Victoria Lovell, a legal sector assistant manager at accountants Armstrong Watson, explains the most common mistakes that law firms make when preparing draft financial information for their accountants to use for the annual accounts and tax computations. (20 November 2023)
Getting your accounts correct first time saves time. It also allows your firm to make better business decisions and can save tax.
Below are seven accounting issues that often cause confusion and necessary adjustments at the end of the firm’s financial year.
1. Fixed assets
Your fixed asset register lists your firm’s assets. This register needs to be regularly updated to reflect any additions (purchases) or disposals (assets either sold or removed). If your accounting software does not have a built-in register, use a simple spreadsheet to record your assets.
Problems can arise when firms choose to capitalise, and therefore track, all equipment purchased. This can range from a new server costing thousands of pounds, down to replacing a faulty mouse costing less than £10.
Capitalising and then keeping track of absolutely every item of equipment incurs a hidden cost, because it leads to significant additional admin, especially when no one can remember what happened to such-and-such an item.
Instead, consider setting a monetary limit for capitalisation, with anything below this value being treated as a renewal and charged to the profit and loss account (i.e. written off in the year it is purchased).
This approach means that there are fewer assets to keep track of, and those assets on the register are the ones that are quick and easy to track.
This asset register also becomes a useful tool when looking to renew building and contents insurance, as the key information is readily available. You can then add in an amount sufficient to cover all the low-cost items.
Meanwhile, appropriate depreciation rates also need to be set for all categories of assets. For example, if a firm’s policy is to renew laptops every four years, computer equipment should be depreciated over four years to reflect the expected useful life of the asset.
2. Bad debt provision
Many firms do not calculate a provision for bad debts and end up paying more tax that year as a result.
In addition to your monthly credit control procedures, you should review all trade debtor balances as part of your year-end procedures. Make a relevant provision for any balances deemed irrecoverable. These provisions can include any known ‘bad debts’ (for example, if a client has gone into liquidation), plus any balances from clients that are overdue for payment. This specific provision, based on listed evidence, is a tax-deductible cost for the firm.
Any unbilled disbursements should also be reviewed for recoverability. Again, make a provision for any thought to be non-recoverable.
Law firms incur several large annual costs, with professional indemnity insurance and practising certificates being the main examples.
These expenses can cover multiple accounting periods (for example, PI insurance for six months of this financial year and six months of the next financial year), which must be reflected in your financial information.
Any large expenses covering future accounting periods should be treated as prepayments, so that relevant costs are spread over the period the costs cover, including any future years.
Some firms attribute 100% of the cost to the current year, which falsely reduces profits (and therefore tax) if it is not corrected.
4. Work in progress
Recoverable non-contingent work in progress (WIP) at the financial year-end date should be included within the firm’s accounts, as an asset on the balance sheet.
However, if a firm time records, this will not simply be the value of WIP recorded as at the year-end.
Thoroughly review any year-end WIP reports, to remove any non-recoverable or contingent WIP and achieve an accurate WIP figure. This can be done by applying a recovery rate that is based on historical analysis, or by reviewing actual billable WIP client-by-client.
If the firm’s policy is not to time record, you can value WIP on a similar basis, by applying a recovery rate for any fixed fee agreements or by reviewing each matter client-by-client. This policy should be applied consistently from year to year.
5. Loans and financing
Many law firms use external finance to cover costs such as professional indemnity insurance or to fund new computer software.
Set up any finance agreements properly within the accounts, showing the amount of outstanding loan as a liability on the balance sheet, plus any interest that has accrued but not yet been paid.
Some firms treat all finance repayments, including future payments, as a profit and loss expense, which is the incorrect treatment.
6. Ledgers not agreeing to nominal codes
As part of a firm’s three-way bank reconciliation, matter balances need to be reviewed and checked against the nominal ledger and the firm’s bank account on a regular basis.
The problems arise when checking of the matter balances to the nominal ledger doesn’t happen often enough and differences creep in.
Differences between the ledgers and nominal codes tend only to occur when journal entries are posted in an attempt to correct an error. It is worth checking the matter balance to the nominal at the year-end to ensure no differences have arisen.
This review should also be extended to cover trade debtors and trade creditors. Check the balances on their respective year-end reports to ensure that they agree with the values in the nominal ledger, so any differences can be swiftly investigated.
At the year-end, ensure that all late invoices from suppliers are recorded and any other anticipated costs relating to the financial year in question are also included.
Common oversights include accountancy and SRA Accountant’s Report fees, and overhead costs such as heat and light that are billed after the end of the financial year.
These are all tax-deductible costs, so it is well worth accounting for them all in the correct year.
Your accountant can help to set up processes that address all seven of these problem areas. There always tend to be some adjustments to make at the year-end, but each year-end should be a learning process for your team — leading to fewer and fewer issues to resolve each year.
Why do law firms choose Armstrong Watson?
It’s because this accountancy firm has built an outstanding reputation in the legal sector, working as preferred partner of the Law Society.