Acquisition can often mean a change in reporting requirements. We provide a guide on what to expect and how best to prepare.
More and more broking entities are being acquired by larger groups. As a result, they may need to change their financial reporting framework from FRS 102 to the recognition and measurement criteria of International Financial Reporting Standards either through FRS 101 (Reduced Disclosure Framework) or full IFRS.
So what does this all mean in practice? And what are the main accounting considerations for a broker in transition to FRS 101 or IFRS?
1) Revenue recognition
IFRS 15 requires a five-step approach to revenue recognition:
Identify the contract(s) with customer
Identify the performance obligations in the contract(s)
Determine the transaction price
Allocate the transaction price to the performance obligations
Recognise revenue when each performance obligation is satisfied
It’s important to review all major customer contracts in detail to understand the potential impact. IFRS 15 has requirements to identify ‘distinct’ performance obligations. The entity must consider the various services they provide, make an allocation to performance obligations based on the relative stand-alone selling prices, and analyse potential patterns of revenue recognition. They may need to exercise judgement as to what constitutes a distinct performance obligation and the period/pattern over which a customer receives the benefits of these distinct services.
The timing of revenue recognition is also likely to be affected. For example, under FRS 102 most broking entities recognise commission income when policies become effective. But, for certain contracts, IFRS 15 might require recognition when policies are legally bound. And this could be before the effective date of those policies.
There will probably also be an impact on revenue from post placement income and claims management. Arrangements that feature contingencies and trail commissions need particular consideration. This is because IFRS 15 requires entities to recognise revenue when a performance obligation is satisfied, even if the amount of that revenue is uncertain.
Some entities may be able to recognise revenue earlier. But if the amount of revenue is highly susceptible to factors outside the entity’s influence, revenue recognition might be constrained. This could be the case with contingent profit commissions which vary with a carrier’s claims experience. At the start of such contracts, the entity may need to constrain revenue recognised. Then, over time, as revenue becomes less susceptible to variation, the entity is able to recognise more revenue.
IFRS 15 might also lead to earlier recognition of revenue than FRS 102 for certain types of renewal commissions (‘trail commissions’). These are where the broker has no additional responsibilities to secure contract renewals or to perform any other activities under the contract. In this case, recognising revenue including commissions relating to expected future renewals may be appropriate.
The impact of the constraint on variable consideration may be different if it is assessed for an individual contract rather than for a portfolio. It might be hard to prove that the revenue for trail commissions, upon renewal of an individual policy, is unlikely to be subject to significant reversal. But the entity may be able to assess the constraint at the portfolio level instead.
In many commercial lines of business, the broker might be performing ongoing services (such as claims management and customer care) on top of the original placement. In such cases, recognition of the total commissions, including any renewals, at initial placement would be inappropriate.
2) Lease accounting
IFRS 16 requires most leases to be brought onto the balance sheet. This could have a significant impact on financial statements and key ratios, as it increases the lease liabilities and right of use assets on the balance sheet. It also increases finance expenses and depreciation of the right of use assets and decreases the operating lease rentals in the income statement.
The IFRS 16 definition of what constitutes a lease might also mean that new contracts are identified as leases that were not previously accounted for as such. For example, in group scenarios, working out which entity has the right of use of an asset could mean new leases and sub-leases are needed – resulting in more complexity.
3) IFRS 9 expected credit losses
IFRS 9 includes an expected credit loss (ECL) model which adds to the information an entity must consider when determining its expectations of impairment. Under the ECL model, expectations of future events must be taken into account, leading to earlier recognition of larger impairments. Although all financial instruments are within the scope of IFRS 9, the most likely areas to be impacted for brokers include trade receivables and intercompany debtors.
There are two main ways to apply the ECL model. The general approach involves three stages and includes concepts such as ‘significant increase in credit risk’, ‘12-month expected credit losses’ and ‘lifetime expected credit losses’. But IFRS 9 recognises that implementing these requirements can be complex in practice. So it also allows (and in some cases obliges) entities to apply a simplified approach to trade receivables, contract assets and lease receivables.
The standard requires the application of the simplified approach to trade receivables and contract assets that do not contain a significant financing component. In our view, most brokers should be able to implement this approach. It means there is no need to monitor for significant increases in credit risk, though entities are required to measure lifetime expected credit losses at all times. But impairments are still higher because historical provision rates need to be adjusted to reflect relevant, reasonable and supportable information about future expectations.
4) Other areas of impact
Whilst the three areas above are those which seem to have had the greatest impact for brokers on transition from FRS 102 to IFRS/FRS 101, we have also seen effects on goodwill, intangible assets and deferred tax.
What should you do if a transition is needed?
Financial reporting framework transitions can be time-consuming and, with the increased data requirements of IFRS, may need input from areas of the business other than finance. For example, the identification and key terms of leases may involve procurement and facilities teams. This all means the transition should be planned well in advance of the year end.
It’s also important to remember that, given the requirements of IFRS 1, entities must calculate the impact of restatement of the two preceding periods. So, if the transition occurred for a December 2023 year end, entities should also have performed the transition for both December 2022 and December 2021 (effectively the opening balance sheet of 2022). Under FRS 101 there is an exemption to present the opening balance sheet (2022 in the example above) at the date of transition.
Equally vital is that finance teams engage and explain the impacts to a wider group of stakeholders so that the whole business can understand the changes to financial reporting. KPIs and key ratios can be impacted, such as profit margins with potential knock-on impacts on reward schemes and the ability to meet financial covenants and pay dividends.
Lastly, management should engage with their auditors early on to understand what they might require and the information they expect to be considered, and to discuss the impact on timelines and fees.
We can help
Our experienced accounting advisory team can help you with impact assessment, implementation and transition to IFRS or FRS 101. Our enthusiastic and experienced individuals have previously worked on IFRS and FRS 101 transitions (including specific transitions in respect of IFRS 9, 15 and 16) and understand the challenges these accounting changes pose.