FRED in this case is FRED82, a ‘Financial Reporting Exposure Draft’ issued by the Financial Reporting Council (FRC) in December 2022. It sets out draft proposals for updated accounting standards used by most companies in the UK (being FRS105 and FRS102).
The document was released under consultation until 30 April 2023. Following the closure of the consultation period, comments from various stakeholders have been published and an implementation date of 1 January 2026 has been set. Until this month, the implementation date was expected to be 1 January 2025, but has now been pushed back 12 months.
The FRC has committed to issuing the final amendments more than 12 months before implementation, which would mean publishing before the end of 2024. Based on the current timeline, accounts in respect of any accounting period commencing on or after 1 January 2026 would have to apply the new standards.
What are the proposed changes?
There are two areas where significant changes to accounting standards will be made under the proposals in FRED 82, namely Revenue Recognition and Leases. Alongside these changes, there are many other small changes proposed by FRED 82. The changes are necessary to keep UK Generally Accepted Accounting Practice (UK GAAP), comprising primarily FRS102 and FRS105, broadly in line with changes made to International Financial Reporting Standards (IFRSs).
The changes to revenue recognition will implement the ‘five step’ model found in IFRS into UK GAAP and will involve more significant changes to FRS105 than FRS102. This is the main reason for the delay to the implementation date, as further simplifications are being sought for the FRS105 amendments.
Changes to lease accounting will involve capitalisation of a right-to-use asset for operating leases with corresponding lease liabilities, which has been mandatory in IFRS since 2019. This will, for some businesses, mean their balance sheets after transition to the new rules look very different to the way they currently appear. Effectively all leases will be accounted for in the same way finance leases currently are. The complication here is that a finance lease nearly always has an observable market rate of interest, whereas an operating lease does not.
If you are preparing accounts for a small company using FRS102 section 1A, there are some other changes to be aware of as well. There are now no ‘encouraged’ disclosures, only required disclosures. This may mean, depending on your particular business, that more disclosures are required than in the past.
Audit issues arising from the proposed changes
This section ignores the changes to FRS105 on the basis that an entity preparing accounts under FRS105 is extremely unlikely to undergo a full scope audit, whether voluntarily or on a statutory basis.
The amendment most likely to cause audit issues in the proposals is the revised lease accounting, specifically management’s justification for selecting a particular interest rate. Where an entity has some borrowings which are at a high rate of interest there may be an incentive for management to find reasons to use a different rate. Where an entity has no borrowings, the UK Government Gilt rate can be used, but only if the entity’s incremental or obtainable borrowing rates cannot be determined – this could create incentives to suppress information.
Further issues exist where an entity holds a head lease but has sub-let a property. The right of use asset should be accounted for at fair value, which could reasonably be determined by a professional valuer, but if a valuation has not been carried out, then verifying the value the directors or management have assigned may prove difficult.
Finally, to determine the period over which the right of use asset should be depreciated, it is necessary to determine the length of the lease. This sounds simple, but that is not always the case. Property leases tend to contain various options at the tenant’s or landlord’s discretion to extend or cut short the lease, and whether those options will be exercised is ultimately a matter of judgement. This increases the uncertainty from an audit perspective.
That is not to say the revenue recognition changes will not cause any issues for auditors.
There are several areas within the proposed revenue recognition model which add uncertainty and could cause issues for auditors.
The first is the FRC watering down the IFRS language around identifying components of the contract, from ‘performance obligations’ to ‘promises’; inherently a less certain term. Secondly the need to allocate the overall revenue between the different promises in a sales contract (which then feeds into timing of revenue recognition, particularly for contracts in progress at a period end), could cause issues, particularly for auditors of smaller entities where records may not be detailed enough to provide sufficient evidence of the basis for the split.
In practical terms, this means the usual issues around revenue recognition will remain unchanged for many entities; work in progress, sales cut-off and accrued or deferred income calculations will still be the focus of auditors’ attention.
What happens next?
In the months since the consultation closed, no updates have been forthcoming, other than the recent announcement delaying the implementation date. The ICAEW’s response (which can be viewed here https://www.icaew.com/insights/viewpoints-on-the-news/2023/apr-2023/fred-82-icaews-initial-views ) proposes some pragmatic changes and highlights that the FRC’s approach may be overzealous.
As things stand, final amendments are expected to be published in the first half of 2024 and the transition will be going ahead on 1 January 2026. The team at Ryecroft Glenton will be here to support you through the changes. Please do not hesitate to speak to your usual contact if you would like to discuss the implications in more detail.
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