When the worlds of accountancy and building surveying combine there is more common ground than one might expect. These are not two professions you would usually associate with one another, but as recent discussions between the authors discovered, there are some important ties between them. If those ties are not encouraged there is scope for inaccuracy and misunderstanding, particularly when it comes to companies’ annual reports and property maintenance costs.
All limited companies need to provide annual reports on their financial position. UK publicly traded companies are currently required by law to apply the International Financial Reporting Standards (IFRS), as endorsed and adopted by the EU, to their consolidated accounts. All other companies must produce their accounts using either EU-adopted IFRS or the UK’s Generally Accepted Accounting Practice.
The International Accounting Standards Board (IASB) issued IFRS 16 in January 2016, but it was not fully effective until 1 January 2019. It replaces IAS 17, under which liabilities from a lease were classified differently in annual accounts as either finance leases or operating leases. Most property leases did not meet the finance lease criteria and were consequently treated as operating leases, and there was no requirement for them to be reported on a company’s balance sheet – which essentially meant that the company’s full financial position was not stated. These off-balance-sheet leases often included some forms of rent and property maintenance. For operating leases, the dilapidation provision was considered separately in accordance with IFRS 15.
Around 55% of commercial property is leased and involves formal contracts between the landlord and the tenant. Most importantly from a building surveying perspective, these leases create a liability on the part of the tenant to maintain the property throughout and at the end of the lease term.
It is understood by the companies involved, investors and associated accountancy firms that property leases create a liability for the parties involved. Most notably, they make the lessee liable to maintain the property during the term of the lease and for dilapidations at the end of the lease. Applying previous lease accounting requirements, these liabilities were often not accurately reported, but the new legislation looks to remove that ambiguity – especially when it comes to dilapidations.
The accountancy rules of IFRS 16 on leases have several implications for the property market and, in our view, could affect its future direction; dealing with dilapidations in particular may become more prominent. Although the new reporting criteria are due to affect 50% of listed companies in the UK, and perhaps cause some internal confusion at the companies affected, there are some significant benefits. The IASB concluded that, by recognising all lease liability in more detail, the financial position and strength of a company will be easier to review and interrogate. This should mean that better information is available to investors and analysts.
Under IFRS 16, more detailed information on the lease liabilities must be recorded. This could have significant implications, particularly if, for example, many leases in a portfolio come to an end in the same reporting period. Under the old standard, entities were able to apply a more generic approach as they estimated the dilapidation provision when considering operating leases, with a rudimentary rate per square metre typically multiplied by the areas of the premises in question. In our experience, this figure was often inaccurate and based on out-of-date, unsubstantiated cost information. It definitely did not take into account the specific location, current condition and specific legal requirements of the lease for the property in question.
Under the new accounting standard, where most of the leases will be recognised on the balance sheet, the dilapidations provision will need to be assessed at the outset of each individual lease agreement and included in the overall liability recognised in the financial statements. In the subsequent period, the lessee will need to remeasure the lease liability if there is a change in the amount expected to be payable for the dilapidations.
Fulfilling those obligations will require a change from standard practice, which sees many companies presenting their liability with generic rates across their property portfolio. The authors believe the best way to avoid the misleading consequences of this approach is to ascertain the dilapidations liability by assessing each property. One benefit of this more rigorous practice is that the potential liability can be reduced in the light of the landlord’s intentions for the property, such as repair works, redevelopment or even disposal – something that is not immediately obvious without the input of a building surveyor specialising in dilapidations.
IFRS 16 notes that companies should be prepared to "incur costs to remeasure lease liabilities over the terms of the lease". It is difficult to define this expectation, but we believe this to be where liabilities or circumstances change, such as where there is a material change in the state and condition of the property or alterations are made to it. Subsequently, the legislation implies that companies should anticipate undertaking a dilapidations liability assessment. RICS’ Reinstatement cost assessment of buildings third edition guidance note advises that a property should be inspected and the assessment updated every three years. It is not unreasonable for these timescales to be adopted in this instance, depending on the duration of the lease.
Under IAS 17, the maximum amount payable by the lessee was to be included in the lease liability. Under IFRS 16, however, companies will need to consider what additional procedures are required to determine the amount that is expected to be paid, both at initial recognition of the lease and thereafter. In addition, staff have to understand the new rules and put internal systems in place to manage and track leases.
The new rules could in future help the retail market and other lessees that favour sales-linked leases, because fixed-payment leases and variable payment terms leases are reported differently. The two types of lease could be viewed as economically similar transactions and may result in similar cash flows, but companies using one would be in a different economic position to those using the other. This is because variable payments that depend on the index or rate are included in the measurement of lease assets and lease liabilities, and change in the expected cash flows should be considered in subsequent measurements.
The new rules are likely also to affect sale-and-lease-back transactions. These have been very popular recently and are a good way for companies to raise capital. Under IAS 17 rules, a company could significantly reduce its reported assets and liability while the balance sheet would have implied a smaller asset base and less financial debt as the lease payments would have been off-balance-sheet leases. It is anticipated that the number of such transactions may fall as IFRS 16 reduces the incentive for them by requiring recognition of assets and liabilities arising from leaseback, and limiting the gain recognised in the sale.
More recent research from CBRE has observed that this approach still has its place in the market, and ‘while companies will lose the off-balance-sheet financing benefit of a sale and lease back, we believe this will be offset by the more tangible benefits of this form of capital raising, which will be unaffected by these changes’ in IFRS 16.
To summarise, the authors recommend that companies review their property lease liabilities, especially those where the lease end is in the foreseeable future. The completion of dilapidations liability assessments is a quick and relatively inexpensive way to assess and record a lessee’s liability.
Related competencies include: Accounting principles and procedures, Landlord and tenant