The Financial Reporting Council (FRC) published on 27 March 2024 amendments to FRS 102 as part of its second periodic review of the standard. The amendments are relevant for all companies reporting under FRS 102, effective from 1 January 2026, with early adoption permitted for any company.
FRS 102 amendments and impact on financial reporting
The amendments focus on updating FRS 102 to align it closer to UK-adopted International Financial Reporting Standards (IFRS) with respect to revenue and leases.
The impact of these changes will vary across different industries and sectors. FRS 102 Section 23 Revenue will typically have a larger impact on the reported revenue of businesses providing services or engaged in long-term contracts, such as telecoms providers, professional services, technology and construction companies. FRS 102 Section 20 Leases will significantly impact the P&L lines and net debt of businesses with large lease portfolios, such as retail, transportation, and real estate – although any business that has leases will likely be impacted.
Section 23 Revenue
The new revenue accounting standard introduces the five-step revenue recognition model, as used in IFRS 15. Implementing this model could potentially alter how and when revenue is recognised. The extent of this will depend on the terms of the transfer of promised goods or services to customers as set out in the contract.
Section 20 Leases
The new lease section requires (in most cases) leases to be capitalised and brought onto the balance sheet, recognising a right-of-use (ROU) asset and a corresponding lease liability. There are limited exceptions for short-term leases (12 months or less) and for leases of low-value items.
The capitalisation of leases, and bringing them onto the balance sheet, won't only affect balance sheet metrics. There'll be a substantial change in how lease costs are recognised in the P&L. Rather than having a monthly rent expense, companies will have to recognise depreciation on the ROU asset and an interest expense relating to the lease liability. (More on this in the next section on how this can impact on deals.)
What’s more, the lease liability is determined by the present value of the lease payments discounted using the rate implicit in the lease, the lessee’s incremental borrowing rate or the lessee’s 'obtainable' borrowing rate. Determining any one of these can be complex and requires additional time and thought when entering a new lease arrangement.
With the amendments affecting calculations for reported revenue, profits and balance sheets, it's vital to start planning for these changes now.
How can this impact your deals?
In an M&A transaction, these amendments may have a significant impact on the target business’s key financial metrics commonly used to determine the headline price and final equity price, including revenue, EBITDA (earnings before interest, tax and depreciation), working capital and net debt, as shown in the illustration below.
(Note: while the profit and loss charges, i.e., depreciation and interest expenses, over the term of the lease will equal the total lease payments, the amount recognised from one period to the next will vary. This is due to the lease liability unwinding on an amortised cost basis, resulting in a larger proportion of the lease expense being recognised in the first half of the lease term. Additionally, the depreciation expense will vary based on the depreciation policy selected, i.e., straight line or written down value. This example is for illustrative purposes only.)
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The amendments should be viewed as reporting changes aimed at improving clarity in financial reporting and aligning with UK-adopted IFRS, rather than as factors that directly impact the underlying valuation of a business (as they don't change its underlying cash flows). However, the headline price or enterprise value offers for businesses are often based on assumed levels of earnings, eg, EBITDA or revenues with a multiple applied. In arriving at the final equity price, adjustments are then made for working capital and net debt, as laid out by the ICAEW Best Practice Guideline on Completion Mechanisms.
To ensure valuations are not distorted, dealmakers may need to modify their approach to setting out and agreeing valuations. For example, they may re-state key financial metrics to be a previous FRS 102 basis, or apply a different EBITDA multiple to nullify the impact of the changes and result in the same headline valuation. Depending on the approach adopted, parties also need to assess whether it's appropriate to classify lease liabilities arising from the amendment as a debt-like item when determining the final equity value.
In technology deals, where the valuation is often based on revenues (and revenue growth), dealmakers may adjust their valuation approach either by resetting the multiple or by restating revenue and profits based on previous FRS 102 basis.
How to approach the SPA
The Sale and Purchase Agreement (SPA) governs the final determination of the equity price, together with any adjustments to be applied in respect of the completion mechanism and, if applicable, the earn-out mechanism. The ICAEW Best Practice Guideline on Earn-out Agreements has further information on this.
Given the significant changes to reported earnings and increased lease liabilities that these amendments will cause, dealmakers need to take care to ensure the SPA aligns to the parties’ intentions, especially where any affected metrics are referred to.
For example, if the transaction completion mechanism includes a deduction for any leases on the balance sheet and this is being measured after the amendments come into effect – i.e., if completion is after 1 January 2026 – the SPA should specify whether the leases would be measured on an old FRS 102 basis.
Similarly, earn-out calculations can be significantly impacted as they're often linked to revenue, EBITDA, or operating profit. Therefore, parties must consider the impact of revisions in accounting standards when agreeing on the basis of preparation for earn-out accounts.
If the transaction includes an earn-out mechanism that covers a period after the amendments come into effect, the SPA should again specify whether the amendments should be applied or adjusted out. This could impact on SPAs being signed before the changes take effect and advice should be taken on any SPAs with earn-outs, to consider whether the accounting treatments should be frozen at the SPA signing date or if changes need to be made to the calculation of earn-out targets.
Next steps to prepare for changes to FRS 102
Although these FRS 102 amendments won't take effect until 1 January 2026, it's crucial to adopt a proactive approach to ensure you're prepared for the changes.
Businesses should evaluate the potential impact of the proposed changes on financial statements and ensure they possess the necessary information, and resource and robust systems in place, to facilitate a smooth transition. They should also review existing customer contracts and decide whether to amend them to align with their preferred position or maintain a position similar to the existing standard. Finance teams should also ensure that their lease data is comprehensive and accurate to determine borrowing rates.
Dealmakers need to consider the impact of these changes on key financial metrics used to agree transaction terms and referenced in SPAs to determine the headline price and final equity price of M&A transactions.
For more insight and guidance, get in touch with Patrick O'Brien or Pinkesh Patel.
