Recent changes in accounting standards are likely to hit the cashflows of many law firms. Unless they take action, some practices could face severe financial difficulties. The problem is that many partners are going to face a one-off additional tax charge and will have to find ways to fund this. At the very least, these developments will affect the way firms do business and the relationships between partners.
These changes have been brought about by a recent amendment to Financial Reporting Standard 5 (FRS5), which affects the way in which revenue is recognised for tax purposes, whether or not the firm’s accounts reflect this standard. Historically, work-in-progress (WIP) has been accounted for at a relatively low figure, generally based on the cost of fee-earning staff and associated overheads, and excluding profit elements as well as equity partner time. In future, revenue will need to be accounted for based on a ‘right to consideration’ at the balance sheet date. In many cases, this is likely to be a figure closer to selling value rather than cost. The difference will be subject to a ‘revenue recognition charge’ to tax. Those organisations that have incorporated or become limited-liability partnerships do not escape. The new rules will impact on virtually all professional practices, irrespective of their size or legal status.
Among the firms that will be worst affected may be those that undertake a significant amount of legal aid work. As many practitioners know to their cost, there can be a very considerable timespan between carrying out the work and eventually receiving payment. It will be most ironic for such firms to be hit by an additional charge, and thus need to contribute to public funds based upon income due to them that has not yet been paid out of public funds. This may exacerbate the trend for law firms to give up legally-aided work.
However, if enough people complain about the effects of this development, there is a chance – and it is just a chance – that the Inland Revenue might be persuaded to review its approach. At a workshop held by the Association of Partnership Practitioners on 26 January, the problem was debated and closed with a call for professional firms to make representations to the Inland Revenue to explain why the tax cost should be spread over a number of years.
Friday 13 February 2004 is the deadline to voice your opinion on the impact of FRS5 to the Inland Revenue. Representations should go to: David Harris, Revenue Policy, Business Tax, 4th and 5th Floor, Kingsway, London WC2B 6NR, or email mailto:David.Harris@ir.gsi.gov.uk.
This may feel like déjà vu, as many will recall the introduction of the ‘catch-up charge’ in 1998. After some 600 representations, including 350 from barristers and Scottish advocates, the Inland Revenue allowed firms to spread the cost of the ‘catch-up charge’ over 10 years, which many are still paying. The Inland Revenue has not yet agreed to such a concession regarding the ‘revenue recognition charge’, even though its impact could be more severe.
The liability, if there is one, also seems to fall unfairly, as it would be split according to the profit-sharing arrangements of the previous accounting period, even though some partners may have left or had their profit shares reduced. Firms will need to consider what arrangements to put in place to deal with this equitably.
In my view, though, firms should argue for the Inland Revenue to relax its position and they should also review how they will manage the liability, whether or not it is payable in instalments. The first step will be to estimate the amount, and thus the size, of the tax charge. Professional assistance may be needed for this calculation.
Each firm’s position is different, but essential advice for maintaining cashflow includes keeping WIP to a minimum. Where appropriate, thought should be given to billing clients earlier and more regularly to improve cashflow. Some firms or partners will need to negotiate additional flexibility with their bankers – and discussions may need to start sooner rather than later.