The legal team at PKF Francis Clark are helping law firm clients address the current challenges they face.
Here we have included a range of practical tips and actions firms might want to consider as part of their current strategy in managing the economic effects of COVID-19.
If you would like to talk to us about any of the issues raised or any other matters you are facing more generally in respect of COVID-19 please do get in touch.
1. Cash not profit is key
In the short term for most law firms cash will be the most important consideration as it is likely that for most firms incoming cash will decline rapidly. As other businesses and individuals consider how they spend their cash it is less likely that settling outstanding legal fees will be at the top of the list!
Understanding the cash point is wider however; for example you may have a work force that is very busy, reporting lots of matter starts and recording lots of time. However if this work stream is not going to generate the cash you need (when you need it) you may still need to take action to reduce short term staff costs and capacity by either considering short working weeks or even redundancies.
We are expecting more announcements on Government support and relaxations of tax regimes to help firms keep their employees in post. The detail of any such arrangements will need to be considered carefully by firms both in terms of the short and medium term impact. In particular if the support ultimately amounts to additional balance sheet debt then firms need to consider the viability of the business longer term in relation to servicing or repaying the debt.
2. Remember 2008 and 2009
A common feature of law firms that suffered longer term financial challenges and even failure was a reluctance to take early action in reducing costs (primarily people costs). Taking action too late in the cash flow position for a firm can increase the redundancy and longer term financial implications. There is a risk for some firms that if they leave important decisions too late the subsequent actions available to them may be more limited in nature and also less effective.
There are lots of different ways that firms can look at reducing people costs in the short and medium term; whilst one of these is redundancies this is certainly not the only option and the Government appear at this point to be supportive to employers in terms of keeping the workforce in employment for as long as possible. However changes within firms such as reduced working weeks, unpaid leave, accelerated holidays, reduced pay and many others will all be things that law firms should be considering as options to preserve cash.
3. Major cash outflows – VAT, PAYE, Income tax & Corporation Tax
Think very carefully before you make these large payments at present; it is going to be much easier to keep hold of cash than get it back – and remember some of these items can often be set up for automatic payment from your bank unless you cancel the arrangements.
There are potential options around Time to Pay (TTP) arrangements with HMRC, which can alleviate short term cash flow pressures for firms. Read more about cash flow and TTP.
HMRC teams do not appear to have been briefed as to how to deal with tax payments of significant size, the advice has all been for much smaller amounts to be spread over 3 months
Avoid using the COVID phone line, instead use the large debts phone numbers as below:
- PAYE 0300 3229243
- VAT 0300 2003830
4. Management of payments / cash out
Early review of the following areas may help firms in their effort to safeguard cash levels over the coming months:-
- Avoid prepayments arising e.g. any rentals paid quarterly in advance, consider renegotiation to monthly in arrears
- Explore expenses that can be spread over a longer period e.g. insurance, monthly rather than annually in advance
- For key suppliers consider whether it is important to continue with prompt payment or whether settlement times could increase; or even potentially maintained in return for a discount
- Review direct debits and automated payments and consider whether the basis needs to change – once the cash is gone it’s gone; may be better to have specific authorisation for many more payments than is currently the case.
5. New matter starts
Clients engaging new matters at this point naturally are doing so with a genuine need for support and legal advice. Whilst having due regard for longer term business relationships with clients it would be prudent to consider asking for considerably higher levels of payments on account from clients at present to ensure the cash is available to transfer from client to office account when the work is completed.
6. Offer discounts for upfront / prompt payment
In many firms we are expecting to see lower productivity or in some cases activity directed at areas that are not likely to be cash generative in the short term. Firms may want to consider offering discounts to clients for either upfront or prompt payment in an effort to bring in cash and to ensure fee earners are working on matters that can bring in cash at the earliest point.
7. Financial forecasting
Many law firms continue to find financial forecasting, particularly cash flow forecasting, a challenge but it is crucial that firms can model their future cash flow at this time with some degree of reliability. Firms should be ensuring they have this capability in place so they can quickly adapt to changing positions and information in their business so they can make decisions.
Preparing a detailed monthly cash flow for the next 12 months is the priority here for firms along with actions to stress test any assumptions that are being used in preparing the forecast.
8. Realistic management information (WIP valuations)
Don’t believe fee earners recorded chargeable time!
Most people, including partners, will be concerned about the future and their personal prospects. With redundancies potentially on the horizon most people will want to look busy and record time. A pessimistic view should therefore be taken when looking to assess WIP movements for management account purposes when assessing profits in firms. Otherwise there is a risk that future planning and forecasts are made on the assumption of higher productivity and WIP (and therefore in the future more expected cash than will actually ever materialise).
9. Credit limits
There is a balance to be struck here in professional firms who often have long term relationships with their clients. However being more stringent about setting and applying credit limits to clients at this point will be an important consideration for firms.
Credit limits for these purposes should include WIP levels as well as fees outstanding (i.e. lockup). Better control systems for setting and enforcing limits in many firms will be an important matter to deal with here.
10. VAT on bad debts
Firms may find some cash flow savings by being more diligent in reviewing bad debts (both fee and disbursements) and considering whether any VAT can be reclaimed.
It’s worth remembering that VAT on bad debts can be reclaimed once the debt is over six months old (from the date the payment was due) and is less than four years and six months old. In order to reclaim you must have: Paid the VAT over to HMRC, and. Written off the debt in your accounts.
11. Provisions affecting partners
Many firms will be considering options surrounding partners to preserve cash as well as including reductions to monthly drawing levels, postponement of capital / current account draws.
It is likely that many lenders will be expecting partners to share in the pain of the additional funding needs for their business over the next few months and early discussion with partners on this subject could be an important aspect.
12. Changing your financial year end
Firms may wish to consider whether a change to their financial year end could be appropriate in order to accelerate the point at which they experience reduced payments on account as a result of declining profits. For example firms with a 30 April financial year end may benefit cash flow wise from earlier reductions to their income tax payments if they change their year-end to 31 March.
13. Accounting provisions – accelerating tax relief on future costs
In an effort to reduce reported profits in the 2019/20 financial year and reduce tax payments firms may benefit from looking closely at accounting standards and the ability to make provisions for future costs in the 2019/20 financial year in order to get tax relief a year earlier (and reduce tax payments).
14. Asset protection – firm
Whilst care and due attention needs to be given to insolvency legislation, firms may wish to consider whether there are actions that can be taken to safeguard retained asset value whilst continuing to trade.
Where a law firm has a solvent business but with exposure to significant risk then it may be prudent to consider whether assets (e.g. freehold property) could be moved out of the trading business into a parent or personal ownership. This could be via a holding company or extraction through a loan account. A de-merger may be a possibility where there are good and bad elements to businesses in one entity.
15. Asset protection – individual partners
Aspects such as partners taking charges over their capital account in an LLP and director’s loan accounts in a Limited Company may be worth consideration, again taking into account insolvency legislation in the process of doing so.
Many firms carry surplus reserves to make income tax payments on behalf of their partners. In most firms these reserves in effect represent the working capital of the firm. However the tax liabilities remain a personal liability of the individual partners regardless of whether the firm is able to make the payments. Whilst we are not specifically advocating that these funds should be removed from firms at this point it is important that firms consider the ability to make these payments in the short to medium term and consider the potential impact on individual partners if it becomes impossible for the law firm to fund such payments.
16. Incorporation as a limited company
Many law firms will remember the high volume of incorporations as limited companies which took place back in 2008 after the financial crisis. This may be relevant for consideration again for LLPs or unincorporated partnerships / sole practitioners.
The key thing to remember with incorporation is that at a basic cash flow level it provides an income tax holiday i.e. whilst the owners are being repaid their directors loan accounts in the new company (i.e. their current accounts, capital accounts and tax reserves) the company is earning profits and paying only 19% on those profits as opposed to say up to 47% (including National Insurance) in an unincorporated structure.
So this eases cash burdens (often very significantly) on the business in the meantime. It needs to be kept in mind that there are longer term implications of incorporation and of course the income tax holiday ultimately does end when the directors’ loan accounts have been exhausted.
17. Losses and reducing future tax payments
Firms who are projecting short or medium term losses in their business need to consider the quickest and best way to access relief for those losses.
Law firms trading as a limited company have the option to carry back losses 12 months and recover Corporation Tax payments made in that period.
For LLPs, partnerships and sole practitioners there is an ability to carry back losses to the prior year (12 months) and this can then potentially reduce future tax payments on account or obtain some recovery of Income Tax paid.
For unincorporated partnerships that incorporate, if losses exist there is potential to claim terminal loss relief which can enable losses to be carried back for over 12 months potentially enabling income tax to be recovered from earlier years.
18. Regulatory matters
Firms need to keep in mind professional obligations to notify the SRA of financial instability and the Code of Conduct more generally in terms of the way their business is operated during these difficult times.
We are all facing uncertain and difficult times and hopefully the above comments and ideas provide some support at this time to you and your firms in making future plans.
PKF Francis Clark have a dedicated Coronavirus area on our website outlining some of the latest government support and information available to businesses at this time.