Overview
On 27th March 2024, the FRC had issued amendments to UK GAAP. This followed extensive feedback from its published exposure draft FRED 82, issued in December 2022.
The changes would impact all companies reporting under FRS 102 and small companies reporting under FRS 102 section 1A. In addition, there were some changes impacting micro companies reporting under FRS 105.
When will the changes become effective?
The effective date for most amendments is periods beginning on or after 1 January 2026, and early adoption is permitted provided all amendments are applied at the same time.
Better information will now be provided for users, along with improved consistency with international standards.
The most significant changes to UK GAAP were changes to revenue recognition and lease accounting to align more closely with IFRS 15 and 16.
Revenue recognition five-step model
There is a new model of revenue recognition, based upon the five-step model for revenue recognition under IFRS 15. This change will also impact micro entities reporting under FRS 102, FRS 102 1A, and FRS 105 with additional simplifications.
5 key steps:
- Identifying the contract (or contracts) with a customer
- Identifying the promises in the contract
- Determining the transaction price
- Allocating the transaction price to the promises in the contract
- Recognising revenue when (or as) the entity satisfies a promise
Impact of revenue recognition changes on retail companies:
For most retail companies, the change to revenue recognition won’t have a discernible impact on their accounting as the customer will be buying a product either in store or online and the only promise in the contract will be the provision of that product so revenue will still be recognised as the customer takes possession of the product they have bought.
Lease accounting
This will have more of an impact on the retail sector particularly those companies that rent a warehouse or physical stores that they trade out of.
There is a new model of lease accounting, based upon IFRS 16’s on balance sheet model. This removes the differentiation between finance and operating leases and creates a ‘right-of-use asset’ on the balance sheet with a corresponding liability, meaning most lessees with operating leases will be impacted.
The right-of-use fixed asset will be subject to depreciation and interest based on the liability will be charged to profit and loss, affecting the presentation of financial information.
- Liability based on contractual lease payments, discounted for time value of money, representing obligation to lessor. Right of use asset, based on liability, represents the right to use underlying assets.
- Right of use asset subject to depreciation and interest based on the liability will be charged to profit and loss.
- Only applies to entities reporting under FRS 102 and small company reporting under FRS 102 1A. Mirco entities reporting under FRS 105 are not required to adopt this model.
- Recognition exemptions are included for short term leases and leases of low value items.
Impact on KPIs
The introduction of the new lease accounting model and changes to revenue recognition under amended UK GAAP will have a noticeable effect on the way key performance indicators (KPIs) are calculated and interpreted.
The removal of operating lease expenses and the recognition of a right-of-use asset and corresponding lease liability on the balance sheet will alter the presentation of both the profit and loss account and the balance sheet.
As a result, the following KPIs may be affected:
EBITDA will increase by the value of the operating lease expense that is removed. For any retail companies with physical stores or a warehouse that they lease, this is likely to significantly increase their EBITDA as rent in their P&L will be replaced by depreciation and interest
Finance and depreciation charge will be higher (could impact covenants).
Balance sheet total (gross assets) test maybe breached impacting company size thresholds.
Net current assets will be decreased by new short-term liability.
Implications for lenders and financial covenants
Impact on leverage ratios:
Lease liabilities increase total debt, leading to a higher debt-to-equity ratio. This may breach loan covenants based on leverage limits.
Operating vs financing cash flows:
Operating cash flow improves (since lease payments move to financing cash flows). If a bank evaluates cash flow-based covenants, the reclassification could impact covenant compliance.
Effect on interest coverage ratios:
Interest expense increases (due to lease liabilities being treated as debt). This may reduce the interest coverage ratio, which could be a concern for lenders.
EBITDA boost (but not cash flow):
EBITDA increases because lease expenses move below EBITDA (i.e., into depreciation and interest). If covenants are tied to EBITDA (e.g., EBITDA-based debt covenants), companies might appear more financially robust than they are.
How do I prepare for these proposed changes?
Companies should begin to consider the impact of the new standard on their current business models and communicate with relevant stakeholders.
Gathering the appropriate information now will help to make the transition as smooth as possible. This may include summarising and analysing all leases on a lease register including the lease term and future payments.
In addition, companies should consider the impact these changes will have on contracts with customers and identify specific contract terms and performance obligations.
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