FRS 102 - Recognising income in law firms - is our firm doing it right? By SPONSOR PKF Francis Clark LLP

FRS 102 - Recognising income in law firms - is our firm doing it right? By SPONSOR PKF Francis Clark LLP

Many partners in law firms will have the terms FRS 5 and UITF40 etched in their memories and will immediately recollect the cash flow horrors and transitional accounting complications of moving from a cash basis of accounting to a full accruals basis in respect on income.

Whilst we all thought this issue was closed unfortunately more recent interpretations of a new accounting standard have called a specific, but important, part of income recognition in law firms into question again.

Briefly, in terms of background, FRS 102 is an accounting standard that has now replaced FRS 5, UITF 40 and all other accounting standards. So FRS 102 becomes the relevant basis on which most law firms will prepare their accounts – certainly for tax purposes and where relevant for statutory reporting purposes.

The area where FRS 102 changes the position compared to FRS 5 / UITF 40 is in respect of conditional fee agreements.

Position under FRS 5 / UITF 40

  • At the balance sheet date if the matter contingency was met e.g. liability was admitted then the best estimate of the matter value at that time would be included in the accounts.
  • For the purposes of valuing such matters post balance sheet events up to the point of signing off the accounts remain relevant.
  • If the matter contingency was not met at the balance sheet date law firms had the option to include the unbilled time at either nil or cost.
  • Post balance sheet events for matters where liability is not admitted at the balance sheet date were not relevant.

Interpretation of position under FRS 102

Sector interpretation here has been evolving over the last year; the following summarises current common thinking:-

  • The significance of the balance sheet date has been removed. The relevant point for assessing contingent fees is now the date the accounts are signed off.
  • At this date if the contingency is met then the best estimate of the matter value at that time would be included in the accounts.
  • If however at this date the contingency is not met then firms will need to either value the matters at nil or full value (estimated recoverable value).
  • In order to support the option of valuing at full value firms will need to demonstrate that:
    • The value of the revenue can be measured reliably
    • It’s probable that the economic benefits associated with the transaction will arise
    • The stage of completion of the transaction at the year-end can be measured reliably
    • Costs incurred and cost to complete the matter can be reliably measured.
  • Crucially the option to include such matters at “cost” has been removed under FRS 102 – it’s either valued at nil or recoverable (full) value.

Impact for law firms

Firms undertaking substantial amounts of contingency and conditional fee agreement based work are the firms who are potentially affected by this interpretation. So; areas such as Personal Injury, Medical Negligence, commercial property and general commercial transaction work are the most obvious cases that come to mind.

Comparing the differing treatments above under FRS 102 there is a challenge for law firms to demonstrate that where the contingency is not met on a matter that it can meet the requirements to support the recognition of any revenue. The exception to this perhaps are firms where they undertake large volumes of homogenous matter types; here it would seem viable to support a revenue value for such matters.

Firms who under FRS 5 valued non-liability matters at cost in many cases will now face the decision as to whether they value such cases at Nil or substantiate why the cases meet the revenue recognition requirements outlined above.

In our view firms in this position will need to be looking at their process for supporting the revenue in such matters but also reasons to keep the valuation of such revenue at a controlled level appropriately taking into account any remaining risks and timeframes over which such income will ultimately be received.

Overall, having been closely involved over the last 10 years in valuing these types of legal matters it seems likely that for many firms where they relied on the “cost” approach to valuation that moving forwards under FRS 102 those same matters may now be either be recognised at either :-

  1. nil
  2. full value but with appropriate commercial reductions

Overall however our expectation is that for the majority of law firms this will not result in a materially different figure for income recognised in any individual reporting period.

There remains a good deal of subjectivity in the interpretation of FRS 102 in this area. Invariably that means that the accounting treatment between law firms acting in the same areas of law could be quite different and may also change over time.

Arguably this is no different to the current position where law firms have the option of cost of nil valuations on matters where the contingency is not met, but the guidance under the previous UITF 40, did enforce a consistency of approach. Under FRS 102 the whole subject is more subjective.

Readers of law firm accounts will need to consider this point moving forwards and the explanation of approach under the accounting policies notes in law firms will become an increasingly important point moving forwards.

Action points for firms:

  • Consider the impact of post balance sheet events - do you want to get your accounts signed off earlier or later than you currently do as a result of FRS 102?
  • If your firm relied on the cost valuation approach under FRS 5 consider the impact on your year-end procedures, recognition approach and what impact this might have on your reported income and profits.

We have significant experience in all aspects of the valuation of unbilled time for law firms. If you would like to speak to us about any specific issue here please get in touch.

This publication is produced by Francis Clark LLP for information only and is not intended to constitute professional advice. Specific professional advice should be obtained before acting on any of the information contained herein. Whilst Francis Clark LLP is confident of the accuracy of the information in this publication (as at the date of its production), no duty of care is assumed to any direct or indirect recipient of this publication and no liability is accepted for any omission or inaccuracy.

 

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