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Don’t get caught out: changes to accounting standards set to impact businesses

wantspacegotspace.co.uk - Don’t get caught out: changes to accounting standards set to impact businessesBusinesses 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 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.

3. Lease dilapidations
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 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.
May 2013 Exposure Draft – the details

•    Lessees would need to record assets and liabilities for a wide range of leases that are currently not recognised
•    The accounting for non-property leases will be more complicated but for leases of property, although assets and liabilities will be recognised on the balance sheet, the lease expense recognised in the profit or loss account will generally be comparable with the under existing accounting requirements. In most cases, this would result in a constant expense over the lease term.

In respect of the balance sheet, a “right-of-use asset” would need to be created at the start of the lease based on the present value of lease payments to be made over the lease term plus transaction costs such as legal fees. A corresponding “liability to make lease payments” would be recognised. This is the key change compared to previous accounting requirements.  

In respect of the profit & loss account, amortisation (and interest in certain circumstances) will be combined into a single lease expense, the value of which will be similar to the expense charged under previous accounting requirements.  

As above, the accounting for non-property leases will be more complicated but for property leases, in most cases, an approach similar to the existing accounting will be retained.  
•    The proposed model is similar to the current operating lease model where the lessor recognises the underlying asset in their net asset statement.  Lease payments receivable would be recognised as income on a straight-line basis.  

Implications for tenants
All leases, including property leases, will now appear on the balance sheet as an asset and as a liability.  A straight line expense would remain to be reported in the profit & loss account.

This will impact on the financial ratios and in turn could cause financial covenant issues. Those who hold property leases whose financial statements are subject to external scrutiny need to ensure that external stakeholders (e.g. banks, lenders, investors) have the implications of the adoption of the accounting changes fully explained to them. This is particularly important in respect of debt covenants.

The moral here is to plan ahead and, once the entity is required to comply with the regulations, communicate with the stakeholders to ensure they understand the implications.  

FRS 102 – the details

The impacts of the accounting requirements under FRS 102 are:

•    The need to keep track of movements on investment property revaluations to separate them from distributable reserves (although a separate reserve could be maintained as a practical solution to this issue)

•    Volatility in the profit & loss account (now to be known as the “income statement”) which is often the key statement looked at by third parties

•    Revaluation movements will be subject to deferred tax (current UK GAAP exempts recognising deferred tax on revaluations). This also applies to revaluations of other assets.  

The other change relates to the definition of investment properties which now extends to properties leased to other group companies. Such properties are excluded under current UK GAAP and therefore accounted for at cost. The impacts of this are:

•    Properties leased to group companies will need to be included in the lessor company’s individual accounts as an investment property at fair value (if easily determinable without undue cost or effort)

•    The same properties will be included as owner occupied in the group accounts and therefore recognised at cost.  

This will lead to a different accounting treatment in the individual parent company accounts versus the group accounts.  

Implications for property owners
Where investment properties are recorded in the financial statements of the owners at value rather than historic cost, the gain or loss as a result of annual revaluations will be reflected in the income statement.  However, these movements do not represent realised profits or losses for legal purposes. As such they are not available for distribution. Depending on the presentation in the financial statements, this will need to be highlighted to shareholders. A practical solution would be to set up a separate reserve related to the investment property revaluations.  Other stakeholders will also need this change highlighted and explained to them.    

Although this change predominantly impacts upon property investors, it may also affect Group companies where the property is held by the parent but occupied by a subsidiary. The accounting treatment of the property in the parent company changes (being accounted for as an investment property), whereas the accounting in the group accounts remains the same. This adds a practical complication to the group financial statement preparation and will also need to be explained to shareholders and other stakeholders.

Lease accounting
With regard to lease incentives these will be spread over the expected lease term rather than the shorter of the lease term and the period to the first rent review. This may result in lease incentives being spread over a longer period impacting on the income statement. However, this change only applies to leases entered into after the date of transition.

Property tenants will need to ensure that the new accounting requirements are adopted for any new leases with rent free periods. The impact on the income statement may be different to previous rent free period accounting and therefore will need to be explained to shareholders and stakeholders.

Lease dilapidations – the detail

Financial Reporting Standard 12 (FRS 12) requires companies to make provisions for such dilapidation liabilities. Reliable estimates can usually be made which will allow the company to budget and account for the dilapidations over the life of the lease. International Accounting Standards and the new FRS 102 standard require similar accounting.  

Implications for tenants
Whilst it is important that all companies comply with the accounting requirements, the implications of an unexpected dilapidations liability can run much deeper.  

Where a company is faced with an unexpected and therefore unbudgeted for liability at the end of a lease, business decisions can be driven by the inability of the company to finance the exit rather than operational requirements. The knock-on effect can be that a company continues to operate from a property that is not fit for purpose for the sole reason that they cannot afford the one-off cost of the exit dilapidations. This can have an adverse long-term impact on a business.

It is therefore important that tenants have an assessment of their future dilapidations liability undertaken. The assessments are designed to enable tenants to understand their liabilities during the term of the lease and make financial provisions accordingly. The assessment can be used to support a one-off or an annual provision in the accounts which over the life of the lease accumulates to meet the exit liability at the lease end. The assessments also enable early consideration of alternative lease exit alternatives and identification of opportunities to minimise exposure.

Where for various reasons the exit liability is less than the sum provided, usually where the landlord is to redevelop the site, then the provision can be written back to the profit & loss account.

Posted by The Editor (wantspacegotspace) on 10th December 2013

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