Published in March 2024, the Financial Reporting Council’s (FRC) periodic review amendments provide a new approach to accounting for revenue. A five-step revenue recognition model is being introduced to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. The same model, but with appropriate simplifications, is being introduced to FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime. In both cases, the changes are effective for accounting periods beginning on or after 1 January 2026. Those familiar with IFRS Accounting Standards will recognise the five steps as they are based on the principles of IFRS 15 Revenue from Contracts with Customers. 

With revenue often being the largest number in an entity’s financial statements, it is important that there are robust requirements that can be applied consistently. The current accounting requirements for revenue in FRS 102 and FRS 105 are less detailed, which can make it challenging for preparers to determine the appropriate accounting and result in diversity in practice. In contrast, the new five-step model will enable more consistent and comparable accounting. This should ultimately make life easier for preparers and provide more useful information to users of financial statements.

The five-step model focuses on identifying the distinct goods or services promised to the customer, determining the amount of consideration that the entity will be entitled to in exchange and the pattern of fulfilment of those distinct elements. For many straightforward businesses, this approach will not alter how much revenue they recognise or when they recognise it. For others, there will be more significant changes to the amount and timing of revenue recognition. However, it is important that all entities take a step back from current practice to assess the impact and implementation of this new model.

The five steps are outlined in the diagram below and explored further in the rest of this article.

Step 1: Identify the contract(s) with a customer

The first step for an entity applying the model is to identify the contract, or contracts, to provide goods or services to a customer. Criteria that a contract must meet to be in scope of Section 23 Revenue from Contracts with Customers are listed in the standard.

Contracts with the same customer should be combined when they are entered into at – or near – the same time and are negotiated as a package, the amount paid in one contract depends on the other or the goods or services promised are a single performance obligation.

The treatment of contract modifications depends on the scope of the changes and the corresponding change in price. Modifications might be accounted for as a separate contract, a termination of the existing contract and the creation of a new contract, or with a cumulative catch up.

Step 2: Identify the performance obligations in the contract

The second step is to identify the performance obligations in the contract. Promises to transfer distinct, or a series of distinct, goods or services to a customer should be identified as separate performance obligations. Section 23 provides criteria to determine if a good or service promised is distinct within the context of the contract. 

Performance obligations do not include activities that an entity must undertake to fulfil a contract unless those activities transfer a good or service to the customer. For example, administrative tasks that do not transfer a good or service to the customer would not be considered performance obligations.

When a good or service promised to a customer is not distinct, it must be combined with other goods or services in the contract until the entity identifies a bundle of goods or services that is distinct. 

Step 3: Determine the transaction price

Step three is determining the transaction price. The transaction price is the amount of consideration an entity is entitled to receive in exchange for transferring goods or services to a customer.

Often, the transaction price includes a variable amount. This may arise because of the contract including features such as discounts, rebates, refunds, penalties or performance bonuses. 

The amount of variable consideration to include in the transaction price must be estimated using either the expected value method or the most likely amount method – based on which method the entity believes better predicts the amount it will be entitled to. Variable consideration must also only be included to the extent that it is ‘highly probable’ that the entity will be entitled to it once the associated uncertainty is resolved.

FRS 102 also considers how the time value of money, non-cash consideration and consideration payable to a customer should be treated in this step of the model.

Step 4: Allocate the transaction price to the performance obligations in the contract

The fourth step is to allocate the transaction price to the performance obligations in the contract. The transaction price should be allocated to each distinct performance obligation based on a relative standalone selling price. This is the price at which an entity would sell a good or service promised in a contract separately to a customer. If a standalone selling price (SSP) is not directly observable, it should be estimated by considering all information that is reasonably available, including market conditions, entity-specific factors and information about the customer or class of customer. 

Discounts or variable consideration may also require allocation to the performance obligations in the contract, depending on the specific circumstances. 

Subsequent changes to the transaction price, eg, due to the estimate of variable consideration being updated or due to contract modifications, may lead to the allocation of the transaction price being reassessed. 

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation

The final step is to recognise revenue as the performance obligation is satisfied. A performance obligation is satisfied by transferring the promised good or service to the customer. A good or service is transferred when the customer obtains control. 

Performance obligations can be satisfied over time or at a point in time, depending on the facts and circumstances. The model defines the criteria that must be met for a performance obligation to be satisfied over time. If a performance obligation is not satisfied over time, it is satisfied at a point in time. 

Transition

The FRC has provided two choices for entities transitioning to the revised Section 23. Entities can apply the requirements retrospectively, including restatement of comparatives. To ease the transition, practical expedients are available when choosing this option. Alternatively, entities may apply the requirements retrospectively but without restating comparatives. Instead, the cumulative effect of initially applying the standard will be recognised as an adjustment to opening retained earnings. Under this option, only incomplete contracts at the date of initial application need be adjusted for. Some of the practical expedients referred to above may also be used.

In summary

While the new five-step model may require a change in mindset and is likely to take time to get used to once effective, having a single revenue recognition model should achieve more consistent and comparable accounting. Ultimately, this will lead to higher quality, more reliable information – an ambition ICAEW supports.

Georgina Chalk, Technical Manager, Corporate Reporting Faculty, ICAEW