Partnership accounts: The new LLP SORP accounting rules

The Statement of Recommended Practice Accounting by Limited Liability Partnerships (the LLP SORP), issued in July 2014, is the fourth version published since LLPs were introduced into UK legislation in 2001.

Within UK Generally Accepted Accounting Practice (UK GAAP), SORPs are not strictly mandatory, although compliance with the recommendations of a SORP is required in order for financial statements to give a true and fair view.

The new LLP SORP is an update to the previously published versions, essentially to ensure that its requirements are consistent with the provisions of Financial Reporting Standard 102 (FRS 102), The Financial Reporting Standard applicable in the UK and Republic of Ireland, which is applicable for accounting periods that commence on or after 1 January 2015.

SORPs provide guidance that is specific to a particular industry, sector or business vehicle. There are elements of FRS 102 that will require professional firms to change their accounting policies, which may impact upon profits. The LLP SORP does not deal with all of these issues as there is nothing in the application of that requirement that is particular to LLPs. The SORP concentrates on those areas where specific guidance is necessary or helpful.

Many of the requirements of the new SORP are consistent with the past and existing practice need not change. There are, however, a small number of substantive changes and clarifications given to existing requirements. These clarifications are not intended to change existing treatment but, if clarification has been required, firms may conclude that a different treatment is required in future.

Financial statements

The form and content of LLP financial statements has remained broadly the same since the first LLP SORP was published in 2002. The latest version, however, introduces changes partly as a result of FRS 102 but, in the case of the members' reports, drawing on the feedback received during the consultation phase. The changes in the new SORP are summarised in
Figure 1.

LLPs are not required under company law to produce an equivalent to the directors' report and strategic report that are required by companies. The explicit requirement for a members' report has been removed from the new LLP SORP, although many of the disclosures previously required have been retained. If a members' report is not produced, those disclosures will need to be included in the financial statements.

The new SORP uses the terminology employed in FRS 102 for the components of the financial statements, which is consistent with that used in International Financial Reporting Standards. Using the familiar titles of 'profit and loss account' and 'balance sheet' will continue to be acceptable.

A new requirement is for the presentation of a statement of changes in equity as a primary statement. If applied in its basic form, this would be a statement reconciling the movement in members' other interests. For many LLPs, this may result in a statement which does not contain any meaningful information.

In companies, equity comprises share capital, retained profits and other reserves. In LLPs, members' capital and profits not yet drawn from the LLP are commonly included in 'loans and other debts due to members', which is not 'equity', although this is dependent on the terms of the members' agreement.

For this reason, the SORP permits the statement of movement in members' interests (which includes both the debt and equity interests of members), currently provided as a note to the accounts, to be presented as a primary statement. Where this approach is taken, a full statement of comparatives for the prior period will also be required.

Application of GAAP

Members' interests

The treatment of members' interests has always been a complex area, in particular:

1. deciding whether members' balances within the LLP represent debt or equity; and

2. understanding the mechanism by which profits of the LLP become due as a debt to the members.

Participation rights

The distinction of whether members' interests in a LLP are equity or debt is an important one. An interest that represents a debt due to members means that the member has a legal entitlement to the interest. In the absence of any agreement otherwise, in the case of an insolvent winding up, the members will rank pari passu with other unsecured creditors of the LLP. Equity interests are, essentially, still under the legal ownership of the LLP itself and so are available for distribution to the creditors in such a situation.

The exception to this rule concerns members' capital. The fact that GAAP may require members' capital to be classified in financial statements as equity or debt does not alter the underlying nature of the transaction; it is widely held that members' capital in an LLP is akin to share capital in a company and is likely to be 'lost' in the event of an insolvent winding up.

The SORP acknowledges this issue in the requirement to disclose where amounts included under loans and other debts due to members (i.e. members' interests classified as debt) would rank on a winding up. This disclosure has been required since the first SORP was published in 2002, on the grounds that LLPs do not have any capital maintenance provisions in law. The new SORP has clarified, however, the disclosure of protection afforded to other creditors on a winding up and the ability of members to reduce the equity of the LLP (see Figure 2).

Profit divisions

How profit is divided among the members is a matter for the members' agreement but, in many agreements, there is a lack of detail not only surrounding the process for division but also in making the distinction with the arrangements for profit-sharing.

The footnote to the definition of 'allocated profits' in paragraph 9 of the SORP states: "The decision to divide profits, which gives rise to a liability in respect of allocated profits, must be distinguished from the arrangements for profit sharing. A provision in an agreement between the members, which sets out the profit shares of the members, does not of itself constitute an agreement for the division of profits. It merely sets out the respective profit shares of the members that will apply to those profits that the members decide to divide among themselves".

This lack of clarity in agreements can make it difficult when preparing financial statements to determine what, if any, profits have been divided during the year and, as a result, whether undrawn profits at the year-end represent debt or equity.

Ordinarily, the mechanisms by which members assume a legal right to their
share of the profits of an LLP are:

1. there is a right to remuneration or profits through the contractual arrangement with the LLP;

2. profits (or a part thereof) are divided among the members through an automatic mechanism;

3. a decision to divide the profits by the LLP under whatever mechanism for that is specified in the members' agreement; or

4. a combination of some or all of the above.

The issue that is fundamental to determining how divisions of profit are treated in the financial statements is whether the LLP has "an unconditional right to refuse payment based on the LLP agreement in force at
the time" (paragraph 48).

The guidance in the revised SORP has been updated and makes it clear that if the LLP agreement provides that the profit for a financial period will be divided to the members at a particular point (which may be, for example, after the accounts for the year have been approved) and there is no decision necessary for that division to be effected, then the profit for the year represents a debt due to the members at the year end and the whole of the profit for the year should be presented in the profit and loss account as remuneration charged as an expense.

Where divisions of profit require a decision of the LLP to divide, then those amounts are discretionary and result from an equity participation; such divisions of profit are reflected only through the statement of movements in members' interests. A discretionary decision to
divide profits after the year-end date is
a non-adjusting post balance sheet event and so should not be reflected in the financial statements for that year.

Salaried members

Although not dealing specifically with the situation that may arise should a member of an LLP be taxed as an employee under the new salaried members' legislation, the LLP SORP has included additional guidance that is applicable in those circumstances.

The LLP SORP has always made it clear that members' remuneration charged as expenses should include any related employment costs (e.g. employers' National Insurance contributions). It is conceivable that a salaried member might receive
a bonus or profit share that should be treated as contractual under the terms
of the members' agreement and requires
a discretionary division of profit.

The SORP now includes guidance in paragraph 36A that "if an LLP incurs incremental tax expense in respect of amounts presented in equity as distributions to members, that incremental tax expense should also be presented in equity". Accordingly, employers' National Insurance contributions on that member's bonus, although reducing the total profits available for sharing amongst the members, will not be charged in the profit and loss account.

The examples and illustrations of different treatments and presentation of members' interests in both Appendix 1
and Appendix 2 of the SORP have been further updated and expanded.

Former members

The guidance on how to deal with post-retirement payments to former members has been expanded significantly, since the various arrangements that might exist require different treatments under the
new UK GAAP.

Although the exact nature of arrangements varies from firm to firm, Figure 3 sets out the most common forms of arrangements, together with an analysis of how they should be dealt with in the future, as well as an indication of whether there may be a significant change in treatment.

A useful flowchart has been included
in the guidance to help preparers of
the financial statements understand
which approach is appropriate for
their particular situation.

Careful analysis

As with many situations with LLPs,
the devil is not only in the detail of the LLP SORP but also in the members' agreements of individual firms. These
will require careful reading and analysis
in determining the appropriate treatments
of members' participation rights and annuities under the new LLP SORP.

Steve Gale is partner at national audit tax and advisory firm Crowe Clark Whitehill (www.crowehorwath.net/uk)