FRS 102 Embedded Leases: Your Preparedness Guide

The updates to Financial Reporting Standard 102 (FRS 102), set to take effect for accounting periods beginning on or after 1 January 2026, have many companies finding themselves in a state of financial transformation. The adjustments are meant to hold companies operating in the UK and the Republic of Ireland to a more formalised standard of disclosures. Some of the biggest changes are to Section 20 and are meant to align with the on-balance sheet lease accounting model of IFRS 16.

The big picture: What’s changing and why?

The previous FRS 102 Section 20 largely adhered to the IAS 17 model, distinguishing between finance and operating leases wherein operating leases remained off-balance sheet. The new FRS 102 Section 20, however, largely mirrors IFRS 16 by creating a single-model of lease classification and requiring lessees to recognize a “right-of-use” (ROU) asset and a corresponding lease liability for nearly all leases. This change aims to provide a more transparent and faithful representation of an entity’s financial position by bringing previously unacknowledged lease obligations onto the balance sheet.

While the core principles are aligned with IFRS 16, the Financial Reporting Council (FRC) has introduced several practical expedients to ease the burden on FRS 102 preparers. These are designed to allow entities flexibility without compromising the integrity of the financial reporting.

Getting prepared: Your 2026 transition checklist

For UK and Republic of Ireland entities operating under FRS 102, a successful transition hinges on planning and cross-departmental collaboration. If this is new territory for you and your team, do not worry, you are in the right place. Here’s what you need to have in order:

Contract inventory and data collection

Start by identifying all lease agreements, both explicit and embedded within other contracts.

Under FRS 102, the treatment of embedded leases has been significantly updated, aligning closely with the principles of IFRS 16.

1. What is an Embedded Lease? An embedded lease is a lease agreement that exists within a broader service contract or other agreement. Historically, these were often overlooked because the primary focus was on the service being provided, not the underlying asset’s use. For example, a contract for IT services might include the use of specific servers for a period, or a contract for logistics might involve the dedicated use of certain vehicles.
2. Identifying an Embedded Lease (Two Key Criteria): At the inception of any contract, entities must assess whether it contains an embedded lease. Under FRS 102, a contract (or part of a contract) conveys the right to control the use of an identified asset for a period in exchange for consideration if:
   • An Identified Asset Exists:
     • The contract explicitly or implicitly specifies a distinct asset. This means the asset must be identifiable (e.g., a specific piece of equipment, a particular building floor).
     • Crucial Caveat: If the supplier has a substantive right to substitute the asset throughout the period of use (meaning they can change the asset and benefit economically from doing so, without the customer’s approval), then there is no identified asset, and therefore no lease.
   • The Customer (Lessee) Controls the Use of the Identified Asset:
     • The customer has the right to obtain substantially all of the economic benefits from using the identified asset throughout the period of use.
     • The customer has the right to direct the use of the identified asset. This often means the customer determines “who, what, when, where, and how” the asset is used, even if the supplier is operating it. For example, the customer dictates the outputs, timing of use, or where the asset is deployed.
3. Accounting Treatment (Lessees) – On-Balance Sheet Recognition: Once an embedded lease is identified, the lessee must recognize it on their balance sheet. The previous distinction between operating and finance leases for lessees is effectively removed for financial statement purposes (except for specific exemptions).
   • Right-of-Use (ROU) Asset: An asset representing the right to use the underlying asset is recognized on the balance sheet.
   • Lease Liability: A corresponding liability representing the obligation to make lease payments is also recognized on the balance sheet.

Initial measurement

• The lease liability is initially measured at the present value of the future lease payments. The discount rate used is typically the rate implicit in the lease, or if that cannot be readily determined, the lessee’s incremental borrowing rate. FRS 102 offers a simplification, allowing the use of an “obtainable borrowing rate” which can be easier to calculate.
• The ROU asset is initially measured at the amount of the lease liability, plus any lease payments made before or at commencement, initial direct costs incurred by the lessee, and an estimate of costs to dismantle, remove, or restore the underlying asset, and minus any lease incentives received.

Subsequent measurement

• The ROU asset is subsequently depreciated over the shorter of the lease term or the useful life of the asset.
• The lease liability is subsequently increased to reflect interest on the lease liability and reduced by lease payments made.

Technical accounting policy decisions

The new standard offers some choices. You’ll need to decide:

• Recognition Exemptions for Short-Term and Low-Value Leases
  • FRS 102 allows entities to elect not to apply the full on-balance sheet model to short-term leases (12 months or less) and leases for which the underlying asset is of low value.
  • Examples of assets generally not considered low-value include large vehicle contracts, land, buildings, and production line equipment.
  • The election for low-value assets can be made on a lease-by-lease basis.
• Discount Rate Application
  • Entities can choose to apply either the interest rate implicit in the lease (if readily determinable), the lessee’s incremental borrowing rate, or the lessee’s obtainable borrowing rate.
  • The “obtainable borrowing rate” is a simplification designed to be easier to determine.
• Transition Approach
  • FRS 102 generally mandates a modified retrospective approach, adjusting retained earnings at the date of initial application.
  • However, if an entity has already applied IFRS 16 for group reporting, they may use those calculated balances as their opening balances at the date of transition to FRS 102.
• System and Process Overhaul: Do you have a system in place today to handle your lease portfolio? Does it accommodate the requirement for FRS 102 disclosures?
  • Software Solutions: It is imperative to start with the evaluation of your current programs used by the organisation to ensure that your company can remain compliant with the new standards if this impacts your business. The best way to ensure this is by inquiring to your current vendor to make sure they are aware and enhancing their tool to accommodate.
  • Process Redesign: Establishing clear internal processes for identifying, abstracting, and documenting lease agreements, including reassessment triggers for lease modifications or changes in lease terms. The better the system you select, the easier it will be. The ideal scenario is a tool, like LeaseQuery, that has successfully transitioned organisations in multiple other forms of guidance.
  • Internal Controls: Strengthening internal controls around lease data accuracy, completeness, and the proper application of accounting policies.

FRS 102 vs. IFRS 16: Key distinctions and why they matter

While the new FRS 102 Section 20 draws heavily from IFRS 16, some notable differences cater to the specific needs of FRS 102 preparers:

• Low-Value Asset Exemption: As mentioned, FRS 102 offers more flexibility in defining “low-value assets,” allowing entities to apply the recognition exemption more broadly. This can significantly reduce the number of leases requiring on-balance sheet recognition.
• Lessee’s Obtainable Borrowing Rate: FRS 102 introduces this as a simpler alternative to the incremental borrowing rate, easing the measurement burden.

These distinctions are important because they aim to make adoption of the new lease accounting standard more streamlined and practical for the diverse range of entities applying FRS 102 in the UK and the Republic of Ireland.

By taking these steps, your organisation can move beyond merely complying with the new FRS 102 lease accounting standards and instead leverage the transition to enhance financial transparency and strategic decision-making.

For expert guidance on navigating complex accounting standards and preparing your organisation for successful transitions, contact our team of professionals today.

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