UK: RSL Issues - A Briefing For Registered Social Landlords

Last Updated: 1 April 2008
Article by Jonathan Pryor

In this edition of RSL issues, we examine how recent changes to reporting standards and accounting practices affect the RSL sector. We also look at the business plan model, and compare bonus levels in housing associations with other sectors.

SORP 2008

The SORP 2008 has now been issued. Jo Brewer discusses it in light of the contentious changes made to shared ownership accounting.

(SORP) 2008 replaces the SORP 2005 update and has been completely rewritten. It incorporates changes to Financial Reporting Standards (FRS) and other accounting practices since the 2005 update.

The SORP 2008 is applicable for accounting periods beginning on or after 1 April 2008, although, as always, early adoption is encouraged.

Key Amendments To The SORP

The main changes to the SORP relate to:

  • shared ownership
  • mixed tenure development
  • negative land transfers
  • onerous contracts
  • sub market price land acquisitions
  • related parties
  • stock transfers
  • valuations.

The most significant changes relate to accounting for shared ownership and mixed tenure developments. These are often linked.

The SORP 2008 requires associations to include costs relating to first tranche sales as current assets within work in progress and to recognise any profit or loss on disposals within trading profit, i.e. proceeds included as turnover and costs included in the cost of sales.

Costs relating to second and subsequent tranches will continue to be recognised as fixed assets (although the amount may need to be amended to reflect the change in treatment of the first tranche). Any profit or loss on disposal of second and subsequent tranches will also continue to be included after operating profit as fixed asset disposals. There are no changes to the grant regime and therefore grants will continue to be netted off against fixed asset costs.

In reality, the assumptions made in the development appraisal on first tranche disposals change by the time the development is completed. Therefore, what should you do during construction and what happens if the estimate changes?

To record the costs initially, you should apply a best estimate, typically the development appraisal estimate, of first tranche sales. If the initial estimate changes, you should adjust it accordingly so that at each accounting period end the accounts reflect the latest estimate.

However, it is quite common for shared ownership properties to be included as part of a mixed tenure scheme. Where this is the case, to complicate matters further, there are other issues to consider. With any mixed tenure scheme, if one part is in deficit and the other part is in profit, you should reduce the profit by the amount of the deficit, i.e. you should only reflect the overall profit in the accounts.

How Are Group Structures Affected?

There are further complications with group structures. Different elements of a scheme can be developed and reported within different entities within a group. It is fairly common for a scheme involving shared ownership, general needs and outright sales to be developed in two or even three entities. In this instance, on an individual entity basis, the performance of each element of the scheme will be reflected in isolation. However, on a group basis, the development will be assessed as one and performance reported as such.

Changes In Accounting Treatment

The changes in the ways ownership accounting and mixed tenure developments are treated should be accounted for as a prior year adjustment, unless the restatement would not be material.

It is clear that accounting for shared ownership and mixed tenure developments will be complex. Additional guidance will inevitably emerge over time.

Although an element of pragmatism may be required, we recommend that detailed planning is performed and advice sought where necessary.

IFRS - WHAT'S ALL THE FUSS ABOUT?

What are the implications of IFRS for the finance directors of RSLs? Jonathan Pryor gives an update.

While it is reasonable to try to gain an overview of International Financial Reporting Standards (IFRS), there is no point in spending significant amounts of time trying to achieve a detailed understanding. Certainly, it is a myth to suggest Registered Social Landlords (RSLs) should start planning now since no one knows what the impact will be. The debate has not even started on several unanswered questions.

We believe the sequence of events will run as follows.

  1. The SORP working party will put together some initial thoughts. This is likely to take several months and its report may not be published until next year.
  2. There will be extensive consultation. This will probably result in the SORP working party needing to rethink some of its original plans, for the following reasons.
    1. IFRS may well change a great deal of current accounting by RSLs and is unfamiliar to most people in the RSL sector. Therefore, IFRS changes are likely to have some consequences which were not fully anticipated.
    2. Both IFRS and FRS are evolving, so the time spent over consultation could lead to refinements in IFRS.
    3. Most crucially, accountancy firms are likely to subject IFRS proposals to a high level of technical examination, which in turn should raise a number of issues. The technical teams may be less familiar with RSLs, but their fresh perspectives may well lead to challenges to the accounting treatment on several fronts.
  3. The SORP working party will then need to modify its proposals.
  4. A further round of consultation will probably follow.
  5. Hopefully, this will lead to the process of finalising the SORP, although this is more likely to be prolonged.

What Are The Anticipated Changes?

Until the extensive programme of design and consultation is sufficiently progressed, no one can reliably predict the outcome. Clearly, covenants will need to be reassessed, but at this stage we can only guess to what degree and in what ways.

Classifying Housing Properties

Under IFRS, housing properties may be classified as investment properties. The IFRS definition is subtly different from the FRS one; property held to earn rentals can be classified as investment property. It is questionable whether this really applies in the RSL sector, since in most cases RSL housing properties are not held in order to earn rentals but to fulfil a social need. However, if they do meet the test, IFRS allows a choice of either cost less depreciation (much the same as at present) or valuation, but with the valuation movements going through the income statement – whether up or down. Even if an RSL chooses to use cost less depreciation, IFRS requires valuations to be performed so that a disclosure note can be made. Clearly, this will have a cost implication for those RSLs not currently obtaining annual valuations.

Calculating Deferred Tax

Unlike in FRS where revaluations are exempted, IFRS revaluations of housing properties are reflected in the deferred tax calculation.

Business Combinations

Under IFRS, when one RSL combines with another there will be no merger accounting (except possibly with group reorganisations). All business combinations (unless they fall outside IFRS 3) must have an acquirer, with fair value adjustments made to the assets and liabilities of the acquiree.

In addition, there are more intangibles such as trademarks that need to be separated out and valued. Positive goodwill is not amortised and negative goodwill is released directly to the income statement in the year it arises.

Accounting And Disclosure

Accounting and disclosure in relation to financial instruments becomes much more challenging. In addition to horribly complex disclosure requirements, derivatives and swaps, etc. are subject to intricate accounting rules, complicated further by hedge accounting. If you needed a reason to fervently hope that IFRS is delayed as long as possible for the RSL sector, then the accounting and disclosures in relation to financial instruments should be at the top of your list.

Implementation Timelines

As IFRS is now operational for listed companies, Aim companies have been complying since the end of 2007. Government is next on the list and IFRS will ultimately be required for the RSL sector. This will either come directly via the SORP adopting IFRS in 2011 or 2012, or at the point FRS and IFRS are fully aligned. This will happen gradually to some extent, but we expect to complete around the same time. It is highly likely that there will be another FRS-based SORP update before this around 2010. It is therefore not a question of whether, but when, IFRS will hit the RSL sector.

However, for RSLs with shared ownership or those which have received stock transferred from a local authority, the new SORP 2008 should be a priority. In our view, for finance directors who are considering financial reporting issues, this is where they should be focusing their energy.

THE IMPORTANCE OF THE BUSINESS PLAN MODEL

It's an interesting time for RSLs to be seeking additional finance. Finance directors need to make sure their business planning tools are robust enough in these uncertain times, says Jonathan Pryor.

There are many reasons for feeling nervous about raising finance at the moment. It may be due to the rise in the London Interbank Offered Rate (LIBOR) relative to base rates (although this is not as bad as it was a few months ago), stock market turbulence, the problems with monoline insurers or, closer to home, the marked increase in margins of RSL bonds over their reference gilts.

Indeed, the larger RSL groups have been discussing the possibility of buying bonds back. This is in sharp contrast to the position last year when a number of RSLs were considering issuing bonds. In addition, we have the uncertain effect of Basel II (the Revised International Capital Framework) and the Housing and Regeneration Bill.

However, for the medium-term, our view is that the gap between deals offered to stronger RSLs compared with weaker ones is likely to widen, possibly providing a further spur to arguments in favour of mergers for some. We anticipate an increased emphasis on lenders, auditors and regulators understanding the strength of an RSL's overall financial position. They will, in turn, have greater expectations of the reliability of an RSL's business planning tools.

Reporting Tools

There are three main financial reporting tools used by RSLs – the statutory accounts, management accounts and the business plan.

Statutory Accounts

It is ironic, to say the least, that the statutory accounts are given huge amounts of resource – finance departments spend up to six months preparing for and producing the year-end numbers and then, across the sector, several millions of pounds are spent having them audited.

They provide a useful base point, but beyond that say little that is useful about the financial performance or prospects of the RSL.

Management Accounts

Management accounts have some value; however, they often apply slightly dubious accounting policies and are too prone to the short term fix close to the year end. For example, deferring maintenance costs so that overall budgets can be met.

Business Plan Models

In contrast, the business plan model, which could give an invaluable longterm picture of what is a very long-term business, is often weakly designed and error-prone. Compared with financial statements and their annual audits, it is obvious that some business plan models used by larger RSLs have never been properly validated.

Priorities For Finance Directors

In these uncertain times and with so much money flooding into the RSL sector, finance directors should be placing much more emphasis on the robustness of their business planning tools. They should be reflecting on the uncertainty in the property market and assessing what would happen in a range of scenarios. The timetable for starting actions to deal with funding needs should be markedly increased as a result. Finance directors should also be looking to build much more headroom into their plans.

It is also crucial that they understand and model the potential implications of interest rate movements, taking into account any derivatives or other financial instruments in place.

BONUS LEVELS IN THE HOUSING ASSOCIATION SECTOR

Historically, bonus payments have been rare in the housing sector, says Karl Ellis. But they are becoming more common, as a recent salary survey of the sector shows.

According to a salary survey by Remuneration Economics, in the year to July 2007, 20% of housing association staff received a bonus, compared with 63% of workers across all sectors. There are also significant differences in the size of bonuses. Workers in the housing sector received an average bonus of 5% of salary, while the typical bonus paid in the UK overall was almost three times this at 13% (Figure 1). Bonuses in housing are also less prevalent and lower than in the public sector and charities overall.

Are Bonuses Essential?

There is a reluctant, yet growing, acceptance that bonuses are necessary to attract the best talent, particularly at executive level, where pay levels are well below their private sector equivalents. Indeed, the survey reveals that while only one in five chief executives in the sector receives a bonus, the figure is almost 90% across all industries. Chief executives' bonuses average 56% of salary across the board, but in housing associations they are just 5%. This reflects the nature of the sector and its regulatory environment, and the pattern is followed at director level in general (Figure 2).

Careful Construction Required

Bonus schemes need to be carefully constructed to drive behaviour that contributes to the organisation's objectives, as there are concerns that bonus schemes can distract senior executives from their goals. However, given the low size of bonuses on offer in the sector, is a chief executive going to be motivated by the possibility of receiving a relatively small bonus of say £5,000, when so many are already driven by the cause of providing a social service?

Bonuses To All Staff?

A small number of housing associations have been tempted to offer bonuses to all staff. But if the available bonus pot is allocated to all employees based on organisation-wide targets, it is unlikely to cultivate high performance and may be quickly taken for granted. These schemes tend to be rather blunt instruments that provide relatively low bonus levels, which are unlikely to influence individual performance. However, if they are effectively designed, communicated and understood then their cultural effect could be more significant than their cost.

Bonus schemes have been in place for many years in the private sector and lessons can be learnt from their experience. For example, strong performance management processes need to be in place to make individual bonus schemes workable, and to ensure that bonuses are targeted towards staff displaying desired behaviour and high performance.

Innovative Payment Methods

Perhaps bonuses are most needed in housing associations where there is a high demand for quality staff in areas that cross over into the private sector. Property development and maintenance is one such area, where bonuses average 15% – three times more than in the rest of the housing sector. This area is also innovative in the way that staff are paid, with some associations using commission payments to pay for quality on delivery of work rather than up front in basic pay.

Bonuses Are Not The Be All And End All

Finally, it must be stressed that pay and bonuses are just two of the key elements of the 'total reward' package. While housing associations will always struggle to compete with the private sector for staff in these areas, they increasingly have the edge in other areas such as job security, job satisfaction, flexible working arrangements and competitive pension arrangements.

Fig 1: Comparison Of Bonus Occurrence And Levels In The Housing Sector With All Sectors

Fig 2: Typical Directors' Bonuses Across Sectors

Source: Remuneration Economics National Salary Survey 2007 and Remuneration Economics Housing Association Survey 2007

TOPICAL TAX ISSUES FOR RSLS

Trudi Amy helps clarify the 'grey areas' created by the new draft guidelines for affordable housing. She also advises housing associations to undertake a review of all intra group transactions.

Low-Cost Home Ownership – Joint Guidance

New draft guidelines were issued jointly by the Housing Corporation, the Charity Commission and HM Revenue & Customs (HMRC) in September 2007 on 'Affordable Home Ownership and Taxation Liability'.

These guidelines are a welcome attempt to clarify the position of charitable housing associations that provide low cost home ownership, in particular to key workers, through mixed developments and regeneration schemes. Certain criteria need to be fulfilled if sales under such schemes are to be categorised as 'charitable activities' and thus be exempt from tax.

Units Bought Outright

Outright sales of units in a development will almost never be treated as part of a charitable activity. However, the guidance attempts to define key workers who may qualify as 'charitable beneficiaries' in terms of their employment, their housing need and the level of household income in their part of the country.

Varying Shades Of Grey

Clearly, such guidelines will always be open to interpretation and there will be 'grey areas'. To assist, HMRC has introduced a procedure whereby a charity contemplating a particular scheme can ask for an opinion on the tax exemption or otherwise of the profits arising.

The guidance does not provide all the answers and acknowledges that advice will always need to be taken. It does, however, further the debate and gives some indication of HMRC's position and of the key tax issues that need to be considered when a charitable association decides on the structure and viability of a potential development project.

Reviewing Intra Group Transactions

Transfer pricing becomes increasingly important as housing associations merge, creating ever larger group structures with a mixture of charitable and non-charitable entities.

Under the self-assessment regime, a 'large' group is obliged to ensure that any tax returns it is required to submit comply with the arm's length criteria for all intra group transactions, so that there is no loss of tax revenue to the Treasury. Compliance must be either within the financial statements, or by adjustment to the tax return to reflect the arm's length position.

Given the potential penalties which can be imposed for non-compliance, it is sensible for all housing association groups to undertake a detailed and critical review of all intra group transactions, including financing, leasing and other property transactions. This is to ensure that there are no areas of exposure to a transfer pricing enquiry from HMRC.

MODELLING WITH BRIXX

Brixx is rapidly becoming one of the main forecasting tools used by RSLs. Roland Brook provides an update.

Brixx is a powerful modelling tool which can create well-structured long-term business plans. RSLs find it particularly useful for financial planning.

On 15 January 2008, Brixx company representatives held their first user group meeting in Birmingham. Attended by users from more than 40 RSLs, it was a valuable forum to discuss the tool's strengths and application. Technical representatives from Brixx also advised on future developments. More meetings are planned for later this year, including a meeting at Smith & Williamson's Moorgate office scheduled for 17 September.

As a partner to Brixx, Smith & Williamson now has several members of staff trained to use it. We offer business plan validation services to RSLs, either for internal purposes or in connection with a submission to funders or regulators.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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