Revenue Recognition - Rent 2 Rent Sector

Accounting Treatment of Revenue in Rent 2 Rent Sector - Revenue Recognition

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Accounting Treatment of Revenue in Rent 2 Rent Sector

Good afternoon all.  I have a wide range of Land & Property accountancy experience, but this query is stumping me a bit.

My employer has one Company that is within the Rent to Rent Sector.  Essentially the Company leases a property from a landlord (<7 years), refurbishes property, and leases on to a social housing providor.

The concern is the business model has a payback period of approximately 68 months into a 84 month cycle and thus the accounts will show substantial losses until that point.  All expenditure has been capitalised to a point (Leasehold Improvements, Furniture & White Goods etc) but there is still approximately 20% of expenditure that that can only be described as general Repairs & Maintenance and therefore expensed to P&L.  Overheads and interest costs will increase any losses.

I am fairly fimilar with accounting for long term construction contracts under FRS102 using the percentage of completion method and was wondering whether I could use a similar method of revenue recognition with this business model?

It is a stand alone Company and exempt supplies only, so no issues regarding VAT.

 

Thank you in anticipation

Paul

 

 

 

Replies (14)

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By Bobbo
27th Feb 2024 14:58

FRS 102 is very clear, in para 20.25, that lessors should recognise rental income on a straight line basis over the lease term.

Is the payback period to which you refer cash basis or accruals basis?

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Replying to Bobbo:
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By Paul Leicester
27th Feb 2024 15:11

Thanks Bobbo, so effectively there will have to be losses?

Yes accruals

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Replying to Bobbo:
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By paul.benny
27th Feb 2024 16:17

Whilst of course you're right about FRS102, I think it can be construed as two contracts as outlined below. The lessee could have rented property from OP and then contracted with third party to refurbish.

Ultimately, I think it's a question of materiality and how concerned OP is with the timing of reported profits.

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Replying to paul.benny:
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By Bobbo
27th Feb 2024 19:51

I think perhaps there is some confusion as to the parties involved here and their responsibilities - I don't think the idea of unbundling the contract into constituent elements like under IFRS is relevant here.

My understanding, OP do correct if wrong, is:

A owns a property which is not quite in a pristine state. A grants a lease of that property to B for a term of 7 years. Such lease includes an obligation for B to refurbish the property and generally return it at lease end in a reasonable state. (now wondering whether some element of these refurbishments would be a deemed premium for A?)

B refurbishes property so it is ready occupation. B then grants a lease to C (social housing provider) of the refurbished property for the unexpired element of the 7 year term.

C uses property in its business of providing social housing.

As far as I can see its just regular property rental income for B.

Paul I think what you are saying could be applicable were the property let unrefurbished to C and the refurbishment was a condition of the lease. But as noted above, I believe the B to C lease was for a refurbished property.!

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Replying to Bobbo:
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By paul.benny
28th Feb 2024 09:04

I'm trying not to have two separate conversations. I think our difference of opinion comes down to whether the refurbishment and the rental are separable elements.

And since we're reporting under FRS102, the auditors may just say no to a separation of the two elements.

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By paul.benny
27th Feb 2024 15:10

Have you looked at IFRS15? The thrust of that is to split the contract into different deliverables - so with a phone, the total contractual amount is split between sale of a handset on day 1 and an airtime contract over 24 months.

Even if you're reporting under UK GAAP, this is probably the best guidance.

You can download the all IFRS/ISA from ifrs.org. Free registration required.

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Replying to paul.benny:
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By Paul Leicester
27th Feb 2024 15:13

Hi Paul, I'm not sure I fully understand?

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Replying to Paul Leicester:
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By paul.benny
27th Feb 2024 16:02

In a phone contract you might pay £40/month for 24 months = £960. Under IFRS15, that would be accounted for by the network as sale of a handset on day 1 for £600 and then 24 months' revenue at £15.

It seems to me that the contract with your lessee has two parts
- refurbish property to be ready to occupy
- rent out property

So I would potentially take all the revenue and costs of the refurbishment on day 1 and then the incoming and outgoing rent over the seven year term.

IFRS15 does take a bit of getting your head round- both these examples accelerate revenue. More commonly, it defers revenue, such as where there are service or maintenance obligations built into the periodic charge.

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Replying to paul.benny:
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By paul.benny
27th Feb 2024 15:15

superseded

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Replying to paul.benny:
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By Paul Leicester
27th Feb 2024 18:09

Hi Paul, fully understand your phone contract example but the Lessee hasn't really contracted with the Company for the refurbishment works, more expected them to comply with strict conditions before taking the lease on, and therefore there is no revenue attached to this expenditure.

Would your way still have any merits to it?

If say refurb costs were 25K could we say revenue at day 1 was, say 30K (taken out of future rents) to cover refurb and profits/overheads and the remainder then split over the lease term?

Thanks

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Replying to Paul Leicester:
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By paul.benny
28th Feb 2024 08:59

The essence of IFRS15 is that even though there is a single contract, there may be multiple performance obligations, as in the mobile phone example.

So in your position, I would seek to account for the refurbishment separately from the continuing rentals. I think it shows a fairer view. It’s certainly valuable for management to see profitability of the two elements – otherwise an overspend on the refurbishment is hidden until the last months of a long contract when it’s far too late to do anything at all about it.

To be clear, I wouldn’t front-end all of the anticipated profit – there should be a margin on the rent. If the lessee pays regardless of whether the property is occupied or their tenant actually pays, that margin can be quite small.

All of that said, you’re reporting under FRS102, not IFRS. I do think separating out the two elements is preferable but I’d be discussing with my auditors before making a final decision.

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Replying to paul.benny:
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By Paul Leicester
28th Feb 2024 09:38

Thanks for the replies.

If I give a rough example then maybe it will be clearer -

We (Company A) lease a property needing some refurbishment from a landlord for <7 years. We pay say 1,200 per month in rent.

We refurbish the property costing say 20K total, consisting of -

1 - say 7.5K for leasehold Improvements, consisting of fire doors, compliance items (Capitalised)
2 -Furniture and White Goods, say 7.5K (Capitalised)
3 - General repairs & maintenance, say 5k (Expensed to P&L)

After refurbishment we lease onto Company B (term mirroring our original lease) who is a Social Housing provider who pays us say 1,600 per month

Length of refurb is circa 3 months of which we outflow rent without any income

The 5k general R&M, interest payments and overheads obviously mean a substantial accounting loss until we get much further down the line of the lease cycle. (generally we have a payback period in say month 68 out of 84 - Cash flow wise).

Times this by 30 properties per year.

The key for us is to publish accounts that show us in a positive way as we have investors. 2 options seemed to be available to me -

1 - A note in the accounts explaining our MO

2 - Some sort of revenue recognition along the lines that Paul was touching on

We do not require an audit.

Any ideas would be most appreciated

Thanks in anticipation

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Replying to Paul Leicester:
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By paul.benny
28th Feb 2024 10:09

I’m slightly worried by your numbers – allowing for interest there is almost no margin to cover unexpected repairs and contribute to overheads. (I appreciate your numbers were only illustrative – but if they are a fair representation, you may have a bigger problem than presentation)

If you amortise the capital items over the 7 year term and do not split out the refurb, a lease turns monthly profit after the refurb period, but takes 24 months before cumulative monthly profits turn positive. If you have rolling programme of these leases, the margins are so slim that you may never show a profit.

Who are your investors – few or many? Are they purely financial or are they looking for a social return first? And are they shareholders or lenders? What are their expectations? What were they told when they invested? This may all be much more important than the accounting.

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Replying to paul.benny:
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By Paul Leicester
28th Feb 2024 11:04

Thanks Paul. There are no ongoing repairs and maintenance as per the repairing lease. The figures do stack up, the above being very worst case, the problem is the presentation of the accounts.

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