FRS 102 Section 20: What UK SMEs Need to Know Before December 2026

If your company reports under FRS 102 and has leases for offices, vehicles, equipment, IT hardware or other business assets, the accounting is changing.

The revised lease accounting requirements in FRS 102 Section 20 apply for accounting periods beginning on or after 1 January 2026. For companies with a 31 December year end, that makes 31 December 2026 the first mandatory reporting date affected by the new model.

The change is significant. Most leases that were previously treated as operating leases will now be recognised on the balance sheet. Instead of a single lease expense passing through the profit and loss account, the lessee recognises a right-of-use asset and a corresponding lease liability.

That affects more than the accounting entries. Total assets increase. Liabilities increase. EBITDA may change. Net debt and gearing may change. Covenant calculations may need to be revisited. Audit evidence will also need to be stronger, because lease accounting becomes a balance sheet exercise rather than a note disclosure exercise.

Here is what UK SME finance teams need to know.

What is changing

Under the previous FRS 102 model, operating leases were generally expensed on a straight-line basis over the lease term. The lease did not appear as an asset and liability on the balance sheet. Instead, future lease commitments were disclosed in the notes.

The revised Section 20 moves lessee accounting closer to the IFRS 16 approach. The FRC describes the revised Section 20 as an on-balance-sheet lease accounting model, based on IFRS 16 but with simplifications and modifications for FRS 102 preparers.

In practice, lessees will usually need to:

recognise a right-of-use asset for the right to use the leased asset
recognise a lease liability for future lease payments
depreciate the right-of-use asset over the lease term
unwind interest on the lease liability using an appropriate discount rate
present lease costs differently, with depreciation and interest replacing the single operating lease expense line

The total cost over the lease term does not change simply because the accounting model changes. What changes is the timing and presentation of that cost.

For many SMEs, the most visible effect will be that operating lease rental expenses move out of operating expenses and are replaced by depreciation and finance costs. EBITDA often increases, while lease liabilities increase at the same time. Where lease liabilities are included in debt measures, net debt and gearing may also increase.

Who is affected

The changes affect UK and Irish entities reporting under FRS 102 that have leases as a lessee. In practical terms, this includes many SMEs, LLPs, charities and other entities with:

office or warehouse leases
vehicle leases
plant and machinery leases
IT and office equipment leases
embedded leases within wider service contracts

There are exemptions, but they need to be applied carefully.

Short-term leases may remain off balance sheet where the lease term is 12 months or less and the relevant exemption is applied. There is also an exemption for leases of low-value underlying assets. However, the low-value assessment is based on the value and nature of the underlying asset, not the size of the monthly payment.

That distinction matters. Revised FRS 102 gives examples of assets that would not be considered low value, including cars, vans, trucks, forklifts, land and buildings, aircraft, railway rolling stock and production line equipment. That means many common SME leases still come into scope, even where the monthly payment is not large. A low-cost van, forklift or small office lease is not automatically a low-value lease for FRS 102 purposes.

The practical message is simple: do not screen leases only by monthly rent. Start with the contract and the underlying asset, then decide whether an exemption is available.

What this means for your numbers

The balance sheet impact can be immediate and material.

Metric	Before revised Section 20	After revised Section 20
Total assets	No operating lease asset	Right-of-use asset recognised
Total liabilities	No operating lease liability	Lease liability recognised
EBITDA	Reduced by operating lease expense	Often increases, because depreciation and interest replace lease expense
Net debt	Usually excludes operating leases	May include lease liabilities, depending on covenant definitions
Gearing	Lower	Often higher
Interest cover	No lease interest expense	Lease interest expense recognised

For companies with bank covenants, the accounting impact should be assessed before the year-end process starts. The issue is not only whether the statutory accounts are correct. It is whether loan agreements, management reporting and lender conversations still work once lease liabilities are included.

A covenant that was comfortable under the old operating lease model may look different once office leases, vehicles and equipment leases are recognised as liabilities.

The discount rate: constructed IBR explained

Under FRS 102, the discount rate requirements give lessees a practical route through the obtainable borrowing rate, or OBR. The FRC highlights the introduction of the lessee’s obtainable borrowing rate as an alternative to the lessee’s incremental borrowing rate (IBR).

In practice, however, determining and evidencing an OBR can still require judgement. Some companies have a recent bank quote or comparable borrowing arrangement. Many do not. Even where borrowing evidence exists, it may not match the lease term, asset type, security profile or measurement date.

LeaseAccounting.app takes a more automated approach by constructing a defensible incremental borrowing rate (IBR) instead of asking users to determine an OBR manually.

The user completes a light initial setup based on the company’s borrowing profile. After that, the system constructs a timely IBR whenever one is needed.

For UK customers, base rate inputs are drawn automatically from sources such as the Bank of England and the UK gilt yield curve. The system then combines those reference rates with the company’s borrowing profile and lease-type-specific adjustments. This means the rate is constructed for the relevant measurement date, rather than reused from a stale spreadsheet or manually rebuilt each time.

As long as the company’s borrowing profile or size does not change materially, the same methodology can be applied consistently to new leases and to lease modifications that require a revised discount rate, without additional user input.

This reduces the need to collect lease-by-lease bank quotes or manually build proxy rates in spreadsheets. It also creates a documented, repeatable methodology that can be reviewed with auditors and applied consistently across a growing lease portfolio.

Step-by-step transition guide

Step 1: Identify all leases in scope

Start by building a complete lease register. Include property, vehicles, equipment, IT assets and any service contracts that may contain an embedded lease.

This step often takes longer than expected. Lease data is rarely held in one place. Property leases may sit with operations, vehicle agreements with HR or fleet managers, and equipment contracts with local site teams.

The goal is not just to list obvious lease agreements. It is to identify every contract that gives the business the right to use an identifiable asset for a period of time. A useful starting point is to review supplier ledgers, fixed asset records, property schedules, fleet records and recurring service contracts.

Step 2: Extract and confirm the lease data

For each lease, the accounting depends on the contract terms: commencement date, lease term, payment schedule, rent-free periods, incentives, extension or break clauses, indexation, rent reviews, service components and other relevant terms.

Traditionally, this meant reading the agreement manually and keying those details into a spreadsheet or lease accounting tool. That is slow, repetitive and easy to get wrong.

LeaseAccounting.app is designed to remove most of that manual work. The user uploads the lease agreement, and the AI extraction tool reads the document and pre-fills the lease setup form. It identifies the key commercial terms, extracts the payment profile, flags clauses that may affect the accounting, and surfaces judgement points for review.

The user does not need to manually enter every commencement date, payment frequency or fixed payment schedule. Instead, the user reviews the extracted data, confirms the proposed treatment, and provides input only where judgement or external information is needed.

For example, where a lease contains indexation or an open market rent review and the current payment no longer matches the original contract schedule, the system may ask for the latest rent amount or recent payment evidence. Where the lease contains an extension option or break clause, the user may need to confirm whether that option is reasonably certain to be exercised.

The important distinction is that the system does the extraction and calculation work, while the user remains responsible for the accounting judgements that only the business can make.

Step 3: Apply a constructed discount rate

Once the lease terms have been extracted and confirmed, the system applies the discount rate needed to measure the lease liability.

This is one of the areas auditors are most likely to scrutinise, because the discount rate affects the initial lease liability, the right-of-use asset and the interest profile over the lease term.

LeaseAccounting.app’s Discount Rate Advisor is designed to make this process consistent and scalable. After the initial company-level setup, the system constructs the IBR automatically using three inputs:

the relevant base rate for the measurement date
the company’s borrowing profile
lease-type-specific adjustments reflecting the nature and term of the lease

For UK customers, the reference rate inputs are drawn automatically from sources such as the Bank of England and the UK gilt yield curve. The system then applies the configured borrowing profile and lease-specific adjustments to construct the appropriate IBR.

This means the user does not need to rebuild a rate manually every time a lease is added or modified. When a new IBR is required, the system constructs one using the same documented methodology, with current reference rate inputs and a clear audit trail.

Step 4: Generate opening balances

At transition, leases that were previously treated as operating leases need to be brought onto the balance sheet. That requires a lease liability, a right-of-use asset and the related transition accounting.

The finance team still needs to make sure the lease population is complete and that the key judgements are right. But it should not need to calculate the balances manually.

Once the lease agreement has been uploaded, the extracted terms have been confirmed and the discount rate has been applied, LeaseAccounting.app calculates the opening lease liability and right-of-use asset automatically. It also produces the supporting schedule, including the liability unwind, depreciation profile and transition entries.

In most cases, the user’s role is to review and confirm. The main exceptions are judgement points that cannot be solved from the lease document alone, such as whether an extension option is reasonably certain to be exercised, whether a break clause affects the lease term, or whether a current rent amount has changed after indexation or review.

This is where the process becomes more controlled than a spreadsheet. The system directs the user to the few decisions that matter, rather than expecting them to build the full model manually.

Step 5: Set up ongoing accounting

Lease accounting is not a one-off transition exercise.

Once a lease is on the balance sheet, the finance team needs ongoing entries for depreciation, interest, lease payments, liability unwind, reassessments, modifications and expiries.

LeaseAccounting.app generates those journal entries for the user.

That matters because the operational burden of FRS 102 lease accounting is not only the first calculation. It is the recurring monthly or quarterly process: depreciation of the right-of-use asset, interest on the lease liability, reduction of the liability when payments are made, and adjustments when lease terms change.

In a spreadsheet, those entries are often built manually, copied from prior periods or maintained in separate workbooks. That creates version-control risk and makes it harder to explain the numbers during audit.

With dedicated software, the journal entries are generated from the same lease data, discount rate and calculation logic used to produce the lease schedules. The result is a cleaner link between the lease agreement, the accounting calculation, the journals and the audit evidence.

Step 6: Assess covenant impact

The revised lease model can affect covenant metrics even where the economics of the business have not changed.

Finance teams should model the impact on:

net debt
gearing
EBITDA
interest cover
asset-based ratios
any bespoke covenant definitions in facility agreements

The key point is timing. This should be done before the year-end audit, not during it. If covenant definitions need to be clarified with lenders, the conversation is much easier before the accounts are finalised.

Step 7: Prepare transition and year-end disclosures

The final step is disclosure.

The revised model requires more structured information about lease arrangements, right-of-use assets, lease liabilities and lease-related expenses. FRS 102 requires disclosure of several quantitative amounts, including interest expense on lease liabilities, expenses for short-term and low-value leases where exemptions are applied, variable lease payments not included in lease liabilities, total cash outflow for leases, and right-of-use asset information by class of underlying asset.

For practical purposes, finance teams should expect to prepare:

right-of-use asset movement schedules
lease liability movement schedules
maturity analysis of lease liabilities
interest expense
depreciation expense
short-term and low-value lease expense, where exemptions are applied
accounting policy notes
transition explanations

LeaseAccounting.app automates the quantitative part of this process. The system produces the lease schedules, movement tables, journal support and calculation evidence directly from the lease portfolio.

For the qualitative parts of the disclosure, the system can help draft disclosure wording for finance team review, based on the company’s lease data, accounting policy choices and transition approach. The finance team then reviews, edits and approves the disclosure language before it goes into the financial statements.

The aim is not to remove professional review. The aim is to make sure the numbers, schedules and narrative are prepared from the same underlying lease data, with fewer manual reconciliations at year end.

Timeline for December 2026 year ends

For calendar-year reporters, the first mandatory year affected is the year ending 31 December 2026. The effective date has already passed, so the focus should now move from general awareness to year-end readiness.

This is not only a December problem. If the company reports internally on a monthly or quarterly basis, lease accounting entries should already be running from 1 January 2026. If they are not, the finance team may need to catch up the transition calculation and the monthly journals before the year-end close.

Q2 2026: confirm the lease population and catch up any gaps

Confirm that all leases in scope have been identified, including property, vehicles, equipment and embedded leases in service contracts.

Where the lease accounting process has not yet been implemented, the priority is to catch up: upload contracts, confirm extracted terms, apply discount rates, calculate opening balances and generate journals from 1 January 2026 onward.

This is also the point to identify missing documents, unclear payment schedules and judgement-heavy leases before the year-end pressure begins.

Q3 2026: prepare the audit evidence

By Q3, the finance team should aim to have a clean lease register, documented discount rate methodology, confirmed lease-term judgements and generated journal entries.

This is the right time to produce the first evidence pack for auditor review. The goal is to resolve methodology questions before the year-end audit, not during it.

For companies with covenants, Q3 is also the right time to model the expected impact on gearing, net debt, EBITDA and interest cover.

Q4 2026: dry-run the year-end disclosure

In Q4, the focus should shift to year-end outputs.

Run the lease accounting process through to 31 December 2026, review the right-of-use asset and lease liability schedules, check journal postings, and prepare draft disclosure tables.

This is also a good time to give auditors structured access to the lease portfolio, so they can review the evidence before the final accounts process begins.

Early 2027: support the audit and finalise disclosures

For many SMEs, the most difficult part will not be calculating the lease liability. It will be answering auditor questions quickly and consistently.

Auditors may ask how the lease population was identified, how lease terms were determined, how discount rates were constructed, how modifications were handled, and how the disclosure numbers reconcile to the general ledger.

That is why the work needs to be done before the audit starts. If the lease portfolio is already in good order, the audit process becomes a review of structured evidence rather than a back-and-forth search through spreadsheets, contracts and email threads.

How the right tools help

Dedicated lease accounting software reduces the manual burden and makes the process easier to evidence. But the real value is not just calculation. It is moving the hard work to the right point in the process.

LeaseAccounting.app is built around that idea. The system does the work that can be automated, then directs the user to the parts that require business judgement.

AI lease extraction reads the lease agreement and pre-fills the lease setup form. It extracts key dates, payment terms, lease components, indexation clauses, rent reviews, options and other relevant terms from the document. The user reviews and confirms the extracted data instead of manually entering the lease from scratch.

This is more than basic OCR. OCR turns a document into text. AI lease extraction turns a lease agreement into structured accounting inputs, then highlights the areas where the user needs to make or confirm a judgement.

The Discount Rate Advisor constructs and documents a defensible IBR using automated reference rate inputs, company-level borrowing profile data and lease-specific adjustments. After the initial setup, the methodology can be applied consistently to future leases and lease changes.

Journal entries are generated directly from the lease calculation. The system produces the recurring entries for depreciation, interest, lease payments and liability unwind, so the finance team does not need to maintain a separate spreadsheet model to support monthly or quarterly accounting.

Evidence packs give finance teams a structured export of journals, schedules, assumptions and calculation evidence for audit review.

Vault is designed with the auditor workflow in mind. In a traditional process, auditors often receive a folder of lease agreements, spreadsheets and PDF schedules, then spend time working out what is missing, what changed and which assumptions need support. That creates back-and-forth, slows the audit and drains finance team time.

With Vault, the auditor can be given direct access to the lease portfolio in a structured environment. The auditor can review the lease data, supporting documents, rate evidence, judgement points, schedules and journals in one place. AI assistance helps the auditor work through the portfolio and identify the areas that need attention, rather than forcing the finance team to answer the same context-setting questions repeatedly.

For teams preparing for the 31 December 2026 year end, the benefit is consistency. The same lease data, rate methodology and calculation logic can be applied across the portfolio, with a clear audit trail from contract upload through to journal entries, disclosure schedules and auditor review.

The philosophy is simple: automate the work that software can do, surface the judgement calls that only the business can make, and complete the evidence trail before the audit begins.