WIP RIP?

ROBERT MAAS FTII, FCA considers the implications, or otherwise, of the latest advice on revenue recognition.

AS THE RECENTLY retired chairman of the Tax Faculty, I suspect that Mark Lee felt constrained not to tread on the toes of the ICAEW's technical department. His article last week, ' Revenue Recognition ', Taxation, 28 April 2005, p94, seemed to be saying, 'If the accounting rules have changed this is the tax implication'.

In contrast, I have no compunction about expressing my views on the Application Note G/UITF 40 debacle. Or I would do so, if I could work out what the UITF means!

A little history

Before looking at the release from the Urgent Issues Task Force, a little history will probably not go amiss because UITF 40 does not purport to change the rules; it purports to explain Application Note G. It specifically affirms that 'Application Note G confirms that SSAP 9 should be applied in accounting for long terms contracts' (paragraph 9). Accordingly, what it probably really does is either explain the part of SSAP 9 that applies to long term contracts or more likely, explain how that interacts with FRS 5.

So my history starts with SSAP 9. This was issued in 1975. Does it seem likely that everyone has been misinterpreting it for the last 30 years and suddenly the scales have fallen from people's eyes? I think not. The next step is the issue of FRS 5 (Reporting the Substance of Transactions) in April 1994. Interestingly, this states 'The FRS will not change the accounting treatment and disclosure of the vast majority of transactions' (paragraph b). So did it intend to abolish the concept of work in progress? I think not. We move on to July 2001, which is when the Accounting Standards Board (ASB) issued a discussion paper on 'Revenue Recognition'.

Chapter 3 is entitled 'Accounting for Incomplete Contractual Performance'. This proposed that 'revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer'. That seems a sensible test to me.

Next comes the issue of Application Note G by the ASB in November 2003.

The first point to make is that all that the application notes do is to 'specify how the requirement of FRS 5 are to be applied to transactions that have certain features'. In other words, they are not separate from FRS 5; they explain how to apply it. Application Note G does not amend the requirement of SSAP 9 (paragraph G 14). It provides additional guidance. It states that:

'A seller should recognise turnover in respect of its performance under a long-term contract when, and to the extent that, it obtains the right to consideration' (paragraph G 18).

There is then a note by Trevor Johnson in Tax Adviser , May 2004, affirming that concerns that Application Note G might mean the demise of work in progress were without foundation and that the development of the application note was to meet a situation where differing interpretations had arisen of when revenue should be recognised and to address concerns that businesses were in fact anticipating income which had not yet arisen in order to satisfy investor's expectation of growth.

My understanding is that Trevor's note was based on an exchange of correspondence between the Association of Taxation Technicians and the ASB.

UITF 40

I think the history is important because UITF 40 does not stand alone. It needs to be read in the light of FRS 5.

UITF 40 makes the following points:

a) A contract to provide repetitive services (such as general professional advice, accounting support…) on an ongoing basis should not be accounted for as a long term contract (paragraph 12).

b) Contracts with a duration of under a year should be accounted for as long term only if contract activity falls into different accounting periods and a failure to reflect turnover would result in distortion…such that the financial statements would fail to give a true and fair view (paragraph 13).

c) 'Where the substance of a contract is that the seller's contractual obligations are performed gradually over time, revenue should be recognised as contract activity progresses to reflect the partial performance of its contractual obligations. The amount of revenue should reflect the accrual of the right to consideration as contract activity progresses… Where the substance of a contract is that a right to consideration does not arise until the occurrence of a critical event, revenue is not recognised until that event occurs' (paragraphs 26 and 27).

The UITF 40 document can be found on the Accounting Standards Board website at www.frc.org.uk/asb/uitf/pub0758.html .

Examples

Perhaps some examples that illustrate various points would be helpful.

Example 1: Adam the newsagent

Adam runs a newsagent's shop. He charges 50p a day to deliver papers. Ben contracts on Monday for Adam to deliver Tuesday's papers. He contracts on Tuesday for Adam to deliver Wednesday's papers and so on. Charles contracts with Adam that Adam will deliver his paper every day throughout May to July.

Adam prepares accounts to the end of June. I think that Adam has fully performed his contractual obligation to deliver papers to Charles in May and June and should recognise the profit for those two months. But I am sceptical whether that is a long-term contract at all; I think it may well be a repetitive contract within paragraph 12 or a package contract within Application Note G. Be that as it may, I think Adam ought to recognise two month's profit on his deliveries to Ben and Charles.

This example is taken from the July 2001 discussion paper; it illustrates what that paper was seeking to do — although ASB thinking may well have changed so it is not necessarily what UITF 40 is seeking to do.

Example 2: Diana sells jumpers

Diana runs a shop selling jumpers. She buys a woollen jumper in May for £50 and hopes to sell if for £130. She still holds it at the end of June. She realises that she can make more money if she knits the jumpers herself. She buys a skein of wool for £4 at the beginning of May and knits two jumpers. She holds these in stock at the end of June. She hopes to sell them for £120 each.

Fred tells Diana in June that if she puts leather elbow reinforcement on a jumper he will pay her £140 for it. She has not bought the leather by the end of June. It will cost her £5. Should Diana recognise £48 profit at the end of June on the £120 jumper as she has performed the knitting? Should she recognise any profit on Fred's jumper? She has done the knitting, which is probably 95% of the work required to produce the product Fred wants. If so, what should she recognise? 90% of (£140 less £2 wool and £5 leather) = £120?

Surely not when she cannot recognise any profit on the jumper she bought in!

Example 3: Robert the tax adviser

Robert is half way through completing Sam's tax return at the end of June. Has he accrued the right to 50% of the consideration that Sam has agreed to pay for the tax return? Common sense suggests no! Sam has no use for half a tax return. Indeed, it is worth less to him than no tax return as the penalties for submitting incorrect returns are greater than those for submitting no return at all.

This contrasts with Adam's position. The delivery of two months' papers has provided a benefit to Charles and if Adam were to go out of business on 1 July Charles would surely expect to have to pay for the two months' delivery that had been performed.

Accountancy and legal transactions

It is possible to envisage some accountancy and legal transactions that are akin to Adam's.

For example, if I send someone to a client to stand in as a finance director while its director is on holiday and we agree that a fee of £800 a day will be paid, I think that the substance of the transaction is that at the end of each day I have earned another £800. But for most of us the vast majority of accounting transactions do not fall in to that category.

Does head (c) above mean that revenue from services needs to be recognised as the work proceeds? Many people think that it does. But if it does, that effectively means that work in progress can never arise (except perhaps in the circumstances in (a) and (b)).

I have a number of conceptual difficulties with such an interpretation.

If the ASB wanted to abolish work in progress why did it not say so? That would be a fundamental change. I think it improbable that the ASB is so devious that it would not spell out clearly such a move or so arrogant that it would not put it out for full discussion.

What does the ASB mean when it says that FRS 5 will not change the accountancy treatment of the vast majority of transactions if that is what it intends? And why should UITF 40 purport merely to explain Application Note G if it intends to have the opposite effect to the explanation of Application Note G that the ASB apparently gave to the ATT?

The substance of the contract

What has recognising revenue as work in progress got to do with the substance of the contract? The substance of a contract is that I will perform a complete service in return for payment, not that I will be entitled to payment each day for the work that I do that day.

Why does the UITF refer to contractual obligations in the plural? Most contracts for services have a single obligation. If a contract contains several distinct obligations I can see a degree of logic in recognising the revenue from each as it is performed, e.g. Simon has contracted to prepare accounts for Tom and submit them to the Revenue for a single fee, at his year end he has completed the accounts, but has not done the tax return. He may have accrued the right to the accounts element of the fee.

If I accrue a right to consideration when I have completed half a tax return how do I value it? Should I assume that I will complete the return? But if so, am I then valuing what existed at the balance sheet date or am I valuing a part of something that did not come into existence until the next year? I do not think my right to any consideration accrues until I have completed the return, i.e. that the completion of the return is a critical event that triggers the right. But paragraph 19 defines a critical event as something the occurrence of which is outside the control of the seller, so such an interpretation is inconsistent with that.

What is head (a) above seeking to cover? On the face of it tax advice is general professional advice, but I can see no logic in treating such advice differently to the completion of a tax return.

I would like to think that UITF 40 does indeed leave work in progress largely unscathed, but until I can fathom answers to some of the above questions I am unsure. I, and I suspect the editor, would welcome readers views on how they interpret the UITF before I try again. I hope that the editor will then let me return to this topic in a few weeks time.

Issue: 4006 / Categories: Comment & Analysis