Commercial property: accounting terms
Giving a clear account
20 December 2013
Duncan Ashman explains how accounting terms are often misused in regards to service charges
The term 'audit' is widely used in respect of the review of the annual statement of service charge expenditure by an independent accountant. The word is defined as 'an official examination and verification of accounts and records especially of financial accounts' (dictionary.com). However, the definition used by the accounting profession is set out in International Standard on Auditing (UK and Ireland) ISA 200 and goes much further.
It states that:
"The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. The phrases used to express the auditor's opinion are 'give a true and fair view' or 'present fairly, in all material respects', which are equivalent terms." It continues: "The term 'scope of an audit' refers to the audit procedures deemed necessary in the circumstances to achieve the objective of the audit. The audit procedures required to conduct an audit in accordance with ISAs should be determined by the auditor having regard to the requirements of ISAs, relevant professional bodies, legislation, regulations and, where appropriate, the terms of the audit engagement and reporting requirements."
The property profession generally seems to regard any report issued in respect of an annual statement of service charge expenditure, by an independent accountant, as an audit report. However, an independent auditor's report will be clearly titled as such and will include the phrases "give a true and fair view" or "present fairly, in all material respects". If those criteria, and a number of others are not met, then it is not an audit report. The matter is confused by some independent accountants including 'Registered Auditor' under their signature but, just because that phrase is included, it does not make it an audit report.
The property profession generally seems to regard any report issued in respect of an annual statement of service charge expenditure, by an independent accountant, as an audit report
Whether or not an audit should be carried out will be determined by the lease, and case law dictates that if the lease says audit, then an audit should be carried out. Should the owner or agent feel that an audit, in accordance with current auditing standards, will not represent value for money for the occupiers then they should discuss this with the occupiers and agree on alternative procedures. In this case there are a number of options, including:
- preparation of a report on factual findings (International Standard on Related Services [ISRS] 4400 Engagements to perform agreed-upon procedures regarding financial information)
- a review report (International Standard on Review Engagements (ISRE) 2400 Engagements to review financial statements).
If an audit is required, this should be completed in accordance with ISA 800, Audits of financial statements prepared in accordance with special purpose frameworks.
It is worth noting that an audit today is often greater in scope than was originally envisaged at the inception of many leases. Compliance with extensive auditing standards means that it will necessarily be a costly option and, for this reason, it may not represent the best value for money for the occupiers.
In undertaking an audit, the auditor will select those procedures that they consider necessary for them to reach their opinion. Where other reporting frameworks such as ISRS 4400 or ISRE 2400 are used then while ISRE 2400 requires a minimum level of work, the actual procedures may be agreed between the independent accountant and those appointing them, such that specific risks might be addressed.
At the request of the occupiers, a review of expenditure might also be carried out by a commercial organisation, as opposed to an accountant recognised by the Consultative Committee of Accountancy Bodies, on a contingent basis to determine whether the service charge has been properly prepared in accordance with the lease. The purpose of such a review is very different to that carried out by an independent auditor and may not be in accordance with ISAs.
The 2nd edition of the RICS Code of Practice Service charges in commercial property, issued in 2011, states that the annual statement of service charge expenditure should be certified by the manager as representing a true and accurate record of the expenditure incurred by the owner in supplying services to the building and that the sum the owner is seeking to recover is in accordance with the lease. Good practice dictates that a certificate to this effect should be included alongside the statement of service charge expenditure, along with who is responsible for its preparation.
the use of the terms 'sinking fund' and 'reserve fund' are often interchangeable but they represent entirely different concepts
There is also a common misconception that the independent accountant certifies the expenditure when their role is, usually, to report on the expenditure in the terms agreed with the owner or agent. It is rare that they do so, although 'we certify' is occasionally included in a report. This is because the independent accountant is not responsible for the preparation of the service charge statement and, in order to certify it as being 100% correct, they would have to re-perform the work of those preparing it. Risk management and advice from the Institute of Chartered Accountants in England and Wales means that the word 'certify' is rarely used in an independent accountant's report.
Many are familiar with the concept of matching income and expenditure within an accounting period and accruals are routinely used to include expenditure in a statement of service charge expenditure when the invoice may not have been received prior to the property's year-end. However, the definition of an accrual is quite specific and is set out in Financial Reporting Standard (FRS) 18: Accounting policies. It states:
"The non-cash effects of transactions and other events should be reflected, as far as possible, in the financial statements for the accounting period in which they occur, and not, for example, in the period in which any cash involved is received or paid." It goes on: "The accruals concept lies at the heart of the definitions of assets and liabilities which are set out in FRS5 Reporting the substance of transactions."
These definitions mean that a liability should only be recognised if the transaction occurred in the period. Consequently, an accrual should only be made if services were provided, or goods received, in the year.
Often, the owner and agent will seek to spread the cost of major works over a number of service charge periods. Where the lease does not permit forward funding or the use of sinking or reserve funds, an accrual is commonly made in order to equalise the cash demanded of occupiers over a period of time. Because an accrual should not, strictly, be included in these cases, the owner and/or agent should always seek the approval of the occupiers before doing so and disclose the amount charged in the year in the annual statement of service charge expenditure.
Sinking funds and reserve funds
Occasionally, it is necessary to incur significant one-off expenditure to maintain services in a particular property. This is likely to cause major fluctuations in annual service charge expenditure and owners and agents may seek to spread the cost over a number of years to assist occupiers' cash flow. In some cases, sinking funds and reserve funds are prohibited by the lease but, if not, both represent viable options for equalising expenditure over a period of time.
As mentioned in the RICS code, the use of the terms 'sinking fund' and 'reserve fund' are often interchangeable but they represent entirely different concepts. A sinking fund is intended to allow the owner to build up a fund to pay for repair and replacement of major items of plant and equipment, while a reserve fund is intended to equalise costs in respect of regularly recurring items of expenditure to avoid fluctuations in the service charge payable each year. For example, a sinking fund might be set up in order to build up a cash deposit to pay for lift repairs, while a reserve fund might be used to equalise utility costs if they were to fluctuate significantly between years.
An alternative to a sinking fund is for the owner to pay for major repairs and replacements in advance and to include a depreciation expense, allocating the initial cost of the work over a period of time, in the service charge. This method is rarely used.
As the economy picks up, occupiers might find that item of major expenditure are finding their way to the top of the agenda for owners and occupiers and the use of sinking and reserve funds becomes more common again.
Duncan Ashman is a Partner at BDO LLP
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