Unfinished Business?

ANDREW ALLEN, and PETER VAINES continue the debate about UITF 40 from previous issues of Taxation.

There has been much theoretical debate over FRS 5, Application Note G (ANG) and the subsequent issue of UITF Abstract 40. I prefer to focus on practical accounting and common sense. This is best illustrated by an example.

Whilst other examples may not be as clear cut or covered by the precise wording of the guidance, my personal view is that we have to exercise professional judgment which is what we are paid for. My particular interest has been in relation to law firms and my comments here draw on these experiences, although the issues raised are relevant to the wider professional services sector.

How has ANG helped law firms?

Most commentators have focused on the problems generated by ANG. There are also great benefits for those proactive firms that have addressed the issue.

• Application of generally accepted accounting practice (GAAP) — I have seen law firms of all sizes benefit from using ANG as an impetus to review their financial accounts for general compliance with GAAP. Firms often discover additional liabilities that are eligible for tax relief. This not only mitigates the cash impact of recognising accrued income but also improves the accuracy of accounting information.
• Management of lockup (total unbilled income and debtors) — Accounting for accrued income creates a cash requirement for firms for tax purposes. This has focused firms on minimising value held in lockup. Any activity to convert time to cash quickly is good business practice.
• Time recording — Ensuring fee earners accurately record their time has been another area that firms have investigated to control unbilled time. Well-maintained time records give accurate unbilled income and profits and improve financial control.
• Equity — Applying the principles of ANG enables partners to be treated fairly between accounting periods.
• Capital management — This remains a difficult issue for law firms. ANG allows firms to generate a better understanding of why capital is needed and what drives the underlying level. Many firms have used this as an opportunity to 'get their house in order'. Looking forward this will improve overall financial control and understanding of their business.
• Taxation provisions — Experience shows that for many firms the impact of ANG is less than commentators suggest. Consider a law firm with a year-end of 30 April where the accounts include accrued income and work in progress. The income tax due on this income is not payable until 21 months later. In most cases if at this point the unbilled income has not been collected it is debatable whether it should have been recognised anyway.

Many law firms have also adopted a more prudent approach to cash reserving for future tax payments, an activity that will over the long term result in stronger practice management. This is also part of assessing the true working capital requirements of the business.

Other accounting issues

• Do ANG and UITF 40 apply to small (FRSSE) partnerships? — Yes, exemptions only apply where detailed in this FRSSE. When new standards are issued these need to be substantially adopted unless the FRSSE is updated to exclude them. In the case of ANG this has not been excluded from the FRSSE and in fact FRSSE has been updated to include the underlying concepts of it.
• Events after the Balance Sheet date (FRS 21) — In the case of contingent event fees e.g. 'no win, no fee cases' it is generally accepted that there can be no right to consideration and revenue should not be recognised if the event has not arisen at the balance sheet date. Still widely debated is what impact any post balance sheet conclusion of the case has on the accounting treatment. Many argue if the case is won post balance sheet date or there is an abortive fee right then the corresponding WIP should be held at cost. Others state only rights to consideration at the balance sheet date are relevant.
• Materiality (FRS 3) — Particularly in smaller professional firms, the impact of FRS 5 in aggregate may not be material. As such it may not represent a change of accounting basis under FRS 3 — Reporting Financial Performance which defines a prior period adjustment as 'Material adjustments applicable to prior periods arising from changes in accounting policies…'. This in turn will affect the taxation treatment of any accounting adjustment from FRS 5.
• Accounting policies (FRS 18) — Effective since June 2001 and superseding SSAP 2 this includes a requirement for financial statements to be prepared on an accruals basis. I continue to hear many arguments and articles that point to this and emphasise that ANG is only forcing the hand on an accounting treatment that should already be in place. I point back to my opening example here and feel that it difficult to see how the accounts of this firm would be 'true and fair' without accrued income.

Effective date

ANG is effective for accounting years ending on or after 23 December 2003. The UITF abstract on this issue does not alter the effective date of this accounting standard.
The UITF states that its interpretation of ANG does not become obligatory until accounting periods ending after 22 June 2005 although earlier adoption is encouraged. So, do we have to recognise income in accordance with ANG before this date or not for GAAP purposes?
The opinion of advisors is clearly divided on this issue — hence the ongoing debate in this journal. Those that did not interpret the impact of ANG in line with the final UITF abstract argue that they successfully delayed taxation charges. Regardless of UITF 40, tax computations of professional practices must show a true and fair view and so include accrued income. In preparing GAAP accounts, how is accrued income to be assessed if UITF 40 is not implemented? For those firms adopting 'best practice', it must be to apply the ASB guidance.
While the 1998 tax changes required professional partnerships to apply GAAP, it was not until ANG arrived that income recognition was defined. In many respects these requirements deal with the unfinished business of ICAEW Tax 30/98 in bringing such accounts onto a full accruals basis. Much of the noise now is from those who have not grasped the full impact of those changes in 1998. One has only to look at the articles on converting partnerships to LLPs to see this and similar issues addressed. Mind the GAAP!
Andrew Allen is legal sector partner at Winter Rule and a committee member of the ICAEW's Solicitors Special Interest Group (aallen@winterrule.co.uk).

Consideration

The problem of partially completed work in professional firms is an area where many views have been expressed. The ASB's stance is that where the firm's contractual obligations are gradually performed over a period of time, revenue should be recognised as the activity progresses to reflect the partial performance. That is fair enough, but the question is how it should be reflected. They seem to be quite firm about it — saying specifically that it is inappropriate for revenue recognition to be deferred until completion of the contract, and a failure to reflect attributable profit would result in a distortion of the figures so that the financial statements would not give a true and fair view. Again, this is all very well — but what do you bring in to account.

Fee agreements

If the work has been completed but not yet billed and the fee agreed in advance, the position will be reasonably clear. But what if the work has all been completed but the fee has not been agreed? Just bringing in the work in progress at selling price cannot be right. You have to assess what fee is likely to be charged and accepted by the client and this may bear no relation to what is on the clock. You also have to take into account a discount to reflect the time which will elapse until it is expected for the fee to be paid and a further discount if there is any significant risk that the full amount will not be paid, e.g. the credit risk.
This is specifically recognised by paragraph 20 of the latest abstract which says:

'The amount of revenue recognised should reflect any uncertainties as to the amount which the customer will accept and be able to pay. It may be the case for example that even where a contract states that fees are to be calculated on a time basis, the customer will not accept that the time spent is reasonable.'

The real area of uncertainty is how to apply this accounting practice to partly completed work and where the work straddles an accounting period. The statement says the revenue must be recognised 'to the extent that the seller obtains a right to consideration' and this causes a serious difficulty where only half the work has been performed. I cannot say that I have done half the work so I want to be paid half the fee. The contract will almost certainly not give rise to such an entitlement. Until the work has been completed there may be no right to any payment at all. This is Robert Maas' point.

Quantum meruit

The statement works on the premise that if you have performed some but not all of your contractual obligations you must recognise revenue to the extent that you have obtained a right to the consideration through the performance. We need to examine the basis for that right. Whilst it is possible that a claim based on the doctrine of substantial performance could arise, that only applies where the work has been substantially performed; what we are really looking at here is work which has not been substantially performed but only partly performed. The new standard would therefore seem to be based on the idea that the principle of quantum meruit should apply. But it is not as simple as that. Quantum meruit is a remedy for breach of contract (although it can also apply where there is also no contract between the parties). It allows the court to award a sum by way of reasonable remuneration for the services rendered. However, there has to be a breach of the contract. The principle certainly does not provide a general right to receive a reasonable payment of work which you have done so far.
You must therefore fall back on the contract to determine the extent to which a right to consideration has arisen through the performance of the services. If no further work was done what could you insist on being paid for the work done. Not much probably but each case will depend on the precise terms of the engagement, the nature of the work, how much of it hadbeen undertaken and why.
For these reasons, I think the suggestions made in some quarters that you just bring in work in progress at selling price rather over simplifies the position.
Peter Vaines is a partner in the law firm of Haarmann Hemmelrath.

 
Editor's note

The last time something of this sort happened was the abolition of cash accounting, when the change was matched by the introduction of a relief to allow spreading over ten years.  On the assumption that HMRC will eventually insist on accounts that, broadly speaking, recognise revenue by reference to the amount of work performed and the eventual amount that will be received, we need to get a similar spreading provision for this change. In fact, given the structure of ITTOIA 2005, it seems to make sense to introduce a general enabling provision to introduce spreading by regulation in respect of certain types of income falling within s 228 et seq as adjustment income.
The danger is that the ongoing debate about whether the rules have changed will obscure the need to deal with the impact of the change if they have. Passing a general enabling provision in Finance (No 2) Act 2005 would give a breathing space to allow HMRC and tax practitioners to agree on the position post-ANG before introducing a spreading provision by regulation. A failure to make the case for a general enabling provision now will mean that the earliest it can be announced is the pre-Budget report and the earliest it can be introduced is Finance Act 2006. We really do not want to have to wait until then.

Issue: 4010 / Categories: Comment & Analysis