Knees Up In A Brewery
SIMON SWEETMAN discusses the confusion surrounding Financial Reporting Standard 5.
I KNOW THAT for someone who is not an accountant to write about application note G to Financial Reporting Standard 5 is rather like a non catholic writing about the immaculate conception, and liable to incur the accounting equivalent of a papal anathema, but this is not so much about the technicalities as about what has gone on over the last few months.
Section 42, Finance Act 1998 said:
Knees Up In A Brewery
SIMON SWEETMAN discusses the confusion surrounding Financial Reporting Standard 5.
I KNOW THAT for someone who is not an accountant to write about application note G to Financial Reporting Standard 5 is rather like a non catholic writing about the immaculate conception, and liable to incur the accounting equivalent of a papal anathema, but this is not so much about the technicalities as about what has gone on over the last few months.
Section 42, Finance Act 1998 said:
'(1) For the purposes of Case I or II of Schedule D the profits of a trade, profession or vocation must be computed on an accounting basis which gives a true and fair view, subject to any adjustment required or authorised by law in computing profits for those purposes.'
Until Finance Act 1998, the Revenue was happy, on the whole, to accept accounts on a cash basis. This was a statutory possibility for professions, and de facto for many small businesses who prepared their own figures. But since Finance Act 2002 , the legislation no longer just says 'true and fair'; rather it says:
'(1) For the purposes of Case I or II of Schedule D the profits of a trade, profession or vocation must be computed in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in computing profits for those purposes.'
According to the Inland Revenue Business Income Manual at paragraph BIM 31004, 'This was changed in 2002 to generally accepted accounting practice. This is defined in section 836A, Taxes Act 1988 . It means generally accepted accounting practice with respect to accounts of United Kingdom companies that are intended to give a true and fair view'. It should be noted that the Revenue does not restrict this to companies, and it adds quickly 'the changed wording does not change the sense or meaning'.
It is further stated in the manual at paragraph BIM 31020, that 'this definition means that generally accepted accounting practice is specified to be United Kingdom generally accepted accounting practice. It is not the generally accepted accounting practice relevant to another country'. These things too will change as United Kingdom generally accepted accounting practice is tweaked by the Accounting Standards Board to become closer to international standards.
More significant
In recent years, evidence of accepted accounting practice has become more and more significant in decisions made by the courts in tax cases, with the traditional caveat about statutory and case law differences for tax purposes getting weaker and weaker. Many past decisions, e.g. Sharkey v Wernher 36 TC 275 , where the judges lacked the benefit of accounting evidence are beginning to look frayed around the edges.
One might ask whether it is really a good thing to insist that the smallest businesses draw up their accounts to rules designed for the biggest, and whether it really matters to the Revenue that small businesses include all their debtors and stocks and work in progress on absolutely the correct basis when the differences are merely timing.
The Revenue has stated that 'in general, reporting of revenue in accounts is followed for tax purposes. There is no general standard for revenue recognition in United Kingdom generally accepted accounting practice, but the recently added application note G to Financial Reporting Standard 5 goes some way to dealing with certain aspects of International Accounting Standard 18. The general view seems to be that International Accounting Standard 18 and note G may defer the recognition of some revenue, but may in a few cases advance it. The Government has no plans to modify tax law to deal with these changes'. One might ask, why should the Government modify the law? If there are changes to United Kingdom generally accepted accounting practice, they will change taxable profits without any action being needed.
There is an accounting standard for work in progress, Statement of Standard Accounting Practice 9, though it is overtly concerned with the treatment of stock and long term contracts. Accounting note G says 'the application note provides additional guidance on the recognition of turnover derived from [long term] contracts, but does not amend the requirements of that accounting standard'.
Precipitate action
All of that leads us into the point. On 13 November 2003, the Accounting Standards Board issued the application note. Suddenly an arcane interpretation of a piece of accounting has caused panic in many circles, with professional firms, who last went through this mill only a couple of years ago, being told by their accountants that they must change the way in which they account for partners' work in progress, and to include it at full value rather than 'the lower of cost and market value in terms of Statement of Standard Accounting Practice 9 where the cost of partner's time is very small'.
It is not clear where this particular hare started, but at least three national firms of accountants are advising professional practices for whom they act to value partners' work in progress at full value. It is not at all clear that the Accounting Standards Board is proposing anything of the sort. What was exercising the board, it would appear, is quoted companies who include all kinds of possible but far from certain receipts in their top line in order to excite the people who might buy their shares: the concern was that people were overvaluing their incomplete work in order to make things look better.
Sense of déjà vu
As far as the small professional practices are concerned, this has happened before. For accounting periods which began before 7 April 1999, the rule was that while business profits would normally be computed on an earnings basis, the cash basis (where profits measured by excess of cash receipts over cash outlay, ignoring debtors and creditors, accruals, unbilled or uncompleted work) or some other recognisable basis short of a full earnings basis, was accepted for individuals or partnerships carrying on professions or vocations (not trades) if desired and 'provided the profits computed on the new basis will not, taking one year with another, differ materially from the profits computed on the earnings basis'.
Well, that was the theory. Professional firms might build up huge amounts in work in progress. Sometimes the Revenue would ask questions about whether they were making a serious effort to raise their bills in time (especially at the end of the accounting year), but it was a bit shy of seriously taking on professional firms.
That was changed by the 1998 Finance Act.
Besides the requirement for 'true and fair', Finance Act 1998 made it clear that the cash basis had to go, which meant for many small to medium professional firms that they had to introduce work in progress to their accounts and account for the tax on it. Desperate negotiation produced the result that the resulting tax charge could be spread over ten years, and many firms are still paying it off.
Now suddenly it is back to haunt them, and with the added prospect of having to pay for it immediately as well; there is no ten-year pay off this time. But on this occasion, it is not a change introduced by the Inland Revenue.
The Revenue, in its Business Income Manual at paragraph BIM 31055, says of Financial Reporting Standard 5:
'The application of Financial Reporting Standard 5 has a significant impact on company reporting. Inspectors may find that in many instances the Case I treatment may well follow the revised accounting treatment, but that is not inevitably so. In some cases, the tax treatment of transactions following the legal form of those transactions is significantly different from the accounting treatment.'
Revenue reaction
Once the hare had been chased from cover, though, the Revenue began to take a different tack and is now, it seems, sitting back and waiting — perhaps for the opportunity to pounce.
Because no authoritative guidance from the professional institutes has been forthcoming and because, in the real world, there are firms whose accounting dates fall on or after 23 December 2003, it has been left to the accountants in practice to make their own decisions. Most of them, it seems, have opted for the doomsday scenario and are even trying to persuade the Revenue to spread the extra tax over ten years.
This particular problem, it seems, has been entirely generated by the accounting profession. There is substantial disagreement about what the application note means for professional work in progress (see, for instance, Robert Maas's article, 'The WIP Wrangle' , Taxation, 12 February 2004) and a very firm line taken by The Chartered Institute of Taxation (see Trevor Johnson's article, 'Valuation of Work in Progress for Unincorporated Businesses', Tax Adviser , May 2004).
Yet despite this, it appears that auditors are putting pressure on their clients to use the new basis. Once a few people do this, the Revenue will happily accept that this is compatible with generally accepted accounting practice and start to challenge those who take a different view.
From the point of view of the small professional practice, this has been a disaster. How can we work together with the Revenue, if we cannot work together with ourselves?