Kate Beeston and Sally Baker examine the arguments for changing the approach to recognising revenue and lease accounting.
The FRC’s draft amendments to UK GAAP, published in FRED 82 ‘Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and other FRSs – Periodic Review’, propose significant changes to the approach to revenue recognition and accounting for leases. But why are these changes necessary?
As explained in the article Periodic review results in proposals for major changes to UK GAAP, UK accounting standards aim to be consistent with global accounting standards. This is achieved through the application of IFRS-based principles unless an alternative clearly provides a better solution.
Aligning FRS 102 with the accounting models introduced by IFRS 15 Revenue from Contracts with Customers and IFRS 16 Leases is therefore a key element of the changes proposed in FRED 82. Consistency with IFRS Accounting Standards is desirable on several levels – comparability is enhanced and it is more efficient for groups, particularly for those with entities that report under both FRS 102 and IFRS. Consistency also eases transition from UK GAAP to full IFRS for companies on a growth trajectory who may find themselves required to adopt full IFRS in the future.
Understanding the case for change in FRS 102 therefore involves exploring the reasons why new revenue recognition and lease accounting models were introduced in IFRS.
Revenue is a crucial number to users of financial statements seeking to assess an entity’s performance and prospects and is a major driver of other key metrics. It is therefore vital that a robust revenue recognition model exists that is also fit for purpose in the modern business world.
Single recognition model
Under Section 23 Revenue of FRS 102, two categories cover most forms of revenue: the sale of goods and the rendering of services. This is based on IFRS 15’s predecessor, IAS 18 Revenue. A lack of guidance however, on how – and when – to distinguish between goods and services proves problematic for businesses with more complex transactions such as software licensing, online affiliate marketing and pharmaceutical distribution arrangements. The approach can also lead to inconsistency with one entity recognising revenue over time (ie, based on rendering a service) and another entity recognising revenue at a point in time (ie, based on a sale of goods) despite having similar contracts.
A lack of guidance on how – and when – to distinguish between goods and services proves problematic for businesses with more complex transactions
Principles of revenue recognition
The current principles in UK GAAP for recognising revenue from both the sale of goods and rendering of services can be difficult to apply in complex situations. As per Section 23 of FRS 102, revenue from the sale of goods is based on the transfer of ‘significant risks and rewards of ownership’ while revenue from the rendering of services is based on the ‘stage of completion at the end of the reporting period’. Under FRED 82’s proposals (and IFRS 15), revenue is recognised when the customer obtains control of that good or service.
In some cases, the two models coincide but it’s not always the case. For example, to encourage sales an entity may allow customers a full refund if they return the goods within a certain timeframe. The fact that the risks are shared by both the entity and the seller during the return period makes this ‘risks and rewards’ principle difficult to apply. However, under a ‘control’ principle, it is clearer that the entity does not maintain control of the goods after the point of delivery despite retaining some risk that the customer may return the product subsequently. A focus on ‘control’ is intended to reduce divergence in practice.
There are also conceptual arguments behind the proposals. Income is defined in FRS 102 in terms of ‘enhancements of assets or decreases of liabilities’ with the definition of an asset referring to ‘control’ and the definition of a liability referring to ‘a present obligation’. By changing revenue recognition principles to include language such as ‘when the customer obtains control’ and ‘when the entity satisfies a promise’, section 23 becomes better aligned with FRS 102’s underlying concepts.
Leases are an important source of finance for many businesses. It is therefore vital that users of financial statements have a clear understanding of the economic impact of an entity’s leasing transactions.
FRS 102’s Section 20 Leases currently adopts a dual model approach, with leases either being recognised on balance sheet (as finance leases) or expensed to profits over the lease term (as operating leases) depending on whether the lease transfers substantially all the risks and rewards of ownership to the lessee.
These differing treatments can be confusing for users of financial statements as economically similar transactions may be accounted for differently. It also opens the door for manipulation – we’re probably all aware of instances where leases have been deliberately structured so that they are classified as operating leases with the intention of keeping them off-balance sheet and avoiding the negative impact on key metrics such as return on capital employed and gearing.
The proposals to amend FRS 102 – like IFRS 16 – introduce a single lessee accounting model that would require assets and liabilities arising from almost all major lease arrangements to be recognised on the lessee’s balance sheet. There are, however, important exceptions for low-value and short-term leases. This means that investors should no longer need to make arbitrary adjustments to an entity’s accounts to adjust for off-balance sheet items. Moreover, comparability should be improved as there will be less opportunity to structure a lease to achieve a particular outcome.
Conceptually, it is also argued that the single framework for leases provides a more faithful representation of the assets and liabilities arising from lease transactions and therefore provides more useful information to users. Entering into a lease results in the lessee having an obligation to pay the future instalments due under the agreement – the lease liability – and provides the lessee with the right to use the asset for the duration of the agreement – the right-of-use asset.
The single framework for leases provides a more faithful representation of the assets and liabilities arising from lease transactions and therefore provides more useful information to users
While the existing models for revenue recognition and lease accounting may be working well for some, it is clear that there is scope to improve the quality and consistency of reporting under FRS 102 for those with more complex transactions. Introducing IFRS-based solutions, particularly where the experience of IFRS reporters has been allowed to develop, allows for up-to-date thinking and recent developments in the way businesses operate to be reflected in UK GAAP. It is this improvement, together with the benefit of greater global alignment, that lies behind the case for change.
Kate Beeston,Technical Manager, Corporate Reporting, ICAEW
Sally Baker, Head of Corporate Reporting Policy, ICAEW