UK FRS 102 vs. IFRS for SMEs

At first glance, FRS 102, the primary accounting standard for UK and Irish entities, and the IFRS for SMEs Accounting Standard appear to be close relatives. This is no coincidence; FRS 102 was intentionally developed using the IFRS for SMEs Accounting Standard as its foundational blueprint. This shared DNA suggests a high degree of alignment, a premise that held true for many years.

However, despite this common origin, the two frameworks have embarked on distinctly divergent paths. Recent major updates to both the standards i.e.. the 'Periodic Review 2024' for FRS 102 and the 'Third Edition' for the IFRS for SMEs Accounting Standard, have amplified these differences, creating significant gaps in key accounting areas. For finance professionals, accountants, and business owners navigating these standards, understanding these divergences is no longer an academic exercise but a practical necessity.

This article cuts through the complexity to highlight the five most impactful differences between the two standards. These are the critical distinctions that can fundamentally alter a company's balance sheet, income statement, and overall financial narrative.

The most significant divergence to emerge from the recent updates lies in the accounting for leases, where FRS 102 has taken a monumental leap forward. Following its 2024 Periodic Review, the standard has adopted an on-balance sheet lease accounting model based on the principles of the full IFRS 16 standard.

For lessees, this is a fundamental change. The new rules require the recognition of a right-of-use asset and a corresponding lease liability for nearly all leases, effectively bringing previously off-balance-sheet operating leases onto the statement of financial position.

In contrast, the third edition of the IFRS for SMEs Accounting Standard has deliberately maintained the status quo. The update made "Editorial amendments only" to its leasing section. It continues to rely on the older model that requires entities to classify leases as either 'finance' or 'operating', with operating leases remaining off-balance sheet.

This significant divergence has profound consequences. For an FRS 102 entity with significant operating leases, for example, a retailer with a portfolio of store locations, the new rules will dramatically increase reported assets and liabilities. A company with £1 million in annual rent expense could see its balance sheet expand by an estimated £5-7 million in right-of-use assets and lease liabilities, fundamentally altering its debt-to-equity and leverage ratios overnight.

This divergence showcases FRC acting as a national standard setter prioritizing alignment with the trajectory of full IFRS. The FRC has judged that for UK and Irish entities, convergence with the global best practice established by IFRS 16 is more important than maintaining consistency with the more cautious global SME standard.

FRS 102 provides crucial accounting policy options that are strictly forbidden under the IFRS for SMEs Accounting Standard, reflecting a different philosophy on what costs can be treated as assets on the balance sheet.

FRS 102 permits entities to adopt a policy of capitalizing borrowing costs that are directly attributable to the acquisition, construction, or production of a qualifying asset. This means interest costs incurred during the construction of a new factory, for example, can be added to the cost of that factory rather than being expensed immediately.

In contrast, the IFRS for SMEs Accounting Standard requires all borrowing costs to be recognized as an expense in profit or loss in the period they are incurred. There is no option to capitalize.

Similarly, FRS 102 allows entities to capitalize intangible assets arising from the development phase of an internal project, provided a strict set of criteria demonstrating technical feasibility and commercial viability are met.

The IFRS for SMEs Accounting Standard takes a much more conservative approach, requiring all expenditure on research and development to be recognized as an expense when it is incurred.

These variations can lead to vastly different financial outcomes. An entity applying FRS 102 can report a higher asset base and smoother profit profile by capitalizing these costs, whereas an entity under the IFRS for SMEs Accounting Standard must expense them, resulting in lower initial profits and a smaller balance sheet. This philosophical split means that FRS 102 provides a pathway for ambitious, capital-intensive UK SMEs to present financials that are more comparable to their larger, IFRS-reporting peers, potentially improving their appeal to certain investors.

This difference highlights a practical, real-world issue that affects countless small businesses. The general rule for financing transactions in both standards is that they must be measured at the present value of future payments, discounted at a market rate of interest. This means an interest-free loan must be recorded at a discounted value, with the difference being treated as deemed interest over the loan's life.

However, FRS 102 offers a specific, pragmatic exception. A small entity can measure a loan from a person within a director's group of close family members (when that group includes at least one shareholder) at its simple transaction price. This exemption was introduced specifically to provide a proportionate and practical solution for small owner-managed businesses, avoiding unnecessary complexity.

The IFRS for SMEs Accounting Standard contains no such specific exemption for director's loans. Any such loan at a non-market rate of interest must be measured using the stricter present value method.

This is a prime example of FRS 102 being tailored to the specific needs of the UK and Irish SME environment. It demonstrates a key advantage of a national standard; the ability to provide pragmatic, proportionate relief for common local transactions. A global standard-setter like the International Accounting Standards Board (IASB) cannot easily accommodate such jurisdiction-specific norms, leaving entities applying the IFRS for SMEs Accounting Standard with a complexity that their UK and Irish counterparts can avoid.

While the previous points highlight divergence, this section focuses on a major area where the standards are becoming more alike. Both frameworks have recently completed a massive overhaul of their revenue recognition rules to align with the principles-based, five-step model of the full IFRS 15 standard.

The FRS 102 'Periodic Review 2024' completely revised Section 23 to incorporate this five-step model, which focuses on identifying performance obligations in a contract and recognizing revenue as they are satisfied.

In a parallel move, the third edition of the IFRS for SMEs Accounting Standard also revised its Section 23 to align with IFRS 15.

This is a powerful example of "upward convergence." Although both standards aim for simplification compared to the full IFRS 15, this move demonstrates a clear consensus that the principles-based, five-step model provides more useful and comparable information about revenue than older, more rules-based approaches. This is a crucial development for any company dealing with complex contracts with multiple deliverables.

The final point is not a single rule, but the underlying reason for all the other differences; a fundamental divergence in core identity and purpose.

FRS 102 is a national standard, developed specifically for the UK and Republic of Ireland. Its IFRS for SMEs base was intentionally amended to ensure compliance with local legislation like the Companies Act. Furthermore, it deliberately retained certain accounting policy options from previous UK standards to ease the transition for local companies and maintain comparability with entities using full IFRS.

Conversely, the IFRS for SMEs Accounting Standard is a stand-alone, global standard. It is designed for entities that do not have "public company accountability" anywhere in the world. Its modifications from full IFRS are based on the needs of a global user base and broad cost-benefit considerations, not the legal requirements of any single jurisdiction.

This foundational difference is the key to understanding their divergent evolution. FRS 102 is an integrated UK/Irish standard, shaped by local law and practice. The IFRS for SMEs Accounting Standard is a self-contained global framework. This explains why FRS 102 is quicker to adopt certain principles from full IFRS (like the IFRS 16 lease model) while also retaining local pragmatism (like the director's loan exemption) that a global standard cannot accommodate.

While FRS 102 and the IFRS for SMEs Accounting Standard share a common foundation and are moving in the same direction in key areas like revenue recognition, they remain distinctly different frameworks. They have been shaped by their respective purposes—one tailored for a specific legal and commercial environment, the other designed for global application.

The stark divergence in a fundamental area like lease accounting, however, creates significant comparability challenges for investors, lenders, and multinational groups. A company's balance sheet can look dramatically different depending on which of these 'SME' standards it applies. In an era of increasing cross-border investment and supply chain integration, this lack of comparability is not a mere academic inconvenience; it is a practical barrier to capital flow and efficient analysis.

As both the Financial Reporting Council and the International Accounting Standards Board (IASB) look to the future, they must prioritize harmonizing these core accounting areas to reduce complexity and enhance the global comparability of SME financial reporting.

We welcome your thoughts.