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Dilapidations – To account, or not to account: that is the question

22 Jan 2019

By its very nature, the condition of a property will begin to deteriorate from the date a lease starts. Unless there is a contrary or limiting provision, most commercial tenants are obliged to keep premises in ‘good and substantial repair’. As a result, an ongoing and increasing financial liability is created, although it is unlikely to crystallise until the end of the lease – or any renewal lease. 

A prudent company will set aside funds to cover for this future burden.  Accounting rules (IAS 37) indicate that a future repairing obligation may be treated as an expense that can be included within a company’s profit and loss account, so excluded from the company’s tax computation until it is incurred. However, when pursuing damages claims against tenants failing to comply with their terminal repairing obligations, it is staggering that companies are not obliged to include a provision within their annual accounts (or voluntarily seek to do so) to cover this liability, thereby disguising its true financial position.

Their reasons may include factors such as:

a)    Accounting rules only requiring provision to be made where:

-    A present obligation has arisen as a result of a ‘past event’. Comment: Companies regard dilapidations as a future event due to Landlords not pursuing damages claims annually or during the term of the lease.

-    Payment is probable (more likely than not). Comment: Other factors (e.g. a Landlord’s intention to redevelop the property at the end of the term) may cloud the definition of ‘probable’. It is difficult to see why, however, this should preclude annual accounting provision during the lease term, even if this fails to materialise until after the lease ends.

-    The amount can be estimated reliably. Comment; Obtaining an estimated costed schedule from a dilapidations surveyor is easy – assuming he/she is instructed by the tenant to provide one!

b)    Companies consider the amounts to be immaterial so do not include them. Comment: Given how large dilapidations claims can be, this is a classic case of directors ‘digging their heads in the sand’ – only to ‘choke’ when presented with a Landlord’s Schedule at the end of the term.

c)    A company’s profits are artificially inflated, enabling Directors to:

-    reward themselves in the form of dividends even though the accounts may be unreliable and/or inaccurate having regard to a significant accruing liability that is effectively ignored;

-    present a ‘healthier’ looking set of accounts to a Bank, the company’s shareholders and/or to creditors, all which is, of course, advantageous to the company; 

d)    Some directors believe making a provision in the accounts may in some way be regarded as an ‘admission’ to the Landlord of a sum due. Comment: Such belief is misplaced. There are many defences available to a tenant, which will depend on the facts of each case. 

Concerns:

-    Solvency: It is only worth pursuing a tenant company for damages if it is solvent and able to meet any judgment and/or adverse costs orders. Viewing a company’s filed accounts is a critical starting point when advising a Landlord (and/or other creditors) to take action against a defaulting tenant. If, for the above reasons, the accounts are unreliable, a creditor is at greater risk of ‘throwing good money after bad”.

-    Personal liability on Directors if the company becomes insolvent: Where repairing obligations are ignored, but Directors continue to remunerate themselves in the lead up to an insolvent event (e.g. liquidation), they could become personally liable to creditors following investigations and subsequent action by a Liquidator. A Liquidator has a duty to investigate all antecedent transactions giving rise to possible claims for (e.g.) wrongful trading, preference and/or transactions at an undervalue. This could also potentially result in Directors’ disqualification.

Prudently reserving funds to cover ongoing and terminal repairing liabilities will mitigate against  the ‘sting in the tail’ so often encountered by commercial tenants receiving substantial Schedules of Dilapidations at the end of their lease. Current accounting practices would, however, appear to support a continued failure to include provision within a company’s accounts for ongoing repairs to appear as a contingent liability thereby creating concerns outlined above.

In relation to accounting matters referred to above, please seek independent advice from an accountant. If you require advice on any aspects relating to dilapidations and/or insolvency, please contact Keith Pearlman (e: keith.pearlman@dmhstallard.com or t: 020 7822 1605).

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