Accounting for service charges

In October 2010 the institute of Chartered Accountants England and Wales (ICAEW) issued a technical release, “Accounting for service charges.” The release caused a lot of controversy in that it stated that as residential services charges are subject to statutory trust it proposed that where service charges are accounted through a residential management company, the service charge income and expenditure should be excluded from those accounts. This accounting treatment was subsequently considered by the Urgent Issues Task Force (UITF) which is part of the Accounting Standards Board. They concluded that whether the Residential Management Company includes service charge transactions in its accounts depends on whether it is acting as principal, agent or undisclosed agent.

The lease is the principal driver of the basis of preparing the service charge accounts, the report to be attached, the costs to be recovered, and the period of time that the accounts should cover. The requirements of the lease should be followed, as otherwise it may be difficult to recover costs from the tenants.

The Technical Release 03/11 issued by ICAEW entitled, “Guidance on accounting and reporting in relation to service charge accounts for residential properties on which variable services are paid in accordance with a lease or tenancy agreement.” This Technical Release provides guidance on the preparation of service charge accounts generally and where the requirements of the lease are unclear,

In summary the guidance provides for the following:

  • It is best practice to issue service charge accounts within 6 months of the year end. This is because S20B, LTA 1985 sets limits on the recovery of expenditure incurred more than 18 months before the costs are demanded from lessees.
  • Service charge accounts should include a balance sheet as well as an income and expenditure statement and explanatory notes. It is good practice to also include comparatives.
  • Service charge accounts should be prepared on an accruals basis. This means that costs incurred but not paid should be included in the accounts.
  • Service charge accounts should be subject to examination by an independent accountant before issue to lessees. The examination certificate should be attached to the service charge accounts.
  • Service charge monies paid by lessees should be held in a ring fenced bank account. For managing agents this does not mean that each property has to have a designated bank account but the funds for each property must be separately identifiable, as it is a breach of trust for one property to pay the costs of another property.
  • Transactions with a director or Landlord of managing agent should be disclosed. For example if the director is paid for carrying out maintenance work or preparing the service charge accounts.

Reporting on Service Charge Accounts

The guidance provides three types of assignments which may be required by the lease or that may be undertaken if the lease does not provide such guidance.

1. Audit (Appendix 1)

    • The lease may require the service charge accounts to be “audited”. The audit process has evolved over the years, especially since the first auditing standards were first published in 1980. For leases drawn up prior to this date the word audit has much more significant meaning today, than it did then. In this circumstance landlords and managing agents should consider carefully whether another form of examination may be appropriate.
    • To carry out an audit, an auditor must follow International Auditing Standards (UK and Ireland) (ISAs).
    • The ISAs set rigorous procedures and standards to follow in terms of planning, conducting, and recording of the audit work, therefore enabling the auditor to provide an opinion that the accounts are free from material misstatement. An audit is therefore a lengthy process.
    • An audit report provides a high level of assurance on the service charge accounts to the end user.
    • The time needed to complete an audit is much greater than the other types of verification assignments, and the fee will be higher.
    • The managing agent may decide to contract another type of examination. However any change from the lease has to be approved by the lessees.
    • An audit must be carried out by a registered auditor.
    • If an audit is required, International Standard on Auditing 800, “Special Considerations Audit of Special Purpose Financial Statements” provides a framework for the audit of service charge accounts.

2. Report on factual findings (Appendix 2)

    • Where an audit of the service charge expenditure is not carried out. The ICAEW Technical Release refers this as a report of factual findings.
    • The examination procedures carried out are listed in the report that is issued by the accountant. The Technical Release provides a minimum set of procedures that can be performed, but these can be tailored according to the to the managing agent's requirements, or to the circumstances of the property.
    • This report provides comfort that the items listed in the report have been checked, by describing the accountant's factual findings. No opinion is provided on matters of judgement.
    • The procedures are much more limited compared to that of an audit and do not require the same degree of professional judgement. Therefore the cost of this type of report is generally lower than if an audit was required.
    • The report need not be issued by a registered auditor, but must be issued by a qualified accountant who is independent of the managing agent.

3. Deciding between an audit and report of factual findings

    • An audit provides a considerably higher level of assurance than a report of factual findings.
    • An audit will be significantly more expensive than a report of findings. For small residential blocks it is unlikely that the additional cost can be justified. For large blocks the additional cost to the service charge for each additional lease holder may only be marginal.
    • Where the management of a residential block has been outsourced to a managing agent and the managing agent also undertakes the accounting, the “need” for an audit would be greater to ensure the necessary accountability of the managing agent.

4. Reporting under section 21, Landlord and Tenant Act 1985 (Appendix 3)

    • The Lessees may require a summary of relevant costs to be prepared in accordance with the provisions of S21 LTA 1985.
    • The work carried out by the reporting accountants is to ensure that the service charge statement is a fair summary of the costs.
    • The report under section 21 must be prepared by a registered auditor.

 

Reports on service charge accounts

Appendix 1: Illustrative audit report (In accordance with ISA 800)

 
Independent auditors report to the managing agent of [property]

We have audited the accompanying service charge accounts for [property] for the [year]/[period] ended [date], which comprise the statement of service charge income and expenditure account, balance sheet as at [date], and related notes. The accounts have been prepared in accordance with the accounting policies set out in Note 1 to the accounts.

This report is made solely to the managing agent. Our audit work has been undertaken so that we might state to the managing agent those matters that we are required to state to them in the Auditor's Report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the managing agent for our audit work, for this report and for the opinions we have performed.

Managing agent's responsibility for the accounts

The managing agent is responsible for the preparation of these accounts in accordance with the terms of the lease(s), and for such internal control as the managing agent determines is necessary to enable the preparation of accounts that are free from material misstatement, whether due to fraud or error.

Auditor's responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing (UK and Ireland). Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgement, including the assessment of the risks of material misstatement of the accounts, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the preparation of the accounts in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the internal controls. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made, as well as evaluating the overall presentation of the accounts.

Opinion

In our opinion, the service charge accounts of [property] for the year ended [date] are prepared, in all material respects, in accordance with the accounting policies set out in Note 1 to the accounts.

Basis of accounting and restriction on distribution and use

Without modifying our opinion, we draw attention to Note 1 to the accounts which describe the basis of accounting. Our report has been prepared pursuant to the terms of our engagement letter and for no other purpose. No person is entitled to rely on this report unless such a person is a person entitled to rely upon this report by virtue of our engagement letter or has been expressly authorised to do so by our prior written consent. Save as above, we do not accept responsibility for this report to any other person or for any other purpose and we hereby expressly disclaim any and all such liability.

PKF Littlejohn LLP
Chartered Accountants and Registered Auditors
1 Westferry Circus
Canary Wharf
London E14 4HD

Date:

 

Appendix 2: Illustrative clean report of factual findings

 
Independent report of factual findings to the managing agent of [property]

You have stated that an audit of the service charge accounts in accordance with International Standards on Auditing (UK and Ireland) is not required under the terms of the lease(s) for [property]. In accordance with our engagement letter dated [date], we have performed the procedures agreed with you and listed below with respect to the service charge accounts set out on pages … to … in respect of [property] for the year ended [date], in order to provide a report of factual findings about the service charge accounts that you have issued.

This report is made to the managing agent for issue with the service charge accounts in accordance with the terms of our engagement. Our work has been undertaken to enable us to make this report to the managing agent and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the managing agent for our work or for this report.

Basis of report

Our work was carried out having regard to TECH 03/11 Residential Service Charge Accounts published jointly by the professional accountancy bodies with ARMA and RICS. In summary, the procedures we carried out with respect to the service charge accounts were:

  1. We obtained the service charge accounts and checked whether the figures in the accounts were extracted correctly from the accounting records maintained by or on behalf of the managing agent;
  2. We checked, based on a sample, whether entries in the accounting records were supported by receipts, other documentation or evidence that we inspected; and
  3. We checked whether the balance of service charge monies for this property shown on page xx of the service charge accounts agreed or reconciled to the bank statement(s) for the account(s) in which the funds are held.

Because the above procedures do not constitute either an audit or a review made in accordance with International Standards on Auditing (UK and Ireland) or the International Standard on Review Engagements, we do not express any assurance on the service charge accounts other than in making the factual statements set out below.

Had we performed additional procedures or had we performed an audit or review of the accounts in accordance with International Standards on Auditing (UK and Ireland) or International Standards on Review Engagements, other matters might have come to our attention that would have been reported to you.

Report of factual findings:

(a) With respect to item 1 we found the figures in the service charge accounts to have been extracted correctly from the  accounting records;

(b) With respect to item 2 we found that those entries in the accounting records that we checked were supported by receipts, other documentation or evidence that we inspected.

(c) With respect to item 3, we found that the balance of service charge monies shown on page xx of the service charge accounts agrees or reconciles to the bank statements for the account(s) in which the funds are held.

PKF Littlejohn LLP
Chartered Accountants and Registered Auditors
1 Westferry Circus
Canary Wharf
London E14 4HD

Date:

 

Appendix 3: Illustrative report under Section 21, Landlord and Tenant Act 1985

 
Independent accountant's report to the managing agent of [property]

In accordance with our engagement letter dated [date], we have examined the service charge statement of accounts set out on pages … to … in respect of [property] for the year ended (date) together with the books and records maintained by managing agent in so far as they relate to (property).

This report is made to the managing agent for issue with the service charge statement in accordance with section 21 of the Landlord and Tenant Act 1985. Our work has been undertaken to enable us to make this report to the managing agent and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the managing agent for our work or for this report.

Under the terms of this engagement we are not required to, and did not form any opinion as to either the reasonableness of the costs included within the service charge statement or the standard of the services or works provided.

Respective responsibilities of the managing agent and Independent Accountant

Under the Landlord and Tenant Act 1985. the managing agent is responsible for the preparation of this service charge statement in respect of the costs of [property]. The managing agent has taken responsibility for the preparation of the service charge statement on behalf of the landlord. It is our responsibility to form an independent opinion based on our examination, on the service charge statement and to report our opinion to the managing agent.

Basis of opinion

We planned and performed our examination so as to obtain all information and explanations that we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the service charge statement is a fair summary of the costs relating to [property] and is sufficiently supported by receipts and other documents which have been made available to us.

Certificate

We certify that:

(a) In our opinion the service charge statement is a fair summary complying with the requirements of section 21 (5) of the Landlord and Tenant Act 1985.

(b) The summary is sufficiently supported by receipts and other documents which have been produced to me.

PKF Littlejohn LLP
Chartered Accountants and Registered Auditors
1 Westferry Circus
Canary Wharf
London E14 4HD

Date:

 

This guide covers topics only in general terms and is intended to give a wide audience an outline understanding of issues relating to accounting applicable to entities in general, and therefore cannot be relied upon to cover specific situations; applications of the principles would depend on the particular circumstances involved. We recommend that you obtain professional advice before acting, or refraining from acting, on any of the contents. We would be pleased to advise you on the application of the principles demonstrated in the guide, or on any other matters, to your specific circumstances, but in the absence of such specific advice, we cannot be responsible or held liable.