BIM74150 - Abolition of the cash basis: Law Society guidance note

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 BIM74130).

THE LAW SOCIETY GUIDANCE NOTE

WITHDRAWAL OF CASH BASIS: GUIDANCE NOTE

This note has been prepared by the Law Societies of England and Wales, Scotland and Northern Ireland and agreed by the Inland Revenue.

The Finance Act 1998 contains legislation to withdraw the option for professional firms of computing profits for tax on any basis other than the full 'earnings basis', and to require all firms to use an approach based on accounting standards. The new system will apply to accounting periods ending in the year of assessment 2000/2001 (i.e. to any 12 month accounting period beginning after 6th April 1999).

Firms will be required to compute their taxable profits, so as to show 'a true and fair view' of profit for tax purposes. This will include valuing debtors, files completed but not yet billed, and work in progress. The changes may, therefore, affect not only those firms which presently use the cash basis, but also those using a conventional (or hybrid) basis and even those on an earnings basis may require to re appraise their method of calculating work in progress to conform with accounting standards.

The purpose of this note is to provide guidance for the profession in relation to some of the issues arising, particularly upon the valuation of work in progress, and to enable solicitors to discuss the relevant issues with their accountants. It is not intended to be an exhaustive consideration of all the issues. The contents of the note have been agreed by the Inland Revenue. The Revenue have emphasised that there are to be no rigid rules about the approaches to be used, and they will be issuing guidance to their inspectors on the subject. Also, the Tax Faculty of the ICAEW has issued a detailed note, whose text has been agreed with the Revenue which considers the subject more generally. It should be mentioned, however, that the accounting standards mentioned in annex C to the ICAEW note need only be applied so far as they affect the computation of profits for tax purposes; in practice many of the listed standards are unlikely to do so. The note was reproduced in the December Tax Bulletin.

Overheads

One of the key areas will be determining to what extent overheads should be included in the calculation of the value of work in progress. The Revenue have emphasised that they do not wish to put firms, particularly small firms, which might not have the necessary overhead information readily available, to a considerable amount of extra work for little benefit. The concept of 'materiality' will apply, namely whether the value attributable to a particular overhead is material or not in terms of the firm’s profits, and the application of this concept should obviate many potential problems. The Revenue have confirmed that work in progress does not include the time of a principal or equity partner of a firm and indicated that the following approach will normally be acceptable, assuming that work is billed on a regular basis:

• In most cases, overheads in relation to a sole practitioner are likely to be immaterial.
• Similarly, in a two, three or four partner firm, 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. Overheads may become material where there is a high ratio of fee earning staff to equity partners.
• Even in a large firm, where there are a substantial number of equity partners, no value for work in progress falls to be included in relation to the work of the equity partners nor in respect of supporting overhead costs, for example, in respect of the salaries of equity partners’ secretaries. Any reasonable basis of apportionment for determining the proportion of costs that are productive overheads (including an allocation of administration overheads that relate to production) referable to the case work of non equity fee earners will normally be acceptable provided that the basis is applied consistently year on year. For example, a consistent proportion of overheads reflecting the cost of the part of the premises in which non equity fee earners work should be brought in together with salaries and related overheads of fee earners secretaries or typing support.

Clearly, there will be issues of particular importance for the solicitors’ profession.

Contingency and conditional fees

In cases where there is an agreement that fees should only become payable if some contingency or condition becomes satisfied, a distinction is to be drawn between the inclusion of work in progress, on the one hand, and the recognition of profit, on the other.

The general rule is that an estimate of the net realisable value of the work in progress should be made on the basis of the information available at the time the accounts are drawn up. Where work is being done on a speculative or contingency basis, but it is clear at the time the accounts are drawn up that the case has been won and the firm will at least make some recovery of its costs, work in progress on the contract should be valued at cost or (if less) the amount of costs estimated to be recoverable. 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. The Revenue have indicated that it is open to a professional to deal with a large number of similar contingent and conditional 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 determine the value of work in progress accordingly. Under the latter approach, there is no certainty that any particular case will yield a fee, so no value need be recognised for any of them until, if at all, the contingency becomes satisfied.

If the work on a case being worked on a contingency or conditional basis is completed before the end of the period of account but the contingency or condition is not then satisfied, for example, because judgement is awaited, then, even if it becomes subsequently satisfied, before the accounts for that period are finalised, the profit element in the eventual fees to be billed is not required to be brought into account for that period.

Long term contracts and interim bills

In certain circumstances the relevant accounting standards may require the anticipated profit element in the work to date on a long term contract, only partially completed, to be brought into account. A long term contract is one for work which will last for more than one accounting year. This might include, for example, acting in the administration of an estate.

The key factor is that the treatment of long term contracts should not lead to a distortion of turnover or results for the year. If most work in a practice is normally of a short term contract nature, a single long term contract, or indeed a number of such contracts, would not mean that any profit element in the work had to be brought in unless to ignore it would create a distortion. The Revenue would not normally seek to challenge whether a case is short term or long term where it is billed periodically and profit recognised on such billing. However, if interim bills, 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 Revenue have recognised that, in general, the uncertainties of uncompleted litigation mean that, except in so far as interim bills have been rendered, no profit element is required to be brought into account even if such work might be considered to be undertaken on a long term contract basis. Other than in long term contracts the profit element on interim bills can in strictness be written out of the tax computation (to be written back in on completion of the job); in practice, however, it may be unnecessarily complex to undertake the process of identification and adjustment of such bills.

Legal aid

Unfortunately, there is no special treatment of cases where a client is legally aided. Work in progress, and anticipated profit costs in completed cases, have to be brought into account notwithstanding that there might be substantial delay in the receipt of fees. However, the solicitor is entitled to exercise a prudent approach where he or she knows that costs are going to be taxed, as to what the realisable value of work in progress, and anticipated profit costs, might be.

Other issues

1. Approval of accounts

The Revenue recognise that preparing accounts to give a true and fair view of profits will require an element of judgement, to be exercised at a particular time. Further, certain post year end events occurring prior to that time may be required to be taken into account (e.g. affecting whether a particular debt is bad or whether a contingency has been satisfied in a conditional fee case). Unlike companies, unincorporated businesses are not required to follow any formal procedure for approving accounts, but it would be sensible for solicitors to establish one. Similarly, 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 would be helpful in giving certainty to the date of approval to adopt these procedures. The Revenue have indicated that they are prepared to be flexible about what they will accept as the 'date of approval'. Understandably, a firm would not want to have to take into account events taking place after accounts had been recommended but before they had been approved. For example, in a large or medium sized firm, the normal procedure may be for draft accounts to come before the firm’s finance committee, who might take the view that a particular item of work-in-progress was worth less than cost and so they write it down accordingly. Before approval of the accounts at a general meeting of the partners, prospects have improved and the work-in- progress is worth at least cost. If this would effect a material change in the accounts, the revised amount of work-in-progress should be brought in. However, if the cost and effort of re drawing the accounts would not justify the inclusion of the receipt, it need not be brought in. In essence, unless a change was so material that it ought to be taken into account it would not need to be brought in. A common sense approach should be taken in determining whether any subsequent events are so material as to require the rewriting of the accounts.

2. Accruals

Firms on a cash basis would not have made adjustments onto an accrual basis in respect of expenses paid in advance or in arrears. Accrual adjustments will now normally need to be made, such as in respect of quarterly rental payments paid in advance.

3. Catch up charge

For most firms who previously operated on a cash basis or upon a hybrid or other basis, which did not recognise work in progress in full, the application of the new provisions will result in a windfall charge to tax in the first period of account commencing after 6 April 1999. The resulting charge to tax can be spread over a period of ten years starting in the year of assessment 1999/2000. It is important, therefore, that work in progress should not be underestimated in that period because payment of any tax resulting from any adjustment in a later period of account cannot be spread. There may be implications, however, to be considered for the partners inter se as the charge in any year falls on the partners of the firm in the particular year in which the instalment of tax is payable.