Week 2: Revenue Recognition - A Fundamental Shift
The Financial Reporting Council (FRC) recently published significant amendments to FRS 102 as part of its periodic review, aligning UK GAAP more closely with International Financial Reporting Standards (IFRS). This week we delve deeper into the changes in revenue recognition. The updated approach in FRS 102 represents a fundamental shift from the previous standard. Read on to learn more about the new revenue recognition model based on IFRS 15, detailing the significant differences, practical implications, and clear examples illustrating these changes.
New Revenue Recognition Model: IFRS 15’s Five-Step Process
The updated Section 23 introduces a comprehensive five-step model, designed to reflect the timing and substance of revenue more accurately:
- Identify the contract(s) with the customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognise revenue when (or as) each performance obligation is satisfied.
Key Differences from the Previous Model
The transition from a risks-and-rewards model to a control-based criterion significantly affects how and when revenue is recognised. Previously recognised upon the delivery of goods or completion of services, revenue now hinges on the customer’s control over goods or services, rather than just the transfer of risks and rewards. This change is unlikely to affect simple sales transactions but will affect arrangements such as multi-element contracts, service-based contracts, and bill-and-hold agreements.
The new model provides clear guidance on previously judgment-based areas like variable consideration (bonuses, rebates, penalties), significant financing components (advance or deferred payments), non-cash consideration, and payments to customers. Entities must estimate variable consideration using expected value or most likely amount and include it in revenue only if not likely to reverse, improving accuracy but increasing estimation. Unlike the previous FRS 102, which lacked explicit limits on early recognition of variable fees, the new rules impose a constraint to prevent over-recognition.
Illustrative Example 1 – Bundled Service Scenario for Jersey Fund Administrators
A Jersey fund administrator agrees an annual service engagement with a Jersey Private Fund for £32,000. The engagement includes:
- Monthly bookkeeping and management accounts
- Investor reporting and capital call processing
- Annual Compliance Return submission to the JFSC
- Preparation of annual financial statements
Old FRS102:
Under previous practice, the entire fee might have been recognised upon receipt, or alternatively, the full amount might have been spread evenly over time without distinguishing between individual performance obligations.
Updated FRS102:
In line with IFRS 15, revenue must be allocated to each distinct performance obligation based on standalone selling prices and recognised as those obligations are satisfied:
Over time:
Monthly bookkeeping and management accounts (e.g., £15,000) – recognised progressively throughout the year.
Investor reporting and capital call processing (e.g., £10,000) – recognised throughout the year as services are delivered.
At a point in time:
Preparation of annual financial statements (e.g., £5,000) – recognised when prepared, before the audit.
Annual Compliance Return submission (e.g., £2,000) – recognised when completed.
Illustrative Example 2 – Recognition of Carried Interest by General Partner (GP)
A Jersey private equity fund is nearing the exit of its investments. Under the Limited Partnership Agreement (LPA), the GP is entitled to 20% of profits in excess of an 8% preferred return. For this example, the carried interest is treated as a performance-based fee for investment management services (not an equity interest in the fund), and is therefore within the scope of the updated FRS 102 revenue requirements (aligned with IFRS 15).
The GP provides a single performance obligation: continuous investment management services throughout the fund’s life. This performance obligation is satisfied over time. The carried interest forms part of the transaction price for these services and is a form of variable consideration because it depends on the ultimate profitability of the fund and is subject to clawback.
The GP estimates the amount of carried interest using an appropriate method (for example, the most likely amount) but applies the “highly probable” constraint on variable consideration. Due to the whole-of-fund waterfall and clawback mechanics, management concludes that recognising carried interest early in the fund’s life would expose the entity to a significant risk of revenue reversal if subsequent investment performance deteriorated.
Only when cumulative realised gains significantly exceed the preferred return, and the remaining volatility in the fund is low relative to that surplus, does the GP conclude that it is highly probable that a significant reversal will not occur. At that point, the GP recognises a cumulative catch-up adjustment to revenue for carried interest allocated to the investment management services provided to date. Subsequent changes in estimated carried interest continue to be recognised as the constraint is reassessed.
Old FRS 102:
Under the former Section 23 requirements, carried interest was recognised by reference to the stage of completion of services when the outcome could be estimated reliably and it was probable that economic benefits would flow to the entity. Without an explicit “highly probable / significant reversal” test, some entities recognised carried interest earlier in the fund life based on projected returns and less restrictive views of clawback risk.
Updated FRS 102:
By treating carried interest as variable consideration subject to the IFRS 15-style constraint, recognition is generally deferred until the fund’s performance against the hurdle is more firmly established and the risk of clawback is low. This results in more conservative and, typically, later recognition compared with some previous practices, reducing the likelihood of subsequent revenue reversals.
Transition and Preparation
Entities can choose full retrospective adoption or a modified approach adjusting the opening balance of equity.
The modified approach might be more popular for practicality. Under this approach, any contracts still ongoing at the transition point (spanning the 2025/2026 year-end) are reassessed under the new standards. The difference between how much revenue should have been recognised since the contract started (if the new rules had always applied) is recorded as an adjustment to opening retained earnings in 2026. Past income statements for 2025 are not restated.
Companies must disclose which transition approach they took and explain any major financial impact. Auditors will expect careful, well-documented reviews to ensure revenue adjustments for ongoing contracts are accurate.
Preparing early is crucial - reviewing contracts, updating accounting policies, and considering system updates are essential steps.
Stay tuned next week as we explore the significant changes in lease accounting, ensuring your business remains compliant and well-prepared.
Have questions or need detailed assistance with revenue recognition changes? Reach out to schedule a coffee with our team.
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