Work In Progress (WIP) - new basis of valuation.

This issue is about to become a real thorn in the side of any business that invoices their customers based on a chargeable rate per hour. Even accountants will be affected by these changes!

Basically, new accounting regulations dictate that sales must now include work done not billed - valued on a sales basis and not on a cost basis. This will include all the unbilled chargeable time of staff and partners or directors. Strictly speaking this is not a work in progress adjustment but a sales adjustment. The most immediate effect is that in the year in which this adjustment first takes place firms will see an increase in profits, and therefore tax, due to a change in accounting policy. No more funds will be generated by the adjustment and cash flow will suffer as the extra tax bills become due for payment.

For professional practices carrying large unbilled time ledgers the extra tax charge could be significant. For example, if in the past a firm of solicitors has valued work in progress at cost (salary costs) say £100,000, the true sales value of this asset may be nearer £250,000. This would increase the taxable profits of the partnership by £150,000 in one year - for self-employed business owners this could cost an additional £60,000 of extra higher rate tax!

There will be a period of grace before this comes into effect as it will apply to accounting years ending after the 22 June 2005.

A number of practical problems arise:

• When do you introduce the change in valuation into your accounts?
• How big is the additional reserve and how is it calculated? Do you have the systems to cope with this?
• For partnerships, in what partnership profit sharing ratio is it to be apportioned?
• How big a tax bill is it going to create for this first year - a significant amount for most businesses, and needs planning.
• Clients need to take into account that the accounting information we will require for next year onwards will be on a different basis and also needs planning. Do you have the systems to cope?
• As this is a sales adjustment will you need to pay VAT on the total value of the new reserve? The answer for most businesses will be no. Fortunately as long as you can argue that you are providing a continuous service, then the tax point is date of payment or invoice date which ever comes first.

A number of possible mitigating solutions:

• If you have been undecided on the incorporation of your business, this may be the clincher! Companies with profits under £300,000 will only pay tax at 19%.
• If you have work done not billed at the end of the year maybe this is the opportunity to move to monthly billing? Invoice all chargeable hours at the end of your year and this will generate the cash to pay the additional tax.
• Possible spreading rules - the Inland Revenue may introduce rules that allow you to spread the tax cost over a number of years. As yet this is speculation although similar changes to the tax code in the past have included the right to pay over an extended period.

Remember to call us for advice on all the above points, whether you are a company, partnership or sole trader. If you bill your clients on a time basis it's time to start the planning process now!