Avoid panic over a dilapidations invoice

Jake Pearlman looks at the best approach to providing for dilapidations liabilities in company accounts. Dilapidations are costs that are traditionally incurred on the termination of a lease, whereby a tenant is obligated to pay for certain repairs, or rectifications, to the property to restore it to its original condition. Dilapidations have become more prevalent in recent years, with landlords seeking new ways to generate returns without large rental increases. The recent economic environment has contributed to this trend. Tenants increasingly require shorter, more flexible, lease arrangements. This has resulted in landlords facing an increased risk of an empty property as tenants vacate for one more suited to their needs. The risk of a property being empty carries an exposure to the landlord for the rates and maintenance bills and dilapidations can therefore be seen as a method for landlords to preserve their income stream. Why should tenants provide for dilapidations in their accounts? The simple answer is that the accounting standards say so, but this is not the answer most companies want to hear. Many see the exercise as an unnecessary annual cost which solely reduces their surplus for little (or no) benefit. Regularly, leases specify that dilapidations expenses will be due at the termination of the lease – however, no specific provision quantifies the amount. Whether you are reporting under International Accounting Standards or UK Generally Accepted Accounting Practice, the principle remains the same – namely, that a provision is required when: a present obligation (legal or constructive) has arisen as a result of a past event; payment is probable (“more likely than not”); and the amount can be estimated reliably. Signing the lease is the past event that creates a present obligation, albeit one that may not crystallise for a number of years. In order to avoid including a provision in their financial statements, companies often argue that either the payment is not probable or, as it is well into the future, the obligation cannot be reliably measured. The probability point is a matter of judgment, where past history and current practice will be important determinants as to whether the payment is “probable”. However, the provision can be reliably measured by obtaining a surveyor’s report that assesses the cost of meeting the obligations under the lease by producing a quantified schedule of dilapidations. Therefore, the probability issue is likely to be the one subject to the most discussion and judgment. Spreading the cost A company that does not provide for dilapidations can find itself faced with a significant expense in the year in which the obligation crystallises. This might significantly reduce the accumulated reserves that the board of directors believed that they had. Investment decisions may also have been made based on the strong(er) reserves position, resulting in misinformed decisions as a result of a significant missing provision. It’s also worth considering the impact on any bank covenants, with the risk that a significant one-off cost could cause a breach. Recognising a cost annually gives a more accurate position of the financial position of the company and matches the cost of the ultimate dilapidation with the period over which the company has benefited from the asset. It should also lead to financial statements being comparable year on year as the “one-off” hits to profit are avoided. Tax benefits The tax treatment of dilapidation provisions can be complex but, in general, follows well-established tax principles. Revenue expenditure is allowed when recognised in the profit and loss account, whereas capital expenditure is allowed through the capital allowance regime, including the newly introduced structures and buildings allowances. However, these are general principles and professional advice should be sought on individual circumstances, ideally in advance of making the provision in order that the appropriate approach is taken. It is important to establish exactly what is being paid for as part of a dilapidations payment in order to ensure the appropriate tax treatment is applied and the tax relief maximised. A company’s corporation tax liability may be reduced as a result of making specific and supportable provisions with the attendant improvement on the company’s cash flow. There are also likely to be deferred tax implications of making dilapidation provisions, which will need considering. Avoiding surprises Unfortunately, all too often companies do not seek professional advice on their exposure to dilapidations and/or give them little consideration until that large invoice comes through the door. At this time, panic can set in and a dispute between landlord and tenant can follow. However, by keeping a regular check on their dilapidations exposure, companies can plan accordingly, whether through a programme of maintenance or through positive engagement between both parties. It is also likely that the opportunities for maximising the tax efficiency of the dilapidation costs will be greater if advanced planning is undertaken. Although this costs time and money, the savings should more than pay for this. So, what next? Seeking a regular surveyor’s report will, at the very least, give visibility to the exposure to dilapidations and enable effective planning to be undertaken. Directors will then be in the right position to assess whether there really is a dilapidations provision to be accounted for and, if there is, what is the appropriate amount. Financial statements should then be a more accurate and comparable reflection of the company’s financial position, as well as giving possible tax benefits and improving cash flow. Jake Pearlman is a manager in the property team at chartered accountants haysmacintyre