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Compliance: FRC Triennial Review December 2017

Summary of Changes effective from 1 January 2019

(This document contains general information only and does not purport to be the rendering of professional advice or service. In the event of any doubt as to specific disclosure or presentation requirements, it is essential to refer to the source documentation and if necessary, carry out further appropriate technical research or consultation).

The Financial Reporting Council (FRC) has published incremental improvements and clarifications to FRS 102 – ‘The Financial Reporting Standard applicable in the UK and Republic of Ireland’ and “as a result of these amendments, FRS 102 will be clearer and easier to use, some accounting policies will be simplified and additional choices and exemptions will be introduced (FRC)”.

The amendments (the majority of which are editorial in nature or aim to clarify) have arisen as a result of the first triennial review and the review document sets out incremental improvements and clarifications to FRS 102 and amendments to the other UK and Ireland accounting standards [FRS 100, FRS 101, FRS 103, FRS 104 and FRS 105].

The effective date for most of the amendments to FRS 102 is accounting periods beginning on or after 1 January 2019, with early application generally only permitted if all amendments are applied at the same time. The only exceptions are the amendments relating to directors’ loans and the tax effects of gift aid payments, for which early application is permitted separately.

The review document (188 pages) is organised as follows: (a) the amendments to FRS 102 are set out by section including the new small entities (Section 1A) regime in the Republic of Ireland; and (b) amendments to other FRSs are grouped together by standard, including the micro-entities regime (FRS 105) in the Republic of Ireland.

The principal amendments include:

1. Confirming the simplification of the measurement of directors’ and shareholder loans (natural persons, not inter-group) to small entities (irrespective of whether they are applying Section 1A Small Entities), need not now be discounted. They may be measured at transaction price rather than fair value.
2. Requiring fewer intangibles to be separated from goodwill in a business combination.
3. Permitting investment property rented to another group entity to be measured at cost (less depreciation and impairment), rather than fair value – an accounting policy choice.
4. Statement of Cash Flows – Introduction of Net Debt Reconciliation at foot of cash flow statement or in note (similar to what was required under FRS 1 Cash Flow Statements).
5. Simplifying the definition of a financial institution to remove references to ‘generate wealth’ and ‘manage risk’. Likely that fewer entities will meet the definition of a financial institution.
6. Introducing an overriding principle to the definition of a ‘basic’ financial/debt instrument.
7. Allowing the tax effects of gift aid payments by subsidiaries to their charitable parent to be taken into account at the reporting date when it is probable that the gift aid payment will be made in the following nine months.
8. Exemption from disclosing key management personnel (KMP) compensation where KMP and directors are the same and the entity is subject to a legal or regulatory requirement to disclose directors’ remuneration.

Triennial Review December 2017 – (Amendments to FRS 102)

A brief summary [not intended to be comprehensive] is provided below in respect of each of the above amendments.

1. Confirming the simplification of the measurement of directors’ loans to small entities, following the interim relief granted in 2017.
   
   Following the interim amendment made in May 2017 to permit early adoption of the directors’ loan proposals, permanent amendments have been made to FRS 102 to provide small entities with the option to account for loans from a director or a close family member of that director initially at transaction price, when that group of people contains at least one shareholder in the entity. In the case of small LLPs the reference to shareholder should be read as a member who is a person.
   
   The exemption is not applicable in the reverse scenario, i.e. where a small entity makes a loan to one of its directors or a close family member of a director, nor does it apply to intercompany loans.
   
   FRS 102 previously required such loans to be measured initially at the present value of future payments discounted at a market rate of interest for a similar debt instrument. This frequently proved problematic for small entities where commercial funding was not available and it was difficult to determine an appropriate market rate for a similar debt instrument.
   
   Note: Early application of this amendment is permitted without having to apply all the other amendments at the same time.
   
   
2. Requiring fewer intangibles to be separated from goodwill in a business combination.
   
   Section 18 of FRS 102 requires various intangible assets acquired in a business combination to be recognised separately from goodwill. The FRC received feedback from stakeholders that the current wording in paragraph 18.8 of the Standard has presented practical issues upon application, particularly the reference to “and otherwise estimating fair value would be on immeasurable variables” and how this wording should be interpreted in practice.
   
   Following this feedback, changes to paragraph 18.8 will only require entities to recognise intangible assets separately from goodwill if they:
   
   

   (a) meet the recognition criteria for intangible assets generally;

   (b) arise from contractual or other legal rights; and

   (c) are separable (i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged either individually or together with a related contract, asset or liability).

   This amendment is likely to result in fewer intangible assets being required to be identified separately from goodwill and valued. However, when an entity chooses to recognise additional intangible assets, this policy must be applied to all intangible assets in the same class, and must be applied consistently to all business combinations. The transitional provisions make it clear that changes in the recognition of intangible assets acquired in a business combination must take place prospectively (i.e. there is no restatement for past business combinations).

3. Permitting investment property rented to another group entity to be measured at cost (less depreciation and impairment), rather than fair value.
   
   
   • The amendment introduces an accounting police choice for entities that rent investment property to another group entity. The choice is to measure the investment property either at cost (less depreciation and impairment) or at fair value.
   • All other investment property will need to be measured at fair value and no “undue cost or effort” exemption will be available.
   
   
4. Statement of Cash Flows – Net Debt Reconciliation.
   
   There is a requirement for a net debt reconciliation to be provided. The reconciliation is based on what had been required by FRS 1 Cash Flow Statements.
   
   Paragraph 7.22 is inserted as follows: An entity shall disclose an analysis of changes in net debt from the beginning to the end of the reporting period showing changes resulting from: (a) the cash flows of the entity; (b) the acquisition and disposal of subsidiaries; (c) new finance leases entered into; (d) other non-cash changes; and (e) the recognition of changes in market value and exchange rate movements. When several balances (or parts thereof) from the statement of financial position have been combined to form the components of opening and closing net debt, sufficient detail shall be shown to enable users to identify these balances. This analysis need not be presented for prior periods.
   
   
5. Simplifying the definition of a financial institution to remove references to ‘generate wealth’ and ‘manage risk’.
   
   Entities that meet the definition of a financial institution under FRS 102 (and FRS 101) are unable to take the disclosure exemptions in relation to financial instruments available to qualifying entities under those respective standards. Entities applying FRS 102 that meet the definition of a financial institution are also required to comply with additional disclosure requirements relating to any financial instruments they hold as set out in Section 34 Specialised Activities of FRS 102. A financial institution is defined in Appendix 1: Glossary to FRS 102 by reference to a list of types of entities, e.g. certain banks and building societies,retirement benefit plans, credit unions and custodian bank, broker-dealer or stockbroker. The final type of entity included in the list is any other entity “whose principal activity is to generate wealth or manage risk through financial instruments”. This was intended to cover “entities that have business activities similar to those listed above but are not specifically included in the list above”.
   
   Following feedback from stakeholders, the above definition has been amended to remove the references to “generate wealth” and “manage risk”. This is intended to address practical issues in interpreting these concepts and should reduce the number of entities that meet the definition of a financial institution and that consequently have to provide additional disclosures. The amended definition simply refers to “any other entity whose principal activity is similar to those listed above but is not specifically included in that list”.
   
   However, an amendment to Section 11 highlights that the additional disclosures may be required when the risks arising from financial instruments are particularly significant to the business (for example because they are principal risks for the entity), and specifically highlights that paragraphs 34.19 to 34.33 include examples of disclosure requirements for risks arising from financial instruments that may be relevant in such cases.
   
   Stockbrokers have been removed from the list of entities qualifying as financial institutions given the fact that they are not similar to the other types of entities specifically included in that list (i.e. they primarily provide a service rather than hold financial instruments). In addition, retirement benefit plans have been removed because they are already subject to separate disclosure requirements under Section 34 (Specialised Activities) of FRS 102.
   
   This amendment will be welcomed by many entities that previously struggled to reconcile their activities with this definition. It does not completely resolve the uncertainty about the status of group treasury companies but they will not be financial institutions unless their principal activity is similar to a bank or one of the other types of entities listed, which will require the exercise of judgement.
   
   
6. Introducing an overriding principle to the definition of a “basic” debt instrument
   
   Debt instruments are currently classified as ‘basic’ or ‘non‑basic’ under FRS 102 with this classification being based on a list of prescriptive conditions in Section 11 Basic Financial Instruments. In general, those debt instruments classified as basic are measured at amortised cost and those classified as non-basic at fair value through profit or loss. Stakeholders have highlighted to the FRC that applying such a list of conditions has caused a number of problems for entities applying the standard given the nature of the approach which does not leave much room for judgement.
   
   To help address this, the amendments introduce an overriding principle for classification of financial instruments as basic in addition to the list of conditions. In some cases, this will allow for debt instruments that breach the conditions to be classified as basic if they are in line with the principle. However, any debt instrument that meets the prescribed conditions will always be classified as basic.
   
   The principle is that a basic debt instrument is one that gives rise to cash flows on specified dates that constitute repayment of the principal advanced, together with reasonable compensation for the time value of money, credit risk and other basic lending risks and costs (e.g. liquidity risk and administrative costs associated with holding the instrument and lender’s profit margin).
   
   To help illustrate the above principle and how it is intended for the rules and principle to work together, additional examples have been included in the ‘Examples – Debt instruments’ section that follows paragraph 11.9. Amendments to the pre‑existing examples in this section have also been made.
   
   Changes have also been made to the condition contained in paragraph 11.9(c) to allow the instruments that include reasonable compensation payable by the holder to the issuer when a debt instrument is terminated early to be consistent with basic classification.
   
   Entities will only need to consider the principle in cases where an instrument breaches the conditions. This means entities can continue to perform a simple rules based assessment for most basic debt instruments. Due to the minor nature of the amendments to the conditions, it is expected that the vast majority of basic debt instruments will maintain their existing classification under the amendments.
   
   Currently, Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues of FRS 102 allow entities to apply the recognition and measurement requirements of IAS 39 Financial Instruments: Recognition and Measurement as adopted for use in the EU. Following feedback received from respondents the amendments retain this accounting policy choice after the mandatory effective date of IFRS 9 Financial Instruments (1 January 2018). If such an amendment had not been made the choice to apply IAS 39 would no longer be available following the implementation of IFRS 9 given that as of that date IAS 39 is to be withdrawn as part of EU endorsed IFRSs.
   
   The FRC proposes to retain this option until the FRS 102 requirements for the impairment of financial assets have been amended to reflect IFRS 9, or until the decision is made not to amend FRS 102 further in relation to IFRS 9.
   
   Debt for equity swaps
   
   A debt for equity swap is a transaction in which an entity issues equity instruments to extinguish a financial liability (in part or in full). Currently, FRS 102 does not contain any specific requirements for the accounting for such transactions; it does however require an entity to measure equity instruments initially at the fair value of the cash or other resources received or receivable. Section 22 Liabilities and Equity has been amended to make it clear that this requirement should not be applied where the issue of equity instruments is in accordance with the original contractual terms of the liability extinguished (e.g. conversion of convertible debt) or where such transactions are with owners in their capacity as such or are with entities under common control where the substance of the transaction includes an equity distribution or contribution.
   
   
7. Allowing the tax effects of gift aid payments by subsidiaries to their charitable parent to be taken into account at the reporting date when it is probable that the gift aid payment will be made in the following nine months.
   
   Gift aid payments Amendments have been made to FRS 102 as a result of significant differences in practice in the accounting treatment for gift aid payments made by an entity that is wholly owned by one or more charitable entities. The payments are typically made during the nine months following the relevant reporting date, and are treated as a distribution to owners for accounting purposes but as a donation for tax purposes.
   
   For an entity wholly owned by one or more charitable entities, the amendments clarify that:
   
   
   • The gift aid payment, as a distribution to owners, is not accrued at the reporting date (unless a deed of covenant is in place) and is recognised in equity; and
   • The tax effects of the gift aid payment is recognised in profit or loss at the reporting date, when it is probable that the payment will be made in the nine months following the reporting date.
   
   Note: Early application of this amendment is permitted without having to apply all the other amendments at the same time.
   
   This amendment, which was the subject of FRED 68, will be very welcome by entities in the charity, social housing and higher education sectors that have “trading” subsidiaries. It will eliminate the diversity of practice which has arisen as a result of confirmation by the ICAEW in 2014 that the gift aid payments are distributions for legal purposes. It will enable such entities to continue to recognise a nil or low effective tax rate which is a consequence of the tax treatment of the gift aid payments. However, it also clarifies that it is not possible to recognise a liability for the gift aid payment itself in advance of payment unless such an obligation is created by a deed of covenant.