The RICS Service Charge Code of Practice needs the addition of accounting principles and processes to improve transparency

16.09.10

Kingston University and Property Solutions have jointly written a forthcoming paper which sets out the argument for the adoption of proper accounting policies and principles by commercial landlords and managing agents

Tenants should be able to rely on the fact that service charge demands are calculated in accordance with the lease and that the monies paid are correctly held and used for the appropriate purpose. However, as recent research  has shown, tenants are often provided with service charge information that is untimely, inaccurate, incomplete and inconsistent. The 2009 Property Industry Alliance Occupier Satisfaction Index (OSI) also shows that occupier perceptions over value for money service charges have worsened in the three years since the 2006 RICS Code of Practice on Commercial Service Charges (the Code) came into force and the comment in the 2009 OSI findings that “There is nowhere near enough transparency or accountability when it comes to service charges. We should get full access to final accounts but we don't, we only get access to the summary accounts which can be manipulated’ is evidence that transparency remains a major concern for occupiers.

Kingston University and Property Solutions have jointly written a forthcoming paper  which sets out the argument for the adoption of proper accounting policies and principles by commercial landlords and managing agents. The paper gives illustrative examples of best practice service charge certificates incorporating these accounting policies and principles and makes the case for updating the Code as a matter of some urgency.

There are current best practice standards for both commercial and residential service charges although there are significant differences between them.

The Commercial Service Charge Code
The commercial service charge Code is now in its third edition (2006) and has the status of a guidance note for RICS members. It came into force in April 2007 and provides a generic list of ‘best practice’ accounting standards aimed at promoting transparency including:

• providing an annual budget of likely service charge expenditure one month prior to commencement of the service charge year
• preparing certified accounts within four months of the end of the service charge year, that provide a consistent, detailed and comprehensive summary of items of expenditure with explanations of variations against the budget.
• narrative explanation and disclosures about significant individual costs and variances from previous year’s budget/accounts 
• the use of standard cost codes and a clearly defined apportionment basis
• disclosure on interest earned on service charge monies
• disclosure of the calculation basis for any sinking, replacement or reserve fund contribution and the items to which it relates.
• disclosure of contributions to and expenditure from sinking, replacement and reserve funds, together with the opening and closing balances and the amount of interest earned and tax paid in the relevant period

However the Code stops short of providing guidance on accounting policies giving practitioners the choice of how to implement the Code in different situations. This flexibility was intended to allow for differences in the wording of leases and for the range of management problems presented by large complex buildings versus smaller, simpler ones.

Dr Timothy Eccles of Kingston University points out that “Flexibility is not an inherently bad policy, but, in practice, what we find is that the lack of direction causes confusion and widely disparate practices across the industry. The result is that this approach causes far greater problems than the potential ones it was hoping to avoid. Our evidence suggests that it is better to standardise, and face up directly to the resulting issues, rather than leave property managers without guidance on what sort of process is expected as ‘best practice’.”

Additionally many leases don’t provide adequate guidance on how to prepare certificates.  The resulting variety of approaches has prompted concerns of tenants towards transparency issues and accounting deficiencies. 

It is the view of the authors that the commercial property industry could use the already well established template for accounting practices that exists in the residential market as a starting point for improvements in the commercial Code.

The Residential Code compared
Whilst there are clearly differences between property types and lessees, agreement on what is best practice, including the provision of accounting policies, has created the basis for legislation. UK legislation for residential service charges includes provisions within the Landlord and Tenant Act (1985), the Common hold and Leasehold Reform Act (2002) and the Housing and Regeneration Act (2008), which established the current edition of the RICS residential code as a statutory code of practice.

The residential code also establishes benchmarks of good practice, to allow tenants to make informed choices and provides for co-operation with tenants in making decisions. The accounting sections of the residential code requires the use of accrual accounting, reiterates the requirements of residential legislation relating to accounting and tax treatment of service charge monies and contains a section on reserve funds and budgets.

None of these issues are applied in the commercial code and it is proposed that the inclusion of legal and accountancy expertise into the RICS commercial service charge Code working party could provide significant benefit to the next version of the Code 

There is now a clear need for the commercial Code to include the accounting policies and principles that were put in place under primary legislation for residential service charges. The research illustrates the changes that need to be made through proposed best practice examples and starts a discussion on further conceptual problems of commercial service charge accounting.

The authors propose that these changes should be incorporated into the next version of the Code which is currently under review by the RICS commercial service charge code working party.

Proposed Changes to the Code
Certificates should provide the following essential accounting disclosures:
• A comprehensive list of accounting policies and principles upon which the statement was prepared, such as:
o whether the statements are prepared on an accruals or cash basis using the historical cost convention
o the apportionment basis used for dividing the costs between tenants
o whether the building is elected for VAT
o the nature of the management contract and fee
o describing the intended purpose for any sinking fund or reserve fund, together with an explanation of the tax treatment of tenant contributions to and investment returns on such funds, and details of the trust where such monies are held.
o Depreciation policies, asset and depreciation schedule
o Explanation of the link between accounting policies and the requirements of the lease.
o an explanation of the tax treatment of capital expenditure. For example, capital allowances been claimed and by whom?
o disclosure of whether a mechanical and engineering (M&E) contract is Maintenance only, Part comprehensive or Fully comprehensive (if fully comprehensive, a statement as to whether the contractor accumulating a fund for replacement of plant)
o Disclosure of variance analysis – variance against budget and last year’s actual, with commentary to explain trends and variances, where these are significant
• A balancing statement showing the balances held at the end of each period (e.g. bank balance, sinking funds and reserve funds), prepaid or accrued expenses, arrears owed by lessees and service charges paid in advance at the end of the accounting period.

• Sign off statements by the accountant and managing agent with regards to compliance, financial accuracy and the use of appropriate accounting policies.

The inclusion of these policies and principles into the commercial Code would significantly help landlords and managing agents produce certificates which contain the levels of transparency that the tenants are demanding.  

Without the introduction of proper accounting principles and processes in commercial service charges, the industry is likely to be facing many years of continued disputes between landlord and tenant leading to the likelihood of primary legislation being introduced to regularise commercial service charges. 

Joint Authors

Andrew Holt, Principal Lecturer, Department of Accounting and Finance, Kingston University, UK

Timothy Eccles, Senior Lecturer, School of Surveying and Planning, Kingston University, UK

Kellie Bennett, Finance Director, Property Solutions (UK) Limited