Changes to FRS 102: What businesses need to know (part two)

Further to our earlier thoughts, found in part one of this series, here we share updates to revenue recognition for businesses in the context of upcoming changes in FRS 102.

The key changes to revenue recognition for those accounting under UK GAAP

What does this mean for businesses?

The revised Section 23 – Revenue from Contracts with Customers in FRS 102 (2024) is broadly in line with IFRS 15 Revenue from Contracts with Customers, and the five-step revenue recognition model.

In practice this means:

• Requirement to revisit revenue streams and assess how the five-step model applies to each key contract type.
• More focus on contract terms, pricing structures, discounts, rebates, warranties, options and financing elements, these can all change the timing and pattern of revenue.
• A shift from a “risks and rewards” focus to a “transfer of control” model, which may accelerate or defer revenue.
• New balance sheet line items such as contract assets, contract liabilities and contract cost assets, and more granular disclosures about how and when you earn revenue.
• A choice of full retrospective or modified retrospective transition for revenue, which can affect comparatives, KPIs and covenant metrics.

For many businesses, the real work will be less about “the debits and credits” and more about data, systems and processes, ensuring businesses are able to identify performance obligations, track contract balances and support the new disclosures consistently across the business.

What has changed for revenue recognition?

The previous guidance in Section 23 has been replaced with a five-step model that is substantially aligned with IFRS 15:

Identify the contract(s) with a customer

• A Contract is an agreement between two or more parties that creates enforceable rights and obligations. It is within scope only if it has commercial substance, clear rights and payment terms, both parties have approved it, and it is probable the customer will pay.
• Certain contracts with the same customer must be combined if negotiated as a package with a single commercial goal or if consideration in one depends on the other or they form a single performance obligation.

Identify the performance obligations in the contract

• At contract inception, an entity must identify its performance obligations, i.e. each promise to transfer a distinct good or service (or series of distinct goods or services) in the contract.
• A good or service is distinct if the customer can benefit from it on its own (or with other readily available resources) and it is separately identifiable from other promises in the contract.

Determine the transaction price

• This is the amount of consideration an entity expected to be entitled to, excluding amounts collected on behalf of third parties (e.g. VAT).
• Adjustments may be needed for time value of money, non-cash consideration, and amounts payable to customers.

Allocate the transaction price to performance obligations in the contract

• The transaction price is allocated to each performance obligation based on the relative stand-alone selling prices of the underlying goods or services, using observable prices where available, or suitable estimation methods such as adjusted market assessment, expected cost plus margin, or a residual approach.
• Discounts and/or variable consideration are allocated to performance obligations on the basis of relative stand-alone selling prices, unless another allocation method better reflects the consideration to which the entity is entitled.
• Any changes in the transaction price are allocated on the same basis as at contract inception, while contract modifications are assessed separately with adjustments made to performance obligations based on the nature of the modification.

Recognise revenue when (or as) performance obligations are satisfied

• An entity should determine at contract inception whether a performance obligation is satisfied over time or at a point in time.
• Revenue is recognised over time if the customer simultaneously receives and consumes benefits, controls the asset as it is created/enhanced, or the asset has no alternative use to the entity and there is an enforceable right to payment for performance to date. For performance obligations satisfied over time, revenue is recognised using a suitable measure of progress. The method chosen should reflect the value transferred to the customer and the entity’s inputs relative to total expected inputs. Paragraph 23.102 sets out common and appropriate methods for measuring progress.
• Revenue is recognised at a point in time when control transfers, based on indicators such as transfer of legal title or possession, transfer of risks and rewards, the entity’s present right to payment, and customer acceptance.

Some other important considerations in the revised Section 23 include:

• Contract modifications – Contract modification is a change in scope or price of a contract which should be either treated as a separate contract or as part of the existing contract. This determination sets out the appropriate treatment for the modification as set out in paragraphs 23.15 to 23.16.
• Warranties – Basic assurance-type warranties remain under Section 21; warranties that provide additional services become separate performance obligations. In assessing this, paragraph 23.27 should be considered, for example, if the warranty is sold separately, it is an additional service and therefore a separate performance obligation.
• Non-refundable upfront fees – If the upfront fee is an advance payment for future goods or services, revenue is recognised only when those goods or services are provided, and it must be assessed whether these goods or services constitute a separate performance obligation.
• Customer options – An option that gives a customer free or discounted future goods or services may give rise to a material right. A material right is a promise within the contract that the customer would not receive without entering into that contract. A material right is a separate performance obligation. Revenue is recognised when the related future goods or services are transferred, or when the option lapses.
• Principal vs agent – Refined guidance focusing on whether the entity controls the specified good or service before transfer to the customer. Section 23 provides three principal indicators to support the assessment, however, the indicators do not override the assessment of control and should not be viewed in isolation. Principal recognises revenue gross where it controls the good/service before transfer; agent recognises net revenue where it only arranges for a third party to provide it.
• Variable consideration – An entity must estimate and constrain variable consideration (rebates, bonuses, discounts, returns, usage-based fees) using expected value or most likely amount, and include only amounts that are highly probable not to reverse. The estimate of variable consideration is reassessed at each reporting date to reflect changes in circumstances.
• Sale or usage-based royalties – Where a license of IP is the sole or main item to which a royalty relates, royalty income is recognised at the later of: the subsequent sale or usage occurs; and the performance obligation to which royalty relates has been satisfied (or partially satisfied).
• Refund liabilities – A refund liability is recognised when some or all of the consideration received from a customer is expected to be refunded. It is measured at the portion of consideration received that is not expected to be retained.
• Right of Return – For contracts that include a right of return, revenue is recognised only for goods that are not expected to be returned. A refund liability is recorded for the consideration relating to expected returns, and a corresponding refund asset is recognised for the returned products.
• Time value of money – Where payment terms include a significant financing component (for example, extended credit terms or non-market interest), the transaction price is adjusted for the time value of money. The financing element is then recognised separately as interest income or expense, rather than as revenue, in accordance with Sections 11 and 12. No adjustment is required where, at contract inception, the period between transfer of goods or services and payment is expected to be 12 months or less.
• Non-Cash Consideration – Non-cash consideration is measured at fair value. If fair value cannot be reliably estimated, it is measured by reference to the stand-alone selling price of the promised goods or services.
• Amounts payable to customers – Treated as a reduction of the transaction price unless it relates to a distinct good or service provided by the customer. The reduction in revenue is recognised at the later of: when revenue for the related goods or services is recognised, or when the consideration is paid or promised.
• Contract costs – An entity may choose to recognise an asset for costs incurred to obtain or fulfil a contract if they are directly attributable, enhance resources for future performance obligations, and are expected to be recoverable. Costs that do not meet these criteria, or that would be fully amortised within one year, are expensed as incurred. Where other sections of FRS 102 apply, those requirements take precedence. Contract cost assets are carried at cost less amortisation and impairment, with amortisation recognised in line with the pattern of transfer of goods or services to the customer.
• Contract balances – A contract liability arises when consideration is received from a customer before the related goods or services are transferred. A contract asset or trade receivable is recognised when goods or services have been transferred but consideration has not yet been received. A contract asset exists when the right to consideration is still subject to conditions other than the passage of time, whereas a trade receivable reflects an unconditional right to consideration, with only the passage of time required before it falls due.

Overall, the new model is more principles-based and will often require more judgement, more documentation and more involvement from commercial teams than the old FRS 102 approach.

Technical areas to consider

While every revenue stream needs revisiting, some areas are particularly prone to judgement and complexity under the revised FRS 102:

Contract scoping and modifications

• When should multiple contracts with the same customer be combined?
• How should variations, renewals, and change orders be treated – as separate contracts or modifications of existing contracts?

Identifying performance obligations

• Are goods and services truly distinct, or should they be bundled into a single performance obligation (e.g. equipment + installation + ongoing support)?
• How do you treat for e.g. customer options, loyalty schemes – do they create “material rights” that must be accounted for separately?

Variable consideration and constraint

• Estimating rebates, bonuses, returns and performance fees requires robust data and controls.
• Applying the “highly probable” no-reversal constraint, and update estimates at each reporting date.

Over time vs point in time

• Construction, long-term service and manufacturing contracts may move between over-time and point-in-time recognition depending on control and enforceable rights to payment.
• Choosing and applying an appropriate measure of progress can be sensitive, especially where estimates change.

Principal vs agent

• Platform, reseller and intermediary models require careful assessment of control to decide whether revenue is reported gross or net.

Licenses, royalties and Intellectual Property heavy arrangements

• Distinguishing between rights to access and rights to use Intellectual rights will determine whether license revenue is over time or at a point in time.
• Sales- or usage-based royalties linked to licenses follow a specific “later of” recognition rule.

Contract costs

• Deciding which acquisition and fulfilment costs qualify to be capitalised, how they should be amortised, and how to test for impairment.

Contract balances and systems

• Implementing processes to track contract assets, contract liabilities and refund liabilities, as well as right of return assets, may require system changes or new reporting tools.

Transition choices

• Weighing up full vs modified retrospective transition in terms of comparability, system effort, and the impact on equity and covenants, alongside the available practical expedients.

These areas are likely to require cross-functional input from finance, commercial, legal and IT teams, supported by detailed contract reviews.

Disclosures in the financial statements

The revised Section 23 significantly expands the disclosure requirements around revenue. At a high level, entities shall now provide:

• Disaggregation of revenue by relevant economic factors (e.g., types of goods or services, geographic regions or markets, customer types, timing of transfer (over time vs point in time), principal vs agent (gross vs net).
• Information on contract balances such as opening and closing contract assets, contract liabilities and trade receivables, and movements during the period.
• Information on performance obligations, such as the nature of performance obligations, typical payment terms and when they are usually satisfied.
• For revenue recognised over time, the methods used to recognise revenue.
• Quantitative and/or qualitative information about significant unsatisfied performance obligations and when these are expected to be satisfied, however in a couple of scenario’s, exemptions from these disclosures can be claimed.
• Closing balances of contract cost assets, the amount of amortisation and any impairment losses recognised in the period.

Transition

On first applying the revised standard, an entity may choose either a full retrospective or modified retrospective approach. Under the modified retrospective method, comparative figures are not restated, and this section is applied only to contracts that are not complete at the date of initial application. Various practical expedients are available when applying this approach, and the cumulative effect of adoption is recorded as an adjustment to opening retained earnings (or other components of equity) at the date of initial application. Under the full retrospective method, comparatives are restated, with simplifications and optional expedients also permitted.

For more information around the upcoming changes, contact our team today.