Update on the SRA’s Financial Stability Indicators
As some of you may be aware, during their annual Risk and Compliance conference a few months ago, the SRA announced that they were going to start risk-assessing practices based on three warning indicators:
• Drawings in excess of profits
• Borrowings in excess of net assets
• Borrowings over a certain (currently undefined) level
Practices will be assessed as red, amber or green, depending on how many indicators they have, and this will determine how much attention they will receive from the SRA.
An update from the SRA at the beginning of June provided further clarification on how practices will be assessed, and also explains how the SRA will obtain the information required to make the assessment.
Whilst the new guidance does not refer directly to the three main indicators listed above, the SRA has drawn up a list of good behaviours for firms to aim for and bad behaviours to avoid. These include:
• All partners regularly receive full financial information, including office account bank balances
• Drawings are linked to cash collection targets and do not exceed net profits
• Provision is made to fund partners’ tax from income received
• A capital element is retained from profit, and a capital reserve account built up
• Profitability levels are tested and unprofitable work is dropped
• Drawings exceeding net profits
• High borrowings to net asset ratios
• Increasing firm indebtedness by maintaining drawing levels
• Key financial information not shared with “rank and file” partners
• Short term borrowings to find partners’ tax bills
• Partners out of touch with office account bank balances
• Heavy dependence on high overdraft borrowings
The SRA also made the more recent announcement that, of the practices they have already assessed, 160 are considered to be at risk of failure, with one fifth of these practices being among the top 200.
Over the course of the next few weeks, the SRA will be writing to 2,000 practices to ask for financial information, and these practices will be selected from sectors that are at higher risk of financial difficulty (such as those firms affected by the recent referral fee ban). The SRA have made it clear that they will be focusing on information regarding drawings compared to turnover, as well as outstanding loans and bank overdrafts (including how these have been managed in the past).
The SRA have not given any more details for now as to what else they might require, but we imagine they will start asking for Profit & Loss Account and Balance Sheet information, as well as financial forecasts.
The update does not mention whether the SRA plans to expand their checks to practices outside of the 2,000 that they are approaching now, but we would not be surprised if they did.
In the meantime, we recommend that now would be a good time to look critically at your own financial systems and reporting and make sure that you can provide up to date financial information to the SRA, should they ask for it.