Judgement Day: Key decisions in transitioning to amended FRS 102
Judgement Day: Key decisions in transitioning to amended FRS 102
On 27 March 2024, the FRC issued various amendments to FRS 102 and other FRSs following its second periodic review. These amendments substantially change the revenue and lease accounting frameworks. Our FRS 102 Amendment Hub provides practical guidance on these changes.
These amendments mean FRS 102 preparers will need to apply their judgement in an increased number of areas. Preparers should expect regulators and auditors to scrutinise these judgements, particularly in the initial periods of adoption. The points below are not exhaustive. They highlight common areas in which preparers may need to apply judgement.
Section 23 Revenue
Identifying a contract with a customer
Although identifying a contract is usually straightforward, judgement may be required where agreements are informal or contracts terms are being renegotiated.
Management needs to consider whether each of the five criteria in FRS 102.23.7 is met in situations such as:
- Informal or oral agreements – where no written agreement exists, but the business operates according to ‘handshake’ agreements or customary business practices
- Agreements exist but are not signed by one or both parties
- A contract term has ended, but the business is still operating under the terms of the expired contract
- A contract is in the process of being renegotiated and the parties continue to trade under ‘uncertain’ terms
Portfolio approach
The five-step model in the amended Section 23 Revenue is generally applied to individual contracts with customers. However, the approach that most preparers are likely to adopt is the ‘portfolio approach’. This allows an entity to group similar contracts or performance obligations if it reasonably expects that doing so would not produce a materially different result from applying Section 23 Revenue to each individual contract or performance obligation individually.
Section 23 Revenue does not explicitly explain what constitutes ‘similar’ or how to determine whether the result would be materially different. Applying the portfolio approach is inherently based on judgement. Auditors are likely to challenge the assumptions made and seek to understand the criteria and characteristics management has used when adopting this approach.
Identifying performance obligations
In some cases, such as an entity selling individual goods, the identification of performance obligations can be straightforward. However, it can be considerably more difficult in scenarios where a contract contains multiple products or promises, especially if some of the promises are not explicit. Some inherently judgemental scenarios include, but are not limited to:
- Contracts for goods and services that also contain warranties, especially if such warranties are optional extras
- Contracts that include options for additional goods or services
- Arrangements in which another party transfers goods or services (principal versus agent considerations)
- Contracts for goods that also include installation and ongoing technical support
- Contracts that include stand-ready obligations
- Contracts with ‘pre-production’ activities
In addition to identifying ‘distinct’ performance obligations, entities should consider whether a task is a performance obligation at all. In some cases, tasks may appear to be performance obligations but do not transfer goods or services to the customer and may, therefore, fall outside the scope of Section 23 Revenue.
Appropriately identifying the performance obligations in a contract is crucial because each obligation forms a separate ‘unit of account’ for determining how much revenue should be recognised and when.
Variable consideration
Variable consideration can arise for a wide range of reasons including discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items.
Variable consideration can be challenging to identify in some situations. For example, provisional pricing upon delivery of goods to a customer is common in the mining and extractives industry. Entities in all sectors will need to consider whether the variable consideration guidance in the standard applies.
Entities can estimate variable consideration using either the ‘expected value’ or the ‘most likely amount’ method. They need to select the method that best predicts the amount of consideration to which they expect to be entitled. Entities must also judge whether to constrain the variable consideration, taking account, of all relevant facts and circumstances.
Section 20 Leases
Identifying a lease
When applying the definition of a lease under amended Section 20 Leases, entities are required to identify the asset, assess whether they have the right to direct its use and determine whether they have the right to obtain substantially all the economic benefits from its use. Each component of the definition can require significant judgement in certain arrangements. Common judgemental scenarios include, but are not limited to, arrangements where:
- The asset is not explicitly identified
- The identified asset is a portion of a larger asset or is expressed as a proportion of an asset’s capacity (e.g. 80% of the production capacity of an item of machinery)
- The supplier has substitution rights
- It is unclear how decisions about the asset are made, including who directs its use
Lease term
To determine the lease term and, consequently, measure the lease liability, management needs to carefully assess the likelihood of exercising extension and termination options. Is it ‘reasonably certain’ that an option will be exercised? All relevant facts and circumstances need to be considered when assessing whether there is an economic incentive to exercise it. Auditors will seek to understand why management is reasonably certain and what it considered in reaching this judgement.
Discount rate
Lease payments should be discounted using the interest rate implicit in the lease. If this rate cannot be determined, entities may use either the Incremental Borrowing Rate (IBR) or Obtainable Borrowing Rate (OBR). Determining the appropriate IBR or OBR requires judgement, should be based on available market evidence and may require expert input.
In transitioning to amended FRS 102, preparers should document their judgements and methodologies to support timely and effective audits. Even where the accounting outcome does not change, preparers will need to consider and document how they have complied with the amended requirements.
For further guidance or to discuss how these changes may affect your organisation, contact Rachel Turner.