New UK GAAP: Tax implications of transitioning to FRS 102
Donald Drysdale reflects on the importance of managing the tax implications of a transition to FRS 102.
New UK GAAP
Over the past four years the Financial Reporting Council (FRC) has replaced almost all pre-existing accounting standards for the UK and the Republic of Ireland, and in doing so has created a new generally accepted accounting practice (GAAP) for these jurisdictions.
The new GAAP consists of a range of financial reporting standards, from which an appropriate standard must be chosen and applied for periods of account beginning on or after 1 January 2015 – or, for those applying the Financial Reporting Standard for Smaller Entities (FRSSE), one year later. Changes in accounting treatment on implementation of the new UK GAAP can have a significant impact on UK tax liabilities.
What is FRS 102?
Financial Reporting Standard 102 (FRS 102) is one of the key optional accounting standards available under the new UK GAAP, and it will be used widely. It is a largely freestanding financial reporting standard for companies and other entities (including not-for-profit entities) that choose not to apply:
- EU-adopted International Financial Reporting Standards (IFRS); or
- FRS 101 (IFRS Reduced Disclosure Framework), which can be applied in the accounts of individual undertakings which are part of a group which applies EU-adopted IFRS in the consolidated accounts; or
- FRS 105, which is available to entities which qualify as micro-entities.
FRS 102 is designed to apply to general purpose financial statements – i.e. those intended to meet the needs of a wide range of users including shareholders, lenders, other creditors, employees and members of the public.
FRS 102 and other information relating to the new UK GAAP, including FRC editorial amendments and clarification statements, can be found on the FRC website. It is intended that once the transitional phase is over the FRC will only review and update FRS 102 every three years. However, revisions have already been made to the initial standard published in 2013 and the FRC is currently inviting comments from stakeholders on their experiences of implementing the standard in order to inform the first triennial review. Comments received by the FRC by 31 October will be used to inform the development of proposals for changes to the standard, which will be subject to formal consultation at a later date, in advance of a planned effective date of 1 January 2019.
FRS 102 is based on the IFRS for Small and Medium-sized Entities (IFRS for SMEs) but has been subject to certain changes to make it more appropriate for use in the UK environment. It also shares certain similarities with FRS 101, which is effectively the recognition and measurement requirements of full IFRS subject to some adjustments to ensure alignment with the UK Companies Act and also reduced disclosure requirements.
Smaller entities, depending on their circumstances, may have a choice of three core regimes under the new UK GAAP – the micro-entities regime (FRS 105) provided that the micro-entity criteria are met, the small entities regime (Section 1A of FRS 102), and full implementation of FRS 102. The FRSSE can no longer be used for periods of account beginning on or after 1 January 2016.
Accounting transition to FRS 102
Entities applying FRS 102 for the first time must restate their balance sheet for the beginning and end of the comparative period. For example, where the first period of account of mandatory application is the year ending 31 December 2015, they must restate their opening balance sheet as at 1 January 2014 (known as the date of transition) and their comparative balance sheet as at 31 December 2014.
Transition to FRS 102 impacts on an entity’s accounts in two key ways:
- assets and liabilities at the date of transition are identified, recognised and measured in line with the requirements of FRS 102 (subject to some mandatory and some optional exemptions); and
- thereafter profits and losses are recognised in accordance with FRS 102, and are likely to differ from those that would have been reported had the old UK GAAP been retained.
On transition there may be a significant number of adjustments – both to the carrying value of assets and liabilities recognised previously under the old UK GAAP, and in terms of assets and liabilities newly recognised under FRS 102. For accounting purposes these adjustments are made as at the date of transition, with corresponding adjustments directly to the opening reserves.
Tax implications of the transition
HMRC require financial statements for tax purposes to be prepared in accordance with GAAP.
A change of accounting basis from one valid basis to another, or a change of accounting policy such as a change from the old UK GAAP to FRS 102, may bring about prior period adjustments. Positive adjustments, which increase profits or reduce losses, are taxed as receipts. Negative adjustments are allowed as expenses. For tax purposes these prior period adjustments are treated as arising on the date of transition.
On 12 August 2016, HMRC updated their FRS 102 overview paper containing guidance for entities choosing to apply FRS 102. This provides a comparison of the accounting and tax differences between the old UK GAAP and FRS 102, and a summary of the key accounting and tax considerations that arise for entities transitioning from the old UK GAAP to FRS 102. It is equally relevant to smaller entities electing to apply section 1A of FRS 102.
HMRC’s paper concentrates on the corporation tax position. It may also assist individuals or other entities subject to income tax, as many of the accounting and tax issues are similar. However, please bear in mind that there are specific regimes for loan relationships, derivative contracts and intangible fixed assets which only apply for corporation tax.
The guidance from HMRC tabulates certain transition adjustments that may be required for accounting purposes, and their tax implications, including:
- Accounting adjustments recognised as at the date of transition – to ensure that business receipts are taxed only once and deductions are given only once;
- Accounting adjustments reflecting changes of accounting policy;
- Differences in the treatment of intangibles; and
- Adjustments in the treatment of loan relationships or derivative contracts.
The following are examples of ways in which differences between FRS 102 and the old UK GAAP may affect both the current tax computation and the calculation of deferred tax liabilities:
- Investment property: Under FRS 102, gains and losses on fair value fluctuations are taken directly to profit or loss (although are not distributable profits); this contrasts with their being recognised previously as unrealised gains in the Statement of Total Recognised Gains and Losses.
- Intangible assets and goodwill: Under FRS 102, where the entity is unable to estimate reliably the useful economic life, it should not exceed 10 years.
- Financial instruments: The FRS 102 treatment for many basic financial instruments is the amortised cost basis of accounting.
- Loan relationships: FRS 102 requires loans not at a market rate of interest to be discounted, unless they are repayable on demand.
- Leasing: FRS 102 regards a lease as indicative of a finance lease when ‘substantially all’ of the present value of the minimum lease payments is equivalent to the fair value of the leased asset; there is no 90% test, but this is not anticipated to result in a major change in practice.
- Stock valuation: FRS 102 prohibits the use of the LIFO method.
- Grants: FRS 102 offers a choice of accounting policies – a performance model and an accrual model – the latter being similar in nature to previous accounting requirements.
- Employee benefits: FRS 102 requires accruals to be made for unpaid short-term employee benefits such as unpaid sick pay and holiday entitlement.
- Deferred tax: Under FRS 102, deferred tax is recognised on a revalued asset, regardless of whether or not there is a binding agreement to sell, and the tax rate is that which would apply on a disposal.
Feedback from HMRC suggests that some entities are failing to apply FRS 102 correctly, or not recognising appropriate tax adjustments on the transition. Where this causes incorrect self-assessment of tax liabilities, any under-declaration of tax may attract interest and penalties.
HMRC’s overview paper provides only general guidance and is not intended as a substitute for detailed study of FRS 102 and the related tax law. Changing the basis on which accounts are prepared is a complex matter. Practitioners need to be able to ensure that their clients comply with the new UK GAAP, and that the tax implications of transition adjustments are duly recognised.
Article supplied by Taxing Words Ltd