The 2025 FRS 102 changes will bring most leases onto the balance sheet, with potentially significant implications for reported assets, liabilities, EBITDA and loan covenants. With the changes applying to accounting periods beginning on or after 1 January 2026, now is the time to understand the impact on your business, your results and your financing arrangements — well before your first affected year end, which for many providers will be 31 December 2026.
Leasing is central to many residential care businesses. From long-term property leases for care homes to vehicles, specialist equipment, office equipment and technology, these arrangements can represent a significant financial commitment. Under revised FRS 102, the accounting changes substantially for lessees. With limited exceptions, the distinction between operating and finance leases will disappear, bringing leases onto the balance sheet.
For residential care providers, this is more than an accounting change.
Long-term, high-value property leases could result in substantial right-of-use assets and lease liabilities. This may affect reported net assets, gearing and EBITDA, change how costs are recognised in the profit and loss account, and influence loan covenant calculations. Understanding these implications early will help you plan ahead, manage potential risks and avoid unwelcome surprises.
What is changing?
A lease is a contract, or part of a contract, that conveys the right to use an identified asset for a period of time in exchange for consideration. Care providers should therefore look beyond agreements labelled “lease”. A wider service contract may contain an embedded lease if it gives the provider control over the use of a specified asset. Conversely, an arrangement with a rolling notice period or no right to use a specific asset may fall outside the definition.
For a qualifying lease, the lessee will generally recognise:
- A lease liability: Initially measured at the present value of future lease payments; and
- A right-of-use asset: Initially based on the lease liability and adjusted for items such as advance payments, lease incentives, reinstatement obligations and relevant initial costs.
The familiar straight-line operating lease rental charge will be replaced by depreciation of the right-of-use asset and a finance cost on the lease liability. The finance cost is highest at the start of the lease and reduces as the liability is repaid. As a result, the total accounting charge is normally front-loaded: higher in the early years and lower in the later years than the straight-line rental expense that would previously have been recognised – in exactly the same way that you home mortgage unwinds.
Recognition exemptions
Two exemptions may reduce the administrative burden. A lease may remain off the balance sheet where its term at inception is 12 months or less and it contains no purchase option, or where it relates to a low-value asset. Phones, laptops, tablets and small office equipment may qualify as low-value assets whereas land and buildings, motor vehicles, aircraft and ships do not. The test concerns the value and nature of the underlying asset, not whether the lease payment is immaterial to the organisation.
Lease term and discount rate
The lease term begins with the non-cancellable period. It also includes an extension period where the provider is reasonably certain to exercise an extension option, and the period after a break clause where it is reasonably certain not to exercise that break. This judgement may be particularly important where continuity of care, local commissioning relationships, planning restrictions, the cost of relocating residents or significant investment in a property make continued occupation more likely.
Future payments are discounted using a prescribed hierarchy. Firstly the interest rate inherent in the lease, if it can be determined, otherwise the incremental borrowing rate. Secondly the obtainable borrowing rate, and thirdly as a last resort, the deposit rate. Selecting and documenting the rate will be a key judgement, especially for property leases where the inherent rate may not be readily observable.
Why the balance sheet impact matters
The most visible change will be the grossing-up of the balance sheet. A provider with leased care homes may recognise sizeable right-of-use assets together with corresponding lease liabilities. The right-of-use asset must be shown as a separate balance sheet line item or as a separate class within fixed assets. The liability will normally be split between amounts due within and after one year.
This presentation can materially change how the organisation appears to directors, lenders, commissioners and other stakeholders. Total assets and reported debt will rise. Net assets may also change on transition or over the life of a lease because the right-of-use asset and lease liability do not subsequently reduce at the same rate. The larger asset base may affect size thresholds and related reporting requirements, while higher reported indebtedness may affect gearing measures.
Impact on the profit and loss account or SoFA
Under the current operating lease model, rent is generally recognised on a straight-line basis. Under the new FRS102, that single rental charge is replaced by two components – depreciation and finance cost. Although total expense over the full lease term is unchanged, its timing changes. The combined depreciation and interest charge will usually exceed the old straight-line rental charge in the early years and fall below it in later years.
EBITDA will generally increase because the operating rental expense is removed and replaced by depreciation and finance cost, both of which sit below EBITDA. However, operating surplus, surplus before tax and other performance measures may move differently depending on how they are defined. Management information, budgets, forecasts and board reporting should therefore be recast so that like-for-like performance remains clear.
Loan covenants: An early conversation is essential
Lease accounting can improve some covenant measures and weaken others. EBITDA-based interest cover may improve because lease rentals are no longer included in operating costs. By contrast, debt, gearing and debt-to-EBITDA measures may deteriorate if recognised lease liabilities are included within covenant debt. Measures based on net assets or tangible net worth may also be affected.
The accounting outcome does not by itself determine the covenant outcome. The wording of each facility agreement is critical. Some agreements use frozen generally accepted accounting practice, some automatically follow changes in accounting standards, and others contain negotiated adjustments for lease liabilities or right-of-use assets. Providers should model each covenant using the contractual definitions, identify headroom under the new basis and engage with lenders well before the first reporting date. Where necessary, amendments or waivers should be agreed before a technical breach occurs.
Worked examples
The financial effect is illustrated in the worked calculations in Appendix 1. Example 1 shows the accounting for a new ten-year property lease with a rent-free first year. Example 2 shows the modified retrospective transition for an equivalent lease with five years remaining at 1 January 2026.
Other issues for residential care providers
- Property reinstatement obligations: Dilapidation or reinstatement provisions may need to be recognised separately, with the initial cost added to the right-of-use asset.
- Rent reviews: Variable payments linked to an index or rate are included using the index or rate at commencement. Subsequent differences require appropriate accounting.
- Break and extension clauses: Decisions should reflect operational realities, including the effect on residents, staffing, registration and local authority or NHS commissioning arrangements.
- Donated or subsidised facilities: Peppercorn or below-market arrangements require separate consideration. A peppercorn arrangement may not meet the definition of a lease, while a discounted lease may create donated facilities income and a right-of-use asset that differs from the lease liability.
- Embedded leases: Contracts for equipment, vehicles, catering, laundry or technology should be reviewed to determine whether they convey control over an identified asset.
Disclosures and ongoing accounting
Accounts will need to identify right-of-use assets separately and explain material lease arrangements, including future cash flows, commitments and options, restrictions or covenants, and the nature of the discount rates used. Additional disclosures may be needed for modifications, peppercorn rentals, donated facilities and sale-and-leaseback transactions.
Lease estimates must also be kept under review. A change in an option assessment, lease term or future payments may require the liability to be remeasured with a corresponding adjustment to the right-of-use asset. A negotiated change to the scope or consideration of a lease may be a lease modification and can produce a gain or loss.
Let’s get prepared!
- Know what you’re working with: Build a complete register of property, vehicle, equipment and embedded leases.
- Get clear on exemptions: Identify eligible short-term and low-value leases, and document your rationale.
- Capture the detail: Bring together payment schedules, rent-free periods, incentives, indexation, break clauses, extension options and reinstatement obligations.
- Get the judgements right: Determine and evidence lease terms and discount rates for each material lease.
- Understand the financial impact: Model transition adjustments and map out future depreciation and finance costs.
- Look beyond the balance sheet: Reforecast the impact on your profit and loss account or SoFA, cash flows and key performance indicators.
- Protect your covenants: Recalculate loan covenants using the exact definitions in your facility agreements, and speak to lenders early if issues could arise.
- Get your business ready: Update accounting policies, disclosures, budgets, board reporting and internal controls.
Conclusion
FRS 102 brings lease commitments into sharper focus, with potentially significant implications for residential care providers with long-term property leases. Recognising leases on the balance sheet and replacing rent with depreciation and finance costs will change how expenditure is reported and when it hits the accounts.
The impact on loan covenants will depend on the wording of individual agreements, making early preparation essential. Start gathering the data, modelling the impact and engaging with lenders now to avoid surprises, understand the implications for your business and ensure a smoother transition. If you would like to discuss any of the above in further detail, please reach out to me directly.
Appendix 1: Worked example calculations
Example 1: New ten-year property lease
Assumptions: The lease commences on 1 January 2026, runs for ten years with no break clause, includes a 12-month rent-free period, requires annual payments of £120,000 on the first day of each rental year, and uses a 5% discount rate.
Initial lease liability: The nine payments of £120,000 are discounted to their present value at 5%, producing an opening lease liability of approximately £853,000. The right-of-use asset is initially equal to £853,000, assuming there are no initial direct costs, advance payments, reinstatement obligations or other adjustments. Straight-line depreciation over ten years is therefore £85,300 per year.
| Year | Cash payment | Old straight-line rental charge | Finance cost | Depreciation | Total new charge |
| 2026 | £nil | £108,000 | £42,600 | £85,300 | £127,900 |
| 2027 | £120,000 | £108,000 | £38,800 | £85,300 | £124,100 |
| 2028 | £120,000 | £108,000 | £34,700 | £85,300 | £120,000 |
| 2029 | £120,000 | £108,000 | £30,500 | £85,300 | £115,800 |
| 2030 | £120,000 | £108,000 | £26,000 | £85,300 | £111,300 |
| 2031 | £120,000 | £108,000 | £21,300 | £85,300 | £106,600 |
| 2032 | £120,000 | £108,000 | £16,300 | £85,300 | £101,600 |
| 2033 | £120,000 | £108,000 | £11,200 | £85,300 | £96,500 |
| 2034 | £120,000 | £108,000 | £5,600 | £85,300 | £90,900 |
| 2035 | £120,000 | £108,000 | £nil | £85,300 | £85,300 |
| Total | £1,080,000 | £1,080,000 | £227,000 | £853,000 | £1,080,000 |
Year-one balance sheet: The lease liability increases from £853,000 to approximately £895,700 because no cash payment is made in 2026 and finance cost of £42,600 is added. The right-of-use asset reduces to approximately £767,700 after depreciation of £85,300. Compared with the old straight-line rental charge, the 2026 profit and loss charge is £19,900 higher. EBITDA is £108,000 higher before any covenant-specific adjustments because the rental expense is replaced by depreciation and finance cost.
Example 2: Transition for an existing lease
Assumptions: The lease has the same original terms as Example 1 but commenced on 1 January 2021. Five annual payments of £120,000 remain at 1 January 2026. The present value of those payments at 5% is approximately £545,500. The opening right-of-use asset is adjusted for the £60,000 lease incentive balance carried forward at 31 December 2025, producing an opening asset of approximately £485,500. Depreciation over the remaining five-year term is £97,100 per year.
| Year | Cash payment | Old straight-line rental charge | Finance cost | Depreciation | Total new charge |
| 2026 | £120,000 | £108,000 | £21,300 | £97,100 | £118,400 |
| 2027 | £120,000 | £108,000 | £16,300 | £97,100 | £113,400 |
| 2028 | £120,000 | £108,000 | £11,200 | £97,100 | £108,300 |
| 2029 | £120,000 | £108,000 | £5,700 | £97,100 | £102,800 |
| 2030 | £120,000 | £108,000 | £nil | £97,100 | £97,100 |
| Total | £600,000 | £540,000 | £54,500 | £485,500 | £540,000 |
2026 closing position: After adding the finance cost of £21,300 and deducting the £120,000 payment, the lease liability is approximately £446,800. After depreciation of £97,100, the right-of-use asset is approximately £388,400. The 2026 profit and loss charge is £118,400, which is £10,400 higher than the old straight-line rental charge. Comparatives are not restated under the modified retrospective approach, so the transition adjustment and reduced comparability should be explained clearly.
