Prepare for work in progress tax

Firms must begin to plan ahead now if they want to avoid getting caught in the tax trap warns Anne Gregory-Jones. Anne Gregory-Jones is a tax partner at Kidsons Impey.

The authorisation by the Treasury to the Inland Revenue for the withdrawal of the cash basis method of accounting favoured by many professional practices and barristers, looks set to be one of the most far-reaching changes to affect professional practices for years.

One wonders how long it took for the implications to sink in – the announcement coming, as it did, just days before Christmas. No doubt it passed many by until the festivities were over – not a pleasant way to start a new year.

The outcry that came once the realisation hit home led to extensive lobbying which, to a certain extent, has paid off. While solicitors and barristers are still going to feel its effect, the Chancellor's budget, last March, introduced some major changes to the original proposals. Gordon Brown announced that the withdrawal of the cash basis system would be delayed and that the first accounting periods to be affected will be those ending in 2000-2001 – effectively giving practices a year's grace to plan for the changes.

Additionally, the “catch up charge”, which would have caused the most damage for these partnerships, can be spread over a 10-year period rather than the three that had initially been indicated, and the annual charge cannot be more than 10 per cent of profits, except in the last year. As this change will be treated as a Schedule D Case VI receipt, it will not be liable to Class 4 National Insurance. It will, however, qualify as net relevant earnings for pension purposes.

Despite postponement of the move from one system to another, practices will need to address the issues sooner rather than later. They must take advantage of the year in hand to minimise the impact of the change as far as possible.

The legal profession has had an advantage over other businesses in being able to apply a cash basis system and the changes being introduced are to bring professions in line with other taxpayers. The normal, or conventional way of preparing accounts involves the application of accounting standards, so that for earnings, income is recognised when it is earned, not when it is received, and for accruals, expenses are recognised when they are incurred, rather than when they are invoiced, or paid.

The cash basis system favoured by solicitors and barristers and which has been allowed by the Inland Revenue, accounts for income when it is received, and expenditure when it is paid. It ignores work which has been invoiced, but for which the money has not been received, as well as work which has been completed, but not invoiced. Further, it ignores expenditure incurred but not invoiced, and expenditure invoiced but not paid.

A hybrid system has also been allowed by the Inland Revenue which includes debtors and creditors, but ignores work in progress.

Of course, for a number of professional practices there can be a significant time lag from when client work is undertaken, and when it is finally billed, and this is particularly the case for legal aid. This discrepancy can be anything from three to six months, or even longer – for legal aid cases, up to a year is not unusual. The change from a cash to an earnings basis may well, therefore, have serious implications for the stability of a firm's cashflow, particularly for firms with a significant amount of this type of work.

It is accounting for, or valuing work in progress that, when switching from a cash to a conventional basis of accounting, is going to be the major headache and which is leading to fears that large numbers of professionals will see their business in difficulty. The changeover will mean a sudden windfall profit which will increase the tax liability, despite the extended period in which to pay.

Barristers in particular will have problems with this, although they have been given some respite by the Chancellor in that newly practising barristers will have seven years before they have to move from the cash to the earnings basis.

The original indications were that work in progress would have to be valued by applying accounting standards issued by the Accounting Standards Board. Many thought this would necessitate an audit of the accounts. However, the Inland Revenue has confirmed that there is no requirement for an audit. It has also confirmed that the accounts do not need to be drawn up on any particular basis provided that appropriate adjustments are made to convert the profits to an earnings basis in the tax computations. This, at least, will allay concerns regarding increased professional fees.

What is the valuing of work in progress going to mean?

Government documents state that stock and work in progress should be valued at the “lower of cost or net realisable value”. This means that you must take into account the client cost of staff and overheads. This may well be complicated when you will, no doubt, have a mix of partner and fee earner time, billed at different rates and you may not know how much of one, or the other's time, the job will ultimately take.

You will also need to consider questions such as the average number of weeks of work in progress, how to calculate the cost of unbilled work, how much is counted as partner time? As you can see from the tables, the effect is dramatic.

So what actions do you need to consider in the ensuing year:

Scrutinise your system for valuing your work in progress.

Are your systems recording work in progress satisfactorily?

How are you accounting for partners' time?

Bill out for work in progress.

It will be advantageous under the new system to bill frequently and keep work in progress to a minimum.

Does this mean a culture change? If so, how will you manage it?

Can your systems cope?

Does your current time ledger system ensure billed time and unbillable time is regularly written off?

Can you eliminate partner time from your work in progress costs?

What are your systems for reviewing debtors?

Do you regularly write off bad and doubtful debts?

The effect on partners' capital accounts.

Those solicitors who are going to be hit by the move to tax on a conventional basis rather than a cash basis must look at the issue now and take professional advice to ensure that the effect is minimised as far as possible. Be thankful for the extended 10-year period and make the most of the year's reprieve by totally reviewing the way you run your business and you never know, your biggest worry in the year 2000 may be the Millennium Bug, not your tax bill and accounting methods.