Amendments to financial reporting standard FRS 102 will change how revenue is recognised and leases are accounted for. Grant Thornton’s Patrick O’Brien and Pinkesh Patel explain the impact on M&A valuations.
In March, the Financial Reporting Council (FRC) announced changes to FRS 102 as part of its scheduled second periodic five-year review of the accounting standard. The amendments or, as the FRC describes them, “comprehensive improvements”, focus on updating FRS 102 to bring it into closer alignment with UK-adopted International Financial Reporting Standards (IFRS) with respect to revenue and leases, and are relevant for all companies reporting under FRS 102. The changes are effective from 1 January 2026, but early adoption is permitted for any company.
Revenue recognition
The impact of these changes will vary across different industries and sectors. FRS 102 Section 23 Revenue sets out the requirements that apply to revenue arising from the sale of goods, services, construction contracts, and assets yielding interest, royalties or dividends. It will typically have a larger impact on the reported revenue of businesses providing services or engaged in long-term contracts, such as telecoms providers, professional services, technology and construction companies.
The amendments to the revenue accounting standard have introduced the five-step revenue recognition model, as used in IFRS 15. Implementing this model could potentially alter how and when revenue is recognised. The extent of this depends on the terms of the transfer of promised goods or services to customers as set out in contracts.
Treatment of leases
FRS 102 Section 20 Leases sets out the requirements for the classification, recognition and measurement of operating and finance leases. It includes the accounting and disclosure requirements for both lessees and lessors.
FRS 102 Section 20 Leases will significantly impact profit and loss lines and the net debt of businesses with large lease portfolios, such as retail, transport and real estate companies. That said, any business that has leases will be impacted – although some to a lesser, possibly immaterial extent.
In most cases, the new lease section requires leases to be capitalised and brought on to the balance sheet, recognising a right-of-use (ROU) asset and a corresponding lease liability. There are limited exceptions for short-term leases (of 12 months or less), and for leases of low-value items.
The capitalisation of leases, and bringing them on to the balance sheet, won’t only affect balance sheet metrics. There will be a substantial change in how lease costs are recognised in profit and loss accounts. Rather than having a monthly rent expense, companies will have to recognise depreciation on the ROU asset, and an interest expense relating to the lease liability. This can have an impact on deals.
The capitalisation of leases, and bringing them on to the balance sheet, won’t only affect balance sheet metrics
Time for thought
What’s more, the lease liability is determined by the present value of the lease payments discounted using the rate implicit in the lease, the lessee’s incremental borrowing rate or the lessee’s ‘obtainable’ borrowing rate. Determining any one of these interest rates can be complex and requires additional time and thought when entering into a new lease arrangement.
With the amendments affecting the calculation of revenue, EBITDA (earnings before interest, depreciation, taxes and amortisation) and other important key performance metrics, it’s vital that businesses plan for these changes now.
The amendments will have a significant impact on the key financial metrics commonly used to determine the enterprise value and final equity price on M&A transactions, including revenue, EBITDA, working capital and net debt.
A key change will be lease costs moving below the EBITDA line on which headline valuations for deals are typically based, as they cease to be treated as overheads and are replaced by depreciation and interest expenses. Furthermore, while the profit and loss charges – depreciation and interest expenses – over the term of a lease will equal the total lease payments, the amount recognised from one period to the next will vary. This is due to lease liabilities unwinding on an amortised cost basis, resulting in a larger proportion of the lease expense being recognised in the first half of the lease term. Also, the depreciation expense will vary based on the depreciation policy selected – straight line or written down value. Bringing leases on to the balance sheet will also increase net debt, which is typically treated as a negative adjustment in arriving at the final equity price for a deal.
Revenue and EBITDA may also be impacted (positively or negatively) by the changes in revenue recognition. In these cases, there will likely also be an impact on reported working capital as a result of changes to deferred income or accrued income, being the other side of the revenue changes.
The amendments should be viewed as presentational changes aimed at improving clarity in financial reporting, and aligning with UK-adopted IFRS, rather than as factors directly impacting the underlying valuation of a business – they are accounting changes that do not change underlying cash flows that ultimately determine valuations.
The amendments should be viewed as presentational changes aimed at improving clarity in financial reporting
However, the headline price or enterprise value offers for businesses are often based on assumed levels of earnings, for example EBITDA or revenues with a multiple applied. In arriving at the final equity price, adjustments are then made for working capital and net debt, as laid out by the faculty’s Best-Practice Guideline on Completion Mechanisms.
To ensure valuations are not distorted, dealmakers may need to adapt their approach to setting out and agreeing valuations. For example, they may restate key financial metrics to be a previous FRS 102 basis, or apply a different EBITDA multiple to nullify the impact of the changes and result in the same headline valuation. Depending on the approach, parties also need to assess whether it’s appropriate to classify lease liabilities as a debt-like item when determining the final equity value and consider any balance sheet impact of accrued or deferred income changes.
Sale and purchase agreement
The sale and purchase agreement (SPA) governs the final determination of the equity price, together with any adjustments to be applied in respect of the completion mechanism and, if applicable, the earn-out mechanism. The ICAEW Best Practice Guideline on Earn-out Agreements has more information on this.
Given the significant changes to reported earnings and increased lease liabilities that these amendments will cause, dealmakers need to take care to ensure the SPA aligns with the parties’ intentions, especially where any affected metrics are referred to. If the transaction completion mechanism includes a deduction or working capital for any leases on the balance sheet and this is being measured after the amendments come into effect – if completion is after 1 January 2026 – the SPA should specify whether the leases would be measured on an old FRS 102 basis.
Similarly, earn-out calculations can be significantly impacted as they’re often linked to revenue, EBITDA, or operating profit. Therefore, parties must consider the impact of revisions in accounting standards when agreeing earn-out targets and the accounting treatments in preparation of earn-out accounts.
If the transaction includes an earn-out mechanism that covers a period after the amendments come into effect, the SPA should again specify whether the amendments should be applied or adjusted out. This could impact SPAs being signed before the changes take effect, and advice should be taken on any SPAs with earn-outs to consider whether the accounting treatments should be frozen at the SPA signing date.
It’s crucial to adopt a proactive approach to ensure businesses are prepared for the changes
Get ready
Although these FRS 102 amendments won’t take effect until 1 January 2026, it’s crucial to adopt a proactive approach to ensure businesses are prepared for the changes. An evaluation of the potential impact of the proposed changes on financial statements should be carried out, to ensure the company has the necessary information, as well as resources and robust systems in place, to facilitate a smooth transition. Businesses should also review existing customer contracts and decide whether to amend them to align with their preferred position, or maintain a position similar to the existing standard. Finance teams should also ensure that their lease data is comprehensive and accurate to determine borrowing rates.
Dealmakers need to consider the impact of these changes on key financial metrics used to agree transaction terms and referenced in SPAs to determine the final equity price of M&A transactions. It is important that there is complete clarity about how FRS 102 is being applied when it comes to any calculations relating to deal valuations to earn-outs post-completion.
Patrick O’Brien (left) is a London-based partner at Grant Thornton, and head of the firm’s sale and purchase agreement practice.
Pinkesh Patel (right) is a Thames Valley-based partner in Grant Thornton’s financial accounting advisory services practice.
Guidelines
Patrick O’Brien is the co-author of the guidelines below, along with other advisers from Grant Thornton.