This article is part two of a trilogy on dilapidations by Simon Hartley (Partner, Head of Property Litigation at RadcliffesLeBrasseur LLP), co-authored by Andy Crook (Partner at Mercer & Hole). This article first featured in Estates Gazette on 20 February 2021. The first article in the trilogy – “What makes a good dilapidations assessment?” can be found by clicking here.
The impact of recent accounting standards on the landscape of dilapidations liability is explained by Simon Hartley and Andy Crook.
Most commercial tenancies contain repair obligations. They apply throughout the lease term and crystallise on expiry when the tenant is required to yield up the demised premises in a certain condition. These contractual provisions can oblige leaseholders to incur substantial outgoings in maintaining their properties and can represent a significant liability to the landlord if the premises are dilapidated when the tenancy comes to an end.
If a tenant’s accounts are to represent its financial position, they will need to make provision for these dilapidations obligations. The issue of how accounts should address lease covenants has been around for a long time. However, the rules regarding leases introduced by international accounting standard ‘IFRS 16 Leases’ are relatively new and have potentially altered the landscape with regards to accounting for dilapidations.
The previous standard
Accounting for dilapidation costs used to be covered by FRS 12 Provisions, Contingent Liabilities and Contingent Assets. This standard said that tenants should account for the cost of dilapidations when an obligation to pay for the dilapidations exists. Unfortunately, accountants could not agree as to whether this meant at the commencement of the tenancy, when the terms of the lease were agreed, or at the end of the tenancy, when any terminal dilapidations claim arose.
The new regime under IFRS 16
Enter ‘IFRS 16 Leases’. This is an accounting standard about leases – not specifically dilapidations claims. The big change arising from this standard relates to how accounts are to deal with the short-term rental of property. By following the standard, accounts should now show short leasehold property as a depreciating fixed asset in the balance sheet, as opposed to just recording the expense of the rental payments. This presents a problem in deciding what value to place on the short-term lease as a fixed asset. The standard tells us that the value to record in the balance sheet is the total lease costs over the life of the tenancy. This includes the repair and reinstatement costs that the leaseholder is obliged to incur, as set out in the lease.
The standard says that these costs are measured in accordance with FRS 12. It helped clarify the earlier rules by effectively settling the debate as to whether the obligation to account for these liabilities occurs at the start or the end of the tenancy – it is at the start. This is in contrast to the general approach taken by building surveyors specialising in dilapidations, who tend to focus on the liability accruing at lease end.
Using this standard, the future cost of restoring the premises is added to fixed assets at the commencement of the lease so the accounting entries are to debit fixed assets and credit provisions. The fixed asset is depreciated over the term of the lease but the provision is retained until the end of the tenancy when, theoretically at least, the restoration work is carried out or the dilapidations claim is settled and the provision is released. This means that the profit and loss effect of the tenant’s repair obligations is effectively spread over the term of the lease, as the restoration costs that have been capitalised are depreciated