Historically, the Income Tax Act allowed designated professionals such as lawyers, doctors, and qualified accountants to exclude the value of their year-end work-in-progress. This approach was commonly referred to as billed-basis accounting (or BBA) because this amount was included in taxable income when the client was billed.
Last year, the federal government eliminated BBA, albeit in a phased-in manner, for all fiscal years beginning after March 22, 2017. For the designated professionals, WIP is now deemed to be inventory as required by paragraph 10 (5) (a) of the Act.
This change on accounting and costing of WIP will have an impact on law firms. Here is how they will be affected.
Impact of changes on accounting and costing of WIP
In the past, law firms didn’t have to include their WIP in determining their business income. As such, the calculation of WIP for tax purposes was not a priority. That has changed as law firms are now required to include WIP in taxable income . Making matters even more interesting, there is no legislative definition of WIP in the Act. Accounting and costing of WIP will involve some degree of judgment, which I expect will result in different approaches.
Even so, to determine the right approach for this evolving area, the goal should always be an accurate presentation of the tax filer’s profit for the fiscal year.
Currently, inventory is valued at lower of cost (LCM) or fair market value (FMV). This would be acceptable for WIP accounting and costing for law firms. However, there is an option to record WIP at FMV or in a prescribed manner. But depending on the situation it may result in higher business income.
Let’s look at what fair market value and costing of WIP entails.
Similar to other professional services firms, law firms typically carry their WIP based on billing or charge-out rates of lawyers on the file and it’s reasonable to assume this is the expected amount to be billed. From an accounting standpoint, it is the carrying value of the WIP’s approximate fair market value (inclusive of an implicit profit margin).
There are two reasonable ways to determine the WIP cost, based on how the calculation of inventory ought to be done, as discussed in the CRA’s past administrative guidance.
Under the first — the direct costing method — firms must allocate variable overheads to WIP. That will mainly include professional costs in case of law firms. However, it’s important to note that there is no clear guidance in the Act or in CRA’s administrative position, or even in accounting guidance (both under International Financial Reporting Standard or Accounting Standards for Private Enterprises) for professional services providers, like law firms. So, law firms must use their judgment.
Under the second — the absorption costing method — the firm will allocate variable and fixed overheads in the determination of the WIP. This way, in addition to variable cost, the firm must allocate general overhead expenses.
For matters on contingency, the idea is to set an amount that one would reasonably expect to receive from the arrangement. That means, until the contingence is solved and the right to collection of an amount is established, it may be acceptable to recognize no amount in the law firm’s taxable income.
Finally, exercising judgment in valuing WIP still requires “correctly” and “accurately” presenting the firm’s income for the year. Accordingly, I would expect each law firm to make a determination taking into account consideration its situation, type of service provided, and related transaction flow.
All of this amounts to a radical change in accounting and costing WIP for law firms. To help them adapt, the rules allows for a five-year phase-in period for taxation years beginning the effective change date of March 22, 2017. For calendar year law firms, the first tax year affected is the year ending on December 31, 2018. Depending on the level of unbilled activities, law firms may face unexpected tax liability (i.e. stain on cash flow) on unbilled WIP. However, during the transition period they can include 20% of WIP (depending on the approach discussed above) in the first year, 40% in the second year and by fifth year, include 100% of the WIP.
Many law firms have traditionally used the exemption to exclude WIP in the calculation of their taxable income. So, this change will require updating the current system, accounting and costing processes of tracking and reporting WIP. A determination is required of various costs elements within WIP to ensure there is proper supporting documentation for the law firm’s position on the yearly tax filing. Also, law firms should revisit their internal processes to potentially accelerate the billing and collection (where possible) to better manage the cash flow impact of tax liability. Finally, they should assess whether these changes require revisions or amendments (with relation to draws, retirements, taxation income allocation, etc.) to the partnership agreement.