The introduction of the new UK GAAP for small and micro-entities by the Financial Reporting Council (FRC) on 16 July 2015 means that many practitioners dealing with such clients will now be turning their attention to the transitions across to the new regime.
Careful thought needs to be given when advising clients as to the best framework to adopt, because whilst a micro-entity may qualify to adopt FRS 105: The Financial Reporting Standard applicable to the Micro-entities Regime numerically, it may not be the most appropriate standard to adopt in the entity’s circumstances – for example, if the entity wishes to carry assets at revaluation/fair value, or if the pace of growth of the micro-entity is likely to be fast. Where FRS 105 may not be appropriate, then a more comprehensive framework should be adopted (such as FRS 102 with reduced disclosures), and this issue needs to be considered on a case-by-case basis.
FRS 105 is mandatory for accounting periods commencing on or after 1 January 2016 and early-adoption is permissible. The section numbers in FRS 105 are not identical to those of FRS 102 because certain sections of FRS 102 are deemed not applicable to micro-entities; hence the section which deals with first-time adoption of FRS 105 is that of Section 28 Transition to this FRS (Section 35 in FRS 102).
There is a four-stage process that has to be adopted when making the transition to FRS 105:
- recognise all assets and liabilities where FRS 105 requires such assets and liabilities to be recognised;
- derecognise items as assets and liabilities if FRS 105 prohibits the recognition of such assets and liabilities;
- reclassify items that were recognised under previous UK GAAP as one type of asset, liability or component of equity, but which are a different type of asset, liability or component of equity under FRS 105; and
- apply the provisions in FRS 105 from the date of transition in measuring all recognised assets and liabilities.
The date of transition in any move across to a new UK financial reporting framework is the start date of the earliest period reported in the accounts. Hence, using quarter-end dates, the dates of transition can be determined as follows:
Year-end
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Date of transition
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31 December 2016
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1 January 2015
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31 March 2017
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1 April 2015
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30 June 2017
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1 July 2015
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30 September 2017
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1 October 2015
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The rules in FRS 105 are retrospective: in other words they have to be applied as far back as the date of transition and hence it is expected that in many cases, previously reported financial information will change as a result of the transition (and these changes could also have associated tax implications which need consideration). Retrospective application as far back as the date of transition will ensure that the financial statements reflect the new regime as if new UK GAAP had always been the financial reporting framework adopted by the entity (i.e. it will ensure consistency and comparability of the accounts).
Exemptions from retrospective application
To keep the transition to FRS 105 as painless as possible, Section 28 contains two mandatory exemptions from retrospective application. These mandatory exemptions must be applied in all cases. In addition, Section 28 also contains eight optional exemptions which are worth considering because the micro-entity can use all, some or none of the optional exemptions.
It is worth reviewing the optional exemptions and taking advantage of those which are applicable to the client because they are intended to save time and effort in dealing with a transition.
The two mandatory exemptions relate to:
- Derecognition of financial assets and financial liabilities; and
- Accounting estimates.
Derecognition of financial assets and financial liabilities
This mandatory exemption says that where a micro-entity derecognised financial assets and financial liabilities under its previous reporting framework (e.g. the FRSSE (effective January 2015)), then it should not recognise those financial assets and financial liabilities when it moves across to FRS 105.
Also, where financial assets and financial liabilities would not have been recognised on a micro-entity’s balance sheet under FRS 105 in a transaction that took place before the date of transition, but were recognised on the balance sheet under old UK GAAP, then the micro-entity has two options – it can either:
- derecognise them on first-time adoption of FRS 105; or
- continue recognising the financial instruments until they are disposed of or settled.
Accounting estimates
Previously recognised accounting estimates (for example provisions for liabilities) cannot be changed on transition for the benefits of hindsight.
The eight optional exemptions from retrospective application relate to:
- Business combinations and goodwill
- Share-based payment transactions
- Investment property
- Compound financial instruments
- Arrangements containing a lease
- Decommissioning liabilities
- Dormant companies
- Lease incentives
Business combinations and goodwill
On first-time adoption of FRS 105, a micro-entity does not need to apply the provisions in Section 14 Business Combinations and Goodwill to combinations which took place prior to the date of transition. However, where the micro-entity does restate any business combinations to comply with Section 14, it must then restate all later business combinations.
Where a micro-entity takes advantage of this exemption and therefore does not apply Section 14 retrospectively, then it must recognise and measure all its assets and liabilities acquired and assumed in a past business combination in accordance with paragraphs 28.7 to 28.9 (or 28.10(b) to (h) if applicable), but no adjustment is made to the carrying amount of goodwill. Paragraphs 28.7 to 28.9 outline the procedures for preparing financial statements for micro-entities at the date of transition (including the four-stage process identified above), outlines what happens with transitional adjustments (i.e. they are recognised in equity reserves) and deals with the two mandatory exemptions from retrospective application (as above). Paragraphs 28.10(b) to (h) relate to the remaining optional exemptions.
Share-based payment transactions
For share-based payment obligations which have been settled prior to the date of transition, Section 21 Share-based Payment does not apply.
Investment properties
This was the subject of a separate article, as investment property which was previously carried at open market value under the FRSSE has to be restated to historical cost (as FRS 105 prohibits amounts being recognised at fair value or at revaluation amounts).
There are five stages to restating investment property on transition to FRS 105:
- Determine the total cost of the investment property (inclusive of all its components). Where investment property had been previously carried at open market value, the value of the revaluation reserve is reversed against the cost to arrive at a cost for FRS 105 transition purposes.
- Separate the cost of land (if any) from buildings as the land element will not be subject to depreciation.
- Estimate the total depreciated cost of the investment property at the date of transition. This is worked out by calculating depreciation of the investment property from the initial acquisition date to the date of transition based on the property’s useful economic life of the most significant component (i.e. the main structural element).
- A portion of the estimated total depreciated cost calculated above is then allocated to each of the property’s major components (i.e. excluding the main structural element) to determine the depreciated cost. FRS 105 requires this allocation to made on a ‘reasonable and consistent basis’ and suggests a possible allocation being to multiply the current cost to replace the component by the ratio of its remaining useful life to the expected useful life of a replacement component.
- Any amount of the total depreciated cost not allocated under stage 4 (above) is allocated to the most significant component (usually the main structure of the property).
Compound financial instruments
A compound financial instrument is a financial instrument which contains a mixture of debt and equity (for example convertible debt). Paragraph 17.11 of FRS 105 would usually require a compound financial instrument to be split between its liability portion and its equity portion. However, a first-time adopter does not have to do this split if the liability portion is not outstanding at the date of transition.
Arrangements containing a lease
A first-time adopter can elect to determine whether an arrangement which exists at the date of transition contains a lease, based on the facts and circumstances which exist at the date of transition as opposed to when the arrangement was entered into.
Decommissioning liabilities
These relate to decommissioning liabilities which are included in the cost of property, plant and equipment (PPE) or investment property. Paragraph 12.9(c) of FRS 105 requires that the cost of an item of PPE or investment property includes an initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. A first-time adopter can elect to measure this component of cost at the date of transition to FRS 105 rather than on the date(s) that the obligation initially arose.
Dormant companies
A dormant company (as defined in the Companies Act 2006) can elect to retain its accounting policies for reported assets, liabilities and equity at the date of transition to FRS 105 until there is any change in those balances, or the company undertakes new transactions.
Lease incentives
Lease incentives are often given to lessees occupying property. In respect of leases which have been entered into before the date of transition to FRS 105, a micro-entity does not have to apply the provisions in paragraphs 15.15 (which requires lease incentives to be written off over the lease term for lessees) and 15.25 (which, again, requires lease incentives to be written off over the lease term for lessors) to its lease incentives. It can continue to recognise any residual benefit (or cost as the case might be for lessors) in respect of lease incentives on the same basis as that applied at the date of transition to FRS 105. This means the lessee/lessor could recognise lease incentives in profit or loss up to the point at which lease payments revert to market value (i.e. if no break-clause is exercised) rather than over the life of the lease. This, of course, may have associated tax implications which should be considered.
Conclusion
Section 28 outlines the procedures required in respect of a transition across to FRS 105 and it is advisable to do an impact assessment for the client, particularly if they have assets stated at revaluation (e.g. investment property). This is because restatement of such assets to historical cost values might have a detrimental impact on the company’s balance sheet and it may be advisable to use FRS 102 with reduced disclosures if the client wishes to continue reporting certain assets at fair value or at revaluation amounts.