Member s briefing: Emerging risks from financial reporting. Impairment of social housing property and development of new social housing

Transcription

1 19 December 2013 Member s briefing: Emerging risks from financial reporting Impairment of social housing property and development of new social housing

2 1. Executive summary In November 2013, the housing SORP Working Party issued a draft of the housing Statement of Recommended Practice (SORP) for a three-month consultation exercise, which ends on 14 February 2014: /sorpconsultation The housing SORP has been rewritten for consistency with the Financial Reporting Council s (FRC) radical new international-style accounting framework (Appendix 1). The work to rewrite the housing SORP has been ongoing for the past three years and key milestones are approaching (Appendix 2). Associations will be required to adopt the new framework for accounting periods commencing on or after 1 January The consultation includes a significant proposal, which may require housing associations to write down (impair) the value of social housing property in their accounts for both newly constructed and existing homes (Appendix 3). This is a crucial issue for our members which the Federation will confront appropriately. Although the proposed accounting rule change will involve no movement of cash, the impairment charge would lead to a commensurate reduction in reported performance (surplus or deficit) of associations and the reported level of reserves. This would be sufficient for some associations to cease development of new social homes. The reduction in surpluses and reserves would also lead, in turn, to deterioration in the interest cover (the amount of times interest commitments can be covered by reported surpluses) and the indication of indebtedness (gearing).the result for many associations could be a breach in interest cover and gearing loan covenants and banks could respond by seeking to re-price loans Such an impact would inevitably curtail the development of new social housing and reduce expenditure on housing management and neighbourhood services. The impact is likely to be greatest for more recently developed houses which have been funded at lower grant rates. However, the very limited survey we have carried out suggests that the impact will vary for individual associations dependent upon geography, level of reserves, housing stock portfolio, nature of loan covenants, development mix, etc. In addition, it has also emerged that existing methods used by professional property valuers to assess the worth of social housing property may underestimate the value significantly as evidenced by the price that these properties actually command on sale between housing associations. Higher valuations across the board would mitigate the level of impairment required under current proposals in the draft SORP

3 Before the Federation can decide how to proceed, we need to conduct a larger survey with a more representative sample of associations to gauge the scale and scope of the impact of the proposed changes. This will need to factor in the impact of higher social housing property values. The key to any case that the Federation and the SORP Working Party makes to the FRC as part of the consultation process will be that any counter proposals must deliver an accounting treatment that is a true and fair view of the business. There are a number of other significant changes being introduced by the new accounting framework, for example, the treatment for financial instruments such as derivatives and pension fund deficits, which will also have a significant impact on housing associations financial reporting. While these changes have been signalled for some time the cumulative impact will be an important consideration (Appendix 4). 2. Background to accounting changes 2.1 Appendix 1 provides further detail about the background to the accounting changes being implemented. In summary: For the past three years the Federation has been working with members on the preparedness to implement new international-style accounting In March 2013, the FRC published Financial Reporting Standard 102 (FRS 102), requiring all UK businesses to adopt a new international-style accounting framework on or after 1 January 2015 The majority of associations will produce accounts under the new framework for the accounting period from 1 April 2015 to 31 March 2016 However, associations will need to restate accounts for the current financial year 2013/14 in the new format for comparison (see Appendix 2). The process will be time consuming, irksome and costly. Planning for this work should already have begun FRS 102 focuses mainly on commercial organisations and so specialist sectors, such as social housing produce SORPs which plug the gaps The housing SORP Working Party has been rewriting the guidance for the housing SORP 2014 to reflect the new accounting framework. An essential element of the rewrite process has been extensive consultation with the sector Over the summer the FRC raised concern over proposed guidance on the assessment of impairment of social housing property to be included in the housing SORP

4 3. The impairment rule proposals 3.1 The accounting rules for impairment seek to ensure that an organisation shows an asset in its accounts at no more than its recoverable amount (the higher of the net selling price or its value in use). 3.2 The cost of social housing property, net of social housing grant, often exceeds its value. It is understood that the financial feasibility of developing new social housing is increasingly dependent on charging affordable rents on re-lets, property sales, etc. 3.3 Up until now, the FRC has permitted a relaxation of the rules requiring housing associations to impair the cost of social housing property (Appendix 3). The wording in FRS 102 no longer permits the existing basis for assessing impairment of social housing property. 3.4 The FRC maintains that the easement concept of planned internal subsidy currently used by the sector is too subjective. It s position is that where an association expects the cost of a social housing, net of grant, to exceed its value, it will need to reduce the balance sheet figure and take an impairment charge to the income statement - effectively reducing the association s reported surpluses and reserves/net worth. 3.5 The proposed accounting rules seek to be more granular and will require housing associations to recognise that new social housing development tends to require crosssubsidy, therefore eating into the reserves. The new accounting rules will highlight the fact that in the recent past Government capital grant subsidy has reduced substantially. 3.6 With this in mind, the need to impair is more likely to be a risk for more recent schemes where the level of government grant has been substantially reduced. Furthermore, the rent charged for more established properties will have benefitted from annual inflation uplifts significantly above assumptions included in the calculation to determine social housing value. 3.7 Potentially, a partial mitigation of the impairment risk has emerged from discussions with the professional property valuers (Appendix 3). The valuers have acknowledged that their desktop assessment of EUV-SH often understates the price that social housing property changes hands between housing associations. It will be for the Federation, the HCA, professional advisors, etc. to encourage professional valuers to adopt this more appropriate valuation mechanism. This would reduce the number of schemes subject to an impairment charge and the degree to which any impairment charge is required. Nonetheless, the reduction in surpluses and reserves will be sufficient for many associations to cease the development of new social homes. 3.8 Additionally, a real danger from the impairment rule proposal lies with the likely attitude of the lenders to such an accounting rule change. In the short term, it would be the repricing of housing association loans that could lead to social housing sites being mothballed. In making lending decisions, bankers will be aware that housing

5 associations receive lower grant rates and use their internal capacity to make schemes stack up financially. 4. Risks for the Sector 4.1 Financial the proposed changes to the accounting treatment of impairment will impact adversely on interest cover and gearing loan covenants and could significantly undermine the financial health of the sector. The concern is that lenders will use the rule change as an excuse to re-price the sector s historic loan book. 4.2 In addition, the volatility the rule change will create in the financial statements of housing associations could provoke the ratings agencies to downgrade the credit ratings of the sector, increasing the cost of new funding for housing associations. 4.3 Operational any deterioration of the financial health of the sector is likely to impact on appetite of associations to develop new homes (e.g. the next round of Affordable Rent), housing management and community investment activity. This would be particularly the case given other pressures in our operating environment such as welfare reform. 4.4 Reputational the sector currently has a strong reputation for delivery with government and our partners. The drawing in of our horns at this critical time 18 months before what could be a crucial election for housing investment could be to the benefit of the private sector or councils in terms of favoured policy interventions. 5. The cumulative effect of accounting changes 5.1 More generally, FRS 102 will generate a slew of accounting changes to financial instruments, investment property assets, government grant, pension fund deficits, etc. Appendix 4). Any one of these in its own right is significant enough to create volatility in housing association accounts, sufficient to cause loan covenant breaches, deplete reserves and convert surpluses into reported deficits. 5.2 This is important because it will be difficult for associations, using information extracted from new FRS 102 formatted accounts, to comply with existing interest cover, gearing, liquidity and asset cover and other loan covenants. Like impairment, these accounting changes are likely be responsible for technical loan covenant breaches without any real change in the economics of the business. 5.3 Housing associations that have not done so already will need to approach their lenders to negotiate revisions to existing loan agreements, ahead of FRS 102, in order to avoid loan covenants breaches. Many associations have expressed concern that merely approaching lenders to open these discussions will lead lenders to use this as an excuse to re-price these loans. 5.4 A number of associations have already suggested that the resultant depletion of reserves and the risk of reporting losses would curtail their development ambitions.

6 6. The Federation s current plan of action 6.1 A series of SORP consultation Sounding Boards have been organised around the country to raise awareness of the accounting changes, in particular the impairment issue. Two members of the housing SORP Working Party and a property valuer will present on the proposed impairment treatment and valuation aspects and lead discussions on the issue. The Federation will be in attendance. 6.2 Invitations have been issued to Federation members Finance Directors and CEOs. The dates and locations are as follows: Wednesday 8 January 10:30-13:30 Birmingham Thursday 9 January York Friday 10 January 10:30-13:30 Manchester Monday 13 January 14:00 17:00 London Friday 17 January 10:30-13:30 Bristol 6.3 A survey of members will be issued with this briefing to obtain an assessment of the impact of what the new impairment rule (and other key changes) would mean in terms of: a. existing properties b. future developments c. knock-on effects from increased impairment charges attitude of lenders, covenant compliance (e.g. interest cover and gearing) and borrowing costs d. how the proposed change could affect attitudes to the next bidding round 6.4 At this stage, our public affairs will focus on engaging with relevant Ministers to ensure that they understand the implications of an FRC decision to introduce impairment. If impairment is introduced, we will encourage Government to make clear to lenders that it expects them to behave responsibly and not take advantage of the accounting changes. 6.5 In addition we will be approaching the FRC, the HCA, HMT, DCLG and property valuers: a. holding initial informal meetings to begin to discuss emerging concerns and how these might be handled b. subsequent meetings following responses to our survey on impact of the proposals, and explore alternative approaches as appropriate c. meet with the Social Housing Regulator to ensure it understands the issue and potential impacts and d. lobby the sector property valuers to encourage them to change the mechanism they use to assess the value of social housing property. 6.6 Consider an appropriate and measured media handling strategy, avoiding creating hysteria amongst lenders and potential investors in the sector, but raising the issues with heavyweight commentators.

7 6.7 Continued support members with implementation of FRS 102 irrespective of outcome a. maximise mitigation on transition b. work with the housing SORP Working Party and ICAEW (Social Housing Committee) to produce a detailed practical guidance on impairment and c. continue to deliver events, seminars and newsletters.

8 APPENDIX 1 Background For the past three years the Federation has forewarned of the advent of new internationalstyle accounting and we have provided an assessment of its likely impact on the sector. Since 2005, all EU PLCs have been required to prepare financial statements in accordance with the 4,000 plus pages of international financial reporting standards (IFRS) and UK central government, the NHS and local authorities have also since adopted IFRS-style accounting. In March 2013, the Financial Reporting Council (FRC) published Financial Reporting Standard 102 (FRS 102), a slimmed down version of IFRS. This requires all UK businesses - including housing associations - to adopt a radically new international-style accounting framework for accounting periods commencing on or after 1 January FRS 102 focuses mainly on commercial organisations and so does not include accounting requirements for nuanced business models of specialist sectors such as education, charities and social housing. So, for example, it does not contain accounting requirements for shared ownership transactions nor adequate guidance in relation to government grants, etc. As a result, specialist sectors produce SORPs which plug the gaps. The FRC has subcontracted development of the housing SORP to the National Housing Federation, Community Housing Cymru and the Scottish Federation of Housing Associations. In practice, development is overseen by a representative group, the housing SORP Working Party, which is facilitated by the Federation. Over the past three years the housing SORP Working Party has been rewriting guidance to reflect the new accounting framework of FRS 102. An essential element of the SORP rewrite process has been extensive consultation with the sector. A pre-consultation was carried out over the spring to flush out a selection of the more controversial issues. There has been extensive and very helpful liaison with the FRC s Committee for Accounting on Public-benefit Entities (CAPE) throughout and many technical wrinkles have been resolved over time. However, very late in the process - over the summer - CAPE raised a particular concern over draft guidance to be included in the SORP on the assessment of impairment of social housing property. This delayed issuing the SORP for consultation. The draft guidance was debated throughout the summer and over the autumn. Earlier iterations of the draft guidance excluded grant from the assessment of impairment a move which would have led to routine and far more widespread impairment of social housing property and would have been catastrophic for the sector. As part of the protracted negotiations over the summer, the SORP Working Party was able convince the FRC that it should be property cost net of grant that should be compared to value when assessing impairment. The FRC eventually approved the draft housing SORP (which included guidance on impairment) for a three-month consultation exercise on 14 November Consultation closes on 14 February 2014.

9 APPENDIX 1 The delay in issuing the draft SORP for consultation is crucial for housing associations, because although the new accounting rules first apply to accounting periods from 1 January 2015, accounts for the current financial year 2013/14 need to be restated in the new format for comparison (see Appendix 2). Housing associations should have begun the preparatory work for this some while ago.

10 APPENDIX 2

11 APPENDIX 3 Valuation and impairment of social housing property Valuation of social housing property Unlike commercial companies, it is inappropriate to account for social housing property at market value. The reason for this is because the sale by a housing association of tenanted, grant funded social housing property is restricted to other social landlords and at a price which is discounted from the market price, reflecting these restrictions. For lending purposes, housing associations social housing properties are valued by professional valuers on one of two bases: 1. Existing Use Value for Social Housing (EUV-SH) in the past the mechanism for assessing this has been calculated based on the net present value of social rental income streams over say, 30 years or 2. Market Value Subject To Tenancy (MV-STT) this is the market value of the property, discounted to reflect the fact the property is tenanted. It reflects the value a lender would receive if foreclosing on a social housing property this could be an open market sale. Because housing association accounts are prepared on a going concern basis and housing associations would only normally sell to another social landlord option 2. is never used as the valuation basis for social housing property to be included in housing association accounts. Existing assessment for impairment of social housing property The assessment of impairment seeks to ensure that social housing property is shown in accounts at no more than their recoverable amount (EUV-SH). As grant levels have fallen, to get new schemes to stack up, housing associations have had to rely on cross subsidy from their reserves, s106 agreements, higher affordable rent relets, property asset sales and more recently, increasingly from surpluses generated from noncore activity. To that extent, for some while, the sector has been developing new social housing property which on its own does not produce sufficient rental income to fund the scheme s net costs in other words, the cost of the scheme, net of grant, exceeds the scheme s EUV-SH. One of the impacts is that generally developing housing associations have been rapidly eating into their reserves and are gradually running out of development capacity. Under the existing accounting rules agreed in 2010, the now defunct Accounting Standards Board allowed the sector to avoid making an impairment charge on such social housing developments provided housing association boards took the decision to approve a new scheme by cross subsidising scheme costs using its general resources. In such circumstances, the ASB agreed that there was no need for an impairment charge where the housing association board could confirm it had planned internal subsidy and this was supported by the organisation s business plan.

12 APPENDIX 3 As a result, the higher figures for the cost of social housing scheme were included in housing association balance sheets. This was despite the fact that the rules on the assessment for impairment required that the impairment test is carried out on a cash generating unit basis which usually equates to a development scheme or the way groups of properties are managed. New assessment for impairment of social housing property The wording in FRS 102 no longer permits the existing basis for assessing the impairment of social housing property. As a result, the FRC has decided that the concept of planned internal subsidy is too subjective and it has been outlawed. Now, where a housing association is aware that the cost of a social housing property, net of SHG, exceeds EUV-SH for either existing or future social housing developments, they will need to reduce the balance sheet figure accordingly and take an impairment charge to the income statement. Essentially, reducing the housing association s surplus, its reserves and net worth. Revisions to EUV-SH A positive note to emerge from the recent discussions on the impairment of social housing property is mechanism used to determine EUV-SH. In recent discussions with the principal property valuers in the sector, they have acknowledged that EUV-SH has only ever incorporated the future cash flow from social rental income streams. However, in the last few years, an active albeit immature - market in the sale of social housing property between housing associations has developed. The transaction prices agreed can often exceed the desktop EUV-SH values by a significant margin. However, we are alert to the possibility that in parts of the country, transaction values may actually be less than desktop EUV-SH. We will be exploring this. For most housing associations we expect this development to be good news, as higher EUV- SH will raise the impairment threshold for many social housing properties, reducing the potential impact of the proposed impairment rule change. We acknowledge that in parts of the country where EUV-SH exceeds transaction values, this may exacerbate the problem. Early feedback on impacts The initial feedback we have received has been heavily nuanced. The majority of feedback we have received suggests that the impairment charge could be sizeable, generating losses, leading to a depletion of reserves and a commensurate degradation in interest cover and gearing ratios both of these are monitored closely by lenders. The interest cover measures the extent to which loan commitment can be covered by net surplus and gearing ratio measures the level of indebtedness of housing associations. The reduction of housing

13 APPENDIX 3 association surplus and reserves may mean that many will breach interest cover and gearing loan covenants. Why is all this important? Housing associations reporting a loss and suffering a significant reduction in reserves are less likely to continue to develop social housing as this is more likely to exacerbate the situation. Moreover, banks have lent in excess of 43 billion to the sector and many of these long-term, pre-credit crunch loans were agreed at very generous rates of say, 40 basis points (0.4%) above LIBOR. Post credit crunch, banks still have to finance these loans at costs of 100 basis points in excess of pre-credit crunch deals agreed with housing associations. Therefore, banks are holding sizeable onerous contracts and, even by their own admission, they are under pressure from their credit committees to reprice these loans. Therefore, whenever an association breaches a loan covenant, this provides banks with a means to automatically re-price the deal. The widely held fear is that the new accounting rule change will precipitate a wholesale re-pricing of the sector s loan back book. We acknowledge that loans associated with older properties which have benefitted from higher grant levels are unlikely to be impaired. However at this stage, it is difficult to assess the extent of this. However, a one per cent increase in the interest on the sector s entire loan back book would increase borrowing costs by 430 million (or the cost of 3,100 social homes) per annum. It will also increase the sector s cost of new debt and a general repricing would create a cascade of other issues, including attracting the attention of the credit rating agencies. A number of the finance directors we have so far approached on this issue have suggested that these changes will be sufficient for their associations to halt social housing development. Whilst this might limit the damage going forward, it will do little to protect them from covenant breaches on loans in relation to existing stock, which will impact on the level of services the housing association can provide. However, some housing associations have predicted few problems because they have cash loan covenant agreements with lenders for which such accounting changes have no impact. Other housing associations have loan covenant agreements which will be adjusted to ensure that impact of the accounting rule change will bring them back to the current position. We believe that such housing associations are in the minority.

14 APPENDIX 4 Other significant issues arising from the transition to FRS 102 Nature of the issue Financial instrument More financial instruments will be recognised in housing association accounts, e.g. derivatives, intercompany indebtedness Likely impact In December 2008 the housing association sector was required to respond to 400 million cash call on standalone derivatives, virtually overnight. Current UK accounting rules do not require the liability associated with these financial instruments to be disclosed in accounts. However, under FRS 102 these liabilities will be visible in housing association accounts. Many financial instruments will for the first time be included in accounts at their fair value rather than at the cost they were acquired Any difference between the fair value of financial instruments at opening and closing balance sheet dates will need to be processed through the income statement each year. The evidence from housing associations already required to account for financial instruments in this way demonstrates that the magnitude of these adjustments will be significant. Often the size of the adjustment can dwarf the surplus or deficit the organisation would otherwise report on its activities. It can turn a gain into a loss and has a significant impact on reported net worth, etc. It may render existing loan covenants meaningless The accounting offset of derivatives against the loans they were purchased to protect (hedge accounting) may not be permissible. This will lead to very large adjustments in housing association financial statement. The volatility this will create in reported results will make it difficult for housing associations to comply with existing loan covenants Multi-pension scheme deficits SHPS multi-pensions deficits which The SHPS deficit will be a significant

15 APPENDIX 4 housing association are contractually obligated to will be recognise in housing association financial statements for the first time Property assets FRS 102 has a new, stricter distinction of properties held for investment purposes. More housing association assets will be designated as investment properties Investment properties will be shown at their fair/market value Government grant Government grant will no longer be linked to the property it was acquired to fund, in particular the land element new liability in housing association financial statements and will lead to a deterioration in gearing ratios The difference between the fair value of investment property at opening and closing balance sheet dates will need to be processed through the income statement each year The magnitude of these adjustments will lead to greater volatility in housing association reported results and will make it difficult for housing associations to comply with existing loan covenants By removing the link between government grant and associated land costs may lead to a reduction in the housing association net depreciation charge.