Revenue recognition – what’s changing?

New revenue recognition requirements under FRS 102 are coming into effect.

On 27 March 2024, the Financial Reporting Council (FRC) issued its final amendments to UK and Ireland accounting standards arising from its periodic review.

The periodic review amendments come into mandatory effect for accounting periods commencing on or after 1 January 2026. Early adoption is permissible provided all the periodic review amendments are applied at the same time.

The two ‘headline’ changes relate to on-balance sheet lease accounting (which will be examined in a future article) and revenue recognition (which we examine here).

New principles for revenue recognition

Revenue recognition is dealt with in FRS 102 (September 2024), section 23 Revenue from Contracts with Customers and in FRS 105 (September 2024), section 18 Revenue from Contracts with Customers.

Both FRS 102, section 23 and FRS 105, section 18 contain a comprehensive five-step model for recognising revenue. The objective of the model is for an entity to recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The five-step model approach works as follows:

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

FRS 102, para 23.7 sets out specific criteria, all of which must be met, to account for a contract with a customer:

• The parties to the contract have approved the contract and are committed to perform their respective obligations.
• The entity can identify each party’s rights regarding the goods or services to be transferred.
• The entity can identify the payment terms for the goods or services to be transferred.
• The contract has commercial substance.

It is probable (ie more likely than not) that the customer will have the ability and intention to pay the consideration to which the entity will be entitled when it is due.

Example

The principal activity of an IT services provider is to provide support and repair services via the internet and onsite, if required. It has entered into a verbal contract with one of its customers to scan its server for viruses and clean up redundant files. The price to perform this work was agreed with a sales consultant and payment was taken immediately.

The services will be performed at an agreed date when the IT services provider will login to the customer’s server and carry out the work.

The IT services provider and its customer have entered into an oral contract. A contract need not be in writing for it to be enforceable. The customer has provided payment details and consideration for the services to be provided, and the IT services provider is committed to performing the work on the customer’s server.

In this situation, all the criteria in FRS 102, para 23.7 are met and the contract is in scope of section 23.

Step 2: Identify the performance obligations in the contract

A ‘performance obligation’ is defined as a promise in a contract with a customer to transfer to the customer either:

• a distinct good or service (or a distinct bundle of goods or services); or
• a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Some contracts contain more than one performance obligation. For example, a client could sell a machine to a customer and provide one year’s servicing and maintenance. Similarly, a course provider could enter into a contract to provide three lectures at various different times and a textbook either on day one of the course, or on receipt of payment/registration.

Example

Sunnie Ltd is a bookkeeping software developer. It enters into a three-year contract with its customer to provide a licence to access the bookkeeping software. The contract stipulates that Sunnie will provide periodic software updates and technical support throughout the term of the contract.

The bookkeeping software is delivered prior to installation, updates and technical support and is functional without the updates and/or technical support. This means the customer benefits from each good or service individually. Sunnie has also determined that the licence, installation, updates and technical support are separately identifiable. Hence, in this contract there are four performance obligations:

• the licence to supply bookkeeping software
• the installation service
• updates to the software
• technical support.

Step 3: Determine the transaction price

The transaction price is the amount of consideration the entity expects in exchange for satisfying a performance obligation.

Example

Lenny Industries Ltd enters into 30 contracts with its customers to supply various chemicals. Each contract includes the sale of one type of chemical with a selling price of £1,200. The cost to Lenny Industries for each of these types of chemicals is £700. Customers can return the products within 30 days for a full credit and any returned goods can be used in other chemical mixes or sold again at a profit.

The finance director can reliably estimate the return rate for this type of chemical based on previous experience. On this basis, the finance director has estimated that 26 products will not be returned, meaning four are likely to be returned.

As the customers can return the products, the consideration is variable. FRS 102, para 23.44 requires any of the following to be used when estimating variable consideration:

• the expected value method; or
• the most likely amount method.

Using the expected value method, the estimated variable consideration is £31,200 (26 products x £1,200). The variable consideration is included in the transaction price because, based on prior experience, it is highly probable that Lenny Industries will be entitled to the cumulative amount of revenue recognised (£31,200) when the uncertainty associated with the variable consideration is subsequently resolved (FRS 102, para 23.46).

Revenue of £31,200 and a refund liability of £4,800 (four products expected to be returned x £1,200) is recognised (FRS 102, paras 23.53(a) and (b)).

In addition, Lenny Industries will derecognise inventory transferred to its customers. It will also recognise a refund asset (classified as inventory) of £2,800 (four products x £700 cost) as well as a corresponding credit to cost of sales. This represents the company’s right to recover products from customers on settling the refund liability (FRS 102, para 23.53(c)).

Step 4: Allocate the transaction price to the promises in the contract

FRS 102, para 23.65 requires the entity to allocate the transaction price to each performance obligation identified on a relative standalone selling price basis, unless allocating discounts or variable amounts on an alternative basis. If a customer is offered a discount for purchasing a bundle of goods and services, the discount is allocated across all performance obligations within the contract in proportion to their standalone selling prices (unless observable evidence suggests this would be inaccurate).

Example

Salinger Ltd sells a cutting machine with one year’s free technical support for £100,000. The sale of the machine and the provision of technical support have been identified as separate performance obligations.

On a standalone basis, the machine would sell for £95,000. This is the first time Salinger has started to provide technical support for this type of machine. Other support services provided by Salinger, which generate a profit, attract a markup of 50%. It is expected that the technical support service will cost £20,000.

The selling price of the machine on a standalone basis is £95,000 but there is no observable selling price for the provision of technical support. This will need estimating in accordance with FRS 102, para 23.69 using:

• an adjusted market assessment approach
• an expected cost plus a margin approach; or
• a residual approach.

The residual approach would attribute £5,000 (£100,000 – £95,000) to the technical support. This does not approximate the standalone selling price of similar support services, which usually make a profit.

A more appropriate approach would be an expected cost plus a margin approach. Based on this approach, the selling price of the technical support service would be £30,000 (£20,000 x 150%).

The total of the standalone selling prices of the machine and technical support is £125,000 (£95,000 + £30,000). However, the total consideration is only £100,000. This means the customer is receiving a discount of 20% (£25,000 / £125,000 x 100).

FRS 102, para 23.74 assumes that discounts relate to all performance obligations within a contract unless this basis does not depict the amount of consideration to which the entity expects to be entitled (in which case the entity uses a method that does reflect such amounts).

The transaction price allocated to the machine is £76,000 (£95,000 x 80%).

The transaction price allocated to the technical support is £24,000 (£30,000 x 80%).

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

A performance obligation is said to be satisfied over time if one, or more, of the following criteria in FRS 102, para 23.81 (a) to (c) are met:

• The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
• The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
• The entity’s performance does not create an asset with alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

FRS 102, para 23.102 refers to ‘output methods’ (eg surveys of performance) and ‘input methods’ (eg costs incurred as a proportion of total expected costs) for measuring progress towards the satisfaction of a performance obligation.

If the progress cannot be reliably measured, revenue is only recognised to the extent of recoverable costs incurred.

Example

On 3 January 2026, Warrington enters into a contract with Wolves to construct a new building for £8m plus a bonus of £1m if the building is completed within 18 months. Estimated costs to construct the building are £6m.

The winter months are renowned for causing delays to construction and sourcing various materials can also result in delays to construction. Hence, Warrington is uncertain whether the bonus will be received.

At the year-end 31 December 2026, Warrington is still uncertain whether its bonus target will be met due to other delays in the year. Warrington decides to measure progress towards completion based on costs incurred (FRS 102, para 23.102(e)). Costs incurred on the contract to date are £2m.

The construction of the building is a single performance obligation. The bonus element is variable consideration and must be excluded from the transaction price because it is not highly probable that it will be entitled to the cumulative amount of the revenue (FRS 102, para 23.46).

The construction is accounted for as an obligation settled over time. Warrington should recognise revenue based on progress towards satisfaction of the construction of the building. Using the costs incurred approach, the performance obligation is 1/3 (£2.0m / £6.0m) complete. Accordingly, revenue and costs recognised at the year-end are:

	£m
Revenue	2.6	(£8m x 1/3)
Cost of sales	(2.0)	(£6m x 1/3)
Gross profit	0.6

Conclusion

The new revenue recognition requirements in FRS 102 (September 2024) and FRS 105 (September 2024) may result in different revenue profiles than under the January 2022 editions.

Keep in mind that there are new prescriptive requirements for transactions involving (among other things) non-refundable upfront fees and income arising from licensing and royalties which will need careful consideration.