What has been the impact on financial reporting for professional practices due to COVID-19?
The Covid pandemic has raised huge operational challenges as well as some unexpected opportunities. However one of the less talked about issues has been the impact of the pandemic on Financial Reporting.
Firms are now at the point at which they need to consider this in some considerable detail. There are several new issues to focus on and decisions to be made in preparing year-end accounts. We have set out the key areas for consideration below (based on UK GAAP – FRS 102 framework):
Members’ report / Directors’ report
The question here is whether the old adage of ‘less is more’ continues to apply. The challenge we put to firms is that in a period of uncertainty, do readers of the accounts assume the best when disclosure is minimal and boilerplate, or do they assume the worst?
We would advise that now is the time for firms to consider using their Members’ Report, Strategic Report, or for small companies the Directors’ Report to provide the user with reassurance about the firm’s response to the pandemic and a balanced review of the activity for the year and future developments.
CFO’s should consider their reports as a previously untapped shop-window that may be viewed by various stakeholders. These include potential employees and partners, lenders and their credit teams and clients (particularly those with panel/framework arrangements).
The typical push back by CFO’s is that they do not wish the competition to know more about the firm than is absolutely necessary. However, we challenge whether balanced reports and disclosure truly give anything of commercial sensitivity away. Indeed we may struggle to identify how balanced reporting ultimately benefits the competition.
However, the advantage of including a more comprehensive review to accompany the audited financial statements is that it carries greater credibility than boilerplate management information.
As a minimum we recommend to all firms the inclusion of a short Covid impact assessment in their Report.
The area of ‘going concern’ is always sensitive because raising this as a discussion topic may be inferred as a lack of confidence in the business. We encourage firms to think more widely on this point, particularly as the SRA and other regulators are increasingly interested in the financial position of firms.
Accountants or auditors are likely to be asking firms more detailed questions about anticipated cash flows for the year ahead. However, as noted above, we suggest that a robust disclosure within a going concern note in the financial statements may give the various stakeholders greater confidence over the viability and future success of the business.
The crucial aspect of this disclosure is including the key assumptions of how the Members or Directors have made themselves comfortable that the firm has sufficient financial resources to continue trading for the year ahead. This may be through bank facilities, Partner support, existing cash resources, deferral of liabilities, the use of government support, anticipated trading profits or, more likely, a combination thereof.
In presenting financial statements over the Covid period, it is highly likely that firms will have exceptional items to separate out in their financial statements. Separately disclosing the nature and amount of such costs helps the reader to understand those non-recurring costs that have depressed current year profits. This may be of particular importance when lateral hires are considering joining your firm.
FRS 102 is silent on the question of exceptional items, although it notes that additional line items are allowed within the income statement where they are relevant and also aid the user’s understanding of financial performance. Therefore, where a material amount of cost has been incurred during the Covid period, management may wish to show these items on a separate line in the income statement as an ‘operating exceptional item’. This would typically be supported by a brief note.
Furlough income and other grants
Furlough income (and SSP support) is a government grant and therefore should be shown within other operating income in the financial statements. From a timing perspective the income should match against the related expenditure. To be clear, it is not permitted to simply net off the furlough income against wages and salary costs.
Similarly, other grants received in the form of Covid support will need to be accounted for under S.24 of FRS 102. In our experience these are typically revenue grants and as such will be credited to ‘other operating income’ immediately if there are no performance conditions attached to the grant.
Impact of your year-end date
Certain of the accounting treatments discussed below are highly sensitive to the timing of a firm’s year end date. If the year end fell before the Covid lockdown (i.e. up to 29 February 2020) the impact of Covid is likely to be ignored in the financial statements in all but disclosure terms as a post balance sheet event.
Whether an event is adjusting, or non-adjusting is a key judgement. It will be difficult to argue that a Covid related post balance sheet event should be adjusted in accounts made up to a date before the impact of the pandemic was felt.
In terms of making provisions for items such as redundancy or restructuring, a provision may only be made under FRS 102 where a constructive obligation exists at the balance sheet date. Therefore, any provisions relating to the impact of Covid can only be made where an obligation existed at the year end.
For firms wishing to accelerate the impact of Covid in order to smooth profits and reduce tax liabilities we anticipate that this may be an area of some contention. As a related point we suggest you also consider the period end date of your firm as there are certain tax planning opportunities in that regards.
We also note that making a provision for future anticipated operating losses is specifically prohibited.
We have also received queries about provisions for onerous leases, particularly where firms have decided to make a permanent move to more flexible working patterns and therefore will need less office space in the future. For a lease, or part of a lease to be treated as onerous, the space must either be vacated or there should be substantial committed plans in place with the landlord to exit the space in the near future. Simply continuing to occupy the same space but on a less intense basis does not constitute an onerous contract.
WIP and debtors
Most firms have well established policies in place relating to provisions against trade debtors and the valuation of accrued revenue (work-in-progress), but we suggest that in recent months those policies may have become out-dated.
During the lock-down period it has been commonly noted that historic realisation rates of WIP have fallen due to staff feeling they need to charge more time to justify their role and also the impact of less efficient work-flows and practices. This will impact the valuation of accrued revenue at the year end and we therefore recommend that firms consider whether their methodology is still valid. On a related point we also consider there is greater risk that teams are carrying forward irrecoverable WIP due to concerns over job security.
Trade debtor provisions may also need more thought. If there has historically been a mechanical process behind the firms’ provisions this may need further consideration in the post-Covid period. This is likely to involve deepening the provisioning process and looking in more depth at the indicators of objective evidence of impairment losses, such as customers defaulting on payments or asking for concessions that would not otherwise be considered, whether customers are in significant financial difficulty at the reporting date, or it is probable that they will go into administration or liquidation.
In general terms it would seem sensible to have realistic provisions against both accrued revenue and debtors to avoid paying tax on profits that are unlikely to be realised.
Firms will have to consider whether certain assets are impaired and therefore need to be written down, even if there is hope for a rebound in the years ahead. Some areas where asset values may need to be considered are:
- Intangible assets
- Property assets
Unlike in the case of the other assets listed above, an impairment of goodwill can never be reversed in future periods
Where a loan has been received under the government backed scheme there is an interest holiday for the first 12 months, but, as with any other financial instrument, the accounting treatment does not follow the cash flows. Firms must look at the total finance charge over the term of the loan and spread that charge over the term systematically. Therefore, in year one there will still be a hit to the Income Statement even though there is no cash outflow.
Profit allocation in LLPs
Firms may wish to consider the timing of profit allocations in this period of financial stress. The issue is that where profits have not been allocated formally, they remain under the ownership of the entity rather than the partners personally, and therefore remain a business asset.
Historically, some firms have decided to simply allocate all profits once each year at the AGM when the accounts are approved. If this is the case and the firm were to fail before the profits were allocated, then all partner drawings relating to that year’s profits would be potentially repayable to the LLP.
Whilst the allocation of profits does not eliminate the risk to partners, it is one of the building blocks that may assist partners if they find the firm in a distressed state.
We also note that the deferral of partners personal tax payments potentially increases partner risk as HMRC will seek to recover this tax from partners personally should the business fail, but a balance is clearly required between protecting partners and not prejudicing creditors and indeed discharging the fiduciary duties of the office holders of the firm.
Distress and insolvency is a complex area and we therefore suggest appropriate advice is taken before changes are made, but now is a good time for a health check in this area.
In summary, there is a lot to consider and we therefore recommend professional advice it taken early both from an accounting perspective and in relation to the related tax implications. The team at MHA Carpenter Box would be pleased to advise you further on any of these topics in more detail.
For help or advice on any of the issues raised in this item, please contact our team on 01903 234094.