The comment period for Financial Reporting Exposure Draft (FRED) 82 ended in April. Satya Beekarry, Partner in our Insurance team, takes a look at its significance and likely impact for insurance carriers. Should you begin planning now?
FREDs are a way for the Financial Reporting Council (FRC) to seek feedback on proposed changes to financial reporting standards in the UK and Republic of Ireland. The FRC issues FREDs regularly, and at least every five years.
For each FRED the FRC typically holds a consultation period, during which interested parties can send comments. The Council then considers the comments before finalising the proposed changes. FRED 82 was issued in December 2022 following only the second periodic review of FRS 102. It proposes several changes to FRS 102 to broadly align it with IFRS. This means some consequential changes to FRS 103 and its implementation guide (IG). The changes are likely to be effective from 1 January 2025.
Is IFRS 17 coming to UK GAAP?
Before we get to the key proposed changes from FRED 82, let’s dispense with the elephant in the room. It is not proposing to bring IFRS 17 (Insurance Contracts) into UK GAAP, at least not yet. This is a welcome relief for insurance carriers that report under FRS 102/103 or have transferred to it from IFRS.
But FRS 101 as a choice is effectively dead for Schedule 3 insurers. So any insurers that previously reported under FRS 101 would have moved over to either FRS 102/103 or full IFRS, with effect from 1 January 2023. For such insurers, either option could present significant changes depending on their individual circumstances.
Given its complexity, the IASB’s post-implementation review of IFRS 17 is unlikely to be completed by 2026. What’s more, the FRC’s consultation timetable means IFRS 17 in any form is unlikely to be incorporated earlier than 2030, if ever. At least this provides some welcome certainty for the industry in the medium term. Indeed, it will have taken IFRS 15 and IFRS 16 seven years to become effective in some form under UK GAAP.
What are the key changes proposed by FRED 82?
Revenue recognition (Section 23 of FRS 102). The new model for revenue recognition will be broadly aligned with IFRS 15, but with some simplifications. Insurance contracts under the scope of FRS 103 are outside the scope of Section 23 and are not directly affected by these changes (see more below). The five steps of IFRS 15 are:
Identify the contracts with a customer.
Identify the performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognise revenue when each performance obligation is satisfied.
Lease accounting (Section 20 of FRS 102). The new lease accounting model will be broadly aligned with IFRS 16, but with some simplifications. It will require almost all leases to be brought onto the balance sheet from the lessee’s perspective.
Insurance contracts (FRS 103 and IG). Consequential amendments to FRS 103, including to the IG, are proposed in connection with the amendments to Section 23. They seem to seek alignment between revenue recognition for insurance contracts and the proposed amendments in Section 23.
Other changes. FRED 82 also proposes other changes, mostly seeking alignment with IFRS. These include the adoption of the IFRS 13 definition of fair value, guidance on factors to consider when accounting for uncertain income tax positions, share-based payments and business combinations.
What is the potential impact of FRED 82?
Given the challenges IFRS preparers faced with IFRS 15 (Revenue) and IFRS 16, FRED 82 is likely to affect you. For some in a big way and for others less so. The commercial impact of these changes could be wide reaching for the insurance industry.
The good news is there is no change to the accounting for insurance contracts which is currently set out in FRS103. It is however important to review all your other major customer contracts in detail to understand this potential impact. The new revenue standard has requirements for identifying distinct performance obligations. Insurance groups that, in addition to underwriting or assuming insurance risks, earn revenue from other sources in the scope of Section 23 of FRS 102 (such as brokerage income, auto repairs, claims management) need to consider the various services they provide.
They must then make an allocation to performance obligations based on the relative standalone selling prices, and analyse potential patterns of revenue recognition. Entities may need to judge 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 for your business might be affected. Arrangements in the scope of Section 23 of FRS 102 that feature contingencies and trail commissions need particular consideration. This is because the new revenue standard will require entities to recognise revenue when a performance obligation is satisfied, even if the amount of revenue is uncertain.
The consequential amendments to FRS 103’s IG could change the gross written premiums (GWPs) of insurers. This is a concern as it is a key metric for most general insurers. What’s more, as the proposed substantial changes are to the IG, which is non-authoritative in nature, this could lead to unnecessary diversity in practice in an industry that needs more consistency.
What about leases?
The new lease accounting model means most leases must be brought onto the balance sheet. This could have a significant impact on your financial statements and key ratios. It will increase your lease liabilities and right of use assets on the balance sheet. It will also add to finance expenses and depreciation of the right of use assets while decreasing 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 would not have been previously. For example, in group scenarios, consideration of which entity has the right of use of an asset could mean new leases and sub-leases are identified, all leading to more complexity.
All these changes could affect your profit margins, reward schemes, and ability to meet financial covenants and pay dividends. So it’s important to understand the changes that are proposed and to start planning for the transition now.
What are commenters saying?
Most commenters have been broadly supportive of the proposed changes. This is partly because the FRC, to its credit, began the review process early in March 2021 and considered the views of stakeholders in drafting FRED 82. It’s likely most of the amendments will be finalised as proposed, including those relating to Sections 20 (leases) and 23 (revenue).
But not everyone is happy with certain aspects of the proposals. In the insurance industry, most respondents disagree with the proposals to amend the IG to FRS 103 as they may result in changes to current practice.
Insurance contracts are specifically excluded from the scope of Section 23, the IG is not mandated, and the FRC has not yet considered how to align FRS 103 with IFRS 17, if at all.
Some of the proposed changes to the IG appear misguided, as they seem to consider GWPs as revenue in Section 23. In fact, it is gross earned premiums or net earned premiums that would be more closely aligned with the concept of revenue. I share these views and certainly hope the FRC will consider these comments in finalising the amendments.
Several commenters have also expressed concerns that the proposed effective date of 1 January 2025 provides a very short lead time in which to prepare. By comparison, the effective date of IFRS 15, initially issued in 2014, had to be deferred to 1 January 2018 to allow sufficient time for transition.
What other amendments is the FRC working on?
The most recent is FRED 83, which the FRC issued in April, which proposed changes to FRS 102 and FRS 101. These would introduce a temporary exception to the accounting for deferred taxes arising from the implementation of the Pillar Two model rules, together with targeted disclosure requirements.
As my colleague Chris Riley discussed in an earlier edition, the OECD’s Pillar Two model rules introduce a global system of interlocking top-up taxes that aim to ensure that large multinational groups pay a minimum amount of income tax. The FRED 83 proposed amendments are like those issued by the IASB for IFRS reporters in May. We expect FRED 83 to be uncontroversial in the UK. It is broadly supported, as shown by the rapid finalisation of the corresponding IAS 12 (IFRS) amendment by the IASB. The comment period for FRED 83 was much shorter, ending in May, and we expect the FRC to finalise the amendments this summer.
How can we help?
Our experienced accounting advisory team can help you with impact assessment, implementation, and transition to the amended FRS 102 standards. We have previously worked on IFRS 15, IFRS 16 and IFRS 17 transitions and understand the challenges these accounting changes pose. If you would like further guidance on any of the issues raised in this article, please contact Satya Beekarry.