Service charges and year end accounts

What is a service charge? What are annual accounts? Why do I need a certificate of expenditure? And why does it all take so long?

We hear a lot of complaints about fairly basic financial information, and in most cases it should be easily answered or simply explained – hopefully we can help answer some more common questions below:

What are service charges?

A requirement of communal living is that someone needs to take responsibility for the shared ‘common parts’ of a building or estate. How can you ensure that every flat arranges individual property insurance, or that someone will take ownership to arrange roof repairs or communal cleaning? The answer, in parts of the UK at least, has been the leasehold system. One entity owns the freehold (the land on which all the properties sit) and then leases (rents) the flats to individual leaseholders. The freeholder ‘retains’ common parts and areas that are not demised.* The same applies for a housing estate, where individual houses will have their own freehold but an estate freeholder will own the roads, communal grounds and play areas.

So how does the freeholder arrange all this work? Well, glossing over the technicalities of freeholders, management companies and right to manage, in most cases a managing agent will be appointed (like us). This agent acts for their client (e.g. freeholder or management company) to carry out the day-to-day tasks and obligations, such as arranging buildings insurance, setting up electricity supplies, arranging gardening contracts or scheduling cleaning.

Setting budgets

The first stage in terms of the financial year, is setting and distributing a budget. This is an estimate, based on market rates, quotes, costs at similar developments, experience and knowledge of potential upcoming works.

This budget allows the agent requests funds on account (in advance) from all property owners. The agent can then send out demands** for payment. The payment terms will be set out in your lease, for instance annually in advance on 1st January. Note that while service charges must always be reasonable, this doesn’t always mean the cheapest and particularly in the budget, it is generally considered good practice to include a buffer to help to allow a little extra for unknown costs.

Fast forward to the end of the financial year, and the lease generally requires a certificate of expenditure to show what has been spent. This certificate will do one of three things: show money left over for the year (a surplus), show the budget was accurate and leaves a nil balance, or show that more has been spent than was collected in the budget (deficit).

Resolving end of year balances

We can see from there being an estimate at the start of the year, and the certification at the end, that service charges can change throughout the year due to the unpredictable nature of expenditure, unplanned works or reactive maintenance. While this can result in a surplus where owners will be credited money back, most often it leads to a deficit (there are more unpredictable costs than unexpected savings). As such, it is important for agents to keep costs as low as possible throughout the year, but also to be realistic and sometimes generous in their initial budgets to minimise deficits later.

While you might expect technology nowadays to allow a report like this a couple of days after the year end, in practice this certificate often requires an external accountant to review all the figures and produce the year end accounts. This takes into account not only funds received and invoices paid, but any arrears, accruals or prepayments as well as any capital depreciation or other financial factors.

The 18 month rule

Section 20b of the Landlord and Tenant Act 1985 (as amended), known in the industry as the ‘18 month rule’, provides that accounts should be distributed to all owners within 18 months of being incurred- I.e. within 6 the financial year end. This should be accompanied by an explanation as to how the balance will be dealt with e.g. a surplus paid back to each owner or credited to their account, or a deficit being billed to each owner. Because of this 6 month time limit, most agents will aim to get year end accounts sent within about 4 months of the year end.

As always there is a range of legislation which affects the processes and progress for each individual property, and as ever the key document is the lease / transfer agreement. This is a very broad overview of the financial life cycle for service charges, if you have any doubts or queries about time frame, costs or process then it is often best to simply contact your agent for an explanation, or our team would be happy to discuss any general concerns you might have.

Notes

*Your lease will ‘demise’ ownership of the property to you, meaning it will specify exactly what you own in the contract. A common point is windows – if your windows are demised, it means you are responsible for repair and maintenance of those windows, and if not, the freeholder or management company will look after them.

**Demand can sound very formal and almost threatening, however it is the official term for the bill sent for service charges. Because service charges are variable, it is not technically an invoice and the correct term (used throughout the legislation) is therefore a ‘demand’.