Financial Reporting Standard: impact on property business accounts
Giving a different account
2 October 2015
Stacy Eden explains how changes to financial reporting will have a significant impact on property business accounts
All existing UK accounting standards have been replaced by a single standard as from 1 January. Property companies' financial statements will now have to be prepared under the Financial Reporting Standard (FRS) 102, rather than UK Generally Accepted Accounting Practice (UK GAAP) for years ending 31 December 2015 and beyond. For a property company with a 31 December 2015 year end, the 31 December 2013 balance sheet previously prepared under old UK GAAP will need to be restated under FRS 102, which could even give rise to a tax charge due to prior year adjustments.
The effect on a property company's net assets and reportable profit could be hugely significant, with implications to the entity's tax charge and any bank covenants. Early planning is vital to ensure the issues are understood by lenders, directors and shareholders and critical decisions made on matters such as whether to hedge a swap.
The accounting for investment properties, lease incentives, deferred tax, construction contracts, financial instruments and holiday accruals will also be significantly different:
- Revaluation of investment properties will now be recognised through the profit loss account.
- Deferred tax will be recognised in full on all revaluations.
- Lease incentives will be recognised over the lease term as opposed to the period of the first break clause.
- Construction contracts may result in revenue being recognised earlier, increasing a property developer's tax charge.
- Financial derivatives such as swaps will now be held at fair value.
- Unused holiday will be accrued at the relevant year-end, potentially giving rise to a tax deduction.
Financial reporting for investment properties has been substantially revised. Investment properties are defined as assets held for generating rental income or capital appreciation.
Such properties will now be initially recognised at cost but will thereafter be valued at their fair value at the balance sheet date with all changes being recognised through the profit and loss account. Clearly, this can affect covenants, because developers will now be recognising unrealised property valuation movements on investment property in their own profit and loss account.
Investment properties are defined as assets held for generating rental income or capital appreciation
The only exception will be when the fair value cannot be measured reliably. In this case, the asset is treated as a normal fixed asset, carried at cost and depreciated over its expected useful life.
The disclosures relating to investment properties have been extended significantly. The methods and significant assumptions used to determine fair value will need to be disclosed, together with the extent to which it is based on an independent valuation performed by an appropriately qualified valuer. If there has been no such valuation, this must be disclosed.
In addition, any contractual commitments that have been entered into purchase, construct, develop, maintain or enhance investment property will need to be disclosed, as will the term and amounts of leases entered into.
FRS 102 adopts a 'timing difference plus' approach to deferred tax. This is different to the approach currently undertaken in old UK GAAP and will result in the recognition of a greater array of deferred tax assets and liabilities. The main change will be the recognition of deferred tax liabilities on upward property valuations. For property investors with significant property revaluations, this will have a large impact on net assets in the Statement of Financial Position as additional deferred tax liabilities are recognised. This could cause issues with bank covenants as well as distributable reserves, which can affect companies that pay a high proportion of their profits by way of a dividend.
Incentives to enter into a lease will be recognised as a reduction to the rental income passing through the profit and loss account over the lease term.
This differs from UK GAAP, which recognises this reduction to the next rent review rather than the end of the lease. As tax treatment follows the accounting treatment, a higher tax bill may arise because the lease incentive offered by the property investor is spread over a longer term.
When the outcome of a contract can be measured reliably, the property developer will recognise both income and costs by reference to the percentage of completion. If the outcome cannot be reliably measured, all costs are expensed and revenue is only recognised to the extent that it is probable that costs are recoverable.
When it is probable that a loss will occur on a contract, this is recognised in full immediately as an onerous contract provision.
When the outcome of a contract can be measured reliably, the property developer will recognise both income and costs by reference to the percentage of completion
Consideration of revenue recognition should be simplified by a coherent set of criteria. For most property developers, application of these criteria should make no difference to existing revenue recognition. It could be argued that the general application of recognising revenue when it is probable (i.e. more likely than not) and that an economic benefit will flow to the entity, may mean that revenue is recognised at an earlier stage than previously and, therefore, the tax charge will be higher.
Entities with transactions involving reservation of title, or contingent fee arrangements, may need to review their recognition policies in light of the revised guidance.
FRS 102 has a concept of basic financial instruments (such as cash, trade debtors, trade creditors) and other financial instruments (such as interest rate swaps and forward foreign currency contracts). Basic financial instruments are accounted at amortised cost or cost less impairment, whereas other financial instruments will be accounted at fair value with any movements recognised in the profit and loss account.
For property developers that have other financial instruments (swaps, caps, etc), this will result in the recognition of an asset or a liability on the balance sheet for the first time and the movements in the fair value will have a direct impact on the reported results for the year.
The recognition of, for instance, a large fair value liability due to a swap taken out with a bank loan, can result in a reduction in net assets (affecting covenants), and a reduction in distributable profits (affecting dividends). There could, however, be tax benefits because it is possible to recognise the liability as a deductible item. Furthermore, a property developer may be able to reduce the effect on distributable reserves by demonstrating the swap was used as a hedge against a bank loan. Hedging or not hedging something such as a swap would have major implications on a property developer's results, distributable reserves and tax charge.
Holiday pay awards
FRS 102 requires holiday not taken by employees to be accrued. Property companies will have to calculate the amount of unused holiday at the relevant year end. This can be quite onerous, particularly if the holiday and accounting year ends are different. Clearly, any accrual should be tax deductible.
Property companies, particularly those with investment property, need to be prepared that their accounts ended 31 December 2015 and beyond will look radically different, affecting bank covenants, distributable reserves and their tax charge. They also need to be aware that not only may their tax charge alter due to the change in accounting profit, this could even result in their quarterly tax instalment payments being increased.
Stacy Eden is Partner and Head of Property and Construction at audit, tax and advisory firm Crowe Clark Whitehill
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This feature is taken from the RICS Property journal (August/July 2015)