FRED 82 proposes the following principal amendments:
The lease accounting requirements in FRS 102 for lessees will be based on the on-balance sheet model from IFRS 16 Leases. The impact is expected to be significant on the motor retail sector and considered further below.
The accounting requirements for revenue will be based on the five-step model for revenue recognition from IFRS 15 Revenue from Contracts with Customers. The extent to which this will change an entity’s revenue recognition in practice will depend on the form of its contract with customers. In the motor retail sector we foresee changes primarily in revenue recognition for ancillary services, such as warranty sales.
The changes are proposed to be implemented for accounting periods commencing 1 January 2025.
Impact on the motor retail sector of leases on balance sheet
The new leasing standard will have a very significant impact on the look and feel of a typical set of motor retail accounts. The main benefit will be that both profit and loss and balance sheet statements will be much more comparable between companies. The significant variances in in motor retailers’ accounts due to the level of freehold versus leasehold property in use will no longer be present. It will also remove the inconsistency in treatment between those who account under international standards (mainly the listed Plc motor retailers) and those under the UK standards.
Currently a simple leased property is accounted for with rent going through the operating expenses in the profit and loss account. Under the new standard, an asset and liability will be introduced on the balance sheet for the value of the “right of use” of the asset and the present value of the future lease payments. Rather than a rental expense, the profit and loss will have the depreciation of the “right of use” asset as well as an interest charge on the liabilities. As a result, the calculation of EBITDA (Earnings before interest, tax and depreciation) under the new standard will result in a very different value for a business that has any material level of leased assets.
A few commercial implications
Many lending arrangements and banking covenants require compliance with ratios of EBITDA, interest cover etc that will need to be revisited and either the metrics changed or IFRS16 reversal adjustments considered. Our current experience of IFRS16 is that it can cause confusion and it is not unusual for lenders to seek calculations of a reversal back to traditional accounting methods.
Company valuations - At present, it is common practice to use different valuation multiples depending on the type of property ownership – these multiples and valuation methods will need to change going forwards creating additional uncertainty.
Decisions will need to be made regarding management accounts and whether to incorporate the new way of accounting into them (with consequential impact on bonuses and pay plans).
Many long term incentives, shareholder agreements and articles of association include references to EBITDA per the audited statutory accounts as a method of calculating value for some future event. These may need to be revisited to avoid confusion and disputes in the future.
IFRS16 has alternative implementation treatments that can have a significant impact on both the opening balance sheet and future profit and loss presentation. Opting for the treatment that best suits each company’s circumstances will be a critical exercise for businesses and their advisers assuming these alternatives remain in UK GAAP.
Conclusions
Whilst only a draft proposal, these changes have been long predicted and in our view are likely to be implemented in line with the proposed timetable (1 January 2025). Those businesses with significant reliance on leases (especially property) as well as ancillary revenue streams such as warranty sales should carry out an impact assessment sooner rather than later. This will ensure they are well prepared for the forthcoming changes and have sufficient time to implement the new standard to the best benefit of the business.
The next step
For any further questions please contact Paul Daly, or your usual UHY adviser.
