Traditionally, many professionals include only the funds that have actually been received and paid during the tax year when compiling their accounts. The majority have, therefore, excluded debts that are due to the practice, work in progress and even some liabilities.
However, under the new “accruals” system, practices will be required to include all the income and expenditure for a given period, even though some items may not have been received or paid. This means that debts and work in progress will now be included. This new method of reporting profits leads to a more accurate picture of underlying profitability. The peaks and troughs – often caused by the timing of fee receipts – are smoothed out.
The new rules take effect on the date of a partnership’s year-end in the tax year 1999/2000. So, if your year-end is 30 April, the new regulations will affect your practice from 30 April 1999. On that date, the difference between the value of the practice’s assets and liabilities under the new accruals basis and the value of assets and liabilities under the old “cash” basis will be taxable. To help ease the burden, this tax payment can, in most circumstances, be spread over 10 years. Accounts for future years should then be prepared on the accruals basis.
While there is a one-off tax hit as the new procedures bite, there are also benefits. One of the best side-effects of the new regulations is it they will force small practices to use accurate time-recording methods. This comes from having to calculate the worth of work in progress. It is unlikely that the Inland Revenue will simply accept that work in progress represents, say, three months’ billings; it will probably want a detailed analysis. However, the real issue is not what the Revenue may want, but that practice management systems can be enhanced by identifying and analysing the time spent on any project.
One of the best side-effects of the new regulations is that it will force small practices to use accurate time-recording methods
While considering the staff costs of work in progress, it is worth taking into account partners’ work in progress, as this can also provide the opportunity to unlock practice capital. In short, the introduction of a comprehensive time-recording system is a prerequisite for good management. Besides measuring work in progress, individual and departmental targets can be set and an analysis can be made of fee earners’ time and efficiency.
Since the new regulations require outstanding debts to be calculated for a given period, a second area for improving management is debt control. A good debt-control system helps to ensure that fees are collected promptly, which can only improve profitability.
Banks have for some years been guarded about lending to the architectural profession because they have been unable to judge a practice’s true net worth by looking at its balance sheet. The inclusion of debt and work in progress on the balance sheet gives a more accurate picture of the practice’s net worth and should therefore make it easier to raise finance.
Another result of including work in progress and debt on the balance sheet is that each partner’s capital account will increase (probably net of the tax charge), which raises the broader question of partners’ capital accounts. Many smaller practices operate with each partner running just one “capital” account for both capital introduced and undrawn profits. But the new rules should provide the impetus to consider a fairer capital and drawings policy whereby each partner runs a capital account (representing long-term capital) and a current account (representing undrawn profits).
Nick Antoniou is a partner in Smith & Williamson Chartered Accountants and can be contacted on 0181-446 4371.