FRS 105 The Financial Reporting Standard applicable in the UK and Republic of Ireland becomes mandatory for micro-entities choosing to report under FRS 105 for accounting periods starting on or after 1 January 2016.
It is to be emphasised that FRS 105 is optional and a micro-entity that would be eligible to apply FRS 105 can choose to apply a more comprehensive framework if they so choose (such as FRS 102, Section 1A Small Entities). One of the key issues to consider is where a micro-entity may carry assets under the revaluation model.
The Financial Reporting Council are keen to emphasise that while FRS 105 may be appropriate for some micro-entities, it may not necessarily be appropriate for others and hence the suitability of the framework should be judged on a case-by-case basis. Examples of factors to consider where FRS 105 are:
- eligibility criteria: the eligibility criteria outlined in the micro-entities’ legislation is very restrictive and therefore the advisor should consider whether the entity is a business which is ineligible to apply the framework;
- production of non-statutory information: the scope for producing non-statutory information should be considered because the financial statements are significantly reduced in terms of detail than they would have been under, say, the Financial Reporting Standard for Smaller Entities (the FRSSE) and hence banks and other interested third parties may require additional information over and above that required by law;
- pace of growth: the entity may be a new start-up, but is expecting to grow at a rapid rate and hence it may be more beneficial to choose a more comprehensive financial reporting framework; and
- prohibition of fair value accounting and revaluation amounts: the standard does not allow fair values or revaluation amounts to be recognised in the financial statements.
Removal of fair values and revaluations in FRS 105
One of the most significant changes that FRS 105 brings about in terms of changes to accounting methodologies is the removal of the fair value and alternative accounting rules found in the UK’s Companies Act 2006. This is not something which the Financial Reporting Council have chosen to do; it has been done because the EU Accounting Directive prohibits the application of the fair value accounting rules or the alternative accounting rules. The consequence of this is that any assets that have previously been carried at fair value or at a revaluation amount will have to be restated to historic cost principles on transition to FRS 105. In addition, the prior year comparatives will also have to be adjusted to reflect historic cost principles and a depreciation policy will have to be introduced for a micro-entity that has investment property on its balance sheet (this is because under previous UK GAAP, the micro-entity would have taken fair value fluctuations to a revaluation reserve within equity).
Example: Use of a previous GAAP revaluation as deemed cost
A company qualifies as a micro-entity and has decided to use FRS 105 as its financial reporting framework in its first FRS 105 financial statements for the year-ended 31 December 2016 and the micro-entity has an investment property on its balance sheet which was previously accounted for under the FRSSE (effective January 2015) at open market value in accordance with paragraph 6.51.
The accountant is proposing to use the previous year’s revaluation that was undertaken as at 31 December 2015 as deemed cost and apply the historic cost principles going forward as he feels this is a more sensible approach.
The accountant’s proposed treatment is not acceptable under FRS 105. This is because it is not possible to use a previous valuation for investment property as deemed cost on the grounds that this would be inconsistent with the requirements of the law. While the ‘deeming provisions’ provide that accounts prepared in accordance with the minimum legal requirements are presumed to give a true and fair view, the accountant’s proposed treatment would not comply with the law and hence the financial statements would not be presumed to be true and fair. The accountant should, as a minimum, exercise the transitional option contained in paragraph 28.10(c) of FRS 105.
Removing revaluation amounts on transition for an investment property
The rules in FRS 105 are retrospective (as is the case with FRS 102) in that they have to be applied as far back as the date of transition. The date of transition is the start date of the comparative period reported in the financial statements. Therefore, assuming a 31 December 2016 year-end, the date of transition will be 1 January 2015 as this is the start date of the comparative year and hence the opening balances as at 1 January 2015 must be restated so the financial statements are both comparable and consistent (i.e. restated as if FRS 105 had always been the financial reporting framework applied by the micro-entity).
It is likely that micro-entities with investment properties on their balance sheet are going to be affected by the prohibition of the alternative accounting rules (i.e. using revaluation amounts). Therefore, after all issues have been considered, if the micro-entity still wishes to report under FRS 105, the investment property must be restated to the value that it would have been carried at in the financial statements had the investment property been carried under historic cost principles (in other words, at cost less depreciation and less any amounts in respect of impairment).
Many accountants are surprised at this accounting treatment because the value of investment property can (and usually does) increase. The Accounting Council have also expressed their disapproval at the prohibition of micro-entities from adopting the revaluation model for investment property saying in The Accounting Council’s Advice to the FRC to issue FRS 105 at paragraph 16 that:
‘… the Accounting Council continues to believe that investment property should always, where practicable, be measured at fair value as this provides more relevant information to users of the financial statements on an investment property company’s financial position and performance. However, company law prohibits the revaluation of any asset by micro-entities and instead requires that fixed assets are measured at cost less depreciation and impairment.’
In recognition of this issue, the Financial Reporting Council (FRC) have included a transitional provision in FRS 105 at paragraph 28.10(c), which says:
‘A first-time adopter is not required to retrospectively apply paragraph 12.15 to determine the depreciated cost of each of the major components of an investment property at the date of transition to this FRS. If this exemption is applied, a first-time adopter shall:
(i) Determine the total cost of the investment property including all of its components. Where no depreciation had been charged under the micro-entity’s previous financial reporting framework, this can be calculated by reversing any revaluation gains or losses previously recorded in equity reserves.
(ii) The cost of land, if any, shall be separated from buildings.
(iii) Estimate the total depreciated cost of the investment property (excluding land) at the date of transition to this FRS, by recognising accumulated depreciation since the date of initial acquisition calculated on the basis of the useful life of the most significant component of the item of investment property (eg the main structural elements of the building).
(iv) A portion of the estimated total depreciated cost calculated in paragraph (iii) shall then be allocated to each of the other major components (i.e. excluding the most significant component identified above) to determine their depreciated cost. The allocation should be made on a reasonable and consistent basis. For example, a possible basis of allocation is to multiply the current cost to replace the component by the ratio of its remaining useful life to the expected useful life of a replacement component.
(v) Any amount of the total depreciated cost not allocated under paragraph (iv) shall be allocated to the most significant component of the investment property.’
Step 1: Determine the total cost of the investment property
The first step is to determine the total cost of the investment property, including all of its components (the term ‘components’ mean items in addition to the main structural element of the property). Assuming the micro-entity previously carried the investment property at open market value, this is simply a case of reversing the revaluation reserve against cost.
Example: Determining the total cost of the investment property
A micro-entity has an investment property on its balance sheet as at 1 January 2015 (the date of transition) with a carrying amount of £150,000 and an associated revaluation surplus of £25,000. The micro-entity previously applied the provisions in the FRSSE (effective January 2015) and carried the investment property at open market value with fair value fluctuations going through the revaluation reserve account in equity and reported through the entity’s statement of total recognised gains and losses. The investment property was purchased on 1 January 2011 and the accountant is unsure as to how to get the investment property back to historical cost for the purposes of transitioning to FRS 105. The value of the land according to the Chartered Surveyor’s report is £30,000.
For the purpose of transitioning to FRS 105, the financial controller can apply the transitional provision in paragraph 28.10(c)(i) to arrive at a cost for FRS 105 at the date of transition. The revaluation surplus of £25,000 can be reversed against the cost of the investment property and hence at the date of transition the investment property will have a cost of £125,000 (£150,000 less £25,000), the entries being:
Dr revaluation reserve £25,000
The FRC has included this transitional option in recognition of the fact that all revaluation gains and losses would have been recognised within equity and therefore by offsetting the revaluation reserve against the carrying amount of the investment property at the date of transition, the investment property is then reduced to historic cost.
Step 2: Remove the land element from the cost of the investment property
Once the cost in Step 1 has been derived, the value of the land is deducted. This is in recognition of the fact that land does not depreciate.
Example: Removal of the land element
Continuing with the example of the micro-entity above, the Chartered Surveyor’s report in Step 1 said that the value of the land was £30,000. This is removed from the cost calculated in Step 1 as follows:
Cost of land (post reallocation of revaluation reserve) £125,000
Less land element (£30,000)
Step 3: Estimate the total depreciated cost of the property
For micro-entities which previously accounted for investment property at open market value at each balance sheet date, a depreciation policy will have to be derived by management in respect of the investment property. Many reporting entities choose a depreciation policy of 2% on a straight-line basis (i.e. 50 years) and it may be the case that this policy is also assigned to investment property.
The majority of entities tended to assign 50-year useful economic life to buildings on the grounds that FRS 15 Tangible fixed assets required impairment tests to be carried out each year if the asset was being depreciated longer than 50 years. FRS 105 requires impairment tests to be carried out each year regardless of the depreciation policy as per paragraph 22.6, so the policy for depreciation need not, necessarily, be 2% on a straight-line basis; it could, instead, be 1% if the entity so wishes and the entity would still need to consider whether the asset was showing signs of impairment each year.
Paragraph 28.10(c)(iii) says that the accumulated depreciation must be calculated since the date of initial acquisition to the date of transition on the basis of the property’s useful economic life. This is where it is vital that an impact assessment is carried out before advising the client to use FRS 105 where an investment property is concerned, because this may have a significantly detrimental impact on the micro-entity’s balance sheet position. The reason depreciation is being charged from the date of initial acquisition is because the property has to be accounted for under the historical cost principles.
In addition, it is also worth noting that many practitioners have suggested that depreciation could be immaterial. Remember, depreciation reflects the consumption of an asset and hence is not necessarily based on the overall valuation of the asset therefore it is important that the definition of depreciation is carefully borne in mind. Also, the materiality of depreciation should be judged not only in respect of the amount of the charge for the year in question, but as an accumulated value where previous years’ depreciation charges have been judged as immaterial. The reason is, that over time the depreciation charge could become a material amount if it is not brought into account within the financial statements.
Example: Total depreciated cost of the investment property
The total depreciable amount of the investment property so far is £95,000 (see Step 2). Assuming the micro-entity depreciates the investment property at 2% on a straight-line basis, the depreciation to the date of transition is calculated as:
£95,000 x 2% x 4 years* = £7,600
*the micro-entity purchased the investment property on 1 January 2011 and therefore this would mean four years’ depreciation being charged up to the date of transition (1 January 2015).
A transitional adjustment would be made at 1 January 2015 as follows:
Dr accumulated profit and loss (retained earnings) £7,600
Cr accumulated depreciation (investment property) £7,600
Being four years’ depreciation from the date of acquisition to the date of transition
Step 4: Apply component depreciation to each of the major components
FRS 105 (as does FRS 102) places more emphasis on component accounting. Component accounting works by breaking down an asset into its major components and where those major components have a significantly shorter useful economic life than the main asset itself, these are depreciated separately over their useful economic lives. This concept applies in respect of investment property for a micro-entity.
At the date of transition, the investment property in the example so far has a total depreciated cost of £87,400 (£95,000 less £7,600). Paragraph 28.10(c)(iv) then requires the entity to allocate this depreciated cost to the property’s major components.
Example: Component depreciation
Continuing with the example above, the central heating system in the investment property needs to be replaced in three years’ time (being three years’ from the date of transition). The current cost to replace the central heating system is £12,000.
Step 5: Remaining accounts
Finally, paragraph 28.10(c)(v) says that any amount of the total depreciated cost which is not allocated under component accounting (see Step 4) is to be allocated to the most significant component of the investment property (namely the structural element).
Micro-entity wishes to continue carrying investment property at fair value
The importance of an impact assessment is critical where a micro-entity might have an investment property stated at revaluation (or, in fact, any item of fixed asset carried under either the fair value or alternative accounting rules). This is because restating such properties to historic cost values will, in almost all cases, result in a detrimental impact on the balance sheet, because historic cost prices tend to be far less than current prices and therefore if the micro-entity has owned the investment property for several years, the impact of offsetting the revaluation reserve against cost and then charging depreciation from the date of acquisition up to the date of transition, then in the prior year and also going forward will reduce the balance sheet position of the company quite considerably; something which the client may not thank the practitioner for!
If the micro-entity does not want to restate any asset to historic cost principles and hence wishes to continue revaluing, then it must report under FRS 102, Section 1A Small Entities as a minimum because this standard would allow a micro-entity to carry investment property at fair value through profit or loss under Section 16 Investment Property although additional considerations need to be borne in mind where that is concerned (such as an increase in undistributable reserves and the need to bring deferred tax into consideration as per paragraph 29.16 of the standard).
The impact of no fair values or revaluation amounts in FRS 105 is a key factor that must be considered and an impact assessment carried out. As you will see from the worked examples above, depreciation on assets such as investment property is charged from the date of acquisition, not simply from the date of transition and in some situations this could have a detrimental impact on the entity’s balance sheet position.
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Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.