Implementing FRS 102: The key changes
Amy Hutchinson, Assistant Director, Technical Policy, outlines the ten key changes to be aware of to implement FRS 102.
With Financial Reporting Standard (FRS) 102 first applying for years ends from 31 December 2015, now is the time to ensure that all those involved in the financial reporting process understand the key changes required by the new accounting regime.
Whilst there are many similarities between FRS 102 and the existing UK accounting standards, here is a reminder of the key areas where the accounting will change.
1. Transitional adjustments (Section 35 of FRS 102)
Firstly, for the first set of financial statements prepared under FRS 102, specific transition requirements are set in the standard. These require that financial statements are prepared in accordance with the requirements of FRS 102 as if they had always been so, subject to certain mandatory and optional exemptions. The comparatives for the financial period prior to the first set of accounts prepared under FRS 102 require to be restated. The impact of this is as follows.
If we assume that a company has a year end of 31 December then it will be required to prepare its first set of accounts under FRS 102 for the period ending 31 December 2015. Its date of transition will be 1 January 2014, i.e. the earliest date of the financial information presented in those accounts (commencement date of comparative year).
The accounts for the year to 31 December 2013 and 2014 will be prepared in accordance with existing UK GAAP. Users of the financial statements need to be aware that once FRS 102 is applied, the company's opening balances as at 1 January 2014 are unlikely to be the same as the closing balances in the company's accounts as at 31 December 2013.
This is due to the impact of transitional adjustments and application of different accounting policies that will almost certainly be required. Likewise the comparative reported figures for the year to 31 December 2014 are most unlikely to be the same as those previously reported for that year for the same reasons.
Illustration of Transition Dates
31 December 2015
1 January 2014
31 March 2016
1 April 2014
30 April 2016
1 May 2014
30 June 2016
1 July 2014
30 September 2016
1 October 2014
2. Investment properties
Under FRS 102, gains or losses on the revaluation of an investment property will be required to be included in the profit or loss for the year. This is in contrast to the current treatment for such gains or losses being posted via the Statement of Recognised Gains and Losses to the Revaluation Reserve. This change will therefore have an impact on the reported bottom line in the profit and loss account without any change in the economic substance of the entity's activities. Such changes will end up in the profit and loss account reserve although entities may decide to transfer such amounts to a separate reserve, as these profits or losses will not be realised and hence do not impact on the level of profits that may be distributed.
Additionally, currently UK GAAP prohibits a company from classifying an asset as an investment property, if that property is occupied by another company in the group. This prohibition is removed under FRS 102 and such properties will now be accounted for as investment properties in both the company and group accounts.
Companies normally had to invoke the Companies Act 2006 true and fair override to enable compliance with the requirements of Statement of Standard Accounting Practice (SSAP 19). This approach will no longer be required as the Companies Act now allows for such properties to be measured at fair value. Although FRS 102 requires investment properties to be measured at fair value, in contrast to SSAP 19 which required them to be measured at "open market value", we do not see this as having any impact on valuations in practice. For deferred tax implications please see below.
3. Goodwill and intangible assets
For businesses which have goodwill on their balance sheets, FRS 102 might have a significant impact. Currently, entities are required to write off goodwill over a period not exceeding twenty years. FRS 102 requires that where the economic life of goodwill cannot be reliably assessed then it needs to be written off over a period of not more than 10 years (changed from 5 years in the first version of FRS 102). This could result in significant charges to the profit and loss account of such entities as they amortise the remaining goodwill over a potentially shorter period.
For companies acquiring another entity post implementation of FRS 102, greater consideration needs to be given to the actual assets acquired as at the date of acquisition. UK GAAP currently requires the intangible assets to be recognised only where they are capable of being sold separately from the entity as a whole. This requirement has limited the nature and amount of intangible assets recognised in practice. FRS 102 does not contain a similar provision and hence is likely to result in the recognition of considerably more intangible assets on acquisition, the net result of which will be to reduce the level of goodwill recorded on the balance sheet.
4. Deferred taxation
The method of determining deferred tax under FRS 102 has been changed to a "timing differences plus" approach. This is likely to have a significant impact in practice as more companies are going to be required to include provisions in respect of deferred tax. Currently, companies which revalue fixed assets, including investment properties do not recognise the related deferred tax aspects of that revaluation but merely provide information of such in the notes to the accounts. However, FRS 102 requires the deferred tax on such gains or losses to be provided for in the primary financial statements and discounting of any such balance is not permitted.
5. Defined benefit pension schemes
There may be a greater charge to the profit and loss account reported on such schemes, depending on the types of assets held by the scheme. This is because FRS 102 requires net interest to be calculated based on the discount rate (the expected return on high quality corporate bonds). Previously, the interest cost was based on the discount rate and the expected return on the plan assets – if these were mostly equities, this would be likely to give a higher rate. Whilst there will be no overall change in the balance sheet position as the expected return on assets in the profit and loss account is offset by the actual return in the statement of other comprehensive income, the company's reported bottom line is likely to be reduced.
Disclosure of the pension scheme deficit no longer requires to be disclosed on the balance sheet and hence, going forward, may well be included in other liabilities with details of the deficit reported in the specific note to the accounts.
Any related deferred tax will now be reflected in the deferred tax balance and not offset versus the gross surplus or deficit of the scheme.
6. Group defined benefit plans
Going forward individual members of a group defined benefit pension scheme will be required to include their respective share of the assets and liabilities of the group scheme. If there is no contractual agreement in place between the respective group companies then the company which has legal responsibility for the scheme, in most cases the parent company, will have to reflect all of the assets and liabilities on its individual company balance sheet.
7. Multi-employer schemes
In situations where there is a multi-employer defined benefit pension scheme then these will continue to be required to be accounted for as defined contribution pension schemes i.e. the only charge to the profit and loss account in the year will be the contributions payable figure. Such schemes are common in the charity and university sectors. However, if such a scheme has agreed a deficit recovery plan then this deficit will require to be recognised. This recognition could have a significant impact on the balance sheet reported and in some cases might even result in the balance sheet reporting a negative position.
8. Financial instruments
This is regarded by many commentators as the biggest single change required by FRS 102. The term financial instrument covers any "contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". A number of items which would satisfy this definition are specifically excluded from being accounted for as a financial instrument, including investments in subsidiaries, associates and joint ventures, rights and obligations under leases, insurance contracts etc. The full list of excluded items can be viewed at section 11 of FRS 102. That said, within its scope are items such as cash, equity instruments of other entities, trade debtors, trade creditors, loans, options, warrants, future contracts, forward contracts and interest rate swaps etc. Under existing UK accounting standards, the requirements for accounting for financial instruments are fairly basic, and do not require recognition of many types. This is an area which generally UK GAAP did not keep pace with international developments. Although the old Accounting Standards Board issued FRS 26 (effectively International Accounting Standard 39), its applicability was extremely limited. FRS 102 introduces much more comprehensive requirements, splitting financial instruments into two categories:
- Basic financial instruments (such as straightforward loans) which are measured at amortised cost)
- Other financial instruments (such as derivatives, including interest rate swaps and foreign currency forward contracts, and non-basic loans) which are measured at fair value
This will entail more work by entities to identify and correctly value the relevant financial instruments, and will impact both the balance sheet - with a greater number of assets and liabilities recognised , and the profit and loss account – with any fair value changes being recognised here.
The determination of which category a financial instrument falls into is very much the subject of a rules based approach. The category which will be the most challenging relates to determining whether a debt instrument is a basic financial instrument. These specific rules can be found in section 11.9 of FRS 102.
When first recognised, a financial asset or financial liability is measured at the transaction price. This will include the related transaction costs for those items which will subsequently be reported at amortised cost. For financial assets, such costs will be added to the cost of the asset whilst for financial liabilities it will be deducted from the liability recognised. Such costs will then feature as part of the calculation of amortised cost over the item's life or potentially shorter period. In contrast where a financial asset or financial liability is to be subsequently measured at fair value through profit or loss then transaction costs will not be capitalised on initial recognition.
Although normally the transaction price will equate to the fair value of the financial instrument in situations where the transaction is in effect a financing transaction this will not be the case e.g. where credit terms are embedded into the transaction and defer payment beyond normal payment terms. For such transactions the entity is required to measure the financial asset or financial liability recognised at the current estimate of the present value of the future payments, discounted at the market rate of interest for a similar instrument. Such amounts are subsequently measured at amortised cost using the effective interest method, hence transaction costs will be included in the cost recognised at the outset.
9. Inter-company loans
As part of the new requirements on financial instruments, many entities will need to consider the appropriate treatment of inter-company and other related party loans. Loans between group companies, or to or from directors are a common business transaction, and are often provided interest free, or at a below market rate of interest. Currently, these would simply be accounted for at face value, but the treatment under FRS 102 is more complex and will be influenced by factors such as whether there is a written contract; whether the loan is interest free or at a below market level of interest; and whether there is a specific loan term or if it is repayable on demand.
It is quite common for such loans to have no written contractual terms or interest charges applied. In such circumstances the substance of the loan needs to be determined and this may well require legal advice. Per paragraph 11.10 of FRS 102 a loan to a subsidiary which is payable on demand is a basic financial instrument. In such circumstances the accounting under FRS 102 will be the same as under existing UK GAAP i.e. the loan will be stated at the actual amount outstanding. The fact that it is deemed "repayable on demand" negates any need to consider having to discount the amount to be paid although the loan is in effect a financing transaction. Additional complexities could ensue but these are not considered here i.e. could the debtor actually repay the loan on demand if required?
10. Holiday pay
Whilst a strong argument can be made for accruing holiday pay under existing UK GAAP, in practice this is rarely done. FRS 102, however, specifically requires that holiday pay is accrued where applicable. This is most likely to be an issue in companies in which the holiday year does not match the accounting year. In cases where the holiday year mirrors that of the accounting year then this will not be an issue if employees are not allowed to carry forward any unused holidays.