Partnerships
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UITF Abstract 40
Prior to 2000, there were three bases to choose from when preparing accounts of professional firms. The first, and most popular among firms of Solicitors, was the Cash Basis whereby income and expenditure was only recognised when it was either received or paid.
The second basis was commonly referred to as the Conventional Basis which differed from the Cash Basis only to the extent that bills issued but not settled at the year end were taken into account. This basis found favour with many professional firms.
The third basis was the Accruals Basis which extended the Conventional Basis by recognising accrued and prepaid expenditure and also work in progress, ie incomplete work, at cost. This was not widely adopted by professional firms.
In 2000, the Inland Revenue via an earlier Finance Act, imposed the full accruals basis and everyone in business thereafter had to identify and account for work in progress at cost. In professional partnerships generally this meant staff costs inclusive of relevant overheads and excluding any element of partner cost. In limited companies directors take the place of partners and their time will be included, but any profit element will be excluded.
In 2003, by way of an interpretation of FRS5 issued in the 1990's, the Accounting Standards Board (ASB) issued Practice Note G on Revenue Recognition. This caused much debate and the widely held and publicised view was that little if anything had changed.
In March 2005 the ASB through its sub-committee known as the Urgent Issues Task Force issued UITF abstract 40 in which it spelled out quite clearly the basis of recognising income in respect of incomplete work for all service providers. The result is that for all accounting periods ending after 22nd June 2005 the accounts of all service providers have to recognise work in progress at full selling price. This applies to sole traders, partnerships, limited liability partnerships and limited companies.
There are some instances whereby pieces of incomplete work can be omitted from the year end valuation and the simplest to explain is where the outcome of the piece of work is 'at risk'. An example of this is a 'no win no fee' arrangement. If the work in question is incomplete at the year end and this case has not been won by that date then there is no right to any of the income.
Apart from these few instances, all incomplete work will require to be valued at full selling price. It is of no consequence if there is no contractual right to issue a bill for the incomplete work at the year end. It is sufficient that there is a right to expect to be paid for the work when it is completed. Therefore if a piece of work is, say, 50% complete at the year end then 50% of the expected final sales value has to be recognised regardless of whether or not a bill can be issued at that date for this amount.
Up until this time this incomplete work would have been valued at cost and in professional practices this would mostly exclude partner input. It would also exclude profit on the staff cost element. Therefore the change means a recognition of the previously excluded profit element as well as the partner input value. For many, this will represent a significant uplift in value.
The accounting rules state that in the year of change the whole year has to be measured on the same basis. The consequence of this is that the work in progress at the start of the year in which the change takes place has to be revalued on the new basis. The introduction of this revalued amount at the start of the accounting period creates an uplift adjustment of the difference between the new revalued amount and the previous value based on cost. This uplift adjustment is a one-off adjustment to move to the new basis and creates an exceptional one-off tax bill. Gordon Brown, in his pre-Budget Statement, has stated that legislation will be introduced to allow the tax cost arising from this uplift to be spread over at least three years.
What does this mean for you?
For many businesses there is the immediate consequence of the large tax charge arising out of this one-off uplift adjustment. Every year thereafter, because work in progress is now being valued at selling price, there is every likelihood that year on year profits will be greater thus giving rise to increased annual tax bills. All of this means pressure on cash flow and for many, there will be the need to arrange additional long term funding.
However, tax is only one concern arising out of this change. There are the strategic concerns for business continuity through succession. This increased value of work in progress will be added to the Balance Sheets thereby increasing the value of the capital in the business. The consequence is that on retiral the owners of the business, in the case of partnerships, will be seeking a full release of their investment that is now greater and in the case of limited companies a higher disposal price for their shares. This puts more pressure on future cash flows.
In addition, in the case of partnerships, incoming owners will be expected to introduce funds to match the existing owners and as this value is now greater then the incoming owners will require to find a greater amount of cash than previously. In the case of limited companies new management being brought into ownership will require to subscribe for shares that carry a higher acquisition value. All of this could act as a deterrent to the introduction of future owners.
If your business is that of a service provider, or if you have any questions in general, please contact us as soon as possible to discuss how this latest development might affect you.
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