The impact of FRS 102 lease accounting on valuations

The changes to UK accounting standards under FRS 102, taking effect for periods commencing 1 January 2026, include a major overhaul of the way that asset leases are handled. This new lease accounting model could profoundly impact the way businesses with high leasing costs are valued. It is therefore important for business-owners to understand the impacts of these changes.

How accounting for leases is changing

Until now:

• The costs associated with operating leases, such as office buildings, lorries, or pieces of factory machinery, were categorised as operating expenses
• The accounting treatment for operating expenses under FRS 102 is to simply charge them as an expense to the P&L, reducing the company’s profits
• The only record of the company’s contractual obligation to make further lease payments has been the addition of a note towards the end of the financial statements

The concern with the above approach is that those future leasing commitments, which for some companies can amount to millions of pounds, are then not included on the balance sheet. This potentially gives a misleading, inaccurate view of the company’s net assets.

The changes to FRS 102 reflect the main changes introduced to IFRS (IFRS 16) several years ago by bringing these assets and their associated liabilities on to the balance sheet at their  present value (i.e. the value of all future cash inflows and outflows associated with the asset, discounted to present value). This largely eliminates the operating lease as an accounting concept (with a few exceptions).

Each year ‘interest’ is accrued, and the assets are depreciated, with both of these amounts being charged to the P&L. The mechanics of this calculation result in the total annual associated expense reflected in the P&L being  higher than the cash payment in the first years of the lease and  lower in the latter years, but over the life of the lease the amount is the same. In this way the lease is included in both the P&L and the balance sheet.

Watch our video for an introduction to the effect of the FRS 102 changes on lease accounting

An illustration

Company A enters into a five-year property lease on 1 January 2026, the first day of its financial year, at a cost of £100,000 per year, equal to £500,000 over the term of the lease.

Under the old rules, Company A would recognise an expense of £100,000 on its P&L each year for the five-year duration. No asset or liability would be recognised on the balance sheet.

Under the new rules, this asset is brought onto the balance sheet from the outset, at its net present value, discounted at an incremental borrowing rate.

(As these payments will be made in the future, and, in principle, future money is worth less than current money, the value of these payments is discounted to present terms. The annual finance charge, using the same rate as the original discount, brings these back to the present value at that time.)

If, Company A’s incremental borrowing rate is 4%, then:

• The opening balance for the asset, and the corresponding opening liability, will be £445,182
• The asset will then be depreciated over the period of the lease, i.e. £445,182 / 5 years = £89,036 per year
• The company will also recognise a finance charge of 4% of the balance of the liability, i.e. £445,182 x 4% = £17,807 in the first year, and reducing the liability by the £100,000 rent actually paid

The table below sets this out:

And the closing balances in subsequent years:

Impact on valuations

This revised model for the handling of leases will have an interesting, twofold knock-on effect on the valuations of companies with significant leasing costs.

EBITDA

Typically, trading and profitable SMEs are valued on a multiple of their normalised EBITDA (earnings before interest, tax, depreciation and amortisation).

Under the new rules, instead of the costs of the lease falling under operating costs, which are included in the EBITDA figure, the costs are instead categorised as depreciation and interest expenses, which are added back to the company’s profit in order to arrive at EBITDA.

This means that, in the case of Company A above, its EBITDA in the first year will be increased by £100,000 over what it would have been previously. After applying an appropriate multiple, Company A’s enterprise value could be increased significantly.

Net cash/debt

The second effect relates to the next part of the valuation process, where the company’s net cash/debt is added to the enterprise value to arrive at the equity value (the value that a buyer would pay to the shareholders for their shares in the company).

Under the new rules  , Company A has additional debt of £362,990 at 31 December 2026, thus decreasing the company’s equity value. This figure could increase even more dramatically for businesses with significant leasing costs.

Although the increase in debt is offset by the increase in EBITDA, for companies with lease terms of seven or more years, the additional liability will exceed the benefit from the increased enterprise value, resulting in an overall decrease in equity value.

The future

Looking ahead, it will be interesting to see how the M&A adviser community handles these effects.

Will the multiples used to value companies with high leasing costs be reduced to balance the increased EBITDA? Or will such businesses see a general rise in value off the back of this new accounting treatment?

And how will the increased liabilities be viewed? Will they be accepted as a new reality? Or will advisers instead reject them as debt-like and not include them in net cash calculations.

It is likely that, for transactions already in progress when the new accounting policies have been adopted, EBITDA and debt figures will be adjusted to reflect the old treatment, with which people are already familiar. However, it is inevitable that, over time, transactions will be concluded based on figures reported under the new rules.

It is our opinion that the likeliest outcome is that EBITDA multiples will be adjusted to reflect the increased EBITDA and debt that target companies will report.

How BKL can help

Our corporate finance team have a wealth of experience valuing SMEs across a range of industries, for a wide variety of needs, including:

• EOT disposals
• Shareholder exits
• Fundraising
• Taxation reasons
• Issuing share options or growth shares
• Litigation support
• Divorce/probate

We have deep expertise in many valuation methods, ensuring that the most correct method is used to value your business, and that the valuation you receive is fair and accurate.

We’re experienced at guiding business owners and their teams through the practical impacts of changes to accounting standards, including FRS 102. We’re here to help you to navigate the changes to both lease accounting and revenue recognition– from explaining the effect on your numbers to improving your systems and processes – so that you maintain clear, compliant financial reporting as you take your business forward.

For a chat about how we can help your business, get in touch with Daniel Shear or Mendy Shollar from our corporate finance team, or send us an enquiry.