Two Names for Renting Something
If your business uses an asset it does not own, you have a lease. A photocopier on a five year contract, a unit on an industrial estate, three vans, the coffee machine in reception, the storage container in the yard. All leases, whatever the paperwork calls them.
For roughly forty years, UK accounting sorted every one of those into two boxes. A finance lease was treated as though you had bought the asset with borrowed money. An operating lease was treated as though you had simply rented it. The consequences were enormous. One appeared on your balance sheet as an asset and a debt. The other appeared nowhere except as a line of rent in the profit and loss account and a note at the back.
That is why the question "is this a finance lease or an operating lease?" was worth asking. It changed your gearing, your net assets and how a bank read your accounts.
For accounting periods beginning on or after 1 January 2026, that question stops mattering for lessees. The amended FRS 102 has removed the distinction on the customer side of the deal. Almost every lease now goes on the balance sheet.
This guide covers both worlds, because you need both. You need the old classification to read any set of accounts filed before 2026, to understand a lessor's books, and to follow the terminology that leasing companies still use in their sales material. And you need the new model because it is live now and it is doing things to small company accounts that most owners have not been warned about.
What Is a Finance Lease?
A finance lease is a lease that transfers substantially all the risks and rewards of ownership to you, even though legal title stays with the leasing company.
The commercial reality is that you have bought the asset and borrowed the money to do it. You will use it for most of its useful life. You carry the risk if it breaks, becomes obsolete or is worth nothing at the end. The lessor is not really in the business of owning that asset, they are in the business of lending you the money for it and holding the title as security.
A five year lease on a machine with a six year working life, where you pay for maintenance and insurance and the rentals over the term add up to roughly what the machine costs, is a finance lease. Everyone involved knows it is a purchase in a different shape.
Under the old rules, a finance lease was capitalised. You put the asset on the balance sheet at the lower of its fair value and the present value of the minimum lease payments, put a matching liability alongside it, then depreciated the asset and unwound the liability with an interest charge as you paid.
What Is an Operating Lease?
An operating lease is everything else. The lessor keeps the risks and rewards. You are renting.
A twelve month contract on a hire car, a serviced office you can walk away from with three months notice, a photocopier the supplier maintains and takes back after three years to re-lease to somebody else. In each case the leasing company still cares what the asset is worth at the end, because they are getting it back and they intend to make money from it again.
Under the old rules the treatment was as simple as it gets. Charge the rentals to the profit and loss account on a straight-line basis over the lease term. Nothing on the balance sheet. Disclose the future commitment in a note.
That off balance sheet treatment is exactly why the rules changed. A company could commit to £2m of rent over ten years and show none of it as a liability. You had to read the notes, and a lot of people did not.
Finance Lease vs Operating Lease: The Comparison
| Finance lease | Operating lease | |
|---|---|---|
| Who carries the risks and rewards | The lessee | The lessor |
| Typical term against asset life | Most of the asset's economic life | A fraction of it |
| Who maintains and insures | Usually the lessee | Often the lessor |
| Asset on the lessee's balance sheet (pre-2026) | Yes | No |
| Liability on the lessee's balance sheet (pre-2026) | Yes | No |
| P&L charge (pre-2026) | Depreciation plus interest | Straight-line rental |
| Effect on gearing (pre-2026) | Increases it | None visible |
| Who wants the asset back | Nobody, it is worn out | The lessor, to lease again |
| Treatment from 1 January 2026 | On balance sheet | On balance sheet |
How You Actually Told Them Apart
The old FRS 102 Section 20 did not give you a percentage to apply. It gave you a principle, risks and rewards, followed by a list of indicators. Any one of these normally pointed to a finance lease:
- Ownership transfers to the lessee by the end of the lease term
- The lessee has an option to buy the asset at a price low enough that exercising it is reasonably certain from the outset
- The lease term is for the major part of the asset's economic life, even if title never transfers
- At inception, the present value of the minimum lease payments amounts to substantially all of the asset's fair value
- The asset is so specialised that only the lessee can use it without major modification
Three softer indicators could tip a borderline case: the lessee bears the lessor's losses if the lease is cancelled, gains or losses on the residual value fall to the lessee, and the lessee can continue into a secondary period at a rent well below market.
Notice what is missing. There is no "75 percent of useful life" and no "90 percent of fair value" in UK GAAP. Those are American thresholds from older US standards, and we still see them quoted confidently in UK articles and by UK finance staff. They were never the test here. UK GAAP asked you to make a judgement and defend it, which is harder and, in our view, better.
Finance Lease, Hire Purchase and Contract Hire
This is where the language gets muddled, because the words the finance industry sells with are not the words the accounting standard uses.
Hire purchase looks almost identical to a finance lease and is accounted for the same way. The difference is legal, not economic. Under hire purchase you have an option to acquire title, usually for a nominal amount at the end, and once you exercise it the asset is yours. Under a finance lease, title normally stays with the lessor forever. The accounting is the same because the substance is the same, but the tax and VAT can differ, and so can what happens if you want to sell the asset mid-term.
Contract hire is a marketing name for what is usually an operating lease, most often on vehicles. The provider retains the residual risk, which is the whole basis of their pricing, and takes the vehicle back at the end.
Leasing, as used by a van dealer on the phone, means nothing in particular. Ask two questions: who takes the asset back at the end, and who carries the loss if it is worth less than expected. The answers tell you what you have signed regardless of the heading on the document.
VAT is a separate matter again and does not follow the accounting label. On a hire purchase agreement the VAT on the asset is generally charged up front and recoverable in one go. On a lease it is generally charged on each rental. Our guide to how VAT works covers the recovery mechanics, and there is a specific restriction on cars where only 50 percent of the VAT on the lease rentals is recoverable if the car has any private use.
What Changed on 1 January 2026
The Financial Reporting Council published the Periodic Review 2024 amendments to FRS 102 in March 2024. Most of them, including a completely rewritten Section 20 Leases, take effect for accounting periods beginning on or after 1 January 2026. Early adoption is allowed, but only if you apply all the other amendments at the same time.
The core change is one sentence long. For lessees, the distinction between finance leases and operating leases has been removed. Every lease that is not exempt now produces:
- A right-of-use asset, which is your right to use somebody else's asset for a period, sitting among your fixed assets
- A lease liability, being the present value of the payments you have committed to
The right-of-use asset is then depreciated over the lease term, and the liability unwinds with an interest charge. In other words, every lease is now accounted for the way a finance lease always was. This brings FRS 102 close to IFRS 16, which listed companies have applied since 2019, with some deliberate simplifications for smaller businesses.
The two exemptions
You do not have to capitalise everything. There are two escape hatches, and they are the difference between a manageable job and a miserable one.
Short-term leases. If the lease term is twelve months or less, including any extension options you are reasonably certain to exercise, and there is no purchase option, you can keep charging the rentals straight to profit and loss. You have to apply this consistently by class of asset, not lease by lease.
Low-value leases. Leases of assets that are low value when new can stay off balance sheet. This one you can choose lease by lease.
FRS 102 does not give you a number. It gives you examples of things that are never low value: land and buildings, vehicles and production line equipment. IFRS 16 has an indicative figure of around US$5,000 in its background material, and people reach for it, but it is not in FRS 102 and it is not a rule here.
That sounds like flexibility. In practice it hands you the judgement and the argument that goes with it. Our advice is blunt: write down a threshold now, in pounds, put it in your accounting policies, and apply it to everything. A company that decides case by case will end up with an inconsistent set of accounts and no good answer when an auditor or a buyer's accountant asks why the £900 coffee machine is off balance sheet and the £700 laptop is on it.
The discount rate
To work out the liability you have to discount the future payments. FRS 102 gives a three step hierarchy:
- The interest rate implicit in the lease, which is the rate that makes the payments equal the asset's fair value. In theory this comes first. In practice you almost never have it, because it depends on the lessor's costs and their view of the residual value, and they are not going to tell you.
- The incremental borrowing rate, the rate you would pay to borrow, over a similar term and with similar security, enough to buy an asset of similar value.
- The obtainable borrowing rate, which is new and is FRS 102's own simplification. It is the rate you would pay to borrow the total undiscounted lease payments over a similar term with similar security.
That third option is a genuine kindness to small companies. Deriving a proper incremental borrowing rate is a modelling exercise. An obtainable borrowing rate can be a documented quote from your existing bank. Get one, keep the email, and you have supported your figure.
A Worked Example
Numbers make this concrete. Take a five year lease on a small warehouse unit at £20,000 a year, payable annually in arrears, with an obtainable borrowing rate of 6 percent.
The present value of five payments of £20,000 discounted at 6 percent is £84,247. So on day one you recognise a right-of-use asset of £84,247 and a lease liability of £84,247. Your total assets and total liabilities both jump by that amount. Net assets are unchanged at that moment.
Depreciation is straight line over five years: £16,849 a year. Interest is 6 percent of the opening liability each year.
| Year | Opening liability | Interest at 6% | Payment | Closing liability | Depreciation | Total P&L charge | Old operating lease charge |
|---|---|---|---|---|---|---|---|
| 1 | £84,247 | £5,055 | £20,000 | £69,302 | £16,849 | £21,904 | £20,000 |
| 2 | £69,302 | £4,158 | £20,000 | £53,460 | £16,849 | £21,007 | £20,000 |
| 3 | £53,460 | £3,208 | £20,000 | £36,668 | £16,849 | £20,057 | £20,000 |
| 4 | £36,668 | £2,200 | £20,000 | £18,868 | £16,849 | £19,049 | £20,000 |
| 5 | £18,868 | £1,132 | £20,000 | £0 | £16,849 | £17,981 | £20,000 |
| £15,753 | £100,000 | £84,247 | £100,000 | £100,000 |
Three things fall out of that table.
The total is identical. £100,000 either way. Nothing about the cash has changed and nothing about the lifetime cost has changed. This is a timing difference and only a timing difference.
The charge is front loaded. Year one costs you £1,904 more in reported profit than the old treatment, and year five gives it back. Crossover is around year three.
EBITDA goes up by the full £20,000 a year. Under the old rules the whole rental sat above the EBITDA line as an operating cost. Now £16,849 is depreciation and £5,055 is interest, and both sit below it. If you or anyone lending to you uses EBITDA as shorthand for cash generation, the shorthand just broke.
The Consequences People Have Not Budgeted For
The accounting entries are the easy part. These are the things we spend most of our time on with clients.
Banking covenants
If you have any borrowing with covenants, read them this month rather than next year. Leverage, gearing and interest cover ratios all move, and they move in the wrong direction, because you have just added a large liability and a large interest charge that were not there before.
Many facility agreements contain a frozen GAAP clause, which fixes the accounting basis for covenant testing at the standards in force when the loan was signed. If yours has one, you are fine and you should confirm it in writing. If it does not, you could technically breach a covenant on a lease portfolio that has not changed in any commercial way. Lenders are broadly aware of this and are being reasonable about it, but "the bank will probably be fine" is not a plan. Ask them before the year end, not after the accounts are signed.
Distributable reserves and dividends
This is the one that catches owner-managed companies and it is barely mentioned anywhere.
Transition is done by the modified retrospective method, which means the cumulative effect lands as an adjustment to opening retained earnings on the date you first apply the standard. Retained earnings are what your distributable profits are measured against. If the adjustment is negative, your capacity to pay a dividend shrinks on day one, before you have traded for a single day under the new rules.
For a director drawing a small salary and topping up with dividends, that is not a technical footnote. It is a limit on what you can legally take out of your own company. If you have significant lease commitments and you distribute close to your reserves, work out the transition adjustment before you declare anything.
Everything that reads your balance sheet
Credit agencies score net assets and gearing. Suppliers check credit limits. Landlords ask for accounts. Tender processes set minimum financial thresholds. Buyers value businesses on multiples that assume a particular capital structure.
None of these people will adjust their thinking on 1 January 2026 because a standard changed. A construction firm bidding for work against a financial standing test, or a business in the middle of a sale process, should know what its accounts are going to look like well before they are filed. We cover the valuation angle in our guide to how you value a business, and the short version is that enterprise value multiples were always meant to capture lease obligations. Now they are visible, so the adjustment happens in the accounts rather than in the buyer's spreadsheet.
Who Escapes, and the Trap in the Escape
Two groups are outside this.
Micro-entities on FRS 105. FRS 105 has not been changed in the same way. If you qualify as a micro-entity and report under FRS 105, your leases stay off balance sheet and the rental charge stays as it is.
Lessors. The finance versus operating classification is alive and well on the other side of the deal. Lessors still classify their leases and account for them differently depending on the answer. So the distinction has not been abolished. It has been removed from one side of the transaction and left standing on the other, which is not the same thing and matters if you lease assets out as well as in. Property businesses in particular are often both.
The trap sits inside the first exemption. A growing company that moves from FRS 105 to FRS 102, because it has outgrown the micro-entity thresholds, now inherits a full lease capitalisation exercise in the same year it takes on more disclosure, more audit exposure and more scrutiny. That step up was always a jolt. It is a bigger one now. If you are near the micro-entity limits and you carry material leases, this is worth a conversation before the thresholds decide it for you.
Transition: How You Get There
The amended standard requires a modified retrospective approach, with two choices for the right-of-use asset.
Option one, the default, measures the liability as the present value of the remaining payments at the transition date, and sets the right-of-use asset equal to the liability, adjusted for any prepaid or accrued rentals already sitting on the balance sheet. This is the simpler route and it is what most small companies will use.
Option two is for companies already producing IFRS 16 numbers for a group consolidation. They can carry across the IFRS 16 carrying amounts, which keeps the statutory accounts and the group reporting aligned.
Several practical expedients come with it. You can apply a single discount rate to a portfolio of similar leases. You can use hindsight when assessing lease terms and extension options, which means you judge them with what you know today rather than reconstructing what you thought at inception. You can avoid reassessing whether existing contracts contain leases at all.
Critically, comparatives are not restated. The prior year column in your 2026 accounts still shows the old treatment. So the first set of accounts under the new rules will contain two years prepared on different bases sitting side by side, and anyone comparing them without reading the notes will draw the wrong conclusion about what happened to the business. Expect to explain that, and consider saying so plainly in the directors' report rather than burying it.
Tax: Less Dramatic Than It Looks
The reasonable fear is that a large new depreciation and interest charge changes your corporation tax bill. Mostly it does not, and the reason is that Parliament saw this coming.
Schedule 14 of the Finance Act 2019 was introduced when IFRS 16 arrived, precisely so that a change in lease accounting would not change the tax treatment. HMRC's Business Leasing Manual applies the same reasoning to the 2026 FRS 102 amendments, and puts it about as plainly as HMRC ever puts anything: commercially, nothing has changed for a lessee who has adopted the new standard. Most rentals stay on revenue account and stay deductible.
What you get instead is depreciation of the right-of-use asset plus interest on the liability, both generally deductible, replacing a straight-line rental that was deductible. Over the life of the lease the relief is the same. The timing shifts slightly forward, because the interest is heavier early on.
Three things do need attention:
- Capital elements inside the right-of-use asset, such as stamp duty land tax on a property lease, have to be identified separately. Depreciation on those is not deductible, and if they are buried inside one right-of-use figure nobody will spot them.
- Deferred tax. New timing differences between the accounting carrying amounts and the tax position generally create deferred tax entries that were not there before.
- Capital allowances do not follow the accounts. Recognising a right-of-use asset does not give you a capital allowances claim on it. The rules for leased assets are their own regime and the new accounting does not touch them.
Our View
The old classification was gamed, and everyone knew it. Leases were routinely structured to land just on the operating side, not because that reflected the deal but because it kept the debt out of sight. If a rule can be engineered around with a small change to a lease term, it is not much of a rule. Putting the obligations on the balance sheet is the right answer and it is overdue. We say that knowing it makes our clients' accounts look worse on paper.
The real work is finding the leases, not accounting for them. Almost no small company has a lease register. The photocopier is on one system, the vans are with the office manager, the storage unit was arranged by a director who has since left, and the coffee machine contract is in a drawer. Every one of those may need capitalising. If you do nothing else this year, gather the contracts into one place with the start date, the end date, the payment, and any break or extension clause. That list is the whole project. The spreadsheet that follows it takes an afternoon.
Watch the front loading if you are growing. For a single lease, the extra cost in the early years is only a timing difference and it reverses. For a business that keeps signing new leases as it expands, there is always a fresh lease in its expensive early phase, and the reversals never quite catch up with the new arrivals. The effect on reported profit is a timing difference in theory and behaves like a permanent drag in practice. Nobody tells growing businesses this and it is the single point we would most want an ambitious client to understand.
Do not let the accounting change the decision. We have already been asked whether a client should shorten a lease to twelve months to use the exemption. Almost always the answer is no. You would be paying more rent, losing security of tenure and giving up negotiating position, all to keep a number off a page. Sign the lease that suits the business. Then account for it properly.
How IAK Can Help
Most of our lease work in 2026 has been unglamorous and useful. We build the lease register, because the client did not have one. We work out the transition adjustment and show the director what it does to their distributable reserves before they take a dividend they cannot support. We read the covenants and tell the client whether they need to ring the bank. We set a written low-value policy so the judgement is made once and applied consistently, rather than argued over every year.
Our accounting team prepares the statutory accounts under the amended FRS 102 and handles the Section 20 measurement, disclosures and deferred tax. Our management reporting team makes sure your monthly numbers and your covenant reporting move at the same time as your statutory ones, so you are not running two versions of the truth for a year. Our tax planning team deals with the Schedule 14 position, the capital elements and the interaction with capital allowances. If your records are the real problem, our bookkeeping and Xero services are usually where we start.
We do a lot of this for small businesses, construction companies and property developers, where lease commitments tend to be large relative to everything else on the balance sheet.
If your accounting period began on or after 1 January 2026, this is already running. Get in touch for a free consultation and we will tell you within a conversation whether it is a small job or a real one.
Sources
- FRC revises UK and Ireland accounting standards, Financial Reporting Council, on the March 2024 Periodic Review amendments and the 1 January 2026 effective date.
- Amendments to FRS 102 and other FRSs, Financial Reporting Council, the amending document itself, including the rewritten Section 20 Leases.
- FRS 102 Factsheet 9, Initial application of the Periodic Review 2024 amendments, Financial Reporting Council, on the transition requirements and practical expedients.
- BLM50005, Business Leasing Manual, HMRC, on the 2024 amendments replacing the previous FRS 102 for periods beginning on or after 1 January 2026, the removal of the lessee classification, and the tax position.
- Finance Act 2019, Schedule 14, legislation.gov.uk, on the leasing tax provisions introduced so that changes in lease accounting standards would not change the tax treatment.
- FRS 102: Leases under UK GAAP, ICAEW, on the amended Section 20 requirements for lessees and lessors.
- Transition provisions in FRS 102's new lease accounting model, BDO, on the modified retrospective approach and the two options for measuring the right-of-use asset.
- FRS 102 lease accounting changes 2026, Forvis Mazars, on scope including Section 1A entities, the recognition exemptions and the obtainable borrowing rate.
- FRS 102: changes to lease accounting rules, PKF Francis Clark, on the short-term and low-value exemptions and the FRS 105 position.