UK GAAP – another fundamental change
It has been ten years since the publication of Financial Reporting Standard 102 (FRS 102) which consolidated all previous FRSs and SSAPs (Statements of Standard Accounting Practice) into one ‘handy’ standard for small and medium sized entities (SMEs). This was a major change at the time with the intention of harmonising UK accounting standards (GAAP) with international financial reporting standards (IFRS) being used by listed and most public sector entities. Harmonising standards through FRS 102 rather than forcing SMEs to adopt IFRS was seen as a positive step as IFRS is at best a blunt instrument with no consideration for relevance to smaller companies.
So, by harmonising through a different standard, the main principles of IFRS could be adopted, but with allowances and exemptions provided to make them fit more practically and economically with the SME sector. This seemed like a pragmatic answer to the problems being posed by IFRS whilst giving more comparability to the accounts across different size categories. The plan was for FRS 102 to be updated every three years to pick up changes to IFRS and a new utopian world of financial reporting would exist for us all.
Time passed, we had our first triennial review, sensible changes and clarifications were made to pick up on issues found and any necessary amendments were sorted out. It all then went a bit quiet, the reason being that IFRS 15 (Revenue from contracts) and IFRS 16 (Leases), both took effect from 2019 and made significant changes to how transactions were accounted for. IFRS 15 needs some thought but in most cases is not too significant. IFRS 16 is rather more fundamental.
The narrative of FRS 102 then changed from a triennial review to a quinquennial review and finally to a ‘periodic’ review as the challenge of incorporating IFRS 16 was kicked down the road. After various consultations and due consideration, just before Christmas in 2022Financial Reporting Exposure Draft 82 (FRED 82) was published, the gift no one really wanted at that festive time of year.
So, what is IFRS 16 and why does it pose challenges to businesses on adoption? For many years there has been concern about off balance sheet liabilities and how the failure to include these can potentially make the accounts misleading. What IFRS 16 tries to achieve is to look at operating lease arrangements and bring these liabilities and the related ‘right of use asset’ onto the balance sheet. Currently in FRS 102 operating leases are not shown on the balance sheets and the costs are taken to profit and loss (P&L). There is a disclosure note which shows operating lease commitments, but these are not shown on a primary financial statement.
With IFRS 16 the balance sheet shows that a company has, say, signed a five-year lease and therefore has an obligation to pay the rentals for that period. This does seem like helpful disclosure as if the company defaults on that lease it is likely to have significant consequences, it is a liability that contractually will have to be settled. It also changes how the profit and loss (P&L) is impacted, but I acknowledge that this is of interest to people like me and of less relevance to most users as the P&L charge will not vary significantly.
IFRS gives guidance on how the asset and liability is calculated and the accounting once calculated is relatively straightforward. The problem with IFRS16 was that it did not really set a sensible de-minimis on what leases should be capitalised, the worked example referring to leases over $500 (the original guidance notes were to international standards so given in dollars). I think most people would consider the 10 year lease of a building to be significant to include, but possibly not the three year lease of a photocopier. At $500 virtually everything would be captured, albeit if a lease ran for less than a year it could be excluded.
FRED 82 has tried to address this by referring to material leases, but this is a nebulous term that would benefit from some clear definition. It is also proposing some anti-avoidance rules as some clever leasing companies now offer one year rolling leases as a way of trying to avoid the standard.
If FRED 82 is adopted as proposed it will take effect for the accounting period commencing on or after 1 January 2025. It is therefore sensible for businesses to start preparing a register of their operating leases well in advance of this date to start assessing the likely impact of the change on their financial statements. I think that there are two very important and practical points to consider with this change.
The first is the impact on bank covenants, particularly if there is a covenant based on net current assets. The way that operating leases are accounted for means that there is an increase in fixed assets, but the liability will be aged between current and long-term liabilities. This will mean that there is a negative impact on net current assets.
The second is the potential to drag audit exempt entities into audit. One of the size criteria for audit is based on gross assets (fixed assets plus current assets) and under FRED 82 the fixed assets will be increasing by the value of the ‘right of use’ asset. So, if an entity already breaches one of the other criteria (turnover or staff numbers) and this pushes them over the £5.1million limit for gross assets then they may be pushed into audit.
The conversion is an easier job if planned for, so it is probably worth starting to think about it now.
Tim and his team have decades of experience in providing audit services for businesses in the East of England. If you are concerned about how these changes may affect the way you report operating leases, and what you need to do to prepare, do get in touch today to find out more. Email Tim at email@example.com or phone 0330 058 6559.