SQE1 FLK2

## Learning Outcomes

This article outlines disbursement accounting using the agency and principal methods, including:

- Agency vs principal methods and the addressee of the supplier’s invoice as the decisive indicator
- Correct journal entries for both methods, whether paid from client account or business account, including where the client account is not in funds
- VAT treatment under both methods, including recognising when no VAT entry is made by the firm and when both input and output tax must be recorded
- Items that are not disbursements for VAT purposes (for example, many search fees when used in advice) and treatment as part of the firm’s own taxable supply
- Application of SRA Accounts Rules to disbursement payments and reimbursements (for example, paying from business account and reimbursing from client money appropriately, and not using the client account as a banking facility)
- Common pitfalls, such as paying principal-method invoices from the client account, posting VAT-inclusive figures where VAT-exclusive figures are required, and misclassifying expenses as disbursements

## SQE1 Syllabus

For SQE1, you are required to understand the correct accounting treatment of disbursements paid by a firm on behalf of a client, including knowing when to use the agency or principal method, how to record the transactions, and the VAT implications, with a focus on the following syllabus points:

- the distinction between the agency and principal methods for disbursements
- how to determine which method applies based on the addressee of the supplier's invoice
- the correct double-entry bookkeeping for each method, including VAT treatment
- the compliance requirements under the SRA Accounts Rules for disbursements
- the practical impact of each method on VAT recovery for the firm and the client
- recognising when a payment is not a “disbursement for VAT purposes” and forms part of the firm’s own taxable supply (for example, many electronic search fees)

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. A solicitor pays a surveyor's invoice addressed to the client. Which method should be used to account for this disbursement and VAT?
   a) Agency method
   b) Principal method
   c) Either method
   d) Neither method

2. Under the principal method, from which account must the firm pay the third-party supplier's invoice?
   a) Client account
   b) Business account
   c) Either account
   d) Petty cash

3. When using the agency method, who is responsible for reclaiming VAT on the disbursement?
   a) The solicitor's firm
   b) The client
   c) HMRC
   d) The supplier

## Introduction

Solicitors frequently pay expenses to third parties on behalf of clients. These payments, known as disbursements, must be accounted for correctly under the SRA Accounts Rules. The method used—agency or principal—affects both the ledger entries and the VAT treatment. Understanding the distinction is essential for SQE1 and for compliance in practice.

![Disbursement accounting revision topics: VAT treatment, agency and principal methods, cash movements, client-to-client reallocations, and transfers between matters.](https://static.pastpaperhero.com/images/sqe1-flk2-accounting-procedures-and-entries-disbursements-using-the-agency-and-principal-methods_00.png)

_Disbursement accounting revision areas are arranged by VAT treatment and movements of funds, including agency and principal methods and client reallocations._

Correct treatment always begins with two questions:

- Who is the legal recipient of the supply? The addressee of the invoice is the practical indicator.
- Is the payment a true “disbursement for VAT purposes” or part of the firm’s own taxable supply? If the firm buys-in a service and uses it in its advice, it is often part of the firm’s supply, not a VAT disbursement, even though it is commonly called a “disbursement” in practice.

> **Key Term: disbursement**
> A payment made by a solicitor to a third party on behalf of a client in the course of providing legal services.

### Disbursements: Agency and Principal Methods

Disbursements are payments made by a firm to a third party in connection with a client matter. Examples include court fees, search fees, expert reports, and counsel's fees. The correct accounting treatment depends on whether the firm is acting as agent or principal in the transaction.

> **Key Term: input tax**
> VAT paid by the firm to suppliers on goods or services coming into the firm. It may be recoverable on the firm’s VAT return.
> **Key Term: output tax**
> VAT charged by the firm to clients on supplies of legal services going out of the firm. It must be accounted for to HMRC.

The invoice addressee is decisive for selecting agency or principal method. Separately, the nature of the expense determines whether it is a VAT disbursement at all. For example, a local authority search used in giving advice is usually part of the firm’s supply to the client (not a VAT disbursement), and the firm’s VAT charge to the client will reflect that.

### The Agency Method

The agency method applies when the firm simply arranges payment to a third party on the client's behalf, and the third party's invoice is addressed to the client.

> **Key Term: agency method**
> The accounting method for disbursements where the firm acts as agent, paying a third party on behalf of the client. The supply is deemed to be made directly to the client.

Under the agency method:

- The invoice is addressed to the client (the client is the purchaser and bears any VAT).
- The firm pays the third party using client money (if available) or business money.
- The VAT-inclusive amount is recorded as a single figure.
- The firm does not record input or output VAT for the disbursement.
- The client, if VAT registered, can reclaim VAT using the supplier's invoice.

Where the client account is not in funds and the firm pays the supplier from the business account, the payment is still recorded as an agency disbursement (single VAT-inclusive sum) with no VAT ledger entries. When the client reimburses the firm later, that receipt is business money and is posted to the business side of the client ledger and the business side of the cash sheet.

Compliance note. If the firm holds money on account of costs and unpaid disbursements, it may use those funds to reimburse itself for disbursements already paid from business money, provided the client has been informed that such payments may be made for that purpose. In this situation the transfer from client to business can be made under the client money withdrawal rules without the need to deliver a bill for that reimbursement.

### Accounting Entries – Agency Method

If paid from the client account (sufficient client funds):

- DR Client ledger (client account columns) – VAT-inclusive amount
- CR Cash sheet (client account columns) – VAT-inclusive amount

If paid from the business account (insufficient client funds):

- DR Client ledger (business account columns) – VAT-inclusive amount
- CR Cash sheet (business account columns) – VAT-inclusive amount

If later reimbursed by the client (payment received into business account):

- DR Cash sheet (business account columns) – amount received
- CR Client ledger (business account columns) – amount received

### Worked Example 1.1

A solicitor pays a search fee of £120 (including £20 VAT) for a client. The invoice is addressed to the client. The solicitor holds enough client money.

**Question:** What are the correct ledger entries?

> **Answer:**
> DR client ledger (client account) £120
> CR cash sheet (client account) £120
> No VAT entry is made by the firm. The client can reclaim VAT if eligible.

### Worked Example 1.2

The firm receives an expert’s invoice of £600 + £120 VAT addressed to the client. The client ledger shows no client funds. The firm pays the expert from the business bank account and is later reimbursed by the client.

**Question:** What entries are required when paying the expert and when the client reimburses the firm?

> **Answer:**
> Payment to expert (agency method, from business funds):
> DR client ledger (business account) £720
> CR cash sheet (business account) £720
> (Single VAT-inclusive amount. No VAT ledger entries.)
> Later reimbursement by client (receipt into business bank):
> DR cash sheet (business account) £720
> CR client ledger (business account) £720

### The Principal Method

The principal method applies when the firm is treated as receiving the supply from the third party, and then resupplying it to the client. This is the case when the invoice is addressed to the firm.

> **Key Term: principal method**
> The accounting method for disbursements where the firm is treated as principal, receiving the supply from the third party and resupplying it to the client. The invoice is addressed to the firm.

Under the principal method:

- The invoice is addressed to the firm (the firm is the purchaser).
- The firm must pay the third party from the business account.
- The firm records input VAT on the payment.
- When billing the client, the firm recharges the net amount plus output VAT (together with VAT on its profit costs).
- The client can reclaim VAT only if the firm’s invoice is addressed to the client and the client is VAT registered.

Common pitfalls include paying the third party from the client account, and posting a VAT-inclusive figure to the client ledger at Stage 1. Under the principal method, the client ledger entry at the payment stage is the net amount only; VAT is recorded on the firm’s HMRC (VAT) ledger as input tax.

### Accounting Entries – Principal Method

Stage 1: Pay the third-party supplier (from business account):

- DR Client ledger (business account columns) – net amount
- CR Cash sheet (business account columns) – net amount
- DR HMRC VAT ledger – VAT amount (input tax)
- CR Cash sheet (business account columns) – VAT amount

Stage 2: Bill the client (recharge disbursement + VAT):

- DR Client ledger (business account columns) – profit costs (net)
- DR Client ledger (business account columns) – output VAT on profit costs and on the recharged disbursement
- CR Profit costs ledger – profit costs (net)
- CR HMRC VAT ledger – output VAT (total charged to the client)

If there are sufficient client funds at the time of billing, a client-to-business cash transfer is then made to settle the bill. If not, the client’s subsequent payment into the business account clears the business-side balance.

### Worked Example 1.3

A solicitor pays an expert's invoice of £600 + £120 VAT, addressed to the firm. Later, the solicitor bills the client £1,000 profit costs plus the expert's fee, plus VAT.

**Question:** What are the correct entries?

> **Answer:**
> **Stage 1:**
> DR client ledger (business account) £600
> CR cash sheet (business account) £600
> DR HMRC VAT ledger £120
> CR cash sheet (business account) £120
> **Stage 2:**
> DR client ledger (business account) £1,000 (profit costs)
> DR client ledger (business account) £720 (VAT on £1,000 + £600 = £1,600 × 20%)
> CR profit costs ledger £1,000
> CR HMRC VAT ledger £320 (output VAT on profit costs)
> CR HMRC VAT ledger £120 (output VAT on expert fee)
> (The firm reclaims £120 input VAT and accounts for £320 output VAT.)

### Worked Example 1.4

A surveyor invoices the firm £400 + £80 VAT. The invoice is addressed to the firm. There are no profit costs to bill at this stage; the firm wishes to recharge only the survey fee to the client.

**Question:** Show the accounting entries for payment and billing, and how the bill is settled from client funds.

> **Answer:**
> Stage 1 (payment from business account):
> DR client ledger (business) £400
> CR cash sheet (business) £400
> DR HMRC VAT ledger £80
> CR cash sheet (business) £80
> Stage 2 (bill issued to client, disbursement only):
> DR client ledger (business) £80 (output VAT on £400)
> CR HMRC VAT ledger £80
> Client-to-business cash transfer (client account in funds):
> DR cash sheet (client) £480 (transfer out of client account)
> CR client ledger (client) £480
> DR client ledger (business) £480 (transfer into business)
> CR cash sheet (business) £480
>
> **Exam Warning:**
> If the invoice is addressed to the firm, you must use the principal method and pay from the business account, even if client funds are available. Do not pay from the client account in this scenario.

### VAT and Disbursements: Key Points

- Under the agency method, the firm does not account for VAT on the disbursement; the client reclaims VAT if eligible using the third party’s invoice.
- Under the principal method, the firm records input VAT on payment and output VAT on billing the client.
- The addressee of the invoice determines which method applies. Check this first before posting any entries.

> **Key Term: VAT**
> Value Added Tax, a tax charged on most goods and services supplied in the UK, currently at 20%.

### Disbursements for VAT purposes vs expenses

Only some payments are VAT “disbursements” in the strict HMRC sense. HMRC’s conditions (summarised) include that the firm acts as agent, the client is the recipient of the goods or services, the client knew the third party would supply them, and the firm recovers only the exact amount paid and shows it separately. Examples that usually qualify include court fees, Land Registry fees, stamp duty land tax, and oath fees paid to another solicitor. Where those are not VATable in the hands of the third party, the firm does not add VAT when passing them on.

Where the firm obtains a third-party service and uses it in its own advice or work product (for example, many electronic property searches obtained via a provider), that cost is generally part of the firm’s own taxable supply and not a VAT disbursement. In practice, the firm should treat the payment as a business expense, record any input VAT, and then charge VAT to the client when billing (as part of the VATable value of its supply). This treatment aligns with the principal method mechanics for VAT, even where the word “disbursement” is used on the bill for client transparency.

### Worked Example 1.5

A firm pays an online mining search fee of £60 + £12 VAT to a search provider. The result is analysed and used in advice to the client. How is this treated?

> **Answer:**
> This is not a VAT “disbursement” because the firm used the information in its advice. Treat as part of the firm’s taxable supply:
> Payment: DR client ledger (business) £60; CR cash sheet (business) £60; DR HMRC VAT ledger £12; CR cash sheet (business) £12.
> Billing later: Include the £60 in the VAT base (typically within profit costs or as a separately itemised expense forming part of the firm’s supply). Charge output VAT accordingly on the total VATable value.

### Counsel's Fees: Special Concession

Historically, HMRC allowed firms to treat counsel's fees as agency disbursements if the fee note was amended to show the client's name. This allowed the client to reclaim VAT directly. However, unless the facts specify this concession, assume the principal method applies if the invoice is addressed to the firm.

In practice questions, do not apply the concession unless stated. If the fee note is in the firm’s name, treat as principal: pay from business account; post input VAT; recharge to the client and charge output VAT.

> **Revision Tip:**
> Always check the addressee of the invoice. Client's name = agency method; firm's name = principal method.

### Practical compliance pointers

- Use client funds for disbursements only where sufficient funds are held for that specific client. Otherwise pay from the business account and recover appropriately.
- Do not use the client account as a banking facility. Payments out must relate to regulated services for the client’s matter.
- When reimbursing the firm from client money for disbursements already paid from business funds, ensure the client has been informed that money on account may be used for that purpose, and keep clear narrative entries.

## Summary

| Feature             | Agency Method                             | Principal Method                        |
| ------------------- | ----------------------------------------- | --------------------------------------- |
| Invoice addressee   | Client                                    | Firm                                    |
| Payment from        | Client account (if funds) or business a/c | Business account only                   |
| VAT treatment       | No VAT entry for firm                     | Input VAT reclaimed, output VAT charged |
| Ledger entries      | Single VAT-inclusive amount               | Net and VAT amounts recorded separately |
| Client VAT recovery | Uses supplier's invoice                   | Uses firm's invoice                     |

## Key Point Checklist

_This article has covered the following key knowledge points:_

- The agency method applies when the invoice is addressed to the client; the firm acts as agent and does not account for VAT.
- The principal method applies when the invoice is addressed to the firm; the firm must pay from the business account and account for input and output VAT.
- The correct ledger entries differ for each method and must be applied precisely (VAT-inclusive single figure under agency; net and VAT separately under principal).
- The addressee of the invoice is the critical factor in determining the correct method; then consider whether the cost is a true VAT disbursement or part of the firm’s own supply.
- Counsel's fees may be treated exceptionally if the fee note is amended to the client's name, but this is not the default.
- Where the firm pays a disbursement from business funds under the agency method and holds client money on account of costs, reimbursement from client to business can be made under the client money withdrawal rules if the client has been informed about such use.
- Do not pay principal-method invoices from the client account; do not post VAT-inclusive amounts to the client ledger at Stage 1 under the principal method.

## Key Terms and Concepts

- disbursement
- agency method
- principal method
- VAT
- input tax
- output tax


Accounting procedures and entries - Disbursements using the agency and principal methods