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  • Writer's pictureCaroline Lyons

The Importance of Being Earnest-with Provisioning

In the good old days…

It was possible to use cash accounting for revenue recognition in legal and other professional services organisations. This meant that revenue was only recognised when paid. It also meant that neither accounts receivable nor work-in-progress (in the UK) / inventory (in the USA), were reflected in accounts.

This was great because it meant that businesses would not be able to overstate profits or working capital asset values. It was not so good for the tax collection regimes such as HMRC here in the UK or IRS in the US. In 2013 this all changed and both work-in-progress (aka inventory in the USA) and accounts receivable had to be included in their revenues.

Today, GAAP (Generally Accepted Accounting Principles), IFRS (International Financial Reporting Standards), and FRS (Financial Reporting Standards) are in place to ensure that published accounts present an accurate view of a business's financial situation, and a solid basis for charging tax.

Recognising that not all WIP would be billed or accounts receivable realised, and that accounts should show a "true and fair" view, businesses can make “provisions”, also known as “reserves ”, to reflect the likely value of the realisation of an invoice or work-in-progress.

Why are accurate valuations of WIP and Accounts Receivable important?

  • You may not be able to bill WIP at its recorded value—affecting cash flow down the line

  • You may not be able to collect your A/R at its recorded value—affecting cash flow immediately

The consequences of incorrect valuation include:-

  • Your firm may pay-out non-existent profits and, or capital to equity partners

  • Your firm may be paying tax on profits that will not materialise—affecting cash flow

  • You may discover too late that you have breached covenants on loans secured on working capital.

Generally Accepted Accounting Principles (GAAP), IFRS, and FRS are in place to ensure that published accounts present an “earnest” view of a business's financial situation. A/R and WIP are added to “revenue” and reflected in the business’s balance sheet. Provisions are permitted by GAAP and tax authorities to enable impairment in their value to be recognised—but they must be realistic.

What you cannot do for tax purposes is make “general” provisions as these will be treated like “depreciation” and will get added back. What is acceptable for tax purposes is the creation of a policy that is applied consistently for making provisions against individual invoices and matter WIP, where there are justifiable and reasonable grounds for believing that the book value is overstated. Preferably, you should have a system that is capable of being “audited”, and backed up with notes recording the reasons for the provision.

Automate your Valuation and Provision Processes with the CreditForce Working Capital Valuation Calculator

Many Firms only uncover this "inconvenient truth" once a year. Valuing Work In Progress (WIP) can be complicated and time consuming. The CreditForce Working Capital Valuation Calculator, however, will substantially automate this time-consuming business for you. The necessary information is gathered as Credit Controllers and Working Capital Managers are doing their day-to-day work. This enables the valuation and provision calculation process to be:

  1. Continuous and

  2. Included as part of the monthly management accounts reporting

A major benefit is that problems are uncovered, diagnosed, and appropriate action taken as soon as required rather than waiting until it may be too late. As Bill Gates famously quoted, “News must travel fast, but bad news must travel faster”.

You must demonstrate:

  1. Robust and consistent methodologies are in use and

  2. Provide detailed workings and documentation to support your WIP (and A/R) valuation and provision

Because if HMRC decide to investigate, severe consequences such as an assessment for underpaid taxes plus interest and penalties will follow if you fail to do this.

The CreditForce CreditForce Working Capital Valuation Calculator makes all this easy and highly efficient. Provision and valuation methods can be based on:-

  1. Age—the older the invoice or WIP, generally the less likely you are to realise 100%

  2. Classification Status—(e.g. disputed, contingent, no-win-no-fee, partner has left the firm etc.)

  3. Risk Rating—as published by a credit rating agency (e.g. "bankrupt”—in which case a 100% provision can be created.)

  4. FRS102—using average recovery rates for a matter, if this exists, and if not, for the client, and if that does not exist because the client is new, the department to which the matter belongs, and if that does not exist, because the department is new, the firm as a whole.

  5. Manual calculations—where the above are not relevant

CreditForce calculates each of these provision methods and provides a recommendation based on the highest value.

Let’s Recap

Accurate valuations of A/R & WIP mean that you will not:

  • Overpay your taxes

  • Overpay your partners

  • Overpay capital to partners who are leaving.

  • Suddenly discover that you are insolvent! This year there have been some interesting cases of precisely that.

The CreditForce Working Capital Valuation Calculator will help you substantially to avoid all of the above. Click here to request a demo.

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