FRS 102, the Financial Reporting Standard applicable in the UK and the Republic of Ireland is evolving. The changes on the horizon are likely to be significant.
What are the proposed changes to FRS 102 and how will they impact law firms?
FRS 102 is subject to periodic review, with a significant review every five years alongside a three-yearly review in the intervening period. The latest version of this, Financial Reporting Exposure Draft 82 (or “FRED 82” as it is catchily known) was published in December 2022.
One of the proposed key changes is a new model for revenue recognition, using the 5 step model of IFRS 15. The aim is to provide greater consistency of revenue recognition for users of financial statements and a clearer process for preparers to apply. In the legal sector, this will help users like private equity consolidators assess the underlying earnings and recurring revenues of legal practices.
This is a fundamental change, as revenue recognition is a key part of the financial statement preparation process. Revenue is one of, if not the, largest figure in the financial statements. It is a highly sensitive figure which is important in many ways; determining entity size, employee/partner bonuses and entity valuation figures. Views are being sought and will be taken into account when FRS 102 comes to be updated.
Final amendments will be made following the end of the consultation in April 2023. These may be published in Q3 2023. An implementation period is proposed with an effective date of accounting periods commencing 1 Jan 2025, i.e., for 31 December 2025 year ends. Although this date is subject to consultation too!
What will this mean in practice for Revenue Recognition?
Firstly, it is useful to outline the five steps required in determining revenue recognition:
Identify the contracts with the customer
Key considerations include whether a modification to terms of existing contracts results in the creation of a new contract, for instance, if new performance obligations (major scope changes or revisions to terms) are added.
Identify separate performance obligations in the contract
This can involve the “unbundling” of a contract. For instance, the conveyancing process could be deemed as consisting of separate processes relating to right to title, issues of planning, exchange and completion and registry of title.
Determine the contract price
Fundamentally, the transaction price will be the most likely value that the entity expects to be entitled to in exchange for the promised goods or services supplied under a contract. This requires consideration of variable consideration (for instance for rebates or incentives, although not likely relevant to the legal sector) and adjustments for financing components (for instance if cash is paid in arrears or advance).
Allocate the contract price to the different performance obligations
Here, the individual selling price of the goods and services is allocated to the individual performance obligations. Consideration is paid to the allocation of variable considerations which are linked to specific performance obligations if certain conditions are met
Recognise revenue when performance obligations are fulfilled
The key point here is that the point of revenue recognition is the point when the performance obligation is satisfied. Revenue can be recognised in two ways – at a point in time or over time.
How will a move to the IFRS 15 method affect law firms?
A move to the IFRS 15 method of determining revenue recognition will potentially have changes to the timing and profile of revenue recognition for law firms. The IFRS model is far more prescriptive than the current FRS 102.
What will law firms need to consider, should the proposed changes be accepted?
Do engagement letters provide firms with an enforceable right to be paid for work completed to date? If this right is not present, then it is possible that revenue cannot be recognised until the point in time the matter is completed, rather than being recognised over time as is the norm for professional services fees.
Are the systems in place sufficient for identifying separate performance obligations and the amount of the contract price to be allocated to each?
Provided revenue can be recognised over time, IFRS 15 permits the use of inputs to measure completion. For legal firms, the inputs will likely be the hours spent per matter. IFRS 15 however explicitly prohibits including administrative or contract set-up activities in the measurement of inputs. Is your firm’s time recording policy and system set up to identify and exclude such items?
Are systems in place that will record the stage of completion of each contractual obligation?
Contingent fees will need considering. Where contingent fees relate to similar matters and firms have access to enough historical data, firms have used this data to estimate the percentage of contingent WIP that will become revenue. Examples of this are firms that deal with large volumes of personal injury claims. Firms will need to consider carefully whether this method of recognising revenue in relation to contingent fee matters complies with the requirements of IFRS 15.
In summary, the process of determining revenue recognition is to become far more prescriptive in the near future. With the changes to FRS 102 largely following IFRS 15, there is scope to determine in advance whether your entity’s revenue recognition will be affected. Action can be taken to review the content of engagement letters where these do not give the entity the right to be paid for work completed to date.
If you or your firm would like to discuss the content of FRED 82 further, please get in touch.
