FRED 82 – changes are on the horizon for FRS 102

FRED 82 proposes a number of amendments to accounting requirements to reflect changes in IFRS Accounting standards, along with other incremental improvements and clarifications.

The proposed changes include:

• Changes to revenue recognition, based on the five-step model for revenue recognition from IFRS 15 ‘Revenue from Contracts with Customers’, with appropriate simplifications.
• Changes to lease accounting requirements, based on the on-balance sheet model from IFRS 16 ‘leases’, with some simplifications.
• Changes to fair value measurement definitions to reflect the principles of IFRS 13 ‘Fair Value Measurement’.

Revenue recognition

The proposals introduce the five-step revenue recognition model, which originates from IFRS 15 Revenue from Contracts with Customers. Previously under UK GAAP, revenue recognition fell into two areas – revenue from the sale of goods, and revenue from the rendering of services with additional guidance around construction contracts.

This new model will require Housing Providers to consider the individual terms of revenue-generating contracts to appropriately recognise revenue. To apply the model, an entity shall take the following steps:

1. Identify the contract(s) with a customer;
2. Identify the promises in the contract;
3. Determine the transaction price;
4. Allocate the transaction price to the promises in the contract; and
5. Recognise revenue when (or as) the entity satisfies a promise.

It is worth noting that this model does not apply to lease contracts within the scope of Section 20 leases. This is currently a key consideration of the Housing SORP Working Party and we welcome the sector’s thoughts on this matter.

Leases

The biggest change is the proposed removal of the distinction between a finance lease and an operating lease for lessees. All leases, subject to certain limited exceptions, will be brought onto the balance sheet in a manner consistent with the current treatment for a finance lease.

Where a business has, for example, significant property leases, these will need to be recognised on the balance sheet as a ‘right of use asset’ (‘ROUA’) with a corresponding lease liability.

Previously such leases would have been an operating lease accounted for on a ‘pay as you go’ basis, with future liability only a disclosure within the financial statements.

The effect on reported profit will be to remove the rental charge and replace it with amortisation of the ROUA, and an interest expense on the lease liability. Although the total effect on profit for the duration of the lease is the same, the accounting will change the timing of the expense, it becoming front end loaded with a higher total expense recognised in the first third of the lease, and lower comparative expense in the final third.

As the expense is accounted for as amortisation and interest rather than rent, this will change key performance measures such as earnings before interest, depreciation and amortisation (EBITDA) and the interest expense. Reported EBITDA will increase under the proposals, but with an increase in the interest expense which may impact on loan covenants.

In the cash flow statement, the rentals, previously treated as part of operating cash flows, will be replaced with an interest cash flow and liability repayments, the latter being classified as financing cash flows. The net effect is that a business will report higher cash generated from operations, but with an increase in financing cash flows. The overall net cash flow will be the same.

Making the changes

Implementing the changes will also present management with additional challenges in preparing accounts. Management will need to determine, for example, what is a lease, what is the lease term, what future payments to include and what discount rate to apply to the future payments.

What is a lease?

This is quite complex, but broadly, where the arrangement provides the lessee with the ability to control the use of a defined asset for a period of time it will be a lease.

How are the ROUA and lease liability measured?

The ROUA is set as the amount of the lease liability, together with any payments made before commencement of the lease and less any incentives received. The lease liability is the lease payments due to be made over the lease term. Where there are options to extend a lease, these will be included but only where it is reasonably certain that the extension will be taken.

The discount rate must be established, with a fall back to a rate based on gilts if an incremental rate cannot be readily determined. The payments include fixed amounts due under the lease. If the payments are variable, for example, they are linked to turnover, these are only accounted for when due. Where the lease includes amounts for other than the use of the asset, for example, service charges, these need to be identified, quantified and accounted for separately.

Where a business is concerned about the size of the liability being recognised, the use of shorter lease terms and variable payments can reduce this, but consideration should be given to whether this is the right choice commercially, as this may expose the business to a future uncertainty regarding security over the property and the future cost.

Where the business has a number of leases, the assessment will need to be performed for each. If existing lease arrangements are due to be renewed, the changes in accounting may also be a factor in those negotiations, and we would advise understanding the effect in advance.

What exemptions are available?

There are two main exemptions for lessees. If the lease term is no more than 12 months, it may be accounted for as currently for an operating lease. This is on a straight line basis over the lease term, and without recognition of a lease liability on the balance sheet. Similarly, if the underlying asset is of low value, it may also adopt this treatment. A low value asset is not defined by monetary amounts, but typically would include items such as laptops, mobile phones and small items of furniture.

Lessors

The accounting for lessors remains broadly the same as existing requirements, with the distinction, and different accounting applying, depending upon whether the lease is an operating lease or a finance lease. Most leases with tenants will be classed as operating leases.

The changes to lessee accounting will have consequences for lessors where they enter into back-to-back arrangements, or sale and leasebacks.

Fair value

The proposals introduce a new appendix on Fair Value Measurement which provides more details on measurement and valuation techniques. The Housing SORP Working Party do not consider that this will make significant changes to accounting treatment and estimation for housing associations.

Other proposed changes

The Financial Reporting Council (FRC) has stated that the decision on whether to align FRS 102, with the expected credit loss model of financial asset impairment from IFRS 9 Financial Instruments, will be deferred to a further consultation. There are some proposed changes to expected credit loss disclosures to include quantitative and qualitative information, about amounts arising from expected credit losses on certain financial instruments such as loans. The proposed disclosures are only applicable when a rare decision has been made to apply IFRS 9 on Financial Instruments.

The proposals also introduce a new definition of an asset: “An asset is a present economic resource controlled by the entity as a result of past events.

An economic resource is a right that has the potential to produce economic benefits.”

Compared to the existing definition of an asset in FRS102, this definition removes the direct linkage of benefits to cashflows or equivalents. Currently FRS102 states “The future economic benefit of an asset is its potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. Those cash flows may come from using the asset or from disposing of it.”

However, the proposals do not provide further guidance on the capitalisation of asset enhancements intended to provide climate or other ESG benefits which the Housing SORP working party consider an important sector matter due to the net carbon zero targets imposed on housing providers.

The FRC made this comment on the basis of the conclusion. “Stakeholders sought additional guidance regarding the capitalisation of asset enhancements intended to provide climate or other ESG benefits. The amendments proposed to Section 2 introduce a new definition of an asset. This sets out examples of rights that have the potential to produce economic benefits, including a right to use a physical object.

The FRC does not propose to make amendments to Section 17 at this time in relation to this issue.”

We feel it is appropriate for Housing Providers to seek further clarity from the FRC in this regard.

The Housing SORP Working Party are also looking at how these changes to Section 2 and Section 17 impact on the ongoing discussions around building/fire safety work impacts such as capitalisation, provisions and impairment.

Timing

The consultation includes a planned timeline for proposals to be effective for accounting periods beginning on or after 1 January 2025, however we understand that the FRC are now pushing this back to 1 January 2026.

This will mean RPs will prepare first period financial statements for the year end 31 December 2026 or 31 March 2027. You can read FRED 82 draft amendments on the FRC website. We are expecting a final exposure draft to be published by the FRC by 30 June 2024.

Alongside the FRS102 periodic review will be a re-write of the Housing SORP, consultation on planned changes is expected late in 2025. For further information, please get in touch with Julia Poulter or your usual Crowe contact.