Taking control of spending
6 June 1995
After property, a computer system continues to be the single biggest purchase that a law firm makes. Careful appraisal and financial planning are vital when making IT purchases in order to check whether the product is suitable, feasible and acceptable.
Does the proposed purchase fit in with the firm's business strategy? If the strategy is to streamline fee earner work by exploiting computer systems, using technology is essential. But if the firm's strategy is simply to maintain existing fee levels and no more, existing systems may be adequate. The IT strategy should be a reflection of the business strategy to avoid 'techno spend' with no identified business gain.
Given the approximate costs involved, is the firm going to be able to afford a major systems purchase? Alternatively, is it feasible to continue without buying new systems? As they grow old existing systems may become expensive to maintain.
Is the firm looking for the systems purchase to prove itself in strict cost-benefit terms? If it cannot do this, it may not be acceptable. Once the decision has been made to purchase, financial planning needs to take place alongside sourcing the purchase to ensure that the project does not fall at the first financial hurdle.
It is a mistake to treat the supplier's quotation as the final word on the cost of a computer system. Quite apart from the hardware and software which the quotation describes, what will be the cost of installation, training and on-going maintenance? It may not be possible to obtain finance for all these outgoings, but they should be considered when projecting the financial implications of the system purchase.
Computer maintenance can be prepaid for several years in advance, with a corresponding saving in nominal cost. It may be useful to bundle the maintenance costs with all the other elements for finance purposes.
A cash purchase may be appropriate if the firm is cash-rich. However, are the partners happy for the firm's cash to be invested in computer systems rather than distributed to them in the form of drawings? They might argue that they will be able to obtain a better return from the cash as private individuals than as a firm by investing in computer systems.
Hire purchase gives the firm full title to the equipment at the end of the hire purchase term. However, it goes on to the balance sheet from the date on which it is brought into service, together with a corresponding liability for the debt under the hire purchase agreement. The rates of interest payable by the firm would be broadly similar to those payable on the firm's general borrowing. Lenders do not place a high value on computer equipment as security for borrowing. Instead, they will look at the firm's capital base and its trading record.
Leasing differs from hire purchase in that the lender retains title to the equipment. This keeps the liability for the equipment off the balance sheet. While companies are now compelled by accounting standards to show what are termed finance leases, firms of solicitors, as unincorporated bodies, are not under this obligation. The cost of leasing costs are broadly similar to other forms of finance.
With outright purchase or hire purchase, the tax deduction for the purchase is obtained by the partnership via a 25 per cent annual allowance on the written down balance of the system cost. The effect of this is that the allowance dwindles in value each year and full tax relief is only obtained when the system is sold or scrapped. On the other hand, lease rentals can be charged in their entirety against profits in the year they are charged. Normally this makes leasing a more attractive option than hire purchase for tax purposes.
However, any benefit from leasing is currently offset by the transition to a current year basis of assessment for tax from a prior year basis. To avoid one year dropping out of the tax calculations, there is an averaging calculation for the transitional year of 1996/7. This means that tax relief of only 50 per cent is obtained on deductions from income in the two years which go to make up the tax calculation for the transitional year. Lease rentals lose 50 per cent of their value for tax purposes, whereas written down allowances do not.
Who will provide finance?
The firm's existing bankers may be prepared to finance the purchase by way of a medium-term loan, provided this does not take the firm's borrowings above an acceptable level.
There are numerous specialist asset finance houses, many of them offshoots of the clearing banks. Although the rates are not significantly different, they are likely to be more flexible; whereas a bank may only finance a computer system as part of an overall banking arrangement, the specialist finance houses will finance individual pieces of equipment. Computer suppliers also arrange financing for the equipment they sell. It pays to explore a range of options.
The cost of computer systems will continue to fall and the need to upgrade will arise more frequently and eventually systems purchases will become routine. But currently most systems purchases take a major chunk out of the firm's capital and require careful planning.
John Irving and Mark Green are consultants with the professional practices unit, BDO Stoy Hayward Management.