Help, I sell professional services, I need to value my Work in Progress

A recent clarification as to how year end work in progress (WIP) should be accounted for by professional services firms may leave many of them with an unexpected tax bill.

Up to 10 March 2005 it was accepted by both the accountancy profession and by Revenue that professional services firms could account for their year end WIP at cost. This cost figure was made up of office overhead costs plus staff costs (below partner/principal level). The profit element of staff charge out and partner/principal charge out rates were both ignored in calculating year end work in progress.

The accepted reasoning behind this was that in most professional assignments ‘value” is delivered only at the end of a project and usually by a partner/principal. As long as “value” has not been delivered to the client it would be hard to establish any profit. In a law firm the “value” of a conveyancy assignment would only accrue when the partner/principal could tell his client that he has good title to a property. In an audit firm the client in theory is paying for the “value” of a signed audit report by the engagement partner.

All this has been acceptable under the accounting standard SSAP 9 (accounting for stocks and work in progress) which forms part of Irish Generally Accepted Accounting Practice (Irish GAAP).

Parallel to SSAP 9, Revenue’s position on WIP is that as long as the accounting treatment of WIP in a taxpayer’s accounts is consistent year in year out they will accept the taxpayer’s accounts as a valid basis for making an income tax return.

However on 10 March 2005 the Accounting Standards Board (the accounting rule makers) issued a new accounting rule in the guise of UITF40 (Urgent Issues Task Force Statement No. 40) stating that for accounting periods ending on or after 22 June 2005, contracts for services should be accounted for as “contract activity progresses” and resultant income should be recognised to reflect the service provider’s partial performance of its contractual obligations. The amount recognised should reflect any uncertainties as to the amount the customer will pay. However where the right to consideration does not arise until the occurrence of a critical event, income is not recognised until that event occurs.

In practice the following is likely to happen:

• A once off increase in profits due to the recognition of WIP to include profit
• Additional income tax due on the enhanced profits arsing from the change in calculating WIP
• The fair value of contract activity at year end will need to take account of normal (or expected) recovery rates
• If fees are contingent they will not be recognised until the contingency is resolved.

Revenue recognise that professional services firms who adopt UITF40 to comply with Irish GAAP could potentially be hit with a large once off tax bill purely by preparing accounts that give a true and fair view. To ease the cash flow implications of the change in accounting rules, Section 56 of the 2006 Finance Act allows for a 5 year transition period whereby taxpayers can settle their “up lift” tax liability over a 5 year period.

The major points one should take into account when considering the value of professional work in progress are:

• While Revenue have given tax payers a 5 year period to settle their tax bill, growing firms will need to consider the continuing level of “fair value” WIP they must recognise in their accounts and the resultant take by Revenue.
• Firms will need to establish what their “average recovery rate” is and apply this against the time recorded on assignments to work out their year end WIP.
• Firms will need to review partnership agreements to see what implications there are for retiring and newly admitted partners arising from higher WIP levels.
• Firms should review their billing procedures to increase the frequency of stage payments.
• Firms should review their systems and procedures to see how time spent on assignments can be minimised.
• Firms should review their partner pension contributions; increasing pension contributions may cover the uplift in profits against taxation.

The above article has been prepared in good faith in the form of general guidance and is not intended to be relied upon as specific professional advice. If you have queries arising from the article please contact your professional advisor or this office.