From 1 January 2026, FRS 102 Section 20 requires UK and Republic of Ireland organisations to bring most leases onto the balance sheet. The rental expense that previously sat as a single line in your profit and loss account is replaced by two different charges: depreciation on the right-of-use (ROU) asset and interest on the lease liability. This changes the geography of your P&L, lifts your reported EBITDA, and adds lease liabilities to your net debt figure, even though the cash leaving your business each month is exactly the same as it was before.
This post is designed as a briefing document: something a Finance Director can share with a CEO, CFO, or board to explain why the financial statements look different after the first set of FRS 102-compliant accounts. The numbers used throughout are illustrative but realistic for a mid-market business with approximately £2 million of lease liabilities. If you want the broader context on what FRS 102 requires and how to transition, start with our overview: FRS 102: what UK businesses need to know about the new standard.
Updated May 2026.
Under the previous FRS 102 model, leases were classified as either finance leases or operating leases. Finance leases (broadly, those that transferred substantially all risks and rewards of ownership to the lessee) appeared on the balance sheet. Operating leases did not. For most UK organisations, the majority of leases covering office space, vehicles, equipment, and shopfronts fell into the operating lease category and were expensed as a straight rental charge each period.
A company paying £500,000 per year in rent simply recorded £500,000 in operating expenses. The lease obligation itself (the commitment to pay rent for the next five or ten years) appeared only in the notes to the accounts, invisible on the face of the balance sheet.
That rental charge sat above the EBITDA line. It reduced operating profit alongside wages, cost of goods, and other operating costs. Every pound of rent directly reduced EBITDA.
Under FRS 102 Section 20, the single rental expense line disappears from the P&L and is replaced by two separate charges that appear in different parts of the income statement: depreciation on the ROU asset (above EBIT, in operating expenses) and interest on the lease liability (below EBIT, in finance costs). The total cash paid to the landlord or lessor does not change; only the classification of that cash outflow within the financial statements changes.
The total P&L charge across depreciation and interest will not be identical to the old rental expense, and it will not be constant year on year. In the early years of a lease, interest is higher because the liability balance is larger. In later years, interest falls as the liability is repaid. Depreciation, by contrast, runs straight-line throughout. Over the full life of the lease, the total P&L charge is broadly similar to what the total rental expense would have been, but the timing and the classification of each component are different.
The key point: none of this changes the cash leaving your business. The same rent cheque goes out each month. What changes is how that cash flow is reflected in the financial statements, and that distinction matters enormously when you are explaining the numbers to a board, a banker, or a bonus committee.
For a detailed explanation of how the ROU asset is measured and depreciated under FRS 102, see our guide: FRS 102 right-of-use assets: a plain-English guide.
FRS 102 Section 20 increases most organisations' reported EBITDA, because the rental expense that previously reduced EBITDA is replaced by depreciation (which is added back in the EBITDA calculation) and interest (which sits below EBIT and is also added back). The full value of the old rental charge is effectively removed from the EBITDA line, even though the underlying cash cost is identical.
A business that paid £500,000 in annual rent will see its reported EBITDA increase by approximately £500,000, not because the business is performing better, but because the accounting treatment of that cash outflow has changed. The depreciation charge (say, £400,000) reduces operating profit but is added back for EBITDA. The interest charge (say, £80,000) reduces profit before tax but is also added back for EBITDA. The net effect: EBITDA rises by the full amount of the old rental charge, while the business has not generated a single additional pound of cash.
This is a reclassification, not a windfall, but it has real consequences for how the business is perceived, how performance targets are measured, and how loan covenants are tested.
Worked example: the EBITDA mechanics in practice
| P&L line item | Old FRS 102 (pre-2026) | New FRS 102 (from 1 Jan 2026) |
|---|---|---|
| Revenue | £5,000,000 | £5,000,000 |
| Operating costs (excl. rent/depreciation) | (£3,700,000) | (£3,700,000) |
| Operating lease rental expense | (£500,000) | nil |
| ROU asset depreciation | nil | (£400,000) |
| EBITDA | £800,000 | £1,300,000 |
| Less: depreciation (add-back reversed) | nil | (£400,000) |
| EBIT (operating profit) | £300,000 | £900,000 |
| Interest on lease liability | nil | (£80,000) |
| Other interest (bank borrowings) | (£25,000) | (£25,000) |
| Profit before tax | £275,000 | £795,000 |
Assumptions: revenue of £5m; operating costs excluding rent of £3.7m; annual rent of £500,000 on a 5-year lease with £2m of lease liabilities; obtainable borrowing rate of 4% giving first-year interest of approximately £80,000; straight-line depreciation of £400,000 per year; bank borrowings of £500,000 at 5%. Numbers are illustrative.
Notice that profit before tax is actually higher under the new standard. In year one, the combined depreciation plus interest charge (£480,000) is less than the rental expense it replaces (£500,000). The gap narrows in later years as the liability balance falls and the interest charge declines with it. The headline message is clear: EBITDA has risen by £500,000 purely because of a change in how the same cash expenditure is classified.
At the transition date (1 January 2026 for calendar-year businesses), organisations recognise both a right-of-use asset and a lease liability for each qualifying lease. Both are recognised at the same amount on transition: the present value of future lease payments discounted at the obtainable borrowing rate or incremental borrowing rate. Net assets do not change on day one, but the balance sheet grows on both sides simultaneously.
For a business with a property portfolio generating £500,000 of annual rent across several five-year leases, the total lease liability at transition could be approximately £2 million. That amount is added to both sides of the balance sheet at once: assets increase by £2 million (the ROU asset) and liabilities increase by £2 million (the lease liability). For the detailed mechanics of how the lease liability is measured, see our guide: What is a lease liability under FRS 102?
The balance sheet and P&L changes cascade into the financial ratios that lenders, investors, and boards use to assess the business. The changes are structural and material for any organisation with significant lease obligations.
| Metric | Old FRS 102 | New FRS 102 | Direction |
|---|---|---|---|
| EBITDA | £800,000 | £1,300,000 | Increases |
| Total assets | £3,000,000 | £5,000,000 | Increases |
| Total liabilities | £1,500,000 | £3,500,000 | Increases |
| Net debt (incl. lease liabilities) | £500,000 | £2,500,000 | Increases |
| Net debt / EBITDA | 0.6x | 1.9x | Worsens (higher) |
| Gearing (total debt / equity) | 33% | 117% | Worsens (higher) |
| Interest cover (EBIT / total interest) | 12.0x | 8.6x | Worsens (lower) |
Same business. Same cash flows. The ratios look materially different because the lease liability is now on the balance sheet. Finance Directors should run these pro-forma calculations for their own portfolios before the first set of FRS 102-compliant accounts is published.
Gearing is where the balance sheet change creates the most immediate practical risk. Most definitions of net debt (whether used internally, in analyst reports, or in loan covenants) now include lease liabilities as debt. A business that carried £500,000 of bank borrowings and no balance sheet lease liabilities under old FRS 102 now shows £2.5 million of net debt, because the £2 million lease liability is added to the calculation.
Consider a loan agreement with a covenant limiting net debt to EBITDA to no more than 2.0x. Under old FRS 102, the ratio was 0.6x, comfortably within the limit. Under new FRS 102, the same business, with the same cash flows and the same bank debt, reports a ratio of 1.9x. The covenant is not breached, but the headroom has been almost entirely consumed. A single bad quarter could now trigger a breach.
The recommended course of action is to model the post-FRS 102 version of every ratio your loan agreement tests, before your accounts are finalised. Where headroom has been compressed, you need to know in advance.
For businesses with bank lending, FRS 102 creates a covenant risk that has nothing to do with underlying financial performance. Most commercial loan agreements contain covenants that test the borrower's financial health at set intervals, using metrics such as maximum net debt to EBITDA, minimum interest cover, minimum EBITDA, or maximum total gearing.
The practical reality in 2026: most banks are continuing to test covenants on a frozen GAAP basis during the transition period. In plain terms, this means your lender is likely calculating covenant ratios using the pre-FRS 102 accounting treatment, effectively the old operating lease model, even after you have adopted the new standard. Most commercial lenders recognise the mechanical nature of the accounting change and are applying frozen GAAP clauses as a default where the loan agreement permits, so this is not a formal concession from the FCA or a sector-wide mandate.
You should not assume this applies to your facility without checking. The position depends on the specific wording of your loan agreement, and not all facilities contain frozen GAAP protection. There are two clause types to look for:
The recommended course of action is to contact your lender or relationship manager before your first FRS 102-compliant accounts are prepared. Share the pro-forma impact on your covenant ratios, ask explicitly whether frozen GAAP treatment applies to your facility, and get the position confirmed in writing. Most lenders are already familiar with the issue and will have a standard response ready. Early contact avoids the much more difficult conversation of explaining a near-breach or a technical breach after the accounts have been filed.
If any part of your management team's remuneration is linked to EBITDA, profit before tax, or earnings per share, FRS 102 creates a remuneration committee problem. The EBITDA uplift from the new standard is a product of accounting reclassification, not business performance. A management team that hits its EBITDA target only because the accounting treatment of rent changed has not earned an EBITDA-linked bonus in any meaningful sense.
There are three practical responses, and the right one depends on how your scheme is structured:
The remuneration committee should review the scheme documentation before the financial year in which FRS 102 first applies. Waiting until after the bonus is calculated creates a much more difficult conversation.
The biggest risk in the first year of FRS 102 compliance is perception, not arithmetic. A board that sees EBITDA rise by £500,000 and total debt increase by £2 million in the same year, without prior explanation, will ask questions that take time to answer. Investors and lenders looking at the accounts without context may draw the wrong conclusions.
The same cash flows of the business are unchanged. The same underlying profitability is unchanged. The accounts look different because the rules for how leases are reported have changed, not because the business has changed. That explanation is simple and accurate, but it needs to be made proactively, before the accounts are published.
A brief note in the CFO's narrative section of the accounts, explaining the transition and quantifying the impact on each affected metric, is the minimum. For businesses with significant investor or lender relationships, a short briefing document (along the lines of what this post provides) prepared in advance of first publication is worth the investment of time.
All of the analysis in this post depends on one thing: accurate lease data. The pro-forma covenant calculations, the remuneration committee briefings, the investor communications: all of them require a complete and up-to-date record of every lease in your portfolio, including term, payments, options to extend, and the correct obtainable borrowing rate.
The LOIS platform is purpose-built to calculate and maintain FRS 102 lease liabilities and ROU assets, produce the amortisation and depreciation schedules that feed directly into P&L and balance sheet journals, and generate the disclosure notes your auditors will require. For businesses running their lease portfolio on spreadsheets, the transition to FRS 102 is a natural point to move to a system that keeps this data accurate, auditable, and current.
If you are working through your FRS 102 transition and want expert support alongside the platform, read more about our managed lease accounting service. If you are working through your FRS 102 transition and want a complete checklist of the steps involved, start with our FRS 102 Section 20 transition guide.
Does FRS 102 increase or decrease EBITDA?
FRS 102 Section 20 increases reported EBITDA for most organisations. The operating lease rental expense, which previously reduced EBITDA directly, is replaced by depreciation (added back in the EBITDA calculation) and interest (which sits below EBIT and is also added back). A business paying £500,000 in annual rent will typically see reported EBITDA increase by approximately £500,000. This is a reclassification of a cash outflow, not a genuine improvement in business performance.
Can FRS 102 trigger a loan covenant breach?
It can, particularly where loan agreements define net debt without a carve-out for lease liabilities. In practice, most banks are continuing to test covenants on a frozen GAAP basis during the transition period, using the pre-FRS 102 accounting treatment. However, this varies by facility and lender. Finance Directors should check their specific loan agreement wording and confirm the position with their relationship manager before the first FRS 102-compliant accounts are published.
What is a frozen GAAP clause?
A frozen GAAP clause in a loan agreement specifies that financial covenants are calculated using the accounting policies in effect at the date the loan was originally signed. Where a frozen GAAP clause applies, FRS 102 lease liabilities would not be included in net debt for covenant testing purposes, even after the new standard takes effect. In practice, many banks are applying frozen GAAP treatment as a default during the FRS 102 transition period, but you should confirm this with your lender rather than assuming it applies.
Do bonus schemes need to be adjusted for FRS 102?
If bonus targets are based on reported EBITDA, operating profit, or earnings per share, the answer is almost certainly yes. The EBITDA uplift from FRS 102 is a product of accounting reclassification, not business performance. Remuneration committees should review scheme documentation before the financial year end in which FRS 102 first applies.
Does FRS 102 change total profit before tax?
In the early years of a lease, profit before tax is often slightly higher under the new standard than it would have been under the old treatment. This is because the combined depreciation and interest charge is marginally lower than the rental expense in year one. Over the full lease term, the total P&L impact is broadly similar to what the rental expense would have been. The difference is timing and classification, not total quantum.