FRED 82 – changes to UK GAAP
21 Feb 2023
The Financial Reporting Council (FRC) has proposed significant revisions to UK GAAP which will impact the majority of UK GAAP reporters as the FRC seeks closer alignment with International Financial Reporting Standards (IFRS), in particular, around revenue and leases. The implementation of these standards internationally took years in the planning and resulted in large adjustments to certain company’s financial statements.
For example, one engineering company saw a £4.5 billion reduction in net assets resulting from the revenue standard, and one supermarket chain saw an additional £7 billion of assets and £10 billion of liabilities recognised under the international leasing standard. These new proposals are outlined in the periodic review document: FRED 82 Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland.
The proposed changes affect all businesses reporting under FRS 102 (including small companies reporting under FRS 102 section 1A) with some of the proposals also impacting the smallest (micro) entities reporting under FRS 105.
All entities will be expected to apply the five-step revenue recognition model which originates from IFRS 15 Revenue from Contracts with Customers. Previously under UK GAAP, revenue recognition fell into two areas – revenue from the sale of goods, and revenue from the rendering of services with additional guidance around construction contracts. These amendments will now require businesses to get under the skin of their revenue-generating contracts in order to:
- Identify the contract with a customer.
- Identify promises in the contract.
- Determine the transaction price.
- Allocate the transaction price to the promises in the contract.
- Recognise revenue when (or as) the entity satisfies a promise.
A ‘promise’ is defined as an obligation to transfer a good or service (or bundle of goods or services) that is distinct. For example, the sale of a product which also has elements of servicing, maintenance and installation may need to be unbundled into separate promises with possibly different patterns of revenue recognition. This will depend upon whether these goods or services are ‘distinct’, meaning that the customer can benefit from that additional good or service ostensibly on its own, and that the obligation to transfer these goods or services is separate from other obligations in the contract.
It is possible that these proposals could result in changes to the pattern of recognition of revenue, and could present businesses with additional complexities in unbundling contracts into separate promises, allocating the transaction price to those promises as well as navigating the additional guidance on variable consideration. Sectors most likely to be affected include: telecoms and media, software and computer services, construction, support services, aerospace and defence and pharmaceuticals.
There will also be differences in terminology and presentation with ‘contract assets’ and ‘contract liabilities’ representing the relationship between the stage of performance in transferring goods or services to the customer’s payment profile. In other words, consideration received in advance of the transfer of goods or services would result in a contract liability. Transfer of goods or services prior to the receipt of consideration results in a contract asset (excluding amounts presented as trade receivables).
Disclosures are inevitably enhanced under the proposals, although they are not quite as extensive as those under IFRS 15. Transition allows an exemption to fully retrospective application where the cumulative impact of applying the new requirements may be recognised as an adjustment to the opening balance of each affected component of equity at the date of application. Businesses will need to decide whether to take this simplified route and live with the inconsistency between periods in the first year of adoption, or whether to restate comparatives fully.
Perhaps more controversially, the proposals include the adoption of the leasing model in IFRS 16 Leases. This amendment would apply only to FRS 102-reporters (including those taking advantage of section 1A), micro-entities would not need to adopt this model. This would bring the vast majority of leases on balance sheet. As with IFRS 16, short-term (less than 12 months) and low value leases would be excluded (eg mobile phones, computers and small items of furniture). For all other leases, the lessee recognises a right-of-use asset and a lease liability.
The lease liability forms the basis of the initial recognition of the right-of-use asset (plus other costs, incentives and dismantling provisions) and is measured at the present value of the lease payments. This must be discounted at the interest rate implicit in the lease or, if this is not readily determinable, the incremental borrowing or lessee’s obtainable borrowing rate may be used. The ‘obtainable’ borrowing rate is a simplification from full IFRS 16. In addition, in exceptional cases, a gilt rate may be used.
Again, disclosures are enhanced, however, the ‘simplified’ method of transition is proposed to be mandated, eg recognising the cumulative impact of initially applying the amendments to the opening balance of retained earnings at the date of initial application.
Financial reporting considerations
Businesses need to consider how these changes may impact their financial reporting to key stakeholders. Due to the recognition of both a right of use asset and a lease liability under the proposed leasing model, key ratios and covenants will be affected. Even though the impact on net assets may be small, total assets and total liabilities considered separately will both increase. Also, the profit and loss account changes from recording a single operating lease payment to a depreciation charge for the right-of-use asset and finance costs arising from the unwinding of the lease liability.
The costs will also no longer be straight-line. It is important to understand the impact on covenants, for example interest cover ratios. In addition, if there is a focus on EBITDA (earnings before interest, tax, depreciation and amortisation), either for business performance or in relation to covenants, this will be dramatically different as the main ‘cost’ of the lease will become a depreciation charge and therefore added back for the purposes of calculating EBITDA.
In addition, depending upon the transition method financial statements may require more explanation as results may not be comparable with the prior year in the first year of application.
Impact on smaller businesses
Smaller entities who adopt FRS 102, section 1A will still be required to adopt the recognition and measurement changes proposed above for revenue and leases, however there are proposed reductions in the disclosures in these areas. The FRC has also used the periodic review to improve clarity over disclosures under section 1A and would now require certain disclosures which were previously ‘encouraged’. This includes mandatory going concern disclosures including disclosures relating to material uncertainties related to events or conditions that may cast doubt on the ability of the entity to continue as a going concern as well as dividends declared and paid or payable during the period.
In undertaking this periodic review, the FRC were clear that they would be considering changes to IFRS accounting standards, so the changes are unsurprising. They have, however, given time to allow lessons to be learned from the adoption of IFRS 15 and 16 by IFRS-reporters so that guidance is readily available. There is also a notable omission from this review with the FRC choosing not to adopt the expected credit loss model for financial instruments at this time. There may be some benefits for businesses which belong to an IFRS-reporting group as group reporting adjustments would be reduced.
Also, for those seeking to grow and gain financing, comparability with listed entities will be enhanced. A proposed effective date of accounting periods beginning on or after 1 January 2025 (if adopted in the final standard) however, does not allow businesses a long lead-time to prepare for such a step-change in reporting.
For any further queries on the points raised, please speak to your usual Saffery Champness contact, or get in touch with Anna Hicks.