SERVICE CHARGE ACCOUNTS

What are service charge accounts?

Service charge accounts are the statement or statements typically prepared and issued annually to leaseholders by the landlord or manager to account for actual service charge income and expenditure. They are commonly referred to as accounts and legislation uses the term ‘summary of relevant costs’. The lease will usually set out how service charges should be accounted for, the costs that can be recovered and the period of time the accounts should cover.

What are relevant costs?

Leaseholders have the legal right to request and obtain a summary of relevant costs which are defined by Section 18 (2) of the Landlord and Tenant Act (LTA) 1985 as ‘the costs or estimated costs incurred or to be incurred by or on behalf of the landlord, or a superior landlord, in connection with the matters for which the service charges is payable’. Section 18(3) of the LTA also says that ‘(a) ‘costs’ includes overheads, and (b) ‘costs’ are relevant costs in relation to a service charge whether they are incurred, or to be incurred, in the period for which the service charge is payable or in an earlier or later period’.

What are interim charges?

Most leases allow the landlord or manager to make an interim charge based on estimated costs at the beginning of a service charge year so that funds are available throughout the year for expected day-to-day expenditure. This interim charge may also include an annual contribution to a reserve fund. Although it is not a legal obligation it is widely regarded as good practice for landlords and managers to produce a service charge budget and consult with leaseholders about the amount of interim service charge payments.

What is the service charge budget?

A service charge budget is a forecast of the anticipated expenditure for the coming year. The budgeting process usually takes place several months before each accounting year begins therefore the landlord will not have the certified accounts for the current year. This means that most budget forecasts will provide a comparison between the previous year’s budget and the previous year’s accounts showing actual expenditure and the proposed budget. Nevertheless a prudent manager should take the current year’s expenditure into account and make budget adjustments accordingly.

Is there a standard format for service charge accounts?

There is no recognised standard format or accounting framework for the service charge statement specified in any legislation. Although Section 21(5) of the LTA 1985 sets out the requirements for a summary of costs that need to be prepared in accordance with a request made by a leaseholder under Section 21(1) of the LTA, the requirements do not correspond with accruals based accounting and there is no requirement for any type of balance sheet.

This Institute of Chartered Accountants in England and Wales (ICAEW) guidance recommends that service charge accounts are prepared on an accruals basis and should include:

an income and expenditure account;
a balance sheet for the service charge funds; and
explanatory notes.

Although this may be good accounting practice it can create practical problems and misunderstandings, as most leases and relevant legislation seem to presume a cash basis of accounting.

Income, expenditure and surplus

As the name suggests the income and expenditure account shows money owing from service charges and monies owed for expenses. The surplus is the difference between the total income received or receivable and the total actual expenditure. The lease will often state what the manager should do in respect of a surplus or deficit.

It is unlikely that the income receivable and the total expenditure would ever be exactly the same although this can be achieved as an accounting procedure by retrospectively adjusting the amount that is transferred to the reserve fund if applicable. However, where a deficit arises, it is not always good practice to decrease the annual contribution to the reserve fund as it may result in a shortfall of funds available for cyclical maintenance.

Furthermore, it should be noted that when the figures in the income and expenditure account are presented on an accruals basis as opposed to a cash basis the account will show the total amount of service charges demanded, not the actual funds received. This corresponds to the estimated annual income that would have appeared in the budget prior to the accounting year. One anomaly with this system is that even though the income and expenditure account may show a ‘paper’ surplus, if there are service charge arrears it will result in a cash deficit and it is extremely rare for leases or codes of practice to explain how managers should deal with this real shortfall in funds when the accounts show a surplus.

The contents of the account will vary according to the services required by the lease and other factors such as an annual contribution to a reserve fund where applicable. The account will usually show expenditure in two columns of figures, one representing the current year and another representing the previous year for comparison. A third column showing the sums budgeted may also be included.

All items of expenditure will be shown inclusive of VAT, which cannot be recovered on residential expenditure although the VAT on utility supplies such as electricity should be subject to the lower rate of VAT for domestic supplies.

Right to Manage Companies and Resident Management Companies

Where a Right To Manage Company (RTMC) or Resident Management Company (RMC) has the responsibilities of a landlord, the service charges including any reserve funds are still subject to a statutory trust. As these funds do not belong to the RMC or RTMC they should be ring-fenced and not used for any other purpose or included as company assets in the accounts of the RMC or RTMC. The presentation of service charge accounts by an RMC or RTMC has been the subject of much debate among professionals and further guidance from the ICAEW is expected. The LA favours separate RMC or RTMC company accounts (which in most cases will be dormant) and the production of separate service charge accounts as this best protects the rights of individual leaseholders under landlord and tenant legislation.

Reserve Funds

The term ‘Reserve Fund’ and ‘Reserves’ are often confused. A Reserve Fund is a specific fund of monies set aside for future expenditure, usually for major building repairs and maintenance. It should be represented in cash or in a form that can readily be converted into cash in an emergency. Reserves on the other hand, represents the total assets of the estate, which usually includes monies owned in the form of debtors and is not immediately available as cash. Landlords and managers should provide a separate annual account showing the movement of monies in and out of the Reserve Fund and the Reserve Fund balance.

As a matter of good practice the annual accounts should show the following:

The balance in the Reserve Fund at the start of the accounting year;
the amount that was transferred to the Reserve Fund from the annual service charge or if the lease allows it, sums collected at the time of re-sale;
any sums that were withdrawn from the Reserve Fund to meet the costs of major works;
any additional sums such as supervision fees withdrawn from the Reserve Fund;
any interest that has accrued in that annual accounting period; and
the balance in the Reserve Fund at the end of the accounting year.

Please see the LA information sheet 101 Glossary for a precise explanation of the terms used in this information sheet. Although service charge accounting is a complex process there is a great deal of good practice guidance in addition to the protection leaseholders are given by legislation and the terms of their lease. The government approved codes of practice such as those produced by The Royal Institution of Chartered Surveyors (RICS) and the Association of Retirement Housing Managers (ARHM) include good practice guidance on accounting that goes further than what is required by legislation. There is also comprehensive advice and guidance, primarily for managers, provided by the ICAEW which leaseholders may wish to refer to at www.icaew.com

Disclaimer: This is a very general explanation of the subject. Where issues are not governed by statute the information is our opinion or best practice. You are advised to seek professional advice before acting on the guidance contained herein. Whereas The Leaseholder Association endeavours to ensure that published information is correct, it does not warrant its completeness or accuracy. The Leaseholder Association assumes no responsibility or liability for any injury, loss or damage incurred as a result of any use or reliance upon the information and material contained herein.