The Financial Reporting Council (FRC) published a Financial Reporting Exposure Draft (FRED 82) on 15 December 2022, which proposes a number of changes to FRS 102, following the second periodic review of the regulation and other financial reporting standards.
These proposals include:
- a new model of revenue recognition (for FRS 102 and FRS 105)
- a new model of lease accounting (for FRS 102 only)
- various other incremental improvements and clarifications.
Interestingly, the FRC has decided to defer the alignment of the Expected Credit Loss Model for the impairment of financial assets within IFRS 9: Financial Instruments, choosing to retain an incurred loss model for FRS 102 reporters.
The aim of this second periodic review was to produce amendments to FRS 102 to better align the Standard to IFRS, incorporating the IASB's latest proposed changes to the international financial reporting requirements.
These changes are designed to come into effect for periods beginning on or after 1 January 2026. Early adoption is permitted, and certain transition reliefs will be available.
A new FRS 102 Section 23 Revenue is proposed, setting out a five-step model aligned to IFRS 15. This will require businesses to perform five key actions:
1 Identify a contract with a customer
2 Identify promises within the contract
3 Determine the transaction price
4 Allocate the transaction price to the promises
5 Recognise revenue when or as the entity satisfies the promise
Depending on the business and contractual arrangements in place, this could result in significant changes to the pattern of revenue recognition.
The FRC is also raising a new FRS 102 Section 20 Leases, which will require almost all leases to be brought on the balance sheet if you're a lessee. Accounting for lessors will remain largely unchanged. These new requirements mean recognising a right-of-use (ROU) asset in respect of the lease contract, and a corresponding lease liability, being the present value of remaining payments under the lease.
The ROU asset will comprise:
- the present value of the lease liability, plus
- payments made before commencing the lease; less
- any lease incentives; plus
- direct costs and rectification costs.
The lease liability will need to be discounted using the interest rate implicit in the lease. If that rate can't be readily determined, the company’s incremental borrowing rate should be used.
Any difference between the ROU asset value and lease liability is shown as an adjustment to opening reserves on the transition date (for example, 1 January 2026).
The ROU asset needs to be depreciated over the remaining term of the lease, and the lease liability unwound as cash payments are made. The result is that the operating lease expense is replaced by a depreciation charge on the ROU asset, and a finance charge on the lease liability.
There are certain exemptions. If you have leases with less than 12 months remaining at the transition date or leases for assets of low value, these can continue to be accounted for as operating leases, taking the rent expense to profit or loss over the course of the lease term.
Businesses won't be required to go back and reconsider whether an arrangement constituted a lease prior to the transition date. Furthermore, no prior year restatement will be required – the impact of the transition will be posted as an adjustment to opening reserves on the transition date.
Various other changes are being proposed, albeit not as significant as those relating to revenue recognition and leasing. These include:
- going concern: slight changes to disclosure requirements regarding the going concern basis of accounting
- concepts and pervasive principles: various updates to definitions (eg, the definition of an ‘asset’ expanded to include ROU assets)
- a new Section 2A Fair Value Measurement, replacing the Appendix to Section 2 and updated to reflect the principles of IFRS 13.
Financial accounting advisory services (FAAS)
Supporting your finance team with financial reporting expertise and providing scalable resource to navigate change
What does this mean for your business?
In terms of revenue recognition, businesses most likely to be impacted by these changes will be businesses that have long-term contracts or provide services, such as telecoms providers, professional services and construction companies – rather than ship and bill businesses.
Finance teams should analyse their customer contracts to identify whether amended terms need to be issued, particularly if contractual relationships don't demonstrate:
- distinct promises within the contract
- a transaction price that can be allocated to those promises
- an enforceable right to payment for work completed to date.
Contract terms will direct the accounting conclusion on whether revenue can be recognised over time, or at a point in time. This may lead to significant changes to the way revenue was previously recognised. Current FRS 102 guidance focuses more on when risks and rewards are transferred to the customer, rather than when promises under the contract are fulfilled.
Any business with operating leases, as a lessee, will see substantial changes to their EBITDA figures, and balance sheet presentation because of the amendments. Entities with lease portfolios of retail spaces, vehicle fleets, or other such properties will be significantly impacted. Operating profit will likely increase, as part of the cost of the lease will now sit in finance costs, and both gross assets and liabilities will increase as a result of the on-balance sheet lease commitments.
Preparing for the future
The key is to ensure that your business has the information collated, and systems set up, well in advance of the transition date, to capture all relevant information. As it relates to revenue, collating and analysing your customer contracts, and for leases, your lease data – ensuring this is complete and accurate. Finance teams need to determine the appropriate borrowing rates attached to each lease, and the lease term (taking into account options to extend, or terminate, if these are reasonably certain to be exercised).
Organisations should start talking to their lenders now if they have debt covenants involving EBITDA measures or other metrics linked to the balances impacted by these changes.
Finally, earn-out arrangements may need to be reconsidered, if they hinge on certain profit targets.