An exploration into the changes to accounting standards

The latest amendments to FRS 102 are intended to further align UK accounting practices with IFRS international standards. FRS 102 was introduced in 2015 to replace the old UK GAAP standards and applies to most UK companies that do not have to follow the IFRS directly.

The biggest changes relate to operating leases, or those where the lease contract permits use of an asset without any transfer of property rights. In UK accounting practice, these types of leases have always been treated differently to finance leases, where the contract does stipulate the eventual transfer of ownership of the asset. Up until now, there’s been no requirement to record assets held under an operating lease on the company balance sheet.

At present, leases are split into two categories:

• Finance leases – recognised on the balance sheet, with both an asset and a liability.
• Operating leases – kept off balance sheet, with rental payments simply expensed.

This distinction has allowed many businesses (especially in retail, hospitality, and transport) to keep large commitments out of their reported liabilities.

The amended FRS 102 includes a new balance sheet category for ‘right of use’ (RoU) assets – i.e. those held under an operating lease. The value of RoU assets must be recorded along with a corresponding lease liability, or the value of future lease payments.

The RoU is then depreciated over the lease term. Interest is then accrued on the liability.

The changes will be felt most keenly in the hospitality sector, where leaseholds without transfer of ownership rights are the norm, and also in kitchen and vehicle equipment. In practical terms, companies renting property and equipment that will eventually be returned to the owner face a switch from accounting for a fixed periodic rent expense to having to consider depreciation of the asset’s value and interest on the lease liability.

While the new rules will apply to most operating leases, exemptions remain for short-term leases under 12 months and for certain low-value assets like IT equipment. These can continue to be treated as ‘straight line’ rental expenses in profit and loss accounts only.

The other key change to be aware of in FRS 102 is the introduction of a new revenue recognition model. Under the existing system, consideration of when revenue is earned has been based on analysis of transfer of risk and reward between vendor and customer.

From January 1st, emphasis will switch to considering when control of an asset changes hand. In support of this, the new standards introduce a much more prescriptive five-step model for working out when control transfers. This should provide greater clarity to accountants and finance teams, but also sets the bar higher for ensuring the standards are followed to the letter.

This could affect those offering a package of services: ie a spa day, accommodation and a meal.

Those operators who charge one off joining fees (eg Gym memberships, members clubs) will also need to comply with the new standards.

In retail and hospitality, particularly those offering loyalty schemes, vouchers, or promotions eg free coffees after a certain amount of stamps. They must be treated as individual performance obligations, requiring part of the revenue to be deferred.

The option for a customer to acquire additional goods or services for free or at a discount is providing the customer with a material right that they would not receive without entering into that contract. If this is the case, the option is a separate performance obligation.

Vouchers – If the customer is unlikely to exercise their rights to the good or services, ie not using the voucher. The revenue is only recognised when it is highly unlikely that they will redeem the voucher.

If you have not already reviewed your accounting practices in lieu of these changes, especially with regards to any operating leases you hold, the time to act is now. Importantly, the changes to accounting treatment could have real world consequences for your business. The removal of operating leases from operating expenses will push EBITDA up, while the depreciation of RoU assets and liabilities on the balance sheet will affect net profit calculations. These could all have implications for financial performance reporting, potentially affecting debt covenants, gearing ratios and investor relations.