BIM74130 - Abolition of the cash basis: ICAEW note on ‘true and fair view’

This guidance relates to accounting periods before the issue by the Accounting Standards Board (ASB) of Urgent Issues Task Force (UITF) Abstract 40 in March 2005. UITF 40 applies for accounting periods ending on or after 22 June 2005. Further guidance is at BIM74200 onwards. See in particular Appendix 2 paragraph 1 in BIM74275 in relation to the ICAEW’s guidance TAX30/98 (see below).

THE ICAEW GUIDANCE NOTE

WITHDRAWAL OF CASH BASIS

GUIDANCE NOTE ON A TRUE AND FAIR VIEW

Introduction

1. This note has been prepared by the Tax Faculty of the Institute of Chartered Accountants in England and Wales and agreed by the Inland Revenue who intend to include it in guidance to local tax offices.
   
   
2. The object of this note is to provide guidance on computing taxable profits of professional businesses so as to show a true and fair view of profits for tax purposes. The Inland Revenue has told us that their guidance to inspectors on enquiries into work-in-progress stresses that an element of judgement is involved. We attach as Annex A (text in BIM74095) an extract from the Revenue’s forthcoming guidance to Inspectors. The full guidance will be published in the Revenue Manuals in due course when it has been finalised.
   
   
3. This note is designed to give practical help based upon Accounting Standards and practices current at November 1998. The Tax Faculty will keep under review the need to update this note as Standards and practices evolve.

Background

4. The Government announced on 22 December 1997 the withdrawal of cash basis practices for computing taxable profits of professional businesses in favour of a ‘true and fair’ approach.
   
   
5. In summary, the proposals are:

1. Statements of Practice A3 (cash basis for Barristers) and A27 (cash bases for others) will cease to apply after 1999/2000; and
   
   
2. for 2000/2001 onwards profits for tax purposes must be based on accounting standards adjusted as required or permitted by tax law.

6. Head (b) in fact is the corollary of head (a). What is proposed is merely that the approach adopted by the Courts over many years, and re-emphasised recently in such cases as Gallagher v Jones [1993] 1993, 66TC77 and Johnston v Britannia Airways Ltd [1994] 67TC99, should be codified, making explicit by statute that which is already implicit in judicially developed doctrine.
   
   
7. The Revenue view of what this means is set out in paragraphs 24-26 of their March 1998 Budget Day press release IR29 which is reproduced in Annex B (see BIM74085).
   
   
8. There have been concerns that true and fair implies an audit and compliance with Companies Acts disclosure requirements. These concerns are misplaced: the legislation specifically confirms that no audit or Companies Acts disclosure requirements are imposed

Date from which effective

9. Paragraph 3 of the Annex to IR 29 referred to above states that 'The first computations on the earnings basis will normally be for the twelve months ending on the accounting date in 2000/01. The debtors, creditors and work-in-progress used to calculate the ’catch-up’ charge at the end of the previous period will form the opening earnings basis figure'. Special rules apply for periods of account other than one year.

What is a true and fair view?

10. The concept of true and fair view is well known to accountants. It has been the fundamental basis of audited accounts for many years. Accounting Standards have been developed and published since the issue of SSAP1 (Accounting for associated companies) in January 1971. These are required to be used in preparing accounts intended to give a true and fair view. As such, they are integral to the concept of a true and fair view. This is of course a dynamic concept. As new Standards and ASB pronouncements are published they will need to be taken into account in determining whether accounts give a true and fair view. However, Accounting Standards have been developed largely in the context of accounts prepared by companies which, in addition to giving a true and fair view, have to comply with disclosure requirements under the Companies Acts.
    
    
11. As accounts (and the Standardised Accounting Information (SAI) section of the tax return) are needed to quantify the amount of taxable profits, the tax requirement for such documents to show a true and fair view requires them to comply only with those parts of Accounting Standards that are germane to the calculation of profits. Many Accounting Standards affect the presentation of the profit and loss account and the balance sheet and the disclosures to be made by way of notes. For tax purposes such Standards only need to be applied so far as relevant and material to the computation of profits, i.e. to determine when profit arises and the amount of profit to be recognised.
    
    
12. Two standards which are of great importance to accounting by professional businesses are those parts of SSAP2 (Disclosure of Accounting Policies) which set out the four fundamental accounting concepts and SSAP9 which relates to the valuation of stock and long-term contracts. The definition of stock as found in paragraph 16(d) of SSAP9 states that it includes products and services in intermediate stages of completion. This clearly includes work-in-progress in a professional business.
    
    
13. SSAP2 lists going concern, accruals, consistency and prudence as being four fundamental accounting concepts regarded as having general acceptability. To all intents and purposes, these are the same as the accounting principles codified in paragraphs 10-14, Schedule 4, Companies Act 1985 and reproduced in the Financial Reporting Standard for Smaller Entities (FRSSE). As noted in Annex B, the Revenue additionally accept the concept of materiality in arriving at a true and fair view of work-in-progress.
    
    
14. We include in Annex C a list of the other Accounting Standards that may need to be applied in particular circumstances.
    
    
15. The FRSSE, issued in November 1997, is relevant to many partnerships. It specifically makes clear that Accounting Standards are intended to apply to unincorporated entities as well as companies. But the main purpose of the FRSSE is to collect together in one place most of the requirements that small entities must follow.
    
    
16. A small entity for the purpose of the FRSSE follows the Companies Act criteria, i.e. a sole proprietor or partnership will be a small entity for any accounting year in which it does not exceed two or more of the following criteria:

17. Although 'balance sheet total' under the Companies Acts is defined by reference to the statutory company accounting formats, it is clear that it means assets, i.e. neither liabilities can be netted off nor capital account balances can be deducted in arriving at the balance sheet total. An overdrawn capital account balance is not an asset.
    
    
18. The Foreword to Accounting Standards makes clear that the CCAB bodies expect their members to observe Accounting Standards and to justify any significant departure from them. It also states that compliance with Accounting Standards (other than in relation to immaterial items) 'will normally be necessary for financial statements to give a true and fair view'.

Valuation of work-in-progress

Introduction

19. Many people are concerned about how one values professional work-in-progress. The first thing to be said is that work-in-progress, like stock, is an accounting concept. It is not for the Revenue to determine how to value it; it is solely a matter of the appropriate application of accountancy principles.

Valuation

20. The basic principle, which is set out in SSAP9, is that work-in-progress should be stated at the lower of cost and net realisable value. In the case of long-term contracts paragraph 28 of SSAP9 requires each contract to be assessed as contract activity progresses. Paragraphs 28 to 30 give further guidance as to how this should be done. This part of SSAP9 was an issue in Symons v Lord Llewelyn-Davies’ Personal Representative and Others [1982] 56TC630. This case emphasises the principle that profits should not be anticipated and that in ascertaining profits actually earned up to the balance sheet day inherent uncertainties as to the outcome of a contract require a cautious estimate of such profit to be made.
    
    
21. SSAP2 is also relevant. The accruals concept requires that revenue and costs are 'matched with one another so far as their relationship can be established or justifiably assumed and dealt with in the profit and loss account of the period to which they relate'.
    
    
22. The purpose of work-in-progress is to relate expenditure on such work to the period in which the income it produces is earned. Accordingly if there is no expenditure there is no work-in-progress to be matched with the income of a later period. There is of course no expenditure included in the profit and loss account in respect of the proprietor’s or partners’ time because it is an appropriation of profits; accordingly there is nothing to be carried forward in respect of such time.

Chargeable staff

23. A sole trader or partnership with no chargeable staff, i.e. fee-earning employees, will accordingly have no work-in-progress.
    
    
24. If an accountancy practice has chargeable staff, it will have work-in-progress. The starting point for valuing work-in-progress is that salaries and other costs directly attributable to productive staff, such as national insurance and pension contributions, should be matched with the earnings that their work generates. The principle is to carry forward costs that relate to a later period, not to anticipate profits that will not be earned until a later period.

Overheads

25. The key area of difficulty is what, if any, overheads should be included in the calculation of work-in-progress. The only case which appears to relate directly to the recognition, or otherwise, of overheads for tax purposes, Duple Motor Bodies v Ostime [1961] 39TC537 was decided before the introduction of SSAP9. In that case the Commissioners found as a fact that the company's policy of including only direct costs in the valuation of its work in progress accorded with generally accepted accounting practice. It is unlikely that such a policy would now accord with SSAP9 and so it would no longer accord with generally accepted accounting practice.
    
    
26. Paragraph 17 of SSAP9 defines cost as including such costs of conversion as are appropriate to the stock’s condition. Paragraph 19 states that cost of conversion includes production overheads (as defined in paragraph 20) and any other overheads attributable in the particular circumstances of the business to bringing the product or service to its present location and condition. SSAP9 was issued in 1975, although it was revised in September 1988, mainly to cover long term contracts. At that time few, if any, professional practices were incorporated. Accordingly the Standard does not specifically address the question as to what extent overheads of a professional practice constitute 'costs of conversion' in relation to work-in-progress. The SSAP9 definitions are more appropriate to manufacturing operations.
    
    
27. Perhaps because there was no ‘true and fair view’ requirement, this is an area on which there does not appear to have been a consensus amongst practising accountants. Some firms of accountants that currently prepare accounts on an earnings basis exclude overheads whereas others include them. There has been no standard method of ascertaining overheads even where these are included.
    
    
28. However, the Revenue accept that the concept of materiality applies and believe that this obviates many of the potential problems. They have told the Tax Faculty that they do not wish to put firms, particularly small firms, which may not have the necessary overhead information readily available, to a considerable amount of extra work for little benefit.
    
    
29. On this basis the following approach will normally be acceptable, assuming of course that work is normally billed on a regular basis.

3. The Revenue accept that overheads can be ignored in relation to a sole practitioner or partner’s own time - so the value of work-in-progress for their time will be nil as there can be no work-in-progress in relation to a proprietor’s labour.
   
   
4. They are prepared to accept that in most cases overheads in relation to staff time of a sole practitioner are likely to be immaterial.
   
   
5. Similarly in a two, three or four partner firm staff overheads can legitimately be regarded as immaterial in most cases. However this may depend to an extent on the ratio of partners to productive staff.
   
   
6. In a large firm, with many fee-earners located in substantial premises, it is right to recognise a fair proportion of overheads in calculating work-in-progress.
   
   
7. In the intermediate range it will normally be appropriate to recognise overheads, although at the smaller end of the range the Revenue would not object to the adoption of a fairly rough and ready approach to arriving at an appropriate figure.

The Tax Faculty believes that this is a reasonable approach to adopt.

Larger firms

30. Applying the above guidance will be straightforward for smaller firms where work-in- progress is not material. In the case of larger firms each case must be considered on its own merits and in accordance with existing guidance on the valuation of work-in- progress contained in SSAP9 and the concept of materiality whereby immaterial items can be ignored. In addition it is important to recognise the concept of consistency so that work-in-progress is valued on a consistent basis as between one accounting period and the next. It is unlikely that any work-in-progress in an accounting practice would fall to be regarded as a long term contract under the terms of SSAP9, but it may do so in other professions; for example, architects, solicitors, surveyors and others. Treatment of contingent matters and legal aid work should be similar to the guidance given in paragraph 36 below.

No rigid rules

31. It is not possible to lay down rigid rules as to what to do. There might be instances where the inclusion of overheads is appropriate even in cases within 29(a) to (c) above. In an extreme example (admittedly unlikely and perhaps contrary to the rules of his or her professional body), if a sole practitioner has only one client but has rendered no fee note to that client during his accounting year, he may need to treat some of the overheads as work-in-progress. However, it must be remembered that overheads would not relate to the work-in-progress to the extent that the office is needed as a base from which to generate new work, carry out marketing or administrative functions such as billing, etc.
    
    
32. The Revenue have told the Tax Faculty that Inspectors may wish to understand the basis on which work-in-progress has been calculated but the Revenue would not expect Inspectors to dwell on it, except where it did not appear to be calculated on a reasonable and consistent basis.

Absence of time records

33. Some professional firms do not maintain time records. For example solicitors and patent agents will often charge a standard fee for a job. In such cases it is not necessary for the taxpayer to introduce time records where he does not need these commercially. Some other method to arrive at a work-in-progress figure will need to be adopted. Where cost details are kept on individual client files a 'stocktake' may be possible. Where a 'billing exercise' is carried out close to the year end, it may be possible to record details of work not being billed. A review of invoices rendered after the year end may provide a guide to work-in-progress. It may be possible to use statistical techniques to establish the likely number of jobs uncompleted at the year end and an appropriate cost figure.

Valuation: reduction to cost

34. Many professional businesses nowadays record work-in-progress at selling price. It would clearly be conceptually wrong to value it at such a price when computing taxable profits. It is therefore necessary to reduce the book figure at selling price to arrive at the cost of work-in-progress. While there may be ‘rules of thumb’ which can often provide a reasonable approximation the individual circumstances need to be considered, and ‘rules of thumb’ may not always be appropriate.
    
    
35. It needs to be remembered that work-in-progress is the figure that the concept of matching requires to be carried forward. But SSAP2 makes clear that the accruals concept is subservient to the concept of prudence. Among other things this prohibits the carrying forward of current expenditure to the extent that it is not recoverable. If a fixed fee has been quoted for a job the value of work-in-progress will not exceed that fee less the estimated costs that will need to be incurred to complete the job.
    
    
36. As with other judgements, the estimate of the net realisable value of work-in-progress should be made on the basis of the information available at the time the accounts are drawn up (see paragraph 43 onwards). Thus, where work is done on a speculative or contingency basis ('no win, no fee'), but it is clear at the time the accounts are drawn up that the case has been won and that the firm will at least recover its costs, work-in- progress on the contract should be valued at cost. Where, however, the contingency has not been satisfied at that time, so that there is still a reasonable chance that the firm will recover nothing, the net realisable value of work in progress is likely to be nil. Paragraph 49 also gives guidance on the recognition of income and contingent fee cases.

Valuation: more complicated cases

37. If the client is in a precarious financial position and unlikely to be able to pay for the work it is equally unlikely that the work-in-progress has any real value. As with stock, it is necessary to consider each item of work-in-progress to confirm that its net realisable value exceeds its costs and, if not, to write it down to that value. In the case of work-in-progress there is normally only one 'customer' for the work so the net realisable value will depend on an assessment of what that customer can be expected to pay for it. However, the concept cannot be taken too far. What is needed is not an assessment of what the customer will pay for the work in its current state; the assumption that the work will be completed needs to be made.
    
    
38. In some cases it may not be possible to arrive at a value for work-in-progress. Mason v Innes [1967] 44TC326 established that an author cannot have work-in-progress at least before he has entered into a contract with a publisher for the book and the Revenue accept this.
    
    
39. The definition of long-term contracts given in SSAP9 is not easy to follow. The authors of UK GAAP (published by Ernst and Young) express the view that the wording is wide enough to require even uncompleted short contracts to be treated as long-term and comment 'This could hardly have been the Standard’s intention'. They surmise that the crucial factor of the definition is consistency. They also suggest that the distinction that needs to be drawn is between short-term contracting businesses and long-term contracting businesses. A business engaged ordinarily in short-term contracts should normally account for all its contracts on a short-term basis.
    
    
40. Most professionals, other than in the construction industry, are unlikely to be involved in long-term contracts. For example the annual audit or accounting work for a client which is billed regularly is in practical terms a series of short-term contracts. Some corporate finance activities such as seeking over an extended period to find a buyer for a business might be long-term. Other examples are prolonged insolvency work in one company’s liquidation and prolonged probate work by solicitors in handling a complex estate.
    
    
41. The Revenue would not normally seek to challenge whether a job is short-term or long-term where the case is billed periodically and profit recognised on such billing. However, if interim billing, or requests for payment, are held in suspense on the basis that the contract is long-term, and no income or profit is recognised, the Revenue could well challenge the treatment. The key factor is that the treatment should not lead to distortion of the turnover or results for the year.

Examples

42. It was noted in paragraph 31 that it is not possible to lay down rigid guidelines. However, in order to provide further guidance, Annex D sets out five examples as to how the Faculty considers work-in-progress should be valued and calculated (see BIM74145). The examples also highlight the types of problems which will occur in practice and how they may be resolved
    
    
43. 
    
    

    Example 1

Time at which judgement is to be made

The Revenue recognise that preparing accounts to give a true and fair view of profits normally requires an element of judgement (see Annex A). For example someone needs to decide whether the work-in-progress on a particular piece of work should be valued at cost or at net realisable value. Such judgements should be made on the basis of the information available at the date the accounts of the business are approved.

Unlike companies (where accounts must be approved by the Board of Directors) unincorporated businesses are not required to follow any formal procedure for approving accounts. The Revenue will accept as the 'date of approval' any date on which a procedure recognisably similar to that followed by companies is completed. For small partnerships and sole practices this would be when the proprietors give their approval to the accounts. For larger partnerships there might be a body such as an Executive Committee which approves accounts for submission to a general meeting of partners. The 'date of approval' would be the date of approval by the Executive Committee.

While there is no requirement for accounts of unincorporated bodies to be signed by or on behalf of those approving them, or to be dated, it may well be helpful in giving certainty to the date of approval if accounts are signed and dated.

SSAP17 (Accounting for post balance sheet events) requires events arising after the balance sheet date to be taken into account when they provide evidence of conditions existing at that date. In the case of a company the date of approval of the accounts is a convenient cut-off point to review post balance sheet events. Where a partnership has a formal procedure to approve accounts such approval might provide a convenient cut-off point. The Tax Faculty does not believe that where no such procedure exists it is necessary to attempt to identify a cut-off point.

The principle is that post balance sheet events need to be taken into account. Where work-in-progress is ascertained some time after the balance sheet date the review undertaken at that time will reflect post balance sheet events up to that time. We do not believe that any subsequent review is needed unless the taxpayer becomes aware of material knowledge that vitiates a decision made at the time the work-in-progress was ascertained. Common sense obviously needs to be used in determining whether subsequent material events are likely to occur after the time of the initial review.

Income recognition and debtors

49. Profit cannot be deferred by leaving jobs in work-in-progress after they have reached a billable stage. Once a job has been completed the billable amount should normally be recognised as a debtor rather than work-in-progress. Where a request for payment is issued under the VAT Continuous Service rules, the issue of that request will normally trigger a requirement to regard the amount as a debtor for accounting purposes.
    
    
50. Paragraph 36 above discussed the treatment of contingent events in relation to work- in-progress. In the case of income recognition, the Revenue have told us that they accept that income need not be recognised for a job which depends on a contingency until that contingency is satisfied. For example, a lawyer who took on a case on a 'no win, no fee' basis need not recognise the fee until the case is won; only then is the condition met which is necessary to earn the fee. In addition, the Revenue accept that, for this purpose, it is open to the professional to deal with a large number of similar contingent fee cases either in the aggregate or to look at each one separately. Under the former approach it might be possible to say that a certain percentage will yield a fee and to recognise income accordingly. Under the latter approach there is no certainty that any particular case will yield a fee and so no income need be recognised for any of them until the contingency is satisfied in each case.
    
    
51. There is nothing special about valuing debtors of a professional practice: normal practice should be applied. It is as permissible to provide against bad and doubtful debts as in any other business.

Alternative acceptable accounting principles

52. Some accountants are concerned that where there are two or more acceptable approaches to valuing work-in-progress the Inspector of Taxes may take a different view of which method ought to be adopted.
    
    
53. It is well enough established that the Revenue do not have the right to substitute one basis which is valid for tax purposes for another such basis. In Pearce v Woodall- Duckham Ltd [1978] 51TC273 for example Templeman J (later Lord Templeman) said: 'The company was entitled to produce accounts based on its on-cost method prior to 1969. The company was entitled, but not bound, to produce accounts for 1969 and subsequent years by the accrued profit method. The change was made for sound commercial reasons'. Equally the Revenue’s view is that where a basis which is valid for tax purposes has been adopted in a taxpayer’s accounts the taxpayer does not have the right to adopt a different basis in computing the profits figure to be entered on his tax return.
    
    
54. In Johnston v Britannia Airways [1994] 67TC99 Knox J said at page 124C: 'Which of the three ways in which the attribution of cost to a period or periods of accounting is adopted is, in my view, essentially a matter of accountancy judgement, and I am quite unable to detect any legal basis for excluding any of them'. Admittedly in that case the Special Commissioners had expressed a preference for the method actually adopted by the taxpayer, but that was not the basis of their decision.
    
    
55. In a recent case A Firm v Honour (1997STC(SCD)293) the Special Commissioners felt themselves entitled to substitute the Revenue’s basis for the taxpayer’s, albeit both were bases which accorded with normal accountancy principles. However the Revenue did not argue for this - they argued that the taxpayer’s basis anticipated losses and needed to be adjusted as a matter of law to exclude such losses from the taxable profit, which is a different concept. It is understood that this case is going to appeal.
    
    
56. The Revenue consider that adjustments may also be needed to reflect other principles laid down by the courts in tax cases, such as the prohibition on anticipating losses. Such decisions were of course formulated in an environment where accountancy evidence was less frequently put before the courts. The Tax Faculty does not necessarily accept the Revenue’s view. It believes that the current approach of the courts to accounting principles has created a number of unresolved issues that may have be decided by the Courts at some stage.