Accounting issues for property companies - PKF Francis Clark
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Accounting issues for property companies

The introduction of a new accounting standard, FRS 102, in the annual accounts of UK companies has thrown up some interesting challenges for property investment companies. In this article, we will look at three key property accounting changes and consider their practical implications.

Reporting valuation changes

Companies have always been required to carry their investment property at its market value (now ‘fair value’) but in the past, valuation adjustments appeared directly in a revaluation reserve at the bottom of the balance sheet. Under FRS 102, valuation gains and losses are included in the profit and loss account for the year, raising three issues:

1. How should the company present and explain the impact of the valuation and distinguish it from the profit on the rental operation?

2. If the company has bank covenants based on profitability, do they include gains and losses on valuation, and could those distort the company’s performance against its covenants? Banking arrangements that pre-date FRS 102 may not even address the point because the drafting will have presumed that valuations movements will all go direct to reserves.

3. How will the directors ensure that only appropriate profits (‘realised profit’) is used to fund dividends and other distributions? The point here is that valuation gains on property don’t arise from a cash transaction and are therefore treated as ‘unrealised’. Under the previous regime, all valuation gains were in a separate reserve, so it was easy to identify unrealised profit. Now, they will be mixed in with trading profits, increasing the risk of a potential unlawful dividend. Some companies have chosen to deal with this by disclosing the unrealised element of profit in a note to the accounts, although other options are possible.

Deferred tax on property valuations

Deferred tax is an accounting device used to smooth timing differences caused because the tax effect of certain transactions does not coincide with when those transactions are reported as part of profit. Property valuation adjustments are such a difference – the accounts recognise valuations gains and losses as they occur, but the company is only taxed (or receives tax relief) on them when the property is sold.

Previously, deferred tax was not provided in the accounts in relation to property valuations, but the rules have now changed and companies must provide for the tax that would be due on disposal at the valuation amount, based on current rates and allowances. This means that property investment companies must recognise an additional liability in their balance sheet and an additional tax charge against their profit for the year. The additional liability reduces the net assets of the company and, hence, its net worth. For companies with banking covenants to meet, a fall in net worth on the balance sheet might lead the bank to begin an investigation or, even, withdraw funding.

Lease incentives

Lease incentives encompass a variety of methods for encouraging tenants to sign up to a lease, including rent holidays, reverse premiums and contributions to fit out. In the company’s accounts, the cost of incentives has always been spread. What has changed is the period of spreading, so that it now covers the entire period of the lease, ignoring rent reviews. In some instances, this makes little practical difference because of the proximity of break clauses; in others, the longer period of spread means that the annual cost of the incentive is reduced, increasing the annual profit and, hence, the tax charge in earlier years, whilst reducing it in future.

Stephanie is a corporate audit partner based in Exeter, delivering audit, assurance and advisory services to a wide range of clients, from manufacturing and service… read more
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