Key changes to FRS 102

FRS 102 has a major update every three to five years. The next tranche of updates was published at the end of March 2024. These come into effect for periods starting on or after 1 January 2026, unless you choose to apply them early.

There are two big areas of change around leases and revenue recognition. These are based on the equivalent IFRS standards, with appropriate simplifications.

Revenue recognition – five-step model

Previously the revenue chapter in FRS 102 has been short and sweet. It has given a general direction and then you are left to get on with it. The new rules are different. This is not just in the detail of what you need to do, but the way in which you approach it.

Under the new rules there is a five-step model that you need to work through, for each type of revenue in your business.

1. Identify the contract(s)
2. Identify the promises within that contract – e.g. to deliver goods or services
3. Determine the total price
4. Allocate the price between promises
5. Recognise revenue for each promise as (or at the point when) it is fulfilled

Currently, if you hit a roadblock along the way when recognising revenue, you make a common sense call from a range of potential options. Under the new five-step approach, there will be a right answer.

It will make revenue accounting more consistent, but it will also mean that businesses who have picked a different answer – not the ‘chosen one’ in the new rules – may need to change. Changes could impact the timing of revenue recognition.

Areas most likely to incur changes are where contracts have bundles of goods and services, warranties, payments to be determined later or non-refundable upfront fees.

Ultimately everything we deliver in a contract – each promise – is recognised either at a point in time, or over a period. The final answer may be the same as what you do right now, but you have to follow the process, you need to check the rules and these are many and detailed.

It is important to work through revenue changes as soon as possible and before you share any forecasts for 2026 to determine whether or not they alter the timing of your recognition.

Lease changes

 The proposed change to leasing rules bring all leases onto the balance sheet. This will be important to any business with items held under operating leases e.g. vehicles, equipment and, in particular, buildings.

The accounting impact of the changes is that every lease is treated as finance leases are now.

This means you:

• Recognise a lease liability for the present value of future lease payments; and a right of use asset (e.g. as a separate category of PPE) for the same amount plus anything paid before the lease started
• In profit & loss – depreciate the right of use asset and recognise interest on the lease liability

As a rule of thumb, the starting value of the asset will ultimately be recognised as depreciation and the remainder of the lease payments will ultimately be recognised as interest.

There are two exceptions to this:

• Leases running for less than 12 months from their start, or (on transition) less than 12 months from the start of the first year under new rules, can optionally continue to be expensed as short-term leases
• Leases for assets which (when new) were worth less than a small car – which will capture most laptops, photocopiers, or coffee machines – can optionally continue to be expensed as low value leases

For either of those, you disclose the expense.

We will also need to start watching for ‘embedded leases’. This is where part of a larger contract meets the definition of a lease… “A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”.

For example, a contract where you pay for catering services may give you the right to control specific kitchen equipment on your premises throughout the contract. That would quite possibly fall under the new rules – ask your accountant.

What do you need to consider ahead of the lease changes?

Some practicalities to consider:

• What leases do you have in your business?
• Who holds the records?
  • Plenty of businesses do not have a single repository for all leases. You may need to talk to your facilities, maintenance, buildings, or IT teams
• Do you have any short-term or low value leases?
• Determination of lease liability
  • What is the lease term? This should capture the initial non-cancellable period, together with any others where both parties are reasonably certain (at the start of the lease) to extend
  • What are the lease payments across that term?
  • Can you put a value on the right to use the asset over the term?
  • If not, what is your ‘obtainable borrowing rate’ (for discounting)? You may be able to get this from the bank, but it will need refreshing for each lease
  • This will allow you to calculate the present value of future lease payments and therefore the lease liability.

Potential impacts on your business

EBITDA: neither depreciation nor interest on leases forms part of EBITDA, whereas rental payments on operating leases do. Therefore, EBITDA should be positively impacted. However, recognition of the lease liability and asset on the balance sheet – increasing both your assets and liabilities by the same amount – will bring your gearing ratios closer to one, which may impact bank covenants.

Covenants: depending on the definitions in your covenant documentation, it may impact the extent to which you will be able to meet the covenant tests. Of course, that will also depend on what the covenant document says about changes to UK GAAP and the impact on tests. It will also be different if negotiating new covenants during late 2024 and into 2025 that will be tested from 2026, compared to existing covenants.

Bonus or share schemes: if you have a bonus or share schemes driven by EBITDA, you may want to reconsider in light of the changes. Should you and your teams get a bigger bonus just because the accounting rules have changes how profit is reported?

In general, if you plan to share forecasts about your business or set targets for periods under the new rules, it is best to assess the revenue and lease impacts beforehand.

Other (smaller) changes and thoughts

There are a number of other changes that have been proposed, although these are not as significant as those for revenue recognition and leases.

Section 1A accounts: longer list of ‘required’ disclosures

Fair value measurement (new section 2A): FRS 102’s fair value measurement guidance will be more closely aligned to IFRS 13.

Going concern: small changes to the disclosure requirements for going concern basis of accounting.

FRS 105: will include the new revenue rules, but not the new lease rules. If your figures (without putting leases on the balance sheet) fall below micro thresholds, this may be worth considering… as long as you discuss with other interested parties first. Lenders and other large entities are sometimes more comfortable with full FRS 102.

Transition year – what you need to do

Revenue: there is a choice of restating prior year as normal or restating current year opening balances only.

Leases:

• Don’t restate prior year
• For finance leases, keep opening carrying amounts
• For operating leases, carry out the workings described above as if the lease started on the first day of the year – considering future payments only
• If your parent organisation uses IFRS already, you can carry on using their carrying amounts
• For contracts already in progress at the start of the current year, you do not need to reassess whether they contain a lease (as in the catering example above)

 Fair values: don’t need to revisit prior year valuations

Elsewhere: restate prior year unless there are exemptions

Timeline

Key takeaways

There are some key things you need to think about:

• How might your timings work?
• Work through the five revenue steps early – does it need to change?
• Work into forecasts before your 2026 budgeting and targets process concludes

We will be providing additional guidance ahead of this timetable, including a focus on revenue in our next round of Finance Director Seminars in November. If you aren’t on our invite list, please do email Ruth Warren to register your interest.