Leases where the underlying asset is of low value (No monetary threshold, JUDGEMENT is needed; IFRS 16 uses ~$5,000 as a benchmark)
The Discount Rate Challenge for Small Entities
Common Problem: Most small entities don’t have bank loans, making it difficult to determine an appropriate discount rate.
Practical Solutions
Option 1: Risk-Free Rate Approach
Use UK government gilt yields matching your lease term.
Example: For a 5-year lease, use the 5-year gilt yield (currently around 3-4%).
Option 2: Incremental Borrowing Rate
Estimate what you would pay to borrow similar amounts.
Example: Contact your bank for an indicative rate for a 5-year loan of similar value to your lease.
Option 3: Build-Up Method
Start with risk-free rate and add margins:
- Risk-free rate: 3.5%
- Credit risk premium: 1.5%
- Total discount rate: 5.0%
Example: Calculating Present Value
Scenario: Equipment lease – £500/month for 4 years, using 5% discount rate.
Calculation:
- Monthly payment: £500
- Number of payments: 48
- Monthly discount rate: 5%/12 = 0.417%
- Present value: £21,724
Using Excel PV function: =PV(5%/12,48,-500)
Common Lease Types and Treatments
Vehicle Leases
Car lease – £300/month for 3 years:
- Initial recognition: £10,294 (PV at 5% discount rate)
- Monthly depreciation: £286
- Decreasing interest expense
Property Leases
Retail shop – £1,500/month for 5 years:
- Initial recognition: £80,793 (PV at 5% discount rate)
- Annual depreciation: £16,159
- Impact on balance sheet ratios
Equipment Leases
Small value exemption: If individual equipment items are under let’s say £5,000 when new, you can choose to expense monthly payments rather than capitalise.
Practical Implementation Steps
Step 1: Lease Inventory
Create a schedule of all current leases:
- Lease description
- Monthly/annual payments
- Lease term remaining
- Renewal options
- Termination clauses
Step 2: Assess Exemptions
For each lease, determine if exemptions apply:
- Is it 12 months or less?
- Is the underlying asset low-value?
Step 3: Determine Discount Rates
Establish a consistent approach:
- Document your methodology
- Consider different rates for different lease types/terms
- Review annually for reasonableness
Step 4: Calculate Initial Recognition
For each lease to be capitalised:
- Calculate present value of future payments
- Recognise right-of-use asset
- Establish lease liability
Example: Complete Lease Accounting Cycle
Scenario: Manufacturing business leases machinery for £800/month over 4 years, 5% discount rate.
Initial Recognition (Year 1)
- Right-of-use asset: £34,757
- Lease liability: £34,757
Year 1 Accounting
Monthly entries:
- Depreciation: £723 (£34,757 ÷ 48 months)
- Interest (Month 1): £145 (£34,757 × 5% ÷ 12)
- Lease liability reduction: £655 (£800 – £145)
Year-end position:
- Right-of-use asset: £26,081 (£34,757 – £8,676 depreciation)
- Lease liability: £26,620
Impact on Financial Statements
Balance Sheet Effects
- Assets increase: Right-of-use assets added
- Liabilities increase: Lease liabilities added
- Ratios affected: Debt-to-equity, current ratios
Profit & Loss Effects
- Rent expense eliminated
- Depreciation added: Typically front-loaded
- Interest expense added: Decreases over time
- Net effect: Often higher costs in early years
Transition Considerations
Modified Retrospective Approach
- Apply new rules from date of initial application
- No need to restate prior year comparatives
- Measure right-of-use asset at lease liability amount
Example: Transition Calculation
Existing lease: Office space, 2 years remaining, £1,000/month
Transition entry:
- Dr Right-of-use asset £22,826
- Cr Lease liability £22,826
Practical Tips for Small Entities
Documentation
- Maintain lease registers
- Document discount rate methodology
- Keep supporting calculations
Systems Considerations
- Simple spreadsheet models often sufficient
- Consider lease accounting software for multiple leases
- Ensure month-end procedures capture all adjustments
Professional Support
- Engage with your accountant early
- Consider training for finance staff
- Plan implementation timeline
Conclusion
While the revised Section 20 requirements may seem complex, small entities using Section 1A can successfully implement these changes with proper planning and understanding. The key is to:
- Identify all leases requiring capitalisation
- Establish consistent discount rate methodology
- Set up robust calculation and tracking systems
- Understand the financial statement impacts
