The New SORP (part III)

This is the last blog on the subject of the Invitation to Comment (ITC) on the new SORP. The previous two blogs covered Housing Properties, employee benefits and Grants. This blog will look at Financial Instruments.

Financial instruments are a complex area and this blog touches on the main points as they will affect RSLs, but is by no means comprehensive. Those RSLs that have financial instruments that do not meet the definition of basic, in particular, should seek the advice of their auditors as to the effect that the new SORP may have on them.

A financial instrument is defined as “any contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another entity”. So for RSLs, this would include bank deposits, loans and derivative contracts such as Swaps.

FRS 102 requires that financial instruments are categorised as either ‘basic’ instruments or ‘other’ financial instruments.  Basic instruments are defined in section 11.5 of the standard and include cash, deposit accounts, loans, bonds and accounts payable and receivable.  Section 11.6 gives examples of instruments that would not normally meet the definition of ‘basic’ – these include interest rate swaps and forward contracts.

Most loans held by RSLs will be categorised as basic financial instruments and as such will be accounted for using the amortised cost model. There is an option to present debt instruments that meet certain conditions at fair value, but as this would make an RSL’s financial results more volatile it is unlikely that many will take it.

On the face of it the amortised cost model will make little difference where the loan is a straightforward fixed rate or variable rate. The amortised cost is the present value of payments (including interest) required to pay the loan, discounted by the effective interest rate. The effective interest rate is defined as the rate that exactly discounts the payments over the period of the loan.  The effective interest rate will be different from the interest rate on the loan as the effective rate will include transaction costs, for example arrangement fees, in the calculation.

Sounds complicated – but essentially the net result will essentially be the same for most loans.

There are increased disclosure requirements under FRS 102, that will likely be reflected in the new SORP. Most of these will not present too many problems for RSLs as most of the information needed for the accounts would be required for a loan portfolio return in any case.

However, one disclosure that may cause some problems is the requirement to disclose the carrying value of assets held as security for loans. With the introduction of component accounting gathering this information may not necessarily be straightforward. It is also a disclosure that lenders will show an interest in.

For those RSLs that have financial instruments not classed as ‘basic’ , there will be an option to either apply section 12 of FRS 102 or the full International Standard (IAS 39). It is unlikely that going down the IAS 39 will the best idea for most RSLs.

These types of instruments will be measured at their fair value and any changes in fair value will be shown in the Income & Expenditure Account. This will have an impact on those RSLs that have interest rate swaps. Currently, these types of derivative contracts are not shown on the balance sheet, but their value (either asset or liability) is disclosed in a note.

Under the new rules the swap will recognised in the balance sheet either as an asset or liability depending on whether the swap interest rate is higher or lower than the variable interest rate. If the swap interest rate is higher than the variable rate then this will result in a liability which could be substantial.

Furthermore, unless the swap is designated as a hedging instrument, year to year changes in the value of the swap will be taken to the income & expenditure account, which in years where interest rates change could result in a significant debit/credit to the income & expenditure account – and potentially covenant breaches.

To avoid this volatility in the income and expenditure account the RSL could designate the swap a hedging instrument, which will mean that the change in the fair value of the swap will be shown in the Statement of Recognised Gains and Losses (STRGL) (or Other Comprehensive Income as it will be called) rather than the income and expenditure account. There are some hoops to jump through in order to do this, including minuting the decision to treat the swap as hedging instrument, but with a straightforward interest rate swap this shouldn’t be too troublesome.

From a cash flow perspective there is no difference between an RSL that has taken out a £10m fixed loan at 4% for thirty years and an RSL that has taken out a variable rate loan for the same amount (at 2.5% interest) and then agreed to an interest rate swap than effectively fixes the rate at 4% – however, once the new rule apply the second RSL will have to account for a liability in the region of £2.3m.

The concern for RSLs is how will the Financial Reporting Council deal with this anomaly in the future? Will they retreat from this position and go back to only disclosing swap contracts, or will they require a normal fixed rate loan to be treated the same as variable rate loan with a swap contract used to fix it?

The ITC advises Social Landlords to assess the applicability of Section 11 and Section 12 of FRS 102 to their loan portfolio, which is sound advice.

The draft SORP is due to be published in the Autumn and we will be issuing further guidance when this is issued.

FRS 102 can be downloaded from the Financial Reporting Council’s website, or from the link below (Warning – the side effects of reading section 11 and section 12 of the standard include headaches, nausea and a sense of bewilderment).

http://www.frc.org.uk/Our-Work/Publications/Accounting-and-Reporting-Policy/FRS-102-The-Financial-Reporting-Standard-applicabl.aspx

About Phil Morrice

Phil is a Partner at Alexander Sloan. He specialises in providing services to RSLs and commercial businesses and divides his time between our Glasgow and Edinburgh Offices.
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