The financial statements of residential management companies (RMCs) have come under the spotlight this year. A technical release from ICAEW in 2011 (Tech 03/11) and a more recent draft abstract from the Urgent Issues Task Force (UITF) have stimulated accountants, standard-setters and technical experts into trying to resolve a long-standing debate: what information should appear in the RMC’s accounts? Do they show all their income and expenses, or are they just holding money in trust? Different views on this have led to a diversity of practice.
John Boulton, corporate reporting manager with ICAEW’s Financial Reporting Faculty, says ICAEW has been working to bring clarity to the issue. “Tech 03/11 provides best practice guidance for service charge accounts where these are prepared independently. But a number of questions remain regarding the transactions that should properly be included in RMCs’ statutory accounts. The UITF abstract attempts to resolve this issue,” he says.
The standard-setter’s interest stems from a question about service charge money held by RMCs. Legally the money is trust money, Boulton says, whether it is held in a ring-fenced designated bank account or not. As it is collected from leaseholders or joint freeholders, the question is whether it should be included as an asset in the statutory accounts of the RMCs. Without this cash or any of the service charge transactions the accounts might effectively be dormant.
The issue for many of those paying service charges to RMCs, as well as for practising accountants, is that this approach does not present information users want to see. It does not meet the need for a transparent, workable set of accounts that can be understood by lay people, such as those who pay service charges to RMCs.
Peter Hollis, partner at Hollis & Co, acts for several RMCs and has seen a good deal of interest in this issue.
“If you live in a flat where the freehold is managed by an RMC you are generally concerned to learn how your money has been used. Accounts need to tell a story people can relate to. You need to be satisfied money is properly spent and whether any is left in the bank for future maintenance or improvements. Tenants or landlords must be able to look at these documents knowing they tell a credible story.”
The issue for accountants is that RMCs have the same accounting obligation as any company. But there is a question whether they should recognise any service charge balance as an asset when this cash is held on trust. And the lease is further likely to stipulate the information tenants should receive in service charge accounts. This requirement may not be met by company accounts.
The UITF abstract, information sheet 92, goes some way to alleviate such concerns. It states that accounting practice for RMCs should follow an assessment of whether the RMC is acting as an agent or principal. “The UITF has stripped the previously intractable issues in this area down to the well-established principles of FRS 5,” says Boulton.
“The abstract puts matters along the right lines,” says Hollis. “In the vast majority of cases where the RMC acts as a
principal, money collected from tenants in the form of service charges should be recorded as income and the accounts should not be dormant,” he says.
But Stacy Eden, partner in Crowe Clark Whitehill’s corporate business team, says that by focusing on whether RMCs are acting as principals or agents, the UITF’s draft abstract sets up an either/or course, which doesn’t clarify the situation. “The UITF tried to tidy up the debate but in some respects seems to ignore Tech 03/11, and the resulting abstract talks about risk and reward.”
If the RMC is deemed to be acting as a principal, with responsibility for expenditure and income, it will be able to continue to produce active accounts, show transactions within a P&L account. If it is deemed to be acting as an agent it will need to show a dormant set of accounts, disclosing expenditure via a service charge statement.
The result, says Eden, is unclear. “If accounting policy were to be finalised as currently written [in the UITF abstract], I think we would stick to ICAEW’s draft guidance because it reflects the law. But it would put everyone in a slightly difficult situation.”
Change could bring confusion, says Eden, and custodianship – how these matters are accounted for – is also at issue. “Based on the exposure draft, you would, from a technical point of view, construct a dormant set of accounts with disclosures. People are used to seeing income and expenditure.
“At the moment we’ve got this inconsistency. We should be able to look at any two sets of accounts and be able to compare them. Leaseholders need to be assured that this money is properly stewarded and accounted for.”
The property perspective
Roger Southam, chairman of property management company Chainbow, believes a property perspective is lacking from the financial reporting debate. For financial reporting, RMCs should be treated as dormant for trading and transactional purposes, says Southam. “The service charge doesn’t belong to the company.”
But many RMCs treat the service charge as company money. Some public companies class service charge money as turnover, which might enhance their figures. They could also be paying out on audit and other accounting fees.
“There is no consensus or standard as to how the service charge is treated,” says Southam.
Along with a willingness to look at this from a property perspective, he says, a fairly hefty dose of political will must be shown to adjust the company law and tax positions. “RMCs have to have AGMs once a year. Company law could be adjusted with a very simple provision so that leaseholders are protected from maverick directors and directors are protected from maverick leaseholders,” says Southam.
There is long-standing confusion over the ownership of service charge monies paid by leaseholders or tenants and stewarded by RMCs. There are, Southam says, two distinct issues linked to the accountability of these kinds of companies – one involves company law, the other is around financial reporting. For company law issues, RMCs are easy to identify.
“It would be pretty easy to put a clause into the Companies Act to remove them from consideration when it comes to company law requirements,” says Southam, although others point out that these reporting requirements are set out in the EU’s 4th Directive and as such are not in the gift of the UK government.
“For instance, you don’t have to have AGMs for small companies. That’s something some RMCs take advantage of. But in fact it’s very useful and quite important for leaseholders to be able to have AGMs,” he says.
For the UITF’s measures to smooth out the anomalies, Hollis – also chairman of ICAEW’s Practice Committee – does not agree with the legal view that any cash surplus doesn’t belong to the company.
“To most tenants this will be a complete nonsense,” he says. “A lot of these requirements are based on the landlords and tenants legislation, which is designed to protect tenants from abuse. According to the legislation, when you raise a charge you hold the monies on trust.”
“That is correct,” says Hollis. “But that is no different to the position of a charity that holds money on trust until it needs to defray it. Despite being held for the benefit of others, the money still belongs to the charity.
John Boulton, corporate reporting manager at the Financial Reporting Faculty, says ICAeW has worked hard to bring clarity to this area to ensure people have the information they need, but adds there is a lot of complexity. The key, he says, is to understand what users want. Leaseholders and shareholders, not always the same group, have a right to receive information on income and expenditure, so it is important that right is upheld.
“ICAEW has issued an exposure draft offering guidance on the information that should go into service charge accounts when they’re prepared. What isn’t clear from the guidance is what needs to be done to meet Companies Act accounting requirements. It’s essential that members know how the reporting obligations of the rmC can best be discharged while meeting the information needs of users,” he says.
“We know what accounting treatment should be followed if you are an agent or a principal. the key to cracking this is to get clarity on the context in which these companies are acting.”