When published by the Accounting Standards Board (ASB), Application Note G (known as AN G) created uncertainty among professional firms, because some commentators believed it required them to accelerate income recognition on short-term contracts. This would result in partners paying tax on income that they had not yet received. Recognising this risk, many managing partners set about reducing levels of work in progress and maximising billing.
Even in the absence of AN G, this made sound commercial sense.
On 10 March 2005, the ASB's Urgent Issues Task Force issued Abstract 40, which redefines UK Generally Accepted Accounting Practice for revenue recognition of service contracts. This is to be welcomed, although some uncertainties remain.
Abstract 40 requires that, for accounting periods ending in or after 22 June 2005, contracts for services should be accounted for as the contract activity progresses, and revenue should be recognised to reflect the seller's partial performance of its contractual obligations. The amount recognised should reflect any uncertainties as to the amount that the customer will pay. However, where the right to consideration does not arise until the occurrence of a critical event, revenue is not recognised until that event occurs. This is likely to mean that:
l There will be a one-off acceleration of profit recognition as turnover will be increased by the 'fair value' of work, which previously would have been treated as work in progress. For partnerships this could be significant, if only because of the need to recognise the fair value of partner time.
l The fair value of contract activity will take account of normal (or expected) recovery rates. Estimates of fair value may also take account of the stage of completion of the contract at the accounting date.
l If fees are contingent, they will not be recognised until the contingency is resolved.
l Except for genuinely unresolved contingent abstracts, unbilled work on service contracts will be disclosed to debtors as 'amounts recoverable on contracts'. Unresolved contingent contracts will continue to be disclosed as work in progress and stated at the lower of cost and net reasonable value, which could in some cases be nil. However, if the bulk of a firm's work is conducted on a contingent basis, it is likely that the relevant costs, or perhaps a percentage thereof based on past experience, would be carried forward as work in progress to match future income.
If applying Abstract 40 gives rise to material adjustments to financial statements, it is necessary to consider the impact on previous periods and how this should be reflected.
The Task Force gives no guidance on this, but firms must determine which approach to adopt, based on their own circumstances. Consequently, is the SSAP 9 (Statement of Standard Accounting Processes) 'Stocks and Long Term Contracts' superseded by Abstract 40? We expect that most firms will take this approach. Has the firm incorrectly applied SSAP 9 in earlier accounts? Does Abstract 40 do no more than clarify SSAP 9?
The first thing to consider is, has SSAP 9 been superseded by Abstract 40? If so, how will any adjustment arising from Abstract 40 be taxed, and what policy should be adopted for the firm's accounts?
The legislation provides that the 'adjustment' should be treated as arising on the last day of the first period of account for which the new basis is adopted. The adjustment is allocated to the partners in the profit-sharing ratios (PSR) of the 12 months ending immediately prior to the date the new basis is adopted.
If additional income is not recognised in the accounts, and the adjustment treated as applying only for tax purposes, then the effective rate of tax suffered by partners could cause problems where the figures are large.
If additional income is recognised in the accounts, issues of funding the additional profit share may arise.
Companies may therefore wish to restrict the ability of partners to draw down profits, perhaps limiting this to amounts sufficient only to cover the corresponding additional tax liabilities.
Notwithstanding some uncertainties regarding the practical application of Abstract 40, it is clear that many firms will face accelerated tax liabilities as a result. With the first tax payments due on 31 January 2007, firms now need to determine their approach to revenue recognition.
Firms with 30 June 2005 year ends have the least time to plan.
George Bull is head of the professional practices group at accountant Baker Tilly.
Email: george. bull@bakertilly. co. uk