Risks for housing associations in the face of benefit reforms need to be flagged by auditors
The Financial Reporting Council (FRC) recently published Practice Note 14 (Revised), The Audit of Housing Associations in the United Kingdom for consultation. The revised Practice Note is a significant change from the previous version, with further information on the auditor’s interaction with the regulators in each of the four nations of the UK and increased emphasis on the sector’s risks.
Risks for housing associations in the face of benefit reforms need to be flagged by auditors
The Financial Reporting Council (FRC) recently published Practice Note 14 (Revised), The Audit of Housing Associations in the United Kingdom for consultation. The revised Practice Note is a significant change from the previous version, with further information on the auditor's interaction with the regulators in each of the four nations of the UK and increased emphasis on the sector's risks.
Prior to the Welfare Reform Act 2013, housing associations' income sources were relatively stable, with housing benefit covering significant proportions of the association's rental income. Additionally, growth through new development was supported by grant funding and readily available, long-term debt funding from the banking sector. The economic downturn led to traditional bank funding becoming less prevalent. Coupled with welfare reform and a reduction in grant funding, this means that for some associations, cash has become squeezed.
Associations looking for alternative income streams have diversified into wider, and often more commercial, activities, such as providing care services or developing and holding properties for market rent. These activities have a different risk profile which the auditor must consider.
Business risks
In order to fully assess the audit risks in relation to a provider of social housing, auditors need to have a full understanding of its business risks.
Government policy: From 1 April 2013, many recipients of housing benefit who were under-occupying their property saw a reduction in their benefit. The impact on housing associations varies; demand for larger properties may fall, giving rise to a potential impairment risk; and arrears may increase for those tenants unable to make up the remaining rent charge. This means that auditors need to consider the adequacy of bad debt provisions.
Universal Credit, where the tenant will receive housing benefit directly rather than the benefit going straight to the landlord, will probably exacerbate this problem, as tenants manage their income across all competing household bills. The impact on housing associations' business plans and going concern assessments needs to be carefully considered.
Financing: Due to the withdrawal of several banks from the sector and the reduced availability of traditional loan funding, associations are looking for alternative funding. Where associations have issued bonds, the auditor needs to be fully aware of the basis of the bond, for example whether it is listed (and therefore the association has to adhere to listing requirements) or whether there are any related foreign currency risks.
Some housing associations are considering non-traditional approaches to financing. Several have entered into sale and leaseback agreements, particularly where gearing covenants have had little headroom.
The accounting treatment of these leases should be considered before any commitment is made. If the leaseback is a finance lease arrangement, there can be severe implications for gearing. In addition, wherever there are different financing methods the association should have fully considered the affordability of the funding over the life of the agreement and in the context of its strategic plans.
Diversification: As alluded to above, the squeeze on cash has led some housing associations into new areas, such as investment properties and care and support activities. These non-core activities are designed to support the housing association. However, if the activity and the associated risks are not fully understood and mitigated there is a risk that the housing association may be adversely affected, either financially or from a reputational perspective. This risk may be heightened where the association subcontracts third-party organisations to provide the care. Performance management and monitoring arrangements will be critical in these circumstances.
Diversification may be carried out in partnership with other organisations whether informally or through legal joint venture structures. The association and the auditor need to have a clear understanding of where obligations and rights lie to inform accounting judgements. Many of the risks identified in the Practice Note can be linked to the auditor's assessment of the entity's ability to continue as a going concern. Recent events in the sector have demonstrated that housing associations are not immune to threats to going concern.
The future
Many of the issues in the Practice Note are likely to remain relevant for several years to come. Banks are increasing margins on debt wherever possible given the current low base rate of interest rates are likely to increase further over time.
Several of the risks in the sector are as a direct result of the welfare reforms and the auditor will need to monitor the impact of future government policy on the sector.
As part of the 2013 spending round, the government announced that from 2015/16 social housing rents will increase by CPI plus 1% each year for the following 10 years. This has led to concern from social housing providers that have not yet reached target rent, as this could affect their ability to repay their debt, which has been based on annual rent increases at RPI plus 0.5% plus £2 per week. Housing associations are now looking at the implication of this for their business plans. Some associations had planned for future moves towards CPI-based rent increases. However, the removal of the additional £2 per week was not widely expected.
A more immediate issue that could result in an audit risk is the move towards the new International Financial Reporting Standard (IFRS) based UK GAAP.
This will have significant accounting implications for associations, which may increase the volatility of the income and expenditure account.
This is particularly true for associations with complex financial instruments which are not currently accounted for using hedge accounting. In addition, the SORP's [Statement of Recommended Practice] treatment of capital grants will impact on the volatility of the income and expenditure account.
The audit risks associated with the new UK GAAP are twofold. Firstly, it is imperative that the auditor considers whether their client has planned and is equipped to deal with the conversion process, which will undoubtedly be time-consuming and potentially costly. Secondly, the impact of the accounting policies on the reported financials could impact upon associations' abilities to meet non-cash based loan covenants. In addition, the changes in reported performance could affect the attractiveness of bond issues.
The Practice Note provides a foundation for the auditor to consider risk. Given the ongoing change in the sector, the auditor will need to be alert to emerging issues that result in audit risk.
Chris Wilson is a partner and Heather Garrett is a senior manager in the public sector audit practice at KPMG
