The Rules: Accounting for long term arrangements under FRS 102 – what you need to be thinking about today?

Written by Jake Green, director of financial reporting, Grant Thornton

HAVE you considered how contracts and arrangements you are entering into now might be accounted for differently in the future?  Understanding the key requirements of new or changing standards – whether that be wholesale changes like the introduction of FRS 102 or be it regular updates and changes – and making an early evaluation of the potential impact of these changes on your business will help to reduce the risk of surprises and give your business the opportunity to plan for these changes when entering into long term arrangements today.

Why is it important to think about this now?

As many will have seen already from the transition to FRS 102, the impact of implementation of a new standard is not just a compliance exercise but can have much wider implications on your business and a real commercial impact when it comes to decision making including:

• Changes to metrics and impact on covenants.
• Impact of changes in timing of profit recognition.
• Impact on realised profits and, therefore, ability to pay dividends
• Tax implications
• Data capture and integrity

Some arrangements last for many years and will already be in place when changes to accounting standards occur.  But many business will be entering into long term arrangements in the run up to a change in accounting standards.  In either case, those who are ahead of the game and have thought about the wider implications of any accounting changes on these arrangements, will be in a stronger position to manage these changes.

What issues does FRS 102 transition pose?

For those who are yet to transition to FRS 102, it will pay to learn from others’ experiences.  Common issues many have had to deal with on implementation to FRS 102 are;

• Financing arrangements – The classification of financial instruments as basic or non-basic can have a significant commercial and accounting impact. Many of the products used in financing arrangements to manage financial risk are classified as non-basic and so will be accounted for at fair value .  These instruments can sometimes be volatile and changes in interest rates can considerably impact their value.  Being held on the balance sheet at fair value with changes recognised in the profit or loss can significantly impact both balance sheet and profit based covenants.
• Derivative contracts – More derivatives will be recognised on balance sheet under FRS 102 with the corresponding entry on transition to retained earnings impacting distributable profits. This can have an adverse effect on the ability to pay dividends
• Lease contracts – the changes in accounting for lease incentives may impact the amounts charged to the profit and loss and any accrued benefits on balance sheet.
• Joint arrangements – there are three types of joint ventures under FRS 102; jointly controlled entity, jointly controlled asset and jointly controlled operation. Each are accounted for slightly differently and the classification can come down to particular terms or the substance of the contract in place.  Changes to the assets and liabilities or the revenue and expenses recognised as a result of a change in accounting policy on transition could again impact the metrics upon which many commercial decisions are taken, including investment, financing and strategy.
• Pension arrangements are usually in place for very long periods of time and on implementation of FRS 102, a large number have been and will be in place for many years. Unless there is a cost sharing arrangement in place,  FRS 102 requires the group entity that is legally responsible for the plan to recognise the liability on its  balance sheet.  It is common knowledge that many pension schemes have significant deficits.  With the corresponding entry of the FRS 102 transition adjustment going to retained earnings, this could have a significant effect on distributable profits taking many years to recover. Anticipation of this change has enabled some to put agreements in place spreading this liability across the group.
• Arrangements where payments are linked to profits or other performance measures, erg. employee bonus schemes and earn out schemes in purchase agreements could potentially be significantly affected by the implementation of FRS 102, resulting in pay-outs significantly different from those budgeted.  If you are considering modifying terms of these agreements then it is important to  understand how that modification might affect any liability and the cash flows under the arrangement.

So what now?

An impact assessment should be carried out on any contractual arrangement entered into today which extends into a future period and which could be  affected by a new accounting standard. For many, the transition to FRS 102 will still be the focus.

Those that have already implemented FRS 102 may have experienced some unexpected commercial or accounting effects as a result of transition already.  These businesses should also consider the subsequent accounting requirements in future periods, not just changes on transition.  Some might consider  changing current agreements to  reduce the impact going forward.  In other cases, it may just be about weathering the storm until the agreement ends and managing expectations of stakeholders.  Some may even considering withdrawing from some arrangements.

For those that have not yet implemented FRS 102 or are in the process of doing so, it is worth looking to those that have already made this step and learn from their experiences.  Are there any industry or sector interpretations emerging that could impact the accounting for your arrangements?  Could modifying any arrangement terms now help manage the effects of any new accounting policies?  Assessing the impact of the changes on performance measures and distributable profits early can help ensure the changes can be managed  – perhaps by agreeing “frozen GAAP” clauses with key funders or communicating the changes to key stakeholders to help manage expectations.

Whatever your scenario, if a change in accounting standard is approaching, planning and anticipation is key when considering new or existing long term arrangements.