Work in progress: what is true and fair?
The long-awaited guidance on the valuation of work in progress was issued last November. This follows the Revenue's decision to withdraw the cash basis of accounting for periods ending in the year 2000/2001. The guidance is regarded as good news, but some areas still require clarification.
The Revenue is taking a flexible approach to the requirement that the taxable profits of professional businesses should show a true and fair view. The guidance stresses that it is not the accounts that need to show a true and fair view, only the taxable profits, and thus adjustments could be made solely on the tax computations. However, either route will raise the question of equity among partners. Care will be needed to ensure partners are not burdened with a tax charge but receive no corresponding profit share or compensation for the tax charge.
Two Statements of Standard Accountancy Practice (SSAP) are considered important in arriving at a true and fair view: SSAP 2, dealing with going concern, accruals, consistency and prudence, and SSAP 9, relating to the valuation of work in progress.
SSAP 9 states that work in progress should be valued at the lower of cost and net realisable value, the intention being to match income and expenditure. In partnerships there is no expenditure for Schedule D partners' time, as this is a an appropriation of profits. Partners' time is therefore not valued for this purpose. Chargeable staff time should be valued at direct cost (salary, national insurance, pension costs etc) and attributable overheads. There has been ample discussion on how to allocate overheads. SSAP 9 states that all overheads incurred in producing the work need to be included in the calculations. This basically means all overheads other than those used in carrying out marketing and some administrative functions. The guidance states, with certain caveats, that overheads can be ignored for: O sole practitioners and partners' time O staff of sole practitioners O firms of two to four partners where the ratio of staff to partners would make the figure immaterial.
Overhead recognition will be required for large firms and is likely to be needed for intermediate-sized ones.
The Revenue is being flexible as to how the figures are calculated and states that there are no rigid rules, although the matching concept is paramount. Many professional firms do not maintain time records and the Revenue acknowledges that other approaches to determining work in progress are possible, e.g. examining client files where costs are maintained or the review of a post-year-end billing exercise. Whatever the approach, a method of excluding partners' contribution to the work will have to be identified or excess tax may be paid.
The flexibility being shown by the Revenue is encouraging, but there is concern that its approach may cause difficulties for auditors asked to give a true and fair view
Prudence is essential when calculating work in progress and it should not be carried forward if it is not recoverable, but remember that many under recoveries arise only in relation to a calculated selling price. It is rare for direct costs, excluding partners' profit, not to be realised.
The guidance notes provide clarity on speculative or contingent fees. No value should be attributed to these contracts unless, when signing the accounts, the outcome of the contact is known. If fees have been generated, the attributable costs should be included in the work in progress figure.
The question of long-term contracts and the treatment of an account billing are also considered. The Revenue will take a relaxed approach if profits are not distorted year-on-year and if there is no delay in income recognition.
The flexibility being shown by the Revenue is encouraging, but there is concern that its approach may cause difficulties for auditors asked to give a true and fair view. This will need to be considered carefully, if incorporation or the Limited Liability Partnership route is on the horizon. In the meantime, consider how you are going to extract the information you will need to comply with the Revenue's requirements and how you are going to explain your approach.
Finally, and most importantly, do not forget the planning opportunities this change presents.