In an attempt to better align UK GAAP to International Reporting Standards (IFRS), as part of the Financial Reporting Council’s (FRC) second periodic review, a number of revisions to FRS 102 and other UK and Republic of Ireland financial reporting standards (FRS) have been proposed that will have ramifications on entities that report under these reporting frameworks. The FRC have outlined these proposed changed in the Financial Reporting Exposure Draft (FRED) 82.
What are the amendments proposed by FRED 82 and how are they expected to impact the financial statements?
The areas of significant change are revenue recognition and lease accounting. The impact of FRED 82 will be significant for entities that apply FRS 102, including small companies reporting under FRS 102 section 1A, and micro entities reporting under FRS 105. It is important for entities to understand the potential impact that these amendments could have on their financial reports and consider preparing for their implementation now.
Revenue Recognition
Reporters under UK GAAP, including FRS 102, FRS 102 section 1A, and FRS 105 will be required to adopt the five-step model for revenue recognition from IFRS 15 Revenue from Contracts with Customers, with appropriate simplifications.
Currently, under FRS 102, revenue recognition is dependent on whether revenue is earned through the sale of goods, the rendering of services, or a construction contract and is relies on understanding when the risks and rewards are transferred to the customer. The proposed amendments are focused on when the promises under the contract are fulfilled.
Under the proposed amendments, entities will now be required to:
- Identify the contract(s) with a customer;
- Identify the promises in the contract;
- Determine the transaction price;
- Allocate the transaction price to the promises in the contract; and
- Recognise revenue when (or as) the entity satisfies a promise
How will the changes to revenue recognition impact my business and financial statements?
The extent to which this will change an entity’s revenue recognition in practice will depend on the form of its contracts with customers and could result in significant changes to the pattern of revenue recognition.
An entity would be required to assess the goods and services promised in a contract with a customer and identify each promise to transfer a distinct good or service (or a distinct bundle of goods or services). A promise is defined as an obligation to transfer a good or service (or bundle of goods or services) that is distinct.
A good or service that is promised by an entity to a customer is distinct if both, the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and the entity’s obligation to transfer the good or service is separate from other obligations in the contract.
For example, a business that sells a product that includes warranties, servicing and maintenance may need to unbundle the separate promises depending on the terms of the contract and assess whether the ‘add-ons’ constitute distinct good or service and recognise revenue for each separate promise.
Businesses that provide services or are in sectors that have long-term contracts, such as construction companies, telecoms and media, professional services and support services are most likely to be affected by this change.
Certain contracts include a non-refundable upfront fee at contract inception which tends to relate to an activity that the entity is required to undertake to fulfil the contract, but that activity does not directly transfer a good or service to the customer, for example, set-up fees in service contracts. If the non-refundable upfront fee does not relate to the transfer of a good or service, then it would be included in the transaction price and allocated to the promises in the contract.
What can I do now to prepare for this change?
An in-depth review of customer contracts should be undertaken to understand the promises within the contract, the transaction price that can be allocated to those promises and whether there is an enforceable right to payment for work completed to date. If it’s not clear from the current contracts that these exist, the terms may need to be amended.
On transition, companies will be able to take advantage of an exemption whereby the cumulative affect ofthe amendments can be recognised as an adjustment to the opening balance of each affected component of equity at the date of application, rather than apply a full retrospective approach. Businesses will need to consider whether they opt for this exemption or whether they restate comparatives fully.
Lease accounting
The amendment to Leases only applies to companies that report under FRS 102, including FRS 102 section 1A. The proposed amendments look to adopt the IFRS 16 Leases model which will require almost all leases to be brought on the balance sheet if the business is a lessee.
Under the proposed amendments, entities will now be required to:
- Recognise a right-of-use (ROU) asset in respect of the lease contract
- Recognise a corresponding lease liability being the present value of the remaining payments under the lease
The lease liability is measured at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate or lessee’s obtainable borrowing rate. In exceptional circumstances, the lessee can use the gilt rate. As with IFRS 16, certain exemptions will be applicable such as leases less than 12 months remaining at the transition date or leases for assets of low value. These leases are still able to be accounted for as operating leases, with the rent expense taken to the profit or loss over the course of the lease term.
What impact will the changes to lease accounting have on my financial statements?
Disclosure requirements will be more substantial, however on transition companies will be mandated to adopt a ‘simplified’ method where the cumulative impact of initially applying the amendments to the opening balance of retained earnings at the date of initial application is recognised.
Prior to the transition date, companies will not be required to reconsider whether an arrangement constituted a lease. In addition, a restatement of the prior year will not be required.
Adopting the lease accounting model will see significant changes in an entity’s financial reporting and companies should consider how this may impact stakeholders. On-balance sheet lease commitments will see in increase in both gross assets and liabilities. Operating profit will most likely increase as the unwinding of the lease liability will be recognised in finance costs. The profit or loss account will recognise a depreciation charge arising from the depreciating ROU asset.
Should companies use EBITDA (earnings before interest, tax, depreciation and amortisation) as a key measurement metric either internally or for the purposes of covenants, this will be distorted as the associated cost of the lease will now be a depreciation charge and added back for the purposes of calculating EBITDA.
Are there any other changes I should be aware of?
FRED 82 proposes a number of other changes, but not as significant as those discussed above. These include:
- Going concern: Previously ‘encouraged under FRS 102 section 1A, a mandatory going concern disclosure including disclosures relating to material uncertainties relating to events or conditions that may cast doubt on the ability of an entity to continue as a going concern as well as dividends declared and paid or payable during the period will be required.
- Fair value measurement: A new Section 2A replacing the Appendix Fair Value Measurement to Section 2 and updated to reflect the principles of IFRS 13 Fair Value Measurement
What should I do now?
The proposed effective date for the amendments is the accounting period beginning on or after 1 January 2026, with early application permitted provided all amendments are applied at the same time.
Companies should start planning well in advance of the transition date. This includes reviewing existing customer contracts, ensuring the new customer contracts are clear in understanding the promises within the contract.
In addition, companies should ensure all data related to leases are complete and accurate. A consideration over appropriate borrowing rates attached to each lease and review of the lease term, taking into account options to extend and terminate if reasonable certain to be exercised should also be undertaken.
If you would like to discuss any of the points discussed in this article, please get in touch with Jas Marwaha at jas.marwaha@oneadvisory.london.
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