Commercial Tenants Contracts

A common issue that many commercial tenants face is the unavoidable costs of meeting the obligations under the contract.

A typical example is dilapidation costs which are generally incurred at the end of the contract when the commercial property is returned in a particular state of repair as stipulated in the contract.

The Challenge

The buzz of moving to new and better premises sometimes distracts even the most experienced business people from the underlying risks of signing a new lease.

In recent years some experienced entrepreneurs have recounted on social media how they have been left with an ‘unknown’ liability when their lease on commercial property ends.

The guidance note issued by The Royal Institute of Chartered Surveyors (RICS) regarding dilapidation at the end of the lease term sets out the rules for the assessment of damages as follows: ‘Generally speaking, damages are assessed to compensate the landlord for its loss. As a broad rule of thumb, the amount recoverable by a landlord will typically be the lower of the ‘cost of the works’ (i.e. the reasonable cost of the remedial works that would be necessary to remedy a tenant’s breaches – as expressed within the Schedule of Dilapidation) and ‘diminution in value’ (i.e. the reduction in the value of the landlord’s reversion as a consequence of the tenant’s breaches – as expressed if appropriate within a Diminution Valuation)’.

The cost of dilapidation can amount to over a year’s rent and the challenge facing businesses is how to account for this liability over the life of the tenancy agreement to avoid an unusual charge in the company’s profit at the end of the tenancy agreement.

The old way

Under the old accounting standard (which was withdrawn from 1 January 2015), tenants could account for the cost of dilapidation when an obligation to pay for the dilapidation existed. This created doubt 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 dilapidation claim arose. Due to various interpretations of the old accounting standard, users were left with the flexibility of either recognising the potential liability at the start or when the tenancy agreement came to an end.

The new way

The current International Financial Reporting Standards, IFRS 16, have revisited this area and it now requires companies to recognise and account for short term rental of property as short leasehold property in fixed assets in the balance sheet and depreciate this over the term of the lease. The standard elaborates that the value to be recorded in the balance sheet should also include the repair and reinstatement costs that the leaseholder is obliged to incur as set out in the contract (dilapidation cost).

The UK accounting standard, FRS 102, does not allow for similar treatment of bringing short-term leases into the balance sheet as fixed assets. Instead, annual rentals are recorded in the profit and loss account as was previously done under the old accounting standard, FRS 12.

However, as the IFRS 16 is clear in its treatment of dilapidation costs as fixed assets no such clarity is provided under FRS 102, therefore the suggestion would be to set up ‘prepayment’ and provision for the estimates liability and to release this over the life of the lease in the profit and loss account.

How does it work

The way of accounting for dilapidation cost is to make a provision at the commencement of tenancy by recording on the company’s balance sheet the entire amount of the tenancy contract (total lease cost over the life of the tenancy, when using International Standards).

The estimated future cost of restoring the premises to its original condition is added to fixed assets at the commencement of the lease and is then depreciated (written off to the profit and loss account) over the life of the lease. It is worth noting that by capitalising the entire amount of the lease, a liability (dilapidation liability) is also recorded in the company’s balance sheet at the commencement of the tenancy agreement.

As the future liability is recorded on the balance sheet and released to the profit and loss account over the terms of the lease, this eliminates potential unrecognised future liabilities.

A worked example:

A Ltd has signed a new lease on 1.1.2021 for five years which will expire on 31.12.2025. The term of the lease is as follows:

• Annual rent £12,000
• Dilapidation cost £15,000

Under FRS 12, the rent will be charged to the profit and loss account and the dilapidation provision should have been set up as described above.

Using the example above, as the commitment (under IFRS) is recognised at the commencement of the lease agreement and written of over its life, the effect on the balance sheet is as follows:

• Dilapidation cost – £15,000
• Rent (£12,000 x 5) – £60,000

The effect on the balance sheet will be:

31.12.2021	31.12.2022	31.12.2023	31.12.2024	31.12.2025
Short-term lease Less: depreciated to profit and loss account	£75,000 (£15,000)	£60,000 (£15,000)	£45,000 (£15,000)	£45,000 (£15,000)	£15,000 (£15,000)
Net book value	£60,000	£45,000	£30,000	£15,000	£nil
Total Assets	£60,000	£45,000	£30,000	£15,000	£nil
Lease liabilities Less: discharged	£75,000 (£12,000)	£63,000 (£12,000)	£51,000 (£12,000)	£39,000 (£12,000)	£27,000 (£27,000)
Total Liabilities	£63,000	£51,000	£39,000	£27,000	£nil

The effect on the profit and loss accounts will be:

31.12.2021	31.12.2022	31.12.2023	31.12.2024	31.12.2025	Total over five years
Rent	£12,000	£12,000	£12,000	£12,000	£12,000	£60,000
Dilapidation charge	£3,000	£3,000	£3,000	£3,000	£3,000	£15,000
Charge in the profit and loss account	£15,000	£15,000	£15,000	£15,000	£15,000	£75,000

 

Charge in the profit and loss account £15,000 £15,000 £15,000 £15,000 £15,000 £75,000

Tax treatment for dilapidation follows the accounting standards rule in that:

• There is a present obligation as a result of a past event
• It is probable that the economic benefits will be required to settle this obligation
• A reliable estimate can be made.

Where the above are met, HMRC generally accepts provisions that are tax deductible except where there is an express rule to the contrary (e.g. provision for capital expenditures).

It is advisable that before companies enter into such leases to seek professional advice to ensure correct procedures are applied to benefit the company and its shareholder.