Most UK law firms are gearing up for their year-ends, typically 31 March or 30 April. More than usual care will be required this year, as firms must adopt the new accounting standards for revenue recognition, if they have not done so already.
Three particular issues have to be addressed. First, how should firms quantify the effect of the new accounting standards? Second, how will any additional profits be dealt with in the accounts of the firm? And third, what is the tax consequence of this?
The ongoing debate surrounding revenue recognition in professional firms – now in its third year – follows changes to the income recognition rules in the UK’s Generally Accepted Accounting Practice (GAAP).
Professional firms are facing potentially large one-off tax bills because changes to UK GAAP require them to recognise income on a ‘fair value earned’ basis depending on the contract or terms of engagement that they have with their clients. This follows the publication of Abstract 40 by the Urgent Issues Task Force (UITF) in March 2005. Abstract 40 restated UK GAAP and redefined the Statement of Standard Accounting Practice 9 (SSAP 9). Where the contract with the client provides for a right to consideration as the contract progresses, UITF 40 requires that revenue must be recognised in the profit and loss account to reflect the firm’s partial performance. Where the right to consideration does not arise until the occurrence of a critical event, revenue is not recognised until that event occurs.
Although these changes are mandatory for accounting periods ending on or after 22 June 2005 (‘the straddling period’), some firms have responded to encouragement contained in UITF 40 and adopted it early.
On adoption, UITF 40 is likely to produce a one-off acceleration of profit recognition because turnover will be increased by the ‘fair value’ of work that previously would have been treated as work in progress. In future, many firms will have no reportable work in progress. For partnerships this could be significant because of the need to recognise the fair value of partner time.
The fair value of contract activity will take account of normal or expected recovery rates. Estimates of fair value may also take account of the stage of completion of the contract at the accounting date.
If fees are contingent, they will not be recognised until the contingency is resolved. If this occurs before the finalisation of the accounts, albeit after the accounting date, the fair value of work completed before the accounting date must be recognised.
Except for genuinely unresolved contingent contracts, unbilled work on service contracts will be disclosed within debtors as ‘amounts recoverable on contracts’. Unresolved contingent contracts will continue to be disclosed as work in progress and stated at the lower of cost and net realisable value, which in some cases could be nil. However, if the greater part of a firm’s work is conducted on a contingent basis, it is likely that relevant costs, or perhaps a percentage thereof based on past experience, will be carried forward as work in progress to match future income.
Approaching the year-end, finance partners are making arrangements to measure revenue in accordance with the requirements of UITF 40. Most are also using this to encourage partners to maximise their billing before the year-end.
The difference between the old SSAP 9 method and the new UITF 40 treatment will give rise to an adjustment. Tax legislation treats the adjustment as arising on the final day of the straddling period. Although the adjustment is treated as relevant earnings, it is not subject to the 1 per cent class for NIC charge. The adjustment is allocated to partners in the profit-sharing ratio of the 12 months prior to the straddling period.
If the firm has decided not to change the basis of revenue recognition in its accounts, which is possible with general partnerships but not limited-liability partnerships, then the adjustment is treated as applying for tax purposes only. Here, the effective rate of tax suffered by partners could cause difficulties where the adjustment is significant.
If a firm recognises additional income in its accounts, it may decide to restrict the ability of partners to draw down profits, perhaps limiting this to amounts sufficient only to cover the corresponding additional tax liabilities. The balance may be held in a non-distributable reserve account, for example.
Other issues will arise where partners have left or joined the firm during the period.
Without specific legislation, firms with an accounting date of 31 March would have had to pay the entire amount of the additional tax liability on 31 January 2007. For firms with a 30 April accounting date, the tax payment date is 31 January 2008.
Responding to concerns about the funding of the tax liabilities, the Government plans to introduce legislation that will permit spreading of the additional tax liability. While final details of the spreading arrangements will not be published until the Finance Bill 2006 is released, the spreading relief will be available to all businesses. Spreading will be available for adjustment income arising for accounting periods ending after 22 June 2005. All firms will be able to spread the extra tax charge over three years, while those businesses affected most severely will be able to spread the charge over a period of up to six years.
On the tax front, the Treasury is being lobbied to resolve two issues. First, what course of action is open to firms which adopted UITF 40 before 22 June 2005? Unless the Government responds to further lobbying, those firms will not be able to spread the additional tax charge. These firms may consider submitting amended returns to exclude any UITF 40 adjustment from the earlier period. For tax purposes, they would then recognise the UITF 40 adjustment for the first accounting period ending on or after 22 June 2005.
The interaction between the spreading rules and the normal payment on account rules, with instalments of tax liabilities due on 31 January and 31 July, must also be resolved. Firms with a year-end of 31 March 2006 will still have to pay tax on half of the UITF 40 adjustment income on 31 January 2007, with the remaining half spread in three installments over the following 18 months, so the spreading rules may not be as generous as they might appear.
George Bull is head of the professional practices group at Baker Tilly