Financial reporting changes affecting law firms

Law firms have historically never found it so difficult to borrow money as they (and their owners) have over the last seven years.

Apart from the sector just not being as attractive to the banking sector for various reasons - interest on clients’ money, risk of firms failing and the business not generating the cash it should - other factors are now in play.

Accountants are getting blamed in advance for being a huge threat to legal firms over the next decade and whilst I believe there is plenty of space and fees available for (well-run) old and new entrants, the accountancy profession and the Financial Reporting Council’s new Financial Reporting Standard (FRS) may be about to put another spanner in the works.

FRS 102, the new standard, introduces some (mandatory) adjustments to profit, which could well be adverse and it also introduces some disclosures that may not be at all welcome.

The accounting adjustments are likely to have most impact on:

• Goodwill – the period of amortisation cannot exceed 10 years where there is no reliable estimate, so a number of firms that recently incorporated may have a hit to profit through increased amortisation;
• Holiday pay accrual – firms will now need to accrue for any holiday that employees have not taken at a year end. Whilst a prepayment is possible, the likely effect is negative;
• Other accounting changes do exist as well as the profit and loss report being renamed as the income statement and balance sheet being renamed the statement of financial position.

My main concern, though, is that when the legal firm is in default or breach of a loan or borrowing facility covenant (existing or caused by some of the FRS 102 changes) at the reporting date, the accounts of the entity will be required to disclose:

• Details of that breach or default;
• The carrying amount of the related loans payable at the reporting date; and
• Whether the breach or default was remedied, or the terms of the loans payable were renegotiated, before the financial statements were authorised for issue.

My belief is that this would be entirely unwelcome for many legal firms. This very public announcement at Companies House would likely lead to a negative score with credit ratings agencies and loss of appetite from potential future lenders generally.

Prospective clients and recruits may also not look at this favourably. Competitors, and perhaps even the legal press, may refer to these breaches or defaults.

A very public announcement at Companies House would likely lead to a negative score with credit ratings agencies

Those monitoring covenants at law firms therefore have potentially only a couple of months before the upcoming year ends (basically affecting 31 December 2015 year-end onwards) to put their house in order to avoid this unwelcome accounts disclosure.

In some instances it may be worth speaking to your bank and having the covenants reviewed/revised to perhaps reflect a more appropriate scenario.

For example, if you are required to supply management accounts within one month of a quarter-end but never supply before six weeks, then ask for an adjustment to two months. Also, if the covenants contain a profit definition, consider how an increased amortisation charge (as referred to above) could impact.

In summary, it is worth locating your facility, loan agreements, documents and performing a health check to ensure you are compliant. Or you risk those defaults/breaches being announced for all to see.

Peter Noyce is head of professional servies at Menzies LLP