January 17, 2014
Businesses across the UK are being alerted to the consequences of a number of proposed accounting changes which are likely to force organisations of all shapes and sizes to shake up how they account for future property transactions.
Drawing on their combined expertise, accountancy and business advisory firm BDO and property consultancy Vail Williams are advising organisations to be aware of the new standards and carefully plan their property leases and portfolio to avoid being caught out. Here are the main potential implications regarding leases:
1. New international accounting standards (mainly applied by listed companies) will bring property that is subject to operating leases onto the balance sheet for the first time
2. New UK accounting standards (FRS 102) will require any changes in investment property revaluations to be reflected in the profit and loss account.
Vail Williams has re-iterated the need for lessors and, more importantly, lessees to consider lease dilapidation clauses from a commercial standpoint. From its perspective, BDO noted that there are no changes in the accounting requirements related to property dilapidations.
1. May 2013 Exposure Draft
New international accounting standards were set out in the May 2013 Exposure Draft and are expected to take effect from the start of 2017. Although the proposals only affect international accounting standards – which are mainly applied by listed companies – and are still in draft format, they could be extended to apply to all companies in due course.
“The details behind the changes will have an impact on both the tenant and the landlord or owner, with significant implications for each in terms of how they conduct and present their accounts regarding property transactions,” commented BDO director Chris Driver.
The key change is that for lessees a “right-of-use asset” would need to be created on the net asset statement (balance sheet) at the start of the lease, based on the present value of lease payments to be made over the lease term. A corresponding “liability to make lease payments” would be recognised. “With property leases now appearing on the face of the balance sheet, companies need to be aware of the impact that this will have on their financial ratios and in particular any related debt covenants,” warned Mark Llewelyn Jones, partner, Vail Williams.
2. FRS 102 – the new UK GAAP
FRS 102, as the core new UK GAAP, replaces all previous UK accounting standards for all non-listed and non-small businesses. It requires investment property to be accounted for at fair value (if easily determinable without undue cost or effort) compared to open market value under the current and previous standard.
“In reality, fair value and open market value are likely to be similar and this change is therefore unlikely to cause too many problems,” advised Chris Driver of BDO. “The specific accounting requirement of FRS 102 will make a bigger difference; however, in that any changes in the fair value of investment property are to be reflected in the company’s profit & loss account (now to be known as the “income statement”) as opposed to the statement of recognised gains and losses (STRGL). These profits will however not qualify as realized profits for legal purposes.”
The impact will include having to keep track of revaluation movements to separate them from distributable reserves, although BDO commented that a separate reserve could be set up to deal with this practically. There may also be volatility in the income statement (which is often the key statement looked at by third parties) and revaluation movements will be subject to deferred tax – current UK GAAP exempts recognising deferred tax on revaluations.
Many companies will need to start their transition to the new standard from 1 January 2014, because it will be mandatory for periods beginning on or after the start of 2015.
As well as the more accounting-related matters above, businesses must also pay close attention to their contractual requirements for dilapidations when leasing a property – failure to do so could leave them facing hefty charges for repairs, warned Mark Llewelyn Jones of Vail Williams.
“The majority of commercial property leases require the tenant to keep the property in repair and good order – precise requirements will be set out in the lease. The lease is also likely to contain obligations regarding the requirement at the end of the lease to redecorate and to remove any alterations made to the property by the tenant,” he explained.
Failure to comply with the lease requirements will usually result in a property dilapidations claim from the landlord. Depending on the property and the lease, this could range from a few thousand to many millions of pounds.
“Given this potential dilapidations exposure, it is important that any business fully understands the nature of their repairing and reinstatement obligations and makes appropriate financial provision,” advised Mark. “Failure to do this can trap a company in a property simply because they cannot afford the one-off cost of exit dilapidations.”
Chris Driver from BDO confirmed that, unlike other property related matters, FRS 102 does not change the accounting requirements in respect of dilapidation commitments. As with the existing standard (FRS 12), FRS 102 requires businesses to ensure they have considered their lease dilapidation clauses and accounted for any liability adequately in their financial statements.
So don’t get caught out. Take the time now to pay attention to the detail and understand the implications of the proposed changes for your business. Talk to the experts at BDO and contact property consultants at Vail Williams for their advice.