Understanding the new five-step revenue recognition model for FRS 102 and FRS 105
29 May 2024
Steve Collings FCCA examines the practical implications of the FRC’s amendments to revenue accounting under FRS 102 and FRS 105. The amendments, estimated to affect 3.4 million businesses, are designed to enhance the quality of UK financial reporting and to help support the access to capital and growth of the businesses applying them.
See the Navigate Learning Insight courses FRC Periodic Review Amendments 2024 and FRC Periodic Review 2024: Revenue recognition for further guidance.
Amendments to FRS 102 and FRS 105
On 27 March 2024, the Financial Reporting Council (FRC) issued Amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and other FRSs Periodic Review 2024.
The amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland (FRS 102) and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime (FRS 105) come into mandatory effect for accounting periods commencing on or after 1 January 2026, with earlier application permissible provided all the amendments are applied at the same time.
Alignment with IFRS
FRS 102 currently deals with revenue in Section 23 Revenue and FRS 105 currently deals with the issue in Section 18 Revenue. The amendments have changed the title of both sections in FRS 102 and FRS 105 to Revenue from Contracts with Customers. To those accountants familiar with the IFRS regime, that title will be familiar as the same one as IFRS 15 – the FRC have aligned UK and Ireland revenue recognition rules to those of IFRS.
In some cases, the method by which an entity recognises revenue may not change; but this will not be the case for every reporting entity.
The new five-step model approach
FRS 102:23.4 establishes a revenue recognition model for accounting for revenue from contracts with customers. The model’s objective is for an entity to recognise revenue so as to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to receive in exchange for those goods and services.
There are five steps involved in applying this model:
- Step 1: Identify the contract(s) with a customer (FRS 102:23.7–23.16);
- Step 2: Identify the performance obligations in the contract (FRS 102:23.17–23.40);
- Step 3: Determine the transaction price (FRS 102:23.41–23.64);
- Step 4: Allocate the transaction price to the performance obligations in the contract (FRS 102:23.65–23.77); and
- Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation (FRS 102:23.78–23.112).
FRS 105 contains a similar model, but there are further simplifications given the target audience of FRS 105.
In developing the revised FRS 102:23 and FRS 105:18, the FRC have included a new definition of ‘performance obligation’ which relates specifically to revenue:
‘A promise in contract with a customer to transfer to the customer either:
- a distinct good or service (or a distinct bundle of goods or services); or
- a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.’
Warranties
Generally, a warranty is assurance that a goods item will function as intended. Where this is the case, the warranty provided by the customer will be accounted for in accordance with FRS 102:21 Provisions and Contingencies.
If the customer has the option to purchase the warranty separately, FRS 102:23.27(a) states that this provides the customer with an additional service. This means that a portion of the transaction price is allocated to it (per Step 4 in the five-step model). There are few other points to note:
- if the warranty is required by law, this does not provide the customer with an additional service;
- the longer the coverage period, the more likely it is that the warranty provides the customer with an additional service; and
- if it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (such as a return shipping service for a defective product), then those tasks are unlikely to provide the customer with an additional service.
Non-refundable upfront fees
Examples of non-refundable upfront fees may include joining fees for a health club and initial fees in some supply contracts.
Upfront fees are treated as an advance payment for future goods or services and are recognised as revenue when those future goods or services are provided. The mere fact the entity has charged, say, a non-refundable upfront fee to a new member of a health club does not result in the transfer of a promised service to that customer.
Variable consideration
Variable consideration would be looked at in Step 3 (determining the transaction price).
Where a contract includes variable consideration, the entity must estimate the amount that it will be entitled to. There are two methods set out in FRS 102:23.44 as follows:
Method 1: Expected value
This is the sum of the probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if the entity has a large number of contracts with similar characteristics.
Method 2: Most likely amount
The most likely amount is the single most likely amount in a range of possible consideration amounts (the single most likely outcome of the contract). This amount may be an appropriate estimate of the amount of variable consideration if the contract only has two possible outcomes (such as the entity achieves a performance related bonus or not).
Whichever method is applied by the entity, it must be applied consistently throughout the contract when estimating variable consideration.
An important point to keep in mind is that FRS 102:23.46 states that variable consideration is included within revenue only to the extent that it is highly probable that the entity will be entitled to the cumulative amount of revenue recognised when the uncertainty associated with the variable consideration is subsequently resolved.
The term ‘highly probable’ is defined as: ‘Significantly more likely than probable’.
Non-cash consideration
Any non-cash consideration is measured at fair value (FRS 102:23.61). If the fair value of non-cash consideration cannot be estimated reliably, the transaction is measured using the standalone selling price of the good or service promised to the customer.
Preparing for the changes
Reporting entities will need to carefully assess their revenue recognition accounting policies to ensure they are compliant with the new requirements in FRS 102:23 or FRS 105:18. There could well be potential amendments to the timing of revenue recognition under the revised accounting treatments. Companies should also take this opportunity to review their accounting policies for consistency.
Companies will need to review their customer contracts in detail to apply the guidance and this may not be as simple as it appears at first glance.
In addition to understanding how revenue from their customer contracts will need to be accounted for under the new revenue model, companies also should bear in mind the enhanced disclosure requirements under FRS 102:23 which relate to:
- classes of revenues;
- how and when revenue has been recognised; and
- unsatisfied performance obligations.
If significant judgements have been applied in recognising revenue, these will also require disclosure under FRS 102.
Document downloaded on 12-07-2024 from Croner-i Navigate, the UK’s leading online research service for tax, audit and accounting professionals. Find out more at www.croneri.co.uk or call 0800 231 5199.
This article was correct at the date of publication. It is intended as an aid and cannot be expected to replace specific professional advice and judgment. No liability for errors or omissions will be accepted. It is the responsibility of those using the information to ensure it complies with the law at the time of use and that it is used in line with relevant rules and regulations governing the subject matter in question.
Except where otherwise indicated, all content is copyright of Croner-i Ltd.
© Croner-i Ltd, 2024
All rights reserved. No part of this publication may be reproduced without prior permission