Valuing work in progress
Valuing work in progress (WIP) can be complicated and is always a time consuming exercise. While the WIP valuation will always be an estimate, it is essential to use appropriate methodologies to value the various types of WIP within your practice. This will ensure that your year-end accounts are accurate and provide you with the information that you need to run your business efficiently, effectively and profitably.
Should HMRC open an enquiry into your tax affairs you will also need to demonstrate robust methodologies are in use and provide detailed workings and supporting documentation to back up you WIP valuation. Failure to do this could lead to a tax underpayment assessment as well as interest and penalties.
Below are some tips which will be useful to consider when valuing your WIP:
For conditional fee arrangement (CFA) work where the result of the case is not known at the year-end there are two possible outcomes, a fee will be earned or no fee will be earned. Depending on what your CFA win rate is you may choose to value your WIP at anywhere between nil and a calculated WIP value. The estimated WIP value can be reduced by the average caseload win rate and further reduced by the average caseload recovery rate.
Where a contingent case is known to be successful at year end an estimate of WIP needs to be included. This WIP will be the percentage of the estimated final fee that has been earned by the year end. This can be estimated using the formula of year end time costs x estimated fee / estimated total time costs.
Where the CFA is used on a personal injury (PI) matter, there could be a number of different scenarios at the year-end. If no liability has been agreed, then you could choose to value up WIP at nil because there is no guarantee that you will earn a fee at that point. But you could follow the method of looking at your win rates and including a small value for this WIP.
Where the PI matter has liability admitted, then you are highly likely to charge a fee on winning the case. But some Firms still argue that even with liability admitted, a case may still fail, when it gets to Court for instance. So in theory there are still two possible outcomes. You may value WIP at nil because certainty of a win is still not guaranteed, or you may estimate your WIP by looking at your expected fee discounted by average caseload win rate and reduced to the stage of completion that you are at by the year-end.
The final scenario under a PI CFA matter is where the case is settled by year-end but the quantum of costs and damages is still under negotiation. Certainty is there, as the case is settled and so the WIP valuation must include your expected fees to be earned less any additional time costs left to complete the matter, which are likely to be minimal.
If there is an abortive fee structure in place, this fee will be the minimum that the firm will generate from the case and so this can be used as the basis for the WIP valuation. You may then take a percentage off the valuation to take account of the stage of completion of the piece of work.
Fixed Fee Work
Where a fixed fee has been agreed on a case, one of the elements of uncertainty has been removed from the WIP calculation. WIP will again be valued as the percentage of the final fixed fee that has been earned by year end. This equates to the fixed fee multiplied by the year end degree of completion. The degree of completion may need to be estimated or may be calculated as the year end time costs / estimated total costs to completion of the case.
Time Served Fees
Where cases are billed periodically on the basis of time costs incurred, the WIP valuation methodology will differ slightly depending on whether time is written off the costing system when interim bills are raised or not.
Where all of the WIP is still on the costing system this WIP should be valued by reducing the calculated year end WIP by the anticipated recovery rate, which may apply to a particular fee earner or type of work, and then deducting the fees on account already raised.
Where WIP is written off with each interim bill, the recovery rates achieved on these interim fees can be applied to the year-end time costs to estimate the value of the year end WIP.
Another factor which may mean that an additional provision is needed against the WIP value included is the age of the time costs recorded. This is because older time costs are generally harder to recover in full and so may need discounting.
Although we can see different methodologies being used for different types of case the principles for all of them are the same, namely that WIP should only be included at its likely billable and recoverable value.
If you would like to learn more on the subject, please call 01772 821021.