FRS 102 and FRS 105: New revenue recognition treatments
On 27 March 2024, the Financial Reporting Council (FRC) issued the final amendments to UK and Ireland accounting standards arising from its periodic review. The periodic review amendments become effective for accounting periods commencing on or after 1 January 2026 with early adoption permissible.
It is also worth noting that on 10 September 2024, the FRC issued new editions of UK and Ireland GAAP which incorporate the periodic review amendments and are available for free download using this link.
The two headline changes relate to the new rules on lease accounting which was covered in the previous article. This article considers the new revenue recognition rules which affects both FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime. It examines the five-step model included in both standards with some examples to highlight some of the technical concepts.
New principles for revenue recognition
Within both FRS 102 (September 2024), Section 23 Revenue from Contracts with Customers and FRS 105 (September 2024), Section 18 Revenue from Contracts with Customers, is a five-step comprehensive model for recognising revenue. FRS 102, para 23.4 clarifies that the objective of the model is for an entity to recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
The five-step model works as follows (all paragraph references are to FRS 102 (September 2024)):
- Step 1: Identify the contract(s) with a customer (paras 23.7 to 23.16);
- Step 2: Identify the performance obligations in the contract (paras 23.17 to 23.40);
- Step 3: Determine the transaction price (paras 23.41 to 23.64);
- Step 4: Allocate the transaction price to the performance obligations in the contract (paras 23.65 to 23.77); and
- Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation (paras 23.78 to 23.112).
Step 1: Identify the contract(s) with a customer
FRS 102, para 23.7 set out specific criteria, all of which must be met, to account for a contract with a customer. These criteria are as follows:
- the parties to the contract have approved the contract and are committed to perform their respective obligations;
- the entity can identify each party’s rights regarding the goods or services to be transferred;
- the entity can identify the payment terms for the goods or services to be transferred;
- the contract has commercial substance; and
- it is probable (i.e. more likely than not) that the customer will have the ability and intention to pay the consideration to which the entity will be entitled when it is due.
| Example
The principal activity of an IT services provider is to provide support and repair services via the internet and onsite, if required. It has entered into a verbal contract with one of its customers to scan its server for viruses and clean up redundant files. The price to perform this work was agreed with a sales consultant by telephone. Payment was taken at the end of the telephone call. The services will be performed at an agreed date when the IT services provider will login to the customer’s server and carry out the work. The IT services provider and its customer have entered into an oral contract. A contract need not be in writing for it to be enforceable. The customer has provided payment details and consideration for the services to be provided, and the IT services provider is committed to performing the work on the customer’s server. In this situation all the criteria in paragraph 23.7 are met and the contract is within scope of FRS 102, Section 23 Revenue from Contracts with Customers. |
Step 2: Identify the performance obligations in the contract
A ‘performance obligation’ is defined as:
| A promise in a contract with a customer to transfer to the customer either:
a) a distinct good or service (or a distinct bundle of goods or services); or b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. |
Some contracts contain more than one performance obligation. For example, a client could sell a machine to a customer and provide one year’s servicing and maintenance. Similarly, a course provider could enter into a contract to provide three lectures at various different times and a textbook either on day one of the course, or on receipt of payment/registration.
| Example
Sunnie Ltd is a bookkeeping software developer. It enters into a three-year contract with its customer to provide a licence to access the bookkeeping software. The contract stipulates that Sunnie will provide periodic software updates and technical support throughout the term of the contract. The bookkeeping software is delivered prior to installation, updates and technical support and is functional without the updates and/or technical support. This means the customer benefits from each good or service individually. Sunnie has also determined that the licence, installation, updates and technical support are separately identifiable. Hence, in this scenario there are four performance obligations in this contract: · The licence to supply bookkeeping software · The installation service · Updates to the software · Technical support |
Step 3: Determine the transaction price
There are various sub-components in determining the transaction price and FRS 102, paras 23.43 to 23.64 cover the following issues:
- Variable consideration (paras 23.43 to 23.47)
- Sales-based or usage-based royalties (para 23.48)
- Refund liabilities (paras 23.49 to 23.50)
- Sale with a right of return (paras 23.51 to 23.57)
- Time value of money (paras 23.58 to 23.60)
- Non-cash consideration (para 23.61)
- Consideration payable to a customer (paras 23.62 to 23.64)
The transaction price is the amount of consideration the entity expects in exchange for satisfying a performance obligation (ignoring the effects of VAT).
| Example
Lenny Industries Ltd enters into 30 contracts with its customers to supply various chemicals. Each contract includes the sale of one type of chemical with a sales price of £1,200. The cost to Lenny Industries of each of these types of chemicals is £700. Customers can return the products within 30 days for a full credit and any returned goods can be used in other chemical mixes or sold again at a profit. The finance director can reliably estimate the return rate for this type of chemical based on previous experience. On this basis, the finance director has estimated that 26 products will not be returned, meaning four are likely to be returned. As the customers can return the products, the consideration is variable. FRS 102, para 23.44 requires any of the following to be used when estimating variable consideration: · the expected value method; or · the most likely amount method. Using the expected value method, the estimated variable consideration is £31,200 (26 products x £1,200). The variable consideration is included in the transaction price because, based on previous experience, it is highly probable that Lenny Industries will be entitled to the cumulative amount of revenue recognised (£31,200) when the uncertainty associated with the variable consideration is subsequently resolved (FRS 102, para 23.46). Revenue of £31,200 and refund liability of £4,800 (4 products expected to be returned x £1,200) is recognised. (FRS 102, paras 23.53(a) and (b)). In addition, Lenny Industries will derecognise the stock (inventory) transferred to its customers. It will also recognise a refund asset (classified as inventory) of £2,800 (4 products x £700 cost) as well as a corresponding credit to cost of sales. This represents its right to recover products from customers on settling the refund liability. (FRS 102, para 23.53(c)). |
Step 4: Allocate the transaction price to the promises in the contract
FRS 102, para 23.65 requires the entity to allocate the transaction price to each performance obligation identified on a relative standalone selling price basis, unless allocating discounts or variable amounts on an alternative basis. If a customer is offered a discount for purchasing a bundle of goods and services, the discount is allocated across all performance obligations within the contract in proportion to their standalone selling prices (unless observable evidence suggests this would be inaccurate).
| Example
Salinger Ltd sells a cutting machine with one year’s free technical support for £100,000. The sale of the machine and the provision of the technical support have both been identified as separate performance obligations. On a standalone basis, the machine would sell for £95,000 but this is the first time Salinger Ltd has started to provide technical support for this type of machine. Other support services provided by Salinger, which generate a profit for the entity, attract a mark-up of 50%. It is expected that the technical support service will cost £20,000. The selling price of the machine on a standalone basis is £95,000 but there is no observable selling price for the provision of technical support hence FRS 102, para 23.69 requires the standalone selling price to be estimated. FRS 102, para 23.70 suggests suitable methods may include: · An adjusted market assessment approach · Expected cost plus a margin approach · Residual approach The residual approach would attribute £5,000 (£100,000 – £95,000) to the technical support. This does not, however, approximate the standalone selling price of similar support services, which usually make a profit. Hence, a more appropriate approach would be an expected cost plus a margin approach. Based on this approach, the selling price of the technical support service would be £30,000 (£20,000 x 150%). The total of the standalone selling prices of the machine and technical support is £125,000 (£95,000 + £30,000). However, the total consideration is only £100,000. This means the customer is receiving a discount for purchasing a bundle of goods and services of 20% (£25,000 / £125,000). FRS 102, para 23.74 assumes that discounts relate to all performance obligations within a contract unless this basis does not depict the amount of consideration to which the entity expects to be entitled (in which case the entity uses a method that does reflect such amounts). The transaction price allocated to the machine is £76,000 (£95,000 x 80%). The transaction price allocated to the technical support is £24,000 (£30,000 x 80%). |
Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
Revenue is recognised when (or as) the entity satisfies a performance obligation by transferring a good or service to a customer. A performance obligation is said to be satisfied over time if one of the following criteria in FRS 102, para 23.81 (a) to (c) are met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
- The entity’s performance does not create an asset with alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
| Example
On 3 January 2026, Warrington Ltd enters into a contract with Wolves Ltd to provide monthly payroll services at a contracted price of £16,000 per annum. Warrington has a year end of 30 June 2026 and has early adopted FRS 102 (September 2024). The provision of payroll is a separate performance obligation which is performed over time. This is because the customer simultaneously receives and consumes the benefit of the payroll service. Even if Wolves Ltd were to change payroll provider, the payroll would not need to be reperformed. Warrington recognises revenue from the service over time. Hence, in the year to 30 June 2026, the entity would recognise £8,000 (£16,000 x 6/12). |
FRS 102, para 23.102 refers to ‘output methods’ (e.g. surveys of performance) and ‘input methods’ (e.g. costs incurred as a proportion of total expected costs) for measuring progress towards the satisfaction of a performance obligation.
If the progress cannot be reliably measured, revenue is only recognised up to the recoverable costs incurred.
| Example
On 3 January 2026, Wigan enters into a contract with Warriors to construct a new building for £8 million plus a bonus of £1 million if the building is completed within 18 months. Estimated costs to construct the building are £6 million. The winter months are renowned for causing delays to construction and sourcing various materials can also result in delays to construction. Hence, Wigan is uncertain whether the bonus will be received. At the year end 31 December 2026, Wigan is still uncertain whether its bonus target will be achieved due to other delays during the year. Wigan decides to measure progress towards completion based on costs incurred (FRS 102, para 23.102(e)). Costs incurred on the contract to date are £2 million. The construction of the building is a single performance obligation. The bonus element is variable consideration and must be excluded from the transaction price because it is not highly probable that it will be entitled to the cumulative amount of revenue (FRS 102, para 23.46). The construction is accounted for as an obligation settled over time. Wigan should recognise revenue based on progress towards satisfaction of the construction of the building. Using the costs incurred approach, the performance obligation is 1/3 (£2.0m / £6.0m) complete. Accordingly, revenue and costs recognised at the end of the year are:
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Conclusion
The new revenue recognition requirements in FRS 102, Section 23 and FRS 105, Section 18 are completely new and in some cases, the new requirements may result in different revenue profiles than under the January 2022 editions of the standards. Keep in mind there are new prescriptive requirements for transactions involving (among other things) non-refundable upfront fees and income arising from licensing and royalties.
Category: Accounting and standards
