Changing Accounting Standards – The biggest shake-up to UKGAAP in a decade
Simon Rothenberg examines the changes to FRED82 and the subsequent impact to allow you to start your preparations sooner rather than later
Simon Rothenberg discusses the changes to FRED82 and the subsequent impact to allow you to start your preparations sooner rather than later.
Why is it relevant?
Approximately every three years the accounting standards and principles existing for UK companies (FRS102 and FRS105 for micro companies) not adopting IFRS are updated. The next set of these updates are currently in draft form (the excitingly titled FRED82) with the final form expected in the coming months. These updates promise to bring the biggest change to accounting standards in at least a decade.
The expected effective date is for accounting periods commencing on or after 1 January 2026, which may seem some time away, but the more you can do now the easier these changes will be. The major changes under FRED82 impact the following:
- Revised accounting requirements for revenue, bringing FRS102 and FRS105 broadly in line with IFRS15 – the updated IFRS revenue reporting standard. This means all entities in the UK must adopt the five-step model of revenue recognition with some suitable simplifications; and
- Revised lease accounting requirements applying only to FRS102. This is based on the IFRS16 lease accounting standard and means all leases will appear ‘on balance sheet’, again with some suitable simplifications.
Who does it affect?
All UK companies that do not use IFRS as their basis of preparation will be affected, and most of these will be affected significantly. Any company with any form of lease, including property or vehicle, will see their assets and liabilities increase, along with a rise in their interest charge. Any companies which offer additional services to customers as part of a sale will see their revenue recognition potentially change as well.
What do you need to know?
This will all lead to practical issues for businesses, in particular understanding the impact of the changes to financial reporting which is not something that can be dealt with after the fact. These changes will need to be communicated to stakeholders, so preparation is key.
FRED82 proposes the removal of the distinction between finance leases and operating leases for lessees. All leases, bar a few small exceptions, will be brought onto the balance sheet with accounting similar to the current accounting for finance leases.
Companies with property leases, for example, will need to recognise the full present value of these leases on the balance sheet as a ‘right of use asset’ with a corresponding lease liability. Under current rules, these leases are simply expensed each year with minimal balance sheet impact.
This means that the rent expense will be removed from reported profit and replaced with an amortisation (or depreciation) charge of the ‘right of use asset’.
In addition, the lease liability will be subject to an interest charge. Over the life of the lease, the expense reported will be identical (as, at the end of the day the cash payments remain the same). However, the timing of these expenses will charge with more interest in the early part of the lease and a lower interest charge towards the end. The interest rate is subject to judgement and will require careful consideration and thought.
Under current rules, the rent expense is included as a deduction in arriving at EBITDA – a key measure for many businesses. However, under the new rules, both the amortisation and the interest costs would not be included as a deduction in arriving at EBITDA. Hopefully, you can see that if your business uses EBITDA as a KPI, you will need to consider the impact of these changes carefully.
FRED82 proposes to align FRS102 with IFRS15: Revenue from Contracts with Customers, albeit a simplified version with reference to ‘promises’ rather than ‘performance obligations’. This brings the full five-step model into being and means that in order to identify how much revenue should be recognised and when, a five-step process should be considered for each transaction. The five steps are as follows:
- Identify the contract with a customer
- Identify the ‘promises’ in the contract, where a ‘promise’ is an obligation to transfer a distinct good/service (or bundle) to the customer
- Determine the contract price
- Allocate the transaction price to the promises
- Recognise the revenue as the promise is satisfied – either at a point in time or over time.
A big change for some businesses is that there will now be strict rules around recognising revenue over a period of time. In order to do so, one of the following must be satisfied:
- The customer is receiving and consuming the benefits of the entity’s performance as the entity performs
- Another entity would not have to substantially re-perform the work completed to date
- The entity creates or enhances an asset that the customer controls as it is created or enhanced
- The entity’s performance creates an asset that cannot readily be redirected to another customer AND the customer is obliged to compensate for work completed to date
While for many companies the amount of revenue recognised each year may not be impacted, the process must be walked through to ensure this is the case and, if you are audited, I am sure your auditor will want to see and understand the thinking. For those companies with more complex transactions, it is vital that all parties involved in the sales contract process are aware of the impact of changing the standard terms – you don’t want to have to look at each customer sale to consider the five steps of revenue.
What should you do next?
The changes to revenue and leases are likely to impact most companies and the detail included here is very high level.
We held a webinar in December designed to give further insight into the changes and what you can do to prepare. We will also be holding more events over the course of 2024 to help you prepare for these changes.
If you would like to discuss the above matter, or to confirm how this impacts your company, please get in touch with your usual Blick Rothenberg contact, or Simon Rothenberg using the details below or this form to see how we can assist with any future planning.