FRS 102 The Financial Reporting Standard (FRS 102) is one consolidated standard which replaces all existing UK GAAP standards. It is applicable in the UK and Republic of Ireland.
This new standard became mandatory for financial periods starting on or after January 1, 2015. For investment funds and related entities adopting FRS 102 there are some key issues to consider which go beyond simple cosmetic differences to the financial statements. The measurement changes to assets and liabilities on the balance sheet are likely to have operational or financial consequences as discussed below.
Changes to the measurement of financial instruments
For investment funds and related entities (e.g. General Partners) that previously applied the FRS 4 “historical cost” model the biggest impact will be around measurement of financial instruments. Basic debt instruments will need to be measured at amortized cost using the effective interest rate method. This means transaction costs and premiums or discounts on redemption will need to be factored in when calculating amortized cost. In addition any “off market rate” loans will need to be measured at net present value using a market rate as the discount factor. Typically we see off market rate loans when entities within a given fund structure make loans to one another for reasons of liquidity or cash flow.
Investments will need to be measured at fair value through the profit and loss account. There is no longer an option to simply hold these at cost less impairment for subsidiaries and associates or cost less permanent diminution in value for other investments. The best evidence of fair value is quoted prices in active markets. In the event that there is no active market then alternative valuation techniques should be used to determine fair value. These techniques include using recent arms length market transactions between knowledgeable willing parties, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis or earnings multiples techniques.
Derivative contracts that remain open at the reporting date will need to be fair valued and brought on balance sheet. Previously these instruments were simply accounted for when the contract was closed out and the cash was settled.
Disclosures of information pertaining to risk will increase significantly under FRS 102 and are in essence very similar to the IFRS 13 and IFRS 7 type disclosures including:
• Nature and extent of risks (qualitative and quantitative disclosures of credit, liquidity and market risks);
• Risk management policies adopted;
• Analyzing instruments into fair value hierarchy based on the reliability of valuations (level 1, 2 and 3);
• Valuation models and key assumptions used;
• Extent and nature of all derivative instruments.
First time adoption
FRS 102 is mandatory for financial periods that began on or after January 1, 2015. Comparatives will need to be restated on first time adoption and a reconciliation of profit and total equity in the previous financial year under Old UK GAAP is required as well as a narrative description of the material changes. This means that the balance sheet measurement principles will effectively need to be adopted as at January 1, 2014 for a December 31, 2015 set of financial statements in order to obtain full comparative information.
When you consider the impact of the changes above it is very likely that there will be changes to reported earnings and the Net Asset Value (NAV) of the fund and related entities. These changes will be for future periods as well as prior periods due to the requirement that all comparatives are restated. What impact will this have on the Funds contractual arrangements? Let’s consider the example of a leveraged fund that has an agreement with the lender to maintain certain debt covenant ratios. These ratios are likely to become distorted due to changes to reportable earnings and changes to the value of individual assets and liabilities on the balance sheet. In this instance one would need to consider the loan agreement very carefully and possibly redefine the covenant parameters to take account of FRS 102. Failure to do so may result in a breach of the loan covenant which could have operational or punitive financial consequences for the fund.
Another relevant example is that of management and performance fees which are typically based on earnings or NAV of the Fund. You would expect that the agreements clearly define the basis for payment of management and performance fees based on earnings or NAV. These numbers are likely to change resulting in some potential additional payments or refunds to management and performance fees. You would need to consider how the agreements define earnings or NAV and if a change in GAAP will have an impact?
Information requirements will increase not only on an ongoing basis but also information will be needed at the date of transition for prior period restatements. This may have an impact on budgets and software requirements.
Some frequently asked questions
Q. Is the transition process likely to be costly and time consuming?
A. This depends on the previous accounting policies adopted under old UK GAAP and the complexity of the entity concerned. We’ve already started planning the transition for the funds and related entities that it administers. With careful planning, we believe that we should be able to keep transition costs to a minimum in most cases.
Q. What impact will FRS 102 have on portfolio company investments?
A. Portfolio companies reporting under FRS 102 will have to consider all the issues discussed in the article above. Changes to reportable earnings may have an impact on the valuation of portfolio companies particularly those using an earnings multiple based valuation model.
Q. How will this impact UK partnerships that are deemed “Qualifying Partnerships” in accordance with the Partnership (Accounts) Regulations 2008?
A. Qualifying Partnerships are required to prepare accounts in accordance with the UK Companies Act and there may be some conflicts between the UK Companies Act and FRS 102. One example is the FRS 102 consolidation exemption for investment entities which is in conflict with the Companies Act. In the instance of a conflict the directors will need to consider the most appropriate treatment and invoke the “true and fair” override allowable under the Companies Act.
The adoption of FRS 102 could have far reaching implications. Consideration should be given to these issues in advance of first time adoption of FRS 102 to avoid unnecessary complications and costs.
Craig Long is head of accounting at Ipes, a private equity fund administration firm with offices in four European locations – London, Luxembourg, Jersey and Guernsey.