Accounting for property - all change!
Jonathan Cohen examines the proposed accounting standard regarding property leases and urges charities to develop a property strategy
KEY POINTS
- The IASB new lease accounting standards proposal is underway
- If adopted, they affect publicly accountable Tier 1 charities
- However, all charities must develop a property strategy
- Failure to be proactive can be expensive
- Check the taxation impact on property
For most organisations, the second greatest overhead cost after staff is property. Yet in many charities, it does not seem to be a priority for trustees or directors of charitable companies limited by guarantee.
Previous articles on property and premises management have included Andrew Croft’s ‘Premises, premises’ which provides a guide to relocation and what to look out for,1 and Rosamund Cullis’ ‘End of term’ which explains the legal watch points of the lease renewal process.2
However, another aspect of premises occupation has emerged that charities need to think carefully about. New accounting changes mean that occupied and managed properties will have to become a strategic issue for boards, with extensive implications for owners and occupiers.
Financial reporting of lease liabilities
The International Accounting Standards Board (IASB) has proposed to include property lease liabilities onto company balance sheets,3 primarily to improve transparency.4 However, the IASB is influenced by the principle that any obligation should be highlighted on the balance sheet, including property related liabilities.
The significant impact will be on tenants who will have to account for their lease obligations under a new model which will bring both an asset and an obligation onto their balance sheet and introduce complexity to a previously relatively simple subject.
It should be noted that these changes, if adopted, would only affect ‘Tier 1’ charities with public accountability,5 because it is this group that would have to adhere to the EU international finance reporting standards (IFRS). These would include the new lease accounting standards. While this should not be a concern for the vast majority of charities, it is a good opportunity for all charities occupying leasehold premises to look at ways of reducing their costs.
Four key implications for property tenants
The following changes will affect property tenants if the new standard is adopted:
1) Rent commitments over the lease terms need to be recognised as a liability. Simultaneously, the ‘right of use’ of the occupied space will also need to be shown as a non-current asset.
2) Earnings before interest, taxes, depreciation, and amortization (EBITDA) will rise as the rent liability from the income statement will be replaced by depreciation (due to it being shown as a non-current asset). An interest charge on the obligation to pay rentals over the lease term may also be applied. This is illustrated in Figure 1.
3) New financial liability on the balance sheet will also have an effect on the organisation’s gearing ratios when using bank funding. The wording on their bank debt covenants should be reviewed.6
4) There would be higher overall charges in the income statement in the earlier years of the lease which is amortised over the lease term, as the lease obligation reduces and lower charges are incurred in the latter years. This is compared to the current practice with straight-line charging of rental payments, as illustrated in Figure 1.
Need for a property strategy
It appears highly likely that the new standard will take effect from 2013. However, we believe the proposals present immediate opportunities for charities and non-profit organisations to manage their property leases and portfolios with greater efficiency.
As the property market shows signs of recovery and growth, albeit marginal, it is imperative that charity occupiers review all leasing options and determine a property strategy that best complements their short to medium-term charitable objectives.
We expect that tenants may seek to shorten leases and ensure greater flexibility in their lease term by the means of break clauses, in order to reduce their balance sheet liabilities. In recent years, due to the risk of funding cuts and the potential withdrawal of frontline services, it is sensible for charities to position their break clauses in line with their successful tenders or budget.
Break clause management
A strategy was developed for a charity based in north London, to streamline its property-related costs and to minimise risk, following a period of restructuring.
The landlord agreed to lease back the vacant floor space, to re-align the break options in accordance with the charity’s funding streams, and centralise three independent leases into a sole commercial lease. Alongside securing a straight rent reduction and incentive with immediate effect, they reduced their leasing commitments by around £51,000 over the remaining years of their lease which helped support the charity’s frontline services.
Don’t risk a passive approach
It is more important than ever to be vigilant about all lease events, such as rent reviews, tenant-only break options or lease renewals, all of which present strong negotiation opportunities that charities need to take full advantage of in the current financial environment.
One charity in the north-east of England, which specialises in mental health services, owns and occupies a mixed-use portfolio comprising 38 properties, ranging from residential care and therapy centres to shops, offices and a warehouse unit.
Although the original concern was based around its procurement issues and the risks of wasting money by not securing wholesale rates, the risks surrounding its property arrangements were highlighted. These included missing break clauses and not serving notice to exit the premises in the appropriate manner as stipulated by the lease.
By creating a mindset that its property function was a priority, and implementing recommendations on how to streamline its lease management across the property portfolio, the charity is now able to estimate around £250,000 in efficiency savings for the period between 2011 and 2014.
Impact of tax on property
It is now more important than ever for third sector organisations to be aware of all VAT reliefs that are available to them. A tenant can reclaim the VAT on quarterly rent, but it may be worth checking if your landlord is registered for charity VAT on the property.7
According to the Charity Tax Map,8 business rates accounted for £8.61m, or 5.8 per cent of the total tax paid in the sector. Although the majority of registered charities receive the mandatory 80 per cent rates relief, it can be challenging to secure the additional 20 per cent, or ‘top up’ relief as it’s often referred to.
Inconsistently, there is no black and white ruling for local authorities to issue the top up relief to registered charities. It is merely their perception of the value that the respective charity brings to the local community. Unreasonably, it also appears that the larger the size of the charity’s portfolio (such as strategic locality to access service users), the greater the challenge to be awarded the additional 20 per cent rates relief.
St Loye’s Foundation expressed concern over receiving a mere 10 per cent in rates relief for one of their buildings in Exeter. Extensive due diligence identified that a potential re-assessment of their building’s occupied activity and nature of their charitable work could, and did, result in a successful business rates appeal to the Valuation Office Agency. This became a landmark decision for the third sector, as full rates mitigation has been achieved, generating savings of over £38,000 for the foundation.
Keep exploring options
With the current squeeze on most charities having to do more with less, addressing ongoing property liabilities cannot be a mere afterthought and needs to be addressed as soon as possible – if it has not been tackled already. This means developing a strategy that reflects efficiency savings and minimised risk, especially as the standard accounting practice will soon be changing in respect to their property liabilities.
1. www.charitiesdirect.com/caritas-magazine/ premises-premises-739.html
2. www.charitiesdirect.com/caritas-magazine/ end-of-term-169.html
3. See www.ifrs.org/NR/rdonlyres/C03C9E95-822E-4716-81ED4B9CC4943BE/0/EDLeasesStandard0810.pdf
4. Full details of where the IASB has got to on this (the consultation period is now closed) can be found at: www.ifrs.org/Current+ Projects/IASB+Projects/Leases/Leases.htm
5. The new three-tiered structure is explained in www.charitiesdirect.com/caritas-magazine/ a-threetiered-structure-1017.html
6. www.commercialpropertyreport.co.uk/ journal/2011/3/12/new-lease-accounting-standards.html
7. www.thirdsector.co.uk/Resources/ Governance/Article/877477/Recoverable-VAT-rent/
Author: Jonathan Cohen
Jonathan Cohen is a director at Third Sector Alliance LLP, specialising in creative solutions to minimise risk and to deliver efficiency savings for property, procurement, VAT and Gift Aid.
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