UK accounting is about to change – radically
In December 2022, the UK Financial Reporting Council (FRC) exposed its proposed changes to UK accounting rules (‘UK generally accepted accounting principles’ or ‘UK GAAP’).
The main changes proposed in FRED 82 are to two financial reporting standards, FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime. To put it simply, the changes proposed will affect most businesses across the UK and Ireland, and SMEs in particular.
Click here to download Ancoram’s response to the FRC
Why did the UK FRC issue FRED 82?
International accounting rules (IFRS and US GAAP, for example) for revenue recognition, leases and financial instruments (such as loans, derivatives and equity investments) have changed dramatically over the last decade, but UK GAAP has lagged behind its overseas and international equivalents for some time. While there remain considerable differences between US GAAP and IFRS in these areas, the FRC wants to bring UK accounting practices in line with IFRS. FRED 82 contains changes that will cause UK businesses to have more similar accounting practices and business valuations to their global counterparts.
As a draft, FRED 82’s main purpose is to serve as a measure of public opinion. It is a test to see whether the UK financial world will accept the given changes or will propose significant changes within the referendum period, which is up at the end of this month.
What does FRED 82 propose?
Lease accounting changes
The most significant change to UK GAAP is for businesses with leases who apply FRS 102 (but not microentities, which apply FRS 105). While many leases have historically been treated as an operating expense, with payments treated as an administrative expense on an even basis over the lease term, all leases (with only a few exemptions) are now regarded as a form of financing transaction. In short: your business ‘borrows’ an asset, has the right to conduct business using that asset, and so your lease payments are accounted for in a similar vein to a bank loan.
This shift to viewing leases as a form of financing transaction can radically transform your financial results, and perhaps not in the way you expect:
On the balance sheet, you will need to recognise a ‘right of use’ asset for the asset or property being leased, together with a liability for the financing arrangement; while
In the P&L, a notional interest expense is recognised to amortise the financing over the lease term, together with a depreciation charge for the right of use asset.
Crucially, these accounting changes mean that your EBITDA, net profit or loss before tax, liquidity and gearing ratios will radically differ on adopting the proposed changes. Companies with loan covenants dependent on maintaining certain ratios will need to educate their lenders on the impact of these changes, and will need to factor in the new form of lease accounting when applying for or renegotiating existing debt and providing forecasts.
While accounting for leases has been complicated in the past, there is no doubt that these changes will pose significant challenges for businesses with a high number of leases or with complex lease terms. There are however two ‘Get Out of Jail’ cards for SMEs whereby leases with less than 12 months’ duration can be merely expensed over the lease term, as can leases for ‘low value assets’ (which is not defined, but would typically include small items of office furniture, laptops and phones). Larger SMEs with a high volume of leases on substantially consistent terms are able to take a ‘portfolio’ approach to their leases rather than identify, track and assess individual leases.
The FRC has suggested these changes will be effective for accounting periods beginning on or after 1 January 2025. This proposal has faced strong hostility from many in the accountancy profession and so the final standard is more likely to be effective from 2026 or 2027. That in itself is not cause to delay your preparation efforts; an average lease has approximately 120 data points, all of which will need to be captured by your accounting processes.
Ancoram provides SMEs, their accountants and auditors with a ‘done for you’ service to take away the pain of transitioning to these new requirements. You share your leasing contracts with us and we provide you with the booking entries and audit schedules. Click here to book a call with our director, Tim Dee.
Revenue accounting changes
Under the changes in FRED 82, the revenue recognition principles in FRS 102 and 105 would change to be brought in line with IFRS standards. These standards have been simplified for ease of use for UK businesses.
A significant change is in relation to how a business measures and reports its revenue, including the timing of when revenue is recognised. FRED 82 sets out a five-step revenue recognition process, consistent with IFRS 15 Revenue from Contracts with Customers:
Identify the contract(s) with a customer
Identify each promise within the contract
Determine the transaction price
Allocate the transaction price to the promises in the contract
Recognise revenue as each promise in the contract is satisfied
FRED 82 adds a few additional notes concerning:
Warranties: If a warranty contains additional promises to the customer besides the standard warranty promise that the product or service will have the intended result, it must be counted as an additional promise in the contract and measured separately;
Purchase options: Businesses will have the option, but not the requirement, to account for optional material customer rights in the contract as a separate contract promise.
Refunds: FRED 82 suggests that businesses must account for refund liabilities based on whether or not the customer contract included additional consideration besides the transaction price. This is particularly relevant to e-commerce and retail businesses, given UK consumer legislation.
These changes will affect the P&L, and, to a lesser degree, the balance sheet. Companies may have to change when they report certain revenues, affecting income on a month-to-month basis. The refund liability change may affect how much refund liability companies must carry on their balance sheets. The cash flow statement will not be materially affected by this change.
Potential changes for bad debt provisions
The UK has, for some time, only permitted bad debt provisions to be recognised where there is evidence that a debtor will default on an existing balance. IFRS and US GAAP have, for some time, required any bad debts or impairment to be amortised and recognised as a finance expense in the P&L (a throwback to the olden – or golden? – days of having ‘general’ and ‘specific’ bad debt provisions). The FRC has not proposed bringing UK GAAP into alignment with IFRS on this topic, as the IFRS treatment of impairing trade receivables is currently under discussion, but it is possible that a later exposure draft will change the accounting for these bad debt provisions.
Will my business be affected by this change?
UK entities with large or expensive leases will be the most affected by these changes. The lease accounting principles under FRED 82 may significantly change how these businesses operate. Businesses with complex contractual terms in their sales agreements with customers will also be affected.
Micro-entities reporting under FRS 105 will not be affected by the lease accounting changes in FRED 82, but may have to make slight amendments to their revenue recognition practices.
Click here to book a free consultation to discuss how the changes will affect your business.
