Last word: Getting to grips with GAAP

Converting to limited-liability partnership is proving popular among UK law firms, but the accounting pitfalls should be carefully considered before taking the plunge. By Steve Gale, Horwath Clark Whitehill.

Although public financial reporting by law firms is becoming increasingly commonplace, conversion to limited-liability partnership (LLP) still provides plenty of challenges for the finance director who needs to strike a balance between the position that the partners may wish to present and a technically robust application of generally accepted accounting practice (GAAP).

For larger law firms this may be particularly challenging as the numbers that have been released previously for annual surveys may not have been prepared under GAAP and significant variations from the previously stated position evident in publicly available accounts may require some explanation.

The last few years have seen plenty of discussion about the accounting and disclosure issues likely to cause problems for firms becoming LLPs. Many of these, for example disclosures relating to members’ remuneration, have, by and large, turned out to be a non-event.

There are, however, a number of areas that still present very real problems. The requirement under the first LLP Statement of Recommended Practice (LLP SORP) published in July 2002 that annuity obligations for retired partners should be provided on the balance sheet caused enough head-scratching, but the publication of the revised SORP in March 2006 extended that obligation to providing for annuity rights being earned by the current partners. Where these are ‘life’ annuities and are linked to the level of profits, then not only is the number likely to be extremely large but also very difficult to calculate. The desire to move to LLP status will force many firms to examine, and perhaps revise, their annuity arrangements or possibly to investigate whether an LLP structure is available that will enable this future commitment to be kept off the LLP balance sheet.

The 2006 SORP’s discussion of members’ participation rights has also led to a variety of treatments being adopted. The treatment of members’ capital is particularly interesting: is it debt or is it equity? LLP agreements are not public documents and as such it is not possible to examine the subtle differences between those that allow one firm to treat members’ capital as debt and another as equity. Is it important? Well it might be. For an LLP that has a defined benefit pension scheme, the Pensions Regulator puts a levy on the pension scheme that is partly driven by a solvency rating assessed by Dun & Bradstreet. Although “loans and other debts due to members” are now shown in the ‘bottom half’ of an LLP balance sheet, the fact that it is a liability could be unhelpful as far as the solvency rating is concerned. The trouble is, one doesn’t know whether Dun & Bradstreet understands LLP accounts and whether they will understand the reality that members’ capital is actually the long-term funding of the practice.

Those that have defined benefit pension schemes will have to deal with FRS 17 and the prospect of bringing the likely deficit on the scheme onto the balance sheet and dealing with the movements in the deficit on an annual basis. Some practices have realised that a way of avoiding an element of these unwelcome fluctuations may be available by applying international financial-reporting standards (IFRS). The reason for this is that under IFRS, if the unrecognised change in surplus or deficit of a scheme (ie, those changes arising primarily through changes in actuarial assumptions) falls within a defined ‘corridor’, then that change need not be recognised in the accounts. If the unrecognised change is greater than the 10 per cent corridor, then the excess over the ‘corridor’ needs only to be recognised over the remaining service lives of the employees. The ‘corridor’ is the greater of 10 per cent of the fair value of the scheme assets or 10 per cent of the present value of the defined benefit obligations at the start of the accounting period.

So could using IFRS be a good idea? The application of IFRS for LLPs is permitted by the Companies Act, but essentially once the choice to apply IFRS has been made there is no going back. The use of IFRS in the UK is still relatively new and it is only the group accounts of quoted companies that currently have to apply IFRS, although AIM companies will have to follow suit during 2007/2008. The Big 4 accounting firms have largely taken the view that if they are having to see their clients apply IFRS then they will “do as they are doing to others” and will adopt IFRS themselves.

It may be that larger law firms will adopt a similar attitude. In many ways this might be a sensible approach – the convergence programme between UK Accounting Standards and IFRS is such that in a few years’ time there essentially will be no difference. All new UK standards have to comply with the international equivalent and FRS 25, which drove the LLP SORP’s new interpretation of members’ participation rights, is essentially IAS 32. Applying IFRS does not cause any problems for tax purposes; it is a perfectly acceptable set of accounting principles that the taxman will treat exactly the same as UK GAAP, ie, the accounting treatment will apply for tax except where tax law dictates otherwise. However, changing to IFRS would constitute a change in accounting policy and any change to profits will be taxed under the adjustment income rules that applied for the application of UITF 40. Don’t even think about mentioning “spreading” though…

Steve Gale is an assurance partner in the professional practice group of Horwath Clark Whitehill LLP. He can be contacted at Steve.Gale@horwath.co.uk.