Income recognition by professional firms

Revenue recognition and professional firms – the verdict

On 10 March 2005, the ‘Urgent Issues Task Force’ (‘UITF’) of the Accounting Standards Board issued UITF Abstract 40 ‘Revenue recognition and service contracts’. Abstract 40 applies to accounting periods ending on or after 22 June 2005 and so requires prompt attention by professional firms whose current accounting period ends on or after that date. For firms with an earlier year end, it would appear that the detail of the Abstract is unlikely to be relevant until 2006.

While the practical application of the new regime may still be subject to debate, the principles to be applied are now clear. Firms will have to recognise at least some revenue earlier than they have done in the past and, as a result, their tax liabilities will be accelerated.

Revenue or work in progress?

There has been considerable controversy about the recognition of revenue in professional firms following the issue in December 2003 of Application Note G to Financial Reporting Standard 5, “Revenue recognition”. Most of the “anti” brigade dwelt on the statement in Application Note G that it did not change anything in Statement of Standard Accounting Practice 9, “Stocks and Work in Progress” as indicating that firms could continue to calculate profit as they had done in the past. What those commentators failed to address was that Application Note G was not talking about work in progress at all; it was talking about revenue recognition and, hence, about a totally new asset representing accrued income, or “amounts recoverable on contracts” as some accountants are now characterising it. Whether or not it is considered that professional firms needed to be caught by revenue recognition rules designed to prevent large corporates from overstating their turnover, the fact is that they have been, as UITF Abstract 40 makes clear.

UITF Abstract 40 in summary

UITF Abstract 40 requires a fundamental change to the way that professional firms recognise revenue. In essence, we now have to recognise revenue over the period that the service is provided to a client and not at the point of delivery or invoice as in the past. This means that recording at cost work in progress at the year end for all incomplete client work will no longer be an acceptable practice. Instead, firms will record accrued income, including a profit element, and that means including partner time. The amount recognised should take account of uncertainties regarding what will eventually be billed subject to any “critical events” without which there is no entitlement to a fee at all.

To quote from paragraph 16 of Abstract 40:

“The UITF takes the view that Application Note G requires all contracts for services to be accounted for in accordance with its general principles…..The overriding consideration is whether the seller has performed or partially performed its contractual obligations. If it has performed some, but not all, of its contractual obligations it is required to recognise revenue to the extent that it has obtained a right to consideration through its performance”.

Clearly, it is of utmost importance to establish the contractual obligations to the client. The point to bear in mind is that Abstract 40, and Application Note G to which it relates, are both based on the accounting principle of commercial substance taking precedence over legal form. Therefore, it does not matter what the engagement letter says about when bills can be raised or the extent to which costs may be subject to taxing or other moderation, what is important is the service to be provided.

Paragraph 18 is the key:

“Where the substance of a transaction is that the seller’s contractual obligations are performed gradually over time, revenue is recognised as contract activity progresses to reflect the seller’s partial performance of its contractual obligations. This is the case where the substance of the obligation is either (i) to provide the services of staff i.e. where the seller earns the right to consideration as each unit of time is worked or (ii) to require the seller to use its skills and expertise in carrying out acts that will take some time to perform, even when the output is encapsulated in a document such as a report. In such cases, revenue is recognised to reflect the accrual of the right to consideration as contract activity progresses, by reference to the valuation of the work performed as described…in relation to long-term contracts Thus…in case (i).the amount of revenue may be derived from time spent; in case (ii) the amount of revenue will reflect the fair value of the services provided as a proportion of the fair value of the contract, which will reflect the time spent and the skills and expertise that have been provided”.

In other words, it does not matter whether or not a fee is computed by reference to time spent. What firms have to recognise is that the Abstract sees them as supplying our expertise over time in response to clients’ instructions and that supply must be treated as an asset in the form of a right to income. Fixed fee arrangements, capped fees or fees computed on the basis of “no less than £x but no more than £y” make no difference to the basic principle, they are just ways of determining the “price” for the service provided. However, as firms must recognise the value of what has been done at the year end relative to the value of the whole contract, the practical issue now is how they go about making that assessment.

If they use a time recording system, the selling value of time recorded at the year end will be the starting point for determining revenue. Where there is no time recording system, they will have to judge the proportion of the total service which was complete at the year end and recognise an equivalent proportion of the expected or eventual fee. Firms should consider establishing criteria for determining the stage work has reached and the value to be attributed to it so as to develop a relatively straightforward system that does not distract partners and fee earners from their client work.

The significance of critical events

In considering how they might determine the value of the new asset, it is appropriate to consider the circumstances under which they should not recognise an asset at all. Paragraph 19 of Abstract 40 states:

“Where the substance of a contract is that a right to consideration does not arise until the occurrence of a critical event, revenue is not recognised until that event occurs. This only applies where the right to consideration is conditional or contingent upon a specified future event or outcome, the occurrence of which is outside the control of the seller”.

So, to the extent that services are provided on a “no win, no fee” basis there is nothing to recognise unless and until the case has been won. If it has not been won at the balance sheet date, prudence dictates that no income should be carried as an asset. If the case has not been won by the time the accounts are approved, it may even be prudent not to carry the costs incurred so far as work in progress.

Similar considerations would be relevant for fees that are computed by reference to a % of the deal price, or the tax recovered where there is no right to consideration if the deal fails or the tax claim is refuted. Another example might be the conveyance fee that is levied only if completion occurs. The point to watch with these arrangements is that there is often a right to a notional amount to cover expenses. Because this right exists regardless of the contingent event, revenue should be recognised to this extent even if credit is taken for no other amount.

An action point for firms now is to undertake a review of contractual terms with clients to analyse services between those where there is a critical event and those where there is not.

Reflecting billing uncertainties

Turning to the question of the right of the client to challenge the bill, it is hard to see how this can be regarded as a critical event. However, it is definitely relevant in assessing the likely fair value of the total service to which the current % completion has to be applied. In paragraph 20, Abstract 40 states

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

Using estimated amounts where there is uncertainty is an accepted part of accounting practice. Thus it is acceptable to adjust for recovery rates below 100% but only if there is a real uncertainty about what will be recovered. Where, for example, the work is billed post year end and before the accounts are approved at full value it would be difficult to justify the discount if challenged, for example by the Inland Revenue.

One practical action point now is to reassess recoverability of work in progress and agree a policy for partners and fee earners to follow.

Long term contracts

Abstract 40 also deals with the accounting for long term contracts for services, that is, contracts for a single service or project that run for more than twelve months or which run for a shorter period but are so material that it is necessary to treat them as long term to achieve a true and fair view. In practice there is very little practical difference in the recognition of revenue between long term service contracts and other service contracts and so the principles set out elsewhere in this article should be applied.

Applying the new rules – tax and accounting implications

Abstract 40 applies to accounting periods ended on or after 22 June 2005. Effectively, it becomes part of Generally Accepted Accounting Practice (“GAAP”) from that date.

For most firms, adoption of Abstract 40 will represent a change of accounting policy within the terms of Financial Reporting Standard 18. FRS 18 requires the opening figures for the period in which the new accounting policy is adopted to be restated on the same basis. The difference, representing profits not recognised in earlier years, is credited to the profit and loss account for that period as a prior year adjustment.

However, prior year adjustments are only a feature of business accounts that strive to present a true and fair view. Many professional firms prepare their practice accounts primarily with a view to determining how profit is to be shared between partners and to establishing amounts payable by retiring or incoming partners and may not even incorporate a value for work in progress at present. In this context, it is the impact of the new rules on the firm’s tax liability which is more important.

There is specific tax legislation which deals with changes in accounting policy and this requires, in effect, that the prior year adjustment be treated as income arising on the last day of the first accounting period to which Abstract 40 applies. Therefore for accounting periods ending between 22 June 2005 and 5 April 2006, the uplift is taxable for 2005-2006 and for accounting periods ending between 6 April 2006 and 21 June 2006 it will be taxable for 2006-2007. The tax due on the uplift will consequently be payable as part of a ‘balancing payment’ due on 31 January 2007 or 31 January 2008. The uplift is taxable under Case VI of Schedule D, but is earned income and thus counts as ‘relevant income’ for pension purposes.

Impact on practice accounts

The most important points for partners in law firms will be the impact of these new rules on their profit shares and tax liabilities and this is where firms may want to review their current practice. In simple terms, if partners have to suffer tax on accelerated profit they may well consider that they should be entitled to withdraw that profit. This could present real problems for firms in terms of the drain on cash flow of accelerating both tax and profit payments. However, preparing practice accounts for profit sharing purposes and profit computations for tax purposes on different bases may be considered inequitable, particularly by any partner who is about to retire.

How firms tackle the issue will depend on a range of factors including the number of partners, their proximity to retirement, the firm’s cash position, whether goodwill payments are made on accession or retirement and the current capital structure. The need to fund accelerated tax liabilities and possible additional allocation and extraction of profit shares may help to focus our minds on billing and cash collection practices. There are few firms who would claim they could not improve further in these areas, and better cash collection means reduced borrowings and lower interest charges.

Strange as it may seem, Abstract 40 may provide an incentive to review and reorganise the business aspects of a professional practice which could, literally, pay dividends in terms of their profit return.

Author:

Stephanie Barber
Technical Principal
MacIntyre Hudson LLP

Tax comment:
Ken Moody
Tax Technical Manager
MacIntyre Hudson LLP