NEW ACCOUNTING RULES FOR THE WAY INCOME IS TO BE RECOGNISED BY BUSINESSES SUPPLYING SERVICES

This News Flash deals with the recognition of income for businesses supplying services (rather than goods) such as professional practices, barristers, estate agents, designers, and maintenance companies, following the recent publication of UITF Abstract 40 “Revenue recognition and service contracts” (the “Abstract”).

As a result of the Abstract many professional practices and service providers will find that the recognition of income is accelerated, particularly in respect of work done by partners or principals, with a consequential acceleration of the tax liability.

The Abstract is mandatory for accounting periods ending on or after 22 June 2005.

Background

FRS 5 Application Note G “Revenue Recognition” was issued in November 2003 to clarify the criteria for recognising income, principally to prevent businesses from anticipating income prematurely in order to demonstrate revenue growth. When it was issued, a few commentators considered that its implications were wider reaching and required service providers to recognise income on assignments as the work progressed (rather than when it was completed) thereby accelerating the recognition of profit. After much debate, the matter was referred back to the accounting standard setters. The result was the issue of the Abstract.

General Principles

In essence, the Abstract requires that where the substance of a contract is that the provider’s contractual obligations are performed gradually over time, revenue should be recognized as contract activity progresses to reflect the provider’s partial performance of its contractual obligations. In practical terms, this means that work done before the year end, but unbilled, will need to be included in the accounts, as opposed to the ‘old’ treatment of only recognising income when the work had been completed. Consequently, income will now need to be recognised earlier than would previously have been the case. The additional income to be recognised will be based on the anticipated fees that are likely to be recovered from the client for the work done (thereby including partner or principal time and profit).

There is some comfort in that the Abstract recognises that:

Contracts that require services to be provided on an ongoing basis (such as accounting or payroll services, help desk support, and on-going maintenance services) should be accounted for as at present and there is no need to accrue income early.
Where the substance of a contract is that a right to income does not arise until the occurrence of a critical event outside the control of the service supplier (as would be the case, for example, with a no win-no fee type arrangement or commission payable on exchange of contracts), income is not recognised until that critical event occurs.
Where the terms of the contract provide for minimum (or abort) fees and/or fees which are contingent on success, as may be the case with corporate finance work (e.g. being dependent on a transaction completing) or speculative design work (e.g. dependent on planning permission being obtained), then only the minimum fees need initially be recognised, with the success element of the fee being deferred until the conditions for its payment are satisfied.

These principles are best illustrated by means of examples:

Example 1

A solicitor is engaged to provide legal advice which is expected to generate a £30,000 fee. At the year end £20,000 worth of time (including Partner time valued at charge out rate) had been spent and a 95% recovery rate is expected to be obtained. Under the Abstract, £19,000 (£20,000 x 95%) of income should be recognised at the year end.

Example 2

Working on a flotation where the terms of reference provide for fees of £30,000 for preparing the Prospectus and a success fee of £20,000 if the minimum subscription is achieved. At the year-end £20,000 worth of time (including partner time at charge-out rate) has been incurred.

40% (£20,000/£50,000) of the value of the engagement based on the total expected fee has been completed and hence only 40% of the ‘known’ element of the fee of £30,000 i.e. £12,000 should therefore be recognised at the year end (being the deemed proportion of the services to date). No proportion of the success fee should be recognised since the critical event of achieving the minimum subscription had not occurred before the year end.

Tax Implications

In essence, the change in accounting practice will result in accounting profits being taxed faster than before.

There will also be a tax hit when the Abstract is implemented for the first time, reflecting the alignment to the new basis of accounting. The Government has recognised this and the Finance Bill 2006 proposes measures to spread the initial impact of the Abstract on first adoption (‘adjustment income’) over 3 years, with spreading being available for up to 6 years where the impact is greatest.

The basic rule will be that the adjustment income will be initially spread over 3 years. The 1/3rd so calculated will be compared to 1/6th of the taxable profit (before capital allowances and other reductions in profit reflecting other changes in accounting policy) in each year and the lower amount will be taxed. This will continue for up to 5 years, or until the adjustment has been fully taxed. After 5 years, any untaxed balance will be fully taxable in the 6th year.

The adjustment income will be calculated on the opening work-in-progress of the first accounting period affected e.g. for a 31 March 2006 year-end, the adjustment income will be calculated as at 1 April 2005.

A very simple example of a seriously affected business with adjustment income on first adoption of £120,000 and taxable profits for years 1 to 6 of £60,000 per annum would be:

Year 1-5: the uplift for tax purposes would be £10,000 (lower of 1/3 of adjustment income (£40k) or 1/6 of taxable profit for year (£10k)).
Year 6: the balance £70,000 (£120k - (5x£10k)) would be taxable.

For Partnerships, LLPs and sole traders, the Abstract will affect the first accounting period ending on or after 22 June 2005, with the first increased tax payment arising on either 31 January 2007 (for accounting periods ending between 22 June 2005 and 5 April 2006) or 31 January 2008 (for accounting periods ending between 6 April 2006 and 21 June 2006). The spreading provisions will help to lessen the impact, although not as generously as it first appears since the proportion of the adjustment income assessed in a tax year will affect the following year’s payments on account.

Limited companies will be similarly affected, but will also be eligible to take advantage of the spreading provisions mentioned above. For companies not paying corporation tax by instalments, the first tax payment so affected will be payable 9 months and 1 day after the end of the first accounting period ending on or after 22 June 2005. For companies paying their tax by instalments the interim payments may need to be adjusted.

Businesses affected by the Abstract should assess its impact sooner rather than later, particularly to ensure that sufficient funds are available to pay any additional tax arising on its introduction. In addition, billing arrangements should be reviewed to ensure that, wherever possible, work is billed on a regular and timely basis given that tax will now be payable on incomplete work, regardless of whether or not it has been billed.

It is also recommended that action be taken to determine the adjustment income eligible for spreading, so that its tax effect can be considered early on.

Please contact Bond Partners LLP (+44 870 850 6007) if you have any queries or would like to discuss any of the above in further detail.

The above information is general in nature and is subject to change. It is provided without acceptance by Bond Partners LLP of any responsibility whatsoever, and any use you wish to make of it is, therefore, at your own risk.