Prepare for the GAAP shift and FRED 82's updated UK's IFRS 16 Leases. Learn how the updates will change how you report on operating leases, moving them onto balance sheets and see how lease handling and financial statements will differ.
The proposed changes by the FRC mean that UK companies must now be aware of IFRS16 Leases.
The revisions outlined in FRED 82 bring about important changes to FRS 102, aligning it with current IFRS SME practices. These updates aim to enhance the quality and clarity of financial reporting for users.
In this article, we look at the upcoming changes and offer tips on preparing for the new standard that covers:
UK GAAP mirrors FRS in many ways, partially due to the move towards convergence in the early 2000s. But in others, UK GAAP differs significantly, especially when it concerns FRS102, and the treatment of leases is one of these areas.
While the standard aims to improve transparency in financial reporting, it also poses challenges for companies across various industries and smaller entities with fewer resources.
One of the primary challenges lies in the complexity of lease data collection and management. Under IFRS 16, lessees must identify and assess all lease contracts, including those previously classified as operating leases.
This task includes thoroughly reviewing existing lease agreements and gathering comprehensive lease data. Companies must establish robust systems and processes to accurately capture and manage lease information, including lease terms, renewal options, variable lease payments, and modifications.
Determining the appropriate discount rate is another significant challenge. IFRS 16 requires lessees to discount lease payments using the rate implicit in the lease when readily determinable.
However, in practice, this rate is often not readily available. As a result, companies must estimate the discount rate based on their incremental borrowing rate, which requires careful judgement and can impact the measurement of lease liabilities and right-of-use assets.
IFRS 16 also introduces increased complexity in financial statement presentation.
Under UK GAAP, operating lease expenses are currently recognised as operating expenses, while finance lease payments are classified as both interest expense and principal repayment.
Under IFRS 16, all leases are recognised on the balance sheet, resulting in key financial ratios and metrics changes. Companies must understand the impact on financial performance, leverage ratios, and profitability.
In addition, maintaining compliance with the standard needs ongoing monitoring and reassessment of lease contracts. Changes in lease terms, modifications, or terminations can significantly impact the recognition and measurement of lease assets and liabilities. Companies must have mechanisms to monitor lease agreements effectively, identify any changes, and update the financial statements accordingly.
Lastly, IFRS 16 brings about increased transparency in financial reporting but also requires enhanced disclosure requirements. Companies must provide detailed information on lease commitments, lease terms, significant judgments applied, and cash flow implications. Meeting these disclosure requirements necessitates a comprehensive understanding of the standard and meticulous documentation.
The staff draft of the proposals of the proposals gives an excellent guide to the changes that are being considered. (Scroll down to page 218 for the leases section).
The FRC is proposing that an operating lease which has until now been included as an expense, will now be shown as a balance sheet item.
This proposal means that the total of all the lease payments will be stated as a liability, and the value of the underlying right-to-use asset will be shown as an asset.
This proposal also means that the rental charge to the P&L of the lease will be replaced by a depreciation charge on the asset and a corresponding interest charge on the value of the agreement. This, of course, mirrors the way that finance leases have been shown previously but will still impose a burden on SME accounting departments.
What is the difference between IAS 17 and IFRS 16?
As detailed in the iris accountancy blog “IFRS 16 replaces IAS 17 but keeps what the latter set out in terms of lessor accounting requirements and how these businesses should classify their transactions as operating or finance leases.”
Not all leases must be recognised using the standard with the associated work involved.
Instead of sticking to the recognition criteria outlined in IFRS 16, a lessee has the option to treat lease payments as an expense on a straight-line basis throughout the lease term or adopt another systematic approach for two specific types of leases:
i) Leases with a lease term lasting 12 months or less and lacking any purchase options
ii) Leases involving underlying assets that possess a low value when brand new, such as personal computers or small office furniture items
In practice, this will mainly affect the leasing of low-value items as the proportion of leases that run for a term of less than one year is very low, and it's likely that agreements that have a longer term with only 12 months left to run already have a computation carried out and in place.
The proposal notes some types of assets that would usually be classed as low-value:
Section 20.13, though, does note that judgement may need to be used in terms of assets that could fairly be described as low-value.
As noted above, one of the most difficult aspects of accounting for leases is identifying an underlying discount rate, especially where no ready market exists or if it's not explicit in the lease agreement. If adopted, the proposal will now allow companies to rely upon the gilt rate, which is easy to find and publicly available.
The effective date of the proposals is 1st of January 2025, which may seem like a long way away but will soon be here. A great resource for information on this is the FRC website, where you can find the standards proposals and video explainers.
The first step is to consider whether your company is affected by the changes. If you have no operating leases or you only lease small value items, then you can relax to a certain extent as the changes won't affect you but you should bear them in mind in case your business uses operating leases in the future.
The second step is to ensure you have as much information as possible on your operating lease agreements and record the required information correctly in your accounts.
Be aware, though, that changing the categorisation of the operating lease payments may be correct for statutory reporting but could skew your management accounts and ratios.
The most helpful advice is to make your changes as soon as possible. What you don't want to face is gathering information, recording changes and analysing the results when you are a week into your audit visit.
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Trish Toovey works across the UK and US markets to craft content at Payhawk. Covering anything from ad copy to video scripting, Trish leans on a super varied background in copy and content creation for the finance, fashion, and travel industries.