FRS 102: Accounting for dilapidation provisionsby
Dilapidation provisions, which are the works required at the end of a lease, seem to cause disagreements with auditors, file reviewers and clients, with general provisions that build up over time being particularly contentious.
Dilapidation provisions have proven to be somewhat a challenging area. This is due largely to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland not specifically dealing with the issue in Section 20 Provisions and Contingencies, despite them being in scope of that section.
Background to provisions
A provision is recognised in the financial statements when an entity has:
- a present obligation (either legal or constructive) as a result of a past event
- it is probable (that is, more likely than not) that a transfer of economic benefits will be required to settle the obligation, and
- a reliable estimate can be made of the amount of the obligation.
Unless all three of these criteria are met by the balance sheet date, a provision is not recognised and a contingent liability is disclosed instead, if material.
For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This will be the case only where the settlement of the obligation can be enforced by law or, in the case of a constructive obligation, the event creates valid expectations in the mindsets of those affected that the entity will discharge its obligations.
Where the recognition criteria for a provision are met, the amount recognised is the best estimate of the expenditure required to settle the present obligation at the balance sheet date. FRS 102, para 21.7 refers to the amount that an entity would “rationally pay to settle the obligation at the end of the reporting period”. This concept illustrates how an entity can use a best estimate to recognise a provision when the recognition criteria are met. Provisions, therefore, do not have to be recognised in respect of actual cash outflows, but are instead amounts that could be settled in respect of liabilities that arise at the balance sheet date.
As noted above, a provision is only recognised in the financial statements if there is a present obligation as a result of a past event.
With regards to general dilapidations, the tenant will normally maintain the property to a good standard in the early stages of the lease. Assuming no leasehold improvements have been made nor any damage has been caused to the property, there is no obligation and, consequently, no provision is required.
More generally, a dilapidation provision should only be made when damage is caused to the property or when alterations are made. Damage will typically arise towards the end of the lease term when the tenant has ceased to maintain the property to the highest standard.
Some accountants have been known to estimate a final dilapidation provision and then average it out over the term of the lease, giving rise to a provision that builds up over the lease term. This sort of general provision is not permitted under FRS 102 because there is no past event giving rise to an obligation. A provision can only be made once the damage has been caused or the alterations to the property have been carried out, because it is the cause of the damage/alterations that creates the obligating event.
Example 1 – Replacement roof
Wolves Ltd took out a 20-year lease on a property on 1 January 2006. The lease contains general dilapidation provisions that the property should be made good at the end of the lease term.
At the year end 31 December 2022, the condition of the roof had deteriorated to such an extent that it will need replacing imminently. Quotations have been received from various roofing contractors to replace the roof.
The replacement roof is a current obligation as a result of a past event and should be provided for by way of provision. This would not be the case if the roof was not in need of repair at the year end.
Wolves Ltd should not have been making a general provision for this replacement roof at the outset of the lease because such a provision is not permitted under FRS 102. This is because there must be an obligation at the time the provision is made.
Example 2 – Dilapidation provision
Wanderers Ltd took out a 25-year lease on a property on 1 January 2022. The terms of the lease require the property to be returned in the same state as when the tenant took it over.
Wanderers made various alterations to the property during the first year of the lease term which cost £180,000. The best estimate of the cost to reinstate the property to its original condition at the end of the lease is £120,000.
Treatment of leasehold improvement costs
Provided the leasehold improvement costs meet the definition of “property, plant and equipment” and the recognition criteria in FRS 102, Section 17 Property, Plant and Equipment, the costs can be capitalised and depreciated over their useful economic lives.
Assuming this is the case, in the 31 December 2022 financial statements, the carrying amount of the leasehold improvements will be £172,800 (£180,000 less depreciation of £7,200).
Treatment of reinstatement costs
A provision is made for the present value of the cost of the reinstatement work at the time the leasehold improvements were made. If the provision had been made at the start of the lease term (1 January 2022), the cost of £120,000 would be discounted for 25 years. (FRS 102, para 21.7 states that when the effect of the time value of money is material, the amount of the provision is the present value of the amount expected to be required to settle the obligation).
Assuming a risk-free discount rate of 5%, the discount factor is 0.295. Hence, £35,400 (£120,000 x 0.295) is capitalised.
The original entry in the 2022 financial statements is:
|Dr Property, plant and equipment
|Cr Provisions for liabilities
In the 31 December 2022 financial statements, the carrying amount of the reinstatement costs is £33,984.
For the first full year and each year thereafter, the provision is increased by 5% giving the following:
|Year end provision
And so on…
Disclosure of judgments and estimation uncertainty
FRS 102, paras 8.6 and 8.7 require disclosures concerning judgments and key sources of estimation uncertainty. Small entities are encouraged to disclose information about judgments.
In terms of the “judgment” this may include management’s estimate concerning likely future outcomes and other factors such as building and material cost and changes in circumstances which could affect any amount payable in the future.
For “accounting estimates” the disclosure may make reference to the current provision being based on management’s current best estimate of the future obligation and other entity-specific factors (for example, if reference has been made to any third-party estimates, such as those by a surveyor).
The issue of dilapidation provisions seems to cause disagreements with auditors, file reviewers and clients. It would seem “general provisions” that build up over a period of time are the contentious ones because there is no past event that creates an obligation. FRS 102 only allows a provision to be made once work (such as leasehold improvements) has been carried out or damage has been caused to the property because it is this that creates the obligating event.