FRS 105: Investment property on transition

FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime becomes mandatory for micro-entities choosing to report under the micro-entities’ regime for accounting periods commencing on or after 1 January 2016 (earlier adoption is permissible).  The standard has to be applied retrospectively to the date of transition.  The ‘date of transition’ is the start date of the earliest period reported in the financial statements (in other words the start date of the comparative period).

The regime is currently receiving mixed responses.  Some accountants like the standard because it simplifies certain areas (e.g. prohibiting micro-entities from recognising deferred tax); while others remain firmly unsupportive of the standard, questioning how such financial statements give a true and fair view given the sheer amount of disclosure reductions. Micro-entities can choose to make additional voluntary disclosures if they so wish; however because of the presumption in legislation that the financial statements give a true and fair view if the micro-entity’s financial statements have been prepared to the legally required minimum provisions, the directors are not obliged to consider any additional disclosure requirements to achieve a true and fair view.

A notable aspect of the micro-entities’ legislation is that it does not recognise any of the alternative accounting rules or fair value accounting rules.  This is going to potentially present problems for micro-entities who currently have assets carried at revaluation; notably investment property and must be carefully considered when choosing the appropriate financial reporting framework.

Accounting for investment property

Under the FRSSE, investment property is measured at open market value, with changes in market value passing through the revaluation reserve in equity and reported via the statement of total recognised gains and losses.  This accounting treatment is not permitted in FRS 105 because the legislation does not recognise any provision of the alternative accounting rules.  The alternative accounting rules are currently applied by companies when they revalue certain assets and because these rules are prohibited, assets must be carried at historical cost.

It will not be possible to use a previous revaluation amount as deemed cost and then apply the cost model from the date of transition as this would be inconsistent with the legal framework and hence no transitional exemption was provided for in FRS 105 in this respect.

In drafting FRS 105, the Financial Reporting Council (FRC) have included an optional exemption relating to investment property in paragraph 28.10(c).  This optional exemption 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:

1. 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.
2. The cost of land, if any, shall be separated from buildings.
3. 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).
4. A portion of the estimated total depreciated cost calculated in paragraph 3 shall then be allocated to each of the other major components (ie 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.
5. Any amount of the total depreciated cost not allocated under paragraph 4 shall be allocated to the most significant component of the investment property.’

Example – Investment property on transition

Company A Ltd is a micro-entity applying FRS 105 for the first time for the year-ended 31 December 2016.  The opening balance sheet as at 1 January 2015 has an investment property carried at open market value of £100,000 and a revaluation surplus of £20,000.  The investment property was purchased on 1 January 2012 and the value of the land was £25,000.

Step 1

The transitional provision in paragraph 28.10(c)(i) can be applied.  The revaluation surplus of £20,000 can be reversed against the cost of the investment property and hence at the date of transition the investment property will have a cost for FRS 105 purposes of £80,000 (£100k less £20k).

Step 2

Once the cost has been established, the value of the land is taken into consideration and accounted for separately because land does not depreciate.  This will then allow the depreciable amount of the asset to be calculated as follows:

Step 3

Once the depreciable amount has been calculated paragraph 28.10(c)(iii) requires depreciation to be calculated since the date of initial acquisition on the basis of the property’s useful life of the most significant component of the property (i.e. the main structural element).  If this is considered to be 50 years from the acquisition date, the depreciation charge since the date of acquisition is calculated as follows:

Date of purchase:            1 January 2012

Depreciable amount:     £55,000

Depreciation:                   (£55,000 x 2%) x 3 years (i.e. to 1 January 2015) = £3,300

At the date of transition (1 January 2015) an adjustment will be required as follows:

Being three years’ depreciation from the date of acquisition to the date of transition

Step 4

On the date of transition, the investment property has a total depreciated cost of £51,700 (£55,000 less £3,300).  This depreciated cost then needs to be allocated to each of the other major components (i.e. excluding the most significant component) to determine their depreciated cost.

The director has identified that the central heating system will need replacing in three years’ time from 1 January 2015.  The current cost to replace the central heating system is £10,000.

In this example the central heating system has a considerably shorter life than the main structure of the investment property and hence should be depreciated separately from the remainder of the property.  The depreciation charge in the 2015 comparative year is as follows:

Conclusion

The prohibition of fair values and revaluation amounts in the micro-entities’ legislation will mean that all revaluation amounts will have to be removed on transition.  This could have a big impact on an entity’s balance sheet position and therefore should be taken into consideration when establishing the most appropriate financial reporting framework to report under.   FRS 105 is optional and if a micro-entity wants to continue recognising its investment property (and any other assets) at revaluation, then it must apply FRS 102 with reduced disclosures as a minimum.

The transitional exemption allowing to treat the investment property at the date of transition as a single asset for the purposes of estimating accumulated depreciation has been introduced to provide an exemption for micro-entities from having to determine the historical cost of each component that has been replaced in the past and the depreciation charge that would have been charged since their initial recognition.

Many accountants are concerned about the prohibition of applying the alternative accounting rules and this concern is shared by the Accounting Council of the FRC who believe that investment property should always (where practicable) be measured at fair value on the grounds that this will provide more relevant information to users of the financial statements; however this is not possible under the legal framework.

Category: Accounting and standards