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IT WAS ANNOUNCED in the Pre-Budget Report that a spreading relief for the adjustment on a change in accounting basis as required by FRS5 Application Note G (FRS5 ANG) is to be introduced in the Finance Act 2006. The full details of that spreading relief are still not known and this article should be read in that context. However, on the basis of the latest suggestions, I felt compelled to set out my views.
The relief is to take the form of three-year spreading which will be available to all firms, with a potential six-year spreading option where the amount of the FRS5 ANG adjustment represents over half of the annual profits level.
At the outset, and speaking as a partner in a professional practice, I would like to say that FRS5 ANG is a very good thing. It requires accurate matching of revenue and expenses in the appropriate year and as such it enables partners to have faith that the accounts prepared for the practice show a true and fair position on the work undertaken during the year. It is an accounting standard that should now stamp out the accounting abuses that were commonplace in the past. Those abuses normally related to recognising profits in one year so that one set of partners benefited to the detriment of other partners in another accounting period.
As an accounting standard, it is therefore 'a very good thing'.
Furthermore, it eliminates off balance sheet assets and the associated credit balances (whatever form they may take) and as such it requires partnerships to recognise the assets of the partnership in the form of material accrued income and so face up to the true levels of working capital finance required for those practices.
The standard is therefore all about recognising income in the appropriate year so that the right partners benefit, and fairly reflecting the level of capital required to manage and run businesses. Those are the real issues although, unfortunately, all of the debate has tended to concern tax. However, for those advising businesses, these real issues are the more important ones, whilst the tax is a temporary cash flow issue (albeit for many firms a very large one).
The significance of the standard
The reason why tax is less important is that this is only about one aspect of financing the off balance sheet asset. Whilst the acceleration of the tax on this income is an issue, one still needs to consider the funding of the remaining 60% in any event.
For any firm trying to get their accounts onto a proper footing, early adoption of this standard has to be a pre-requisite. Hence, around 70% of the top 100 law firms had already decided to adopt the standard by the end of 2004 and presumably the majority of the remainder will have adopted it by now. Many of the rising 50 and the great majority of other large firms will have done likewise. It is therefore a good accounting practice that should be supported. Those firms have considered the financing issues and looked at their working capital to see how it can be met and managed. In particular, the recognition of this income and the resulting charge is an incentive to further reduce 'lock up' (work in progress, accrued income and debtors) and to make firms financially leaner and more efficient organisations.
The history of FRS5 ANG has been well documented in this publication and I do not think it would be helpful to go back over all of it here. Suffice to say that I first heard about this issue in the summer of 2003 from Kevin Slevin and FRS5 ANG was issued in November 2003. After much debate, the final UITF 40 was issued on 10 March 2005. That is a very crucial date and relevant to much of what follows in this article.
Adopting GAAP
Following the changes introduced in 1998, unincorporated businesses have a legal obligation to use generally accepted accounting principles (GAAP) in their measurement of profits used for tax purposes. This is much easier if firms produce one set of accounts and those are used both for profit-sharing and tax purposes and so I would always recommend that unincorporated businesses adopt GAAP.
Whilst it is open to interpretation what the generally accepted practice was from November 2003 onwards, there can be no doubt that from 10 March 2005, UITF 40 and FRS5 ANG represented GAAP. Ethically, members of the Institute of Chartered Accountants and other professionally-qualified accountants have an obligation to prepare accounts that abide by generally accepted accounting practice. It is therefore reasonable for those accountants to look to apply this accounting practice in any earlier sets of accounts that have not yet been concluded.
In paragraph 30 of UITF 40, headed 'Date from which effective', it is stated that:
'the accounting treatment required by this Abstract should be adopted in financial statements relating to accounting periods ended on or after 22 June 2005 but earlier adoption is encouraged. Where applicable, corresponding amounts should
be restated.'
The morals of the relief
We can now return to the spreading relief that is to be included in next year's Finance Bill.
It is understood, that as currently drafted, this relief
will only apply to accounting periods ending after 22 June 2005. Therefore, for those practices with a 30 April year-end, adoption of UITF 40 in their accounts to 30 April 2005 will not entitle them to benefit from the spreading relief. However, should another firm have an accounting period end date of, say, 30 June, then that firm would benefit from spreading relief for its accounts to 30 June 2005. Both year-ends are in the tax year 2005-06. This is clearly absurd.
There is also the matter of those firms that have adopted FRS5 ANG prior to UITF 40 and there is clearly a lack of equity in this approach in any event.
What we have here is firms being penalised for adopting good accounting practice.
Before coming on to consider the merits or otherwise of the spreading relief, it is worth reflecting that the majority of the large firms had adopted FRS5 ANG prior to the proposed effective date of the spreading relief and as such will not be able to benefit from it. One can only assume that this restriction is revenue driven in that it is those large firms that are likely to have the largest tax liabilities arising under the change in basis. It is therefore a very limited relief being introduced in a mean-spirited and divisive way.
In this respect, it is interesting to consider the Government's attitude to the granting of a relief with their attitude to anti-avoidance. A 'letter of the law' approach to anti-avoidance is considered unacceptable and incorrect on this moral high ground approach and yet a relief clearly designed for a wider purpose is being restricted so that a large number of firms do not benefit from it. This is disgraceful and only brings the Government into disrepute. What we have here is inequitable and uncompetitive behaviour in that firms embracing modern approaches have to suffer the tax consequences of doing so, whilst the laggards benefit from some relief.
As far as the spreading relief itself is concerned, the six-year period is likely to be fairly unusual and certainly we do not have any clients who are likely to benefit from it. The benefits of the three-year relief are also likely to be very limited because of the implications of payments on account.
The year-end effects
If we return to the examples of two practices with year-ends of 30 April 2005 and 30 June 2005, both of whom are making an accrued income adjustment of £1 million, the firm with the 30 April year-end will have a tax liability arising on that adjustment of £400,000. This will be payable on 31 January 2007 and would give rise to payments on account. However, if the partner numbers are consistent and relatively stable, then it should be possible to make a substantial reduction in the payments on account if profits are expected to remain constant.
If one then turns to the example of the firm with the year-end of 30 June 2005, then their tax liability payable on 31 January 2007 will be only one-third of the amount paid by the other firm because of three-year spreading. As such, the balancing payment will be £133,000. However, if we make the same assumptions about level profits and consistent partner numbers, then the payments on account will not be able to be reduced.
There will therefore be a payment on account due at the same time of 50% of that amount, i.e. £67,000 making a total payment in 31 January 2007 of 50% of the tax liability that would otherwise have fallen due. The following 31 July 2007, there will be a further payment due of £67,000 with then further payments of £67,000 due on 31 January 2008 and 31 July 2008.
Depending on your point of view, then this is not so much three-year spreading as 18-month spreading with a further point that two-thirds of the tax that would otherwise have fallen due needs to be paid within six months as opposed to all arising on the same date. For those firms, the financing issues are likely to remain as in our case, the first firm would need to finance a tax payment of £400,000 on 31 January 2007 whereas the second firm would still have to finance tax payments of £267,000 within a six-month period.
Conclusion
The whole history of this relief is thoroughly unsatisfactory, but there is little point campaigning on it on the grounds that we need to get on with concluding accounts to
30 April 2005 (and let's be honest, most should already have been signed off) and it is just a sad reflection on the Treasury and HMRC officials concerned.
John Endacott is a tax partner at Winter Rule Chartered Accountants and Business Advisors and is also Chairman of the SME Business Tax Faculty of the ICAEW. The views expressed here are his own.
