6 February 2006
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The decision of whether to convert to a limited-liability partnership (LLP) has become much more difficult now that there is the added choice of whether to prepare the LLP's financial statements in accordance with UK accounting standards or under International Financial Reporting Standards (IFRS). In the UK, IFRS is only mandatory for the group accounts of companies listed on the London Stock Exchange, but company law allows any other company or LLP to adopt IFRS for accounts where the first day of the accounting period is on or after 1 January 2005.
So is there any reason why law firms will want to consider using IFRS? The reasons may not be linked exclusively to the numbers. Those firms with extensive European or global alliances may want to harmonise the basis of preparation and IFRS provides that opportunity. Those very large firms with a vast blue-chip corporate client base may feel encouraged to 'empathise' with their clients and take the IFRS plunge. When push comes to shove, though, the numbers will matter; so what difference will applying IFRS make?
Acquisitions and mergers
When practices join together, in the UK these have traditionally often been referred to as 'mergers'. The concept of a merger under IFRS, however, does not really exist - one party will always need to be regarded as the 'acquirer'. The accounting will require the acquirer to identify what assets and liabilities the acquired practice has and to account for the difference between what it is paying for the practice and the assets and liabilities it is taking on - the difference is known as 'goodwill'. Under IFRS, goodwill arising from a business combination is treated as an asset on the balance sheet and is not written off unless there is evidence that the goodwill acquired has dropped in value. Although this will strengthen the balance sheet, there can be problems of equity between partners when goodwill needs to be written off against profit.
Another complication is that the assets that are acquired will include what are known as 'intangible assets' as well as those that are 'tangible', such as cash, debtors, fixed assets and work in progress. For a professional services firm, such an intangible might include the client list that is acquired, and this will need to be valued. But what value do you place on a client list? It could be the expected fees that will recur, but there will be plenty of unknowns and subjective judgements that will make the valuation difficult.
When a practice takes on a lease of a building, it will have to separate the lease of land and the lease of the building into separate components. Given that leases are generally not written in those terms, again, this could pose difficulties. When this is done, if the present value of the lease payments in respect of the building is substantially the value of the building, then it may need to be accounted for as a finance lease rather than an operating lease. Accordingly, the building will be capitalised as a fixed asset and the remaining amounts payable under the lease will be accounted for as a creditor.
Where employees are entitled to carry forward unused holiday, or the practice's holiday year does not coincide with financial year-end, there will need to be a provision for the cost of the holiday that has not been taken. Although encouraged under UK accounting standards where significant, it is rarely seen in professional firms. Under IFRS the requirement is clear. For example, XYZ LLP has a year-end of 31 March 2006, but the holiday year is the calendar year. Employee P is entitled to 25 days of holiday and at the end of March 2006 has taken five days since 1 January 2006. In the equivalent period the year before, P had taken eight days. In the financial year ended 31 March 2006, P should have taken 25 days of holiday, but would in fact have taken 22 - the remaining 17 for 2005 plus the five already taken in 2006. Accordingly, the firm will need to make a provision for the cost of the difference between the holiday entitlement and the actual holiday taken.
A practical difficulty for firms might be to locate and collate the holiday records themselves. After all, these may not be managed centrally but might be dealt with on a department basis.
First time adoption of IFRS
In the first year that a firm prepares accounts under IFRS, it not only has to restate its opening position, but also has to restate its position at the beginning of the previous year to enable prior year comparatives to be presented on a consistent basis.
For example, if XYZ LLP decided to adopt IFRS for the year ending 31 March 2006, it will have to restate the position as at 1 April 2004. It may be a challenge to locate all the information that is needed to be able to prepare that opening position. The problems of locating the holiday records mentioned above might be compounded by the fact that they may not be retained after the completion of a holiday year.
These are not the only differences between UK accounting standards and IFRS. Indeed, this overview has not touched on accounting for defined benefit pension schemes, where the IFRS equivalent may provide a more palatable treatment than that required under the UK's Financial Reporting Standard 17.
The accounting regime in the UK is currently on a harmonisation programme with the international equivalents. Any new accounting standards in the UK are consistent with the IFRS equivalent. Within the next few years it may be that there are hardly any differences between UK standards and IFRS.
The adoption of IFRS at this stage may make sense for many reasons, both commercial and financial, but it is not a decision that should be taken quickly or without examining all the potential ramifications. It is a process that requires careful planning and not an inconsiderable amount of time. After all, under company law, it is essentially a choice made once and once only.
There is a saying, 'err in haste, repent at leisure', but if you IFRS in haste, there may be many in the finance department with no leisure at all.
Steve Gale is a partner at business and accountancy advisers Horwath Clark Whitehill