Still work in progress?

ROBERT MAAS FCA, FTII explains why he thinks that UITF 40 does not have much impact on work in progress.

SITTING ON THE fence was how I concluded my article, 'WIP RIP?', Taxation 5 May 2005, page 117 on the impact of Urgent Issues Taskforce (UITF) 40, but I promised to think further. I am now firmly of the view that work in progress is alive and well and that UITF 40 has not changed very much. I am conscious that this seems to be a minority view, so it seems sensible to explain my reasoning.
Before doing so, however, I would like to make a small appeal. Please will readers of Taxation who are accountants and who have not read UITF 40, read it and form their own views. It can be downloaded from the Accounting Standard Board's website. If, afterwards, you agree with me, please spare a few minutes to contact the local council member of your professional body and tell him so, and feel free to do so even if you think I am wrong. The accountancy bodies are under pressure to issue guidance and my understanding is that the current consensus considers that UITF 40 largely abolishes work in progress. It would be a shame for guidance to be issued that does not reflect what the membership of the profession believes. UITF 40 applies to accounts ended after 21 June 2005. Most of us are unlikely to be preparing such accounts much before Christmas, but I suspect that the bodies will decide to issue guidance sooner rather than later.

Key paragraph

I am told that the key paragraph in UITF 40 is paragraph 26. I am not sure what is meant by 'key' in this context. Is it the one that unlocks the interpretation of the abstract or is it the most important one? If it is the latter, why should the UITF have taken 25 paragraphs to get there? Be that as it may, paragraph 26 consists of two sentences:

'Where the substance of a contract is that the seller's obligations are performed gradually over time, revenue should be recognised as contract activity progresses to reflect the seller's partial performance of its contractual obligations. The amount of revenue should reflect the accrual of the right to consideration as contract activity progresses by reference to value of the work performed.'

Let's examine these two sentences. The first question is: are they independent or does one follow from the other, i.e. does the second come into play only where the conditions set out in the first exist, or can it apply independent of the first? To my mind it is the former. The first sentence sets out the circumstances in which income is to be recognised. The second seeks to quantify the amount of such income. It starts 'The amount of revenue'. That begs the very big question, 'What revenue?' unless it refers to the 'revenue' mentioned in the first sentence.
Accordingly the important sentence is the first. What is the substance of a contract? That is an odd expression. Financial Reporting Standard 5 deals with the substance of transactions. A transaction can differ in substance from the contractual framework within which it is performed. But how can the substance of a contract differ from that contract itself? Surely it cannot, except in the limited circumstance where a single contract embraces a number of separate obligations so that the substance of the contract is that it is in reality a bundle of separate contracts.

Fulfilment

Going on from there, how can I perform my contractual obligations gradually over time? Application Note G to FRS 5 tells me that performance means 'the fulfilment of the seller's contractual obligations to a customer through the supply of goods and services'. Fulfil means to accomplish (Cassell's New English Dictionary). I do not think it possible to accomplish something gradually. Accomplish implies the attainment of an end, as does fulfil. While I can work towards that end over time, I can achieve it only at the single point in time at which I complete everything necessary to bring it about.
If I have more than one obligation bound up in a single contract, I can perform my contractual obligations gradually over time, as I can fulfil one of the obligations and then go on to the next and so on. I can see a logic in saying that when I have fulfilled the first of those obligations I have, in substance, completed that part of my bargain and ought to recognise the income from it, subject to being able to quantify the income with reasonable certainty. That would also be consistent with the use of the plural 'obligations' rather than 'obligation' in paragraph 26, even though most service contracts are for the provision of a single service.

Bundled services

The first part of the sentence accordingly leads me inexorably to the conclusion that it can be looking only at 'bundled' services. But surely that would mean that if I contract to perform a single service, I can defer income by inserting contractual terms that result in my contractual obligations being fulfilled only some time after I have performed the service (which as I understand it is what Jon Gammon was suggesting in his letter, 'Service packets', Taxation 19 May 2005, page 188). This is not the case, however, because Application Note G defines performance as the fulfilment of my contractual obligations 'through the supply of goods and services'. It seems to me to be clear from this that once I have fulfilled my obligation to supply a service, FRS 5 requires me to recognise the income even if there are other things that need to happen to trigger my right to consideration.
The second part of sentence one reinforces the conclusion that I have drawn from the first. The only way that I can partially perform my contractual obligations as contract activity progresses, is if there are several obligations which can be performed consecutively. I can always partially perform a service, but that is different from the contractual obligations and, as I said in my previous article, if I only partially perform a service, I cannot see any rational reason why I should be treated as having generated income when half a tax return is clearly of no value to anyone. In any event, that uses 'perform' as a straightforward English word. As UITF 40 refers back to Application Note G, it is more logical to interpret 'perform' by reference to the definition of performance set out in that application note.

Several obligations

Accordingly, in my view UITF 40 changes the rules only where a contract embraces several obligations. For example, I think that if a contract provides for the preparation of accounts and the submission of a tax return, it requires the profit on the accounts to be recognised when they are completed whereas, in the past, there was a good argument that nothing ought to be recognised until the tax return had been submitted. I do not think it requires, or even allows, income to be recognised where half a tax return has been completed if the only contractual obligation is to prepare and submit a complete return.
This also reflects what the UITF says in paragraphs 5 to 7 and 9. Although these are explaining Application Note G, the UITF specifically endorses them in paragraphs 16 and 17. In particular, paragraph 9 of the UITF states 'noting that the guiding principle is to consider the stage of completion of the contractual obligations, which reflects the extent to which the seller has obtained the right to consideration (paragraph G18 [of Application Note G])'. The 'right to consideration' is defined in Application Note G as the 'right to the amount receivable in exchange for its performance', which can only mean the performance of a contractual obligation. In particular, it goes on to say 'stage payments reflect only the agreed timing of payments whereas a right to consideration arises through the seller's performance'. It seems clear that the application note regards performance, i.e. the fulfilment of the contractual obligations through the supply of services, as triggering the need to recognise income even if the contract specifies payment at a different date, either earlier or later. UITF 40 seems to me wholly consistent with that. Leaving aside the illogicalities of recognising income when some only of the contractual work has been done, which I pointed out in my earlier article, if the UITF intended UITF 40 to override, or to conflict with, Application Note G, I think it inconceivable that it would not have said so.

Value of work

The other interesting issue is that addressed towards the end of Andrew Allen and Peter Vaines' article, 'Unfinished business?', Taxation 2 June, page 231, namely where income fails to be recognised what is the 'value of the work performed'. I have a lot of sympathy with what Andrew and Peter say, but I think that they have not taken their argument far enough. Something cannot be income and work in progress at the same time. If I have to recognise income but can value it in accordance with my contract, what happens if my costs, namely staff time and overheads, exceed the income that I feel I need to recognise? Surely the difference is a loss. So perhaps the UITF intended people to defer profits rather than to anticipate them as those who take a contrary view to mine seem to assume.
It is interesting to note that International Accounting Standard 18 requires income to be recognised only to the extent of the expenses recognised that are recoverable (which is what work in progress does) until such time as it is probable that economic benefits will flow to the seller, and the amount of revenue, the stage of completion and the total costs can all be measured reliably. It seems to me that in most cases this will mean that a partially completed job is treated as work in progress. Is not the idea that UK standards should converge with IAS?

MIKE TRUMAN offers an alternative view.

ON COMPLETING MY ICAEW final exams, I breathed a sigh of relief and put away all my books on accounting standards, secure in the knowledge that (as someone who was already specialising in tax, and who had only ever been on three audit assignments in my life) I would never have to open them again.  All I can say is that the Almighty has a wicked sense of humour …
Back in those dimly remembered days, there were two fundamental accounting principles which, we were taught, were in tension with each other. One was prudence — an accountant's glass is generally half-empty rather than half-full. The other was matching — if you are going to recognise the income from the widgets you sold, you have to match it in the same year with the cost of production. What we are dealing with in the debate over revenue recognition is the greater tendency now to emphasise matching over prudence.

FRS 5

Financial Reporting Standard 5 (FRS 5) begat Application Note G (ANG), which begat Urgent Issues Task Force Abstract 40 (UITF 40). To understand what effect the last two have, we must start with the first.
FRS 5 is not really about revenue recognition, it is about off-balance sheet financing and quasi-subsidiaries. It says that you report the substance, and not necessarily the legal form, of a transaction. So, for example, if you have financed the purchase of cars through a finance lease, which has more or less the same commercial effect as borrowing the money to buy them, you recognise the cars as an asset (even though strictly speaking you don't own them) and you recognise the cost of financing as a liability. One of the problems I have with the approach of Robert and others who believe that little has changed with ANG and UITF 40 is that they interpret the transactions according to their legal form. FRS 5 specifically says that you should interpret them according to their substance.

ANG

ANG was about revenue recognition. It was not, however, a response to what was happening in professional partnerships, it was a reaction to some of the excesses of the dotcom era, when traditional ideas like measuring companies on the basis of earnings per share were castigated as outmoded, and instead they were measured on how fast their turnover was growing, regardless of how big the losses (sic) were on that turnover.
Large IT projects typically have stage payments when certain milestones are met. However, the payments made at those milestones do not necessarily reflect the value of the work done so far. Best practice within the industry was apparently to reflect the value of the work done in turnover at year-end, as you would expect under SSAP 9, but this was not universally applied. ANG was an attempt to provide a consistent approach to recognising turnover.

Revenue recognition

Because it is an application note to FRS 5, it has to relate back to it. That is slightly problematic, given the thrust of FRS 5, and the notes to ANG say that they did consider issuing a separate standard, but decided for various reasons that an application note would be best.
Broadly speaking, ANG has to be saying one of two things. It is either saying that you have to recognise income based on the payments you have a right to invoice for, or it is saying that you recognise income based on the work that you have done — because those are the two possible accounting approaches. Paragraph G6 says

'A seller may obtain a right to consideration when some, but not all, of its contractual obligations have been fulfilled.  Where a seller has partially performed its contractual obligations, it recognises revenue to the extent that it has obtained the right to consideration through its performance.'

Given the two choices I outlined, it is hard to interpret this as saying 'recognise income only when the work is billable' rather than 'recognise the income that you are going to get for the work you have already performed'.  Introducing the legal concept of consideration was probably a mistake, but the notes on the development of ANG make it clear that this was meant to distinguish between the right to be paid (eventually) for the work done and the right to a stage payment. The key paragraph is probably paragraph 14 of the notes on development:

'The right to consideration does not represent a contractual right to demand stage payments from the customer. Rather, a seller obtains the right to consideration in exchange for the performance of its obligations under a contractual arrangement with a customer. This approach avoids the recognition of revenue being distorted by the timing of payment; to do so would move towards cash accounting. This would lead to a lack of comparability and allow wide discretion in reporting revenue.'

So the fact that I cannot bill for a half-completed tax return does not change the fact that I have performed some of the obligations under the contract (looked at in a substantive, rather than a legalistic, sense). Because I will in due course bill for that work and should get paid for it, I should recognise the income in this accounting period, where it will be matched with the expenditure that generated it.

UITF 40

Personally I always thought that ANG was quite clear enough, but UITF 40 must surely put the issue beyond doubt. The contention was that ANG, because it was actually addressing the manipulation of revenue recognition by IT companies, was not easy to apply to professional service businesses such as lawyers and accountants.
Again, UITF 40 has to say one of two things. It is either saying that we can continue not recognising revenue 'on the clock' at the year end by carrying it forward as WIP valued at cost, or it is saying that we have to recognise it in the accounting period that the work is done at the value we expect to receive for it when it is eventually billed. Robert refers to paragraph 26 in his piece above, and raises queries about its meaning. But the same point is made in more detail in paragraph 18, where it seems to be absolutely clear:

'Where the substance of a transaction is that the seller's contractual obligations are performed gradually over time, revenue is recognised as contract activity progresses to reflect the seller's partial performance of its contractual obligations. This is the case where the substance of the obligation is either (i) to provide the services of staff, ie where the seller earns the right to consideration as each unit of time is worked or (ii) to require the seller to use its skills and expertise in carrying out acts that will take some time to perform, even when the output is encapsulated in a document, such as a report. In such cases, revenue is recognised to reflect the accrual of the right to consideration as contract activity progresses …'

Of the two possible courses outlined, I cannot see how this can be interpreted as saying anything other than 'recognise what is on the clock at year end, unless you have a good reason for thinking it is not all recoverable'.

Forward, not back

Much as I have enjoyed the debate, I think it now poses considerable risks for the taxation of clients who are affected. We need to get beyond the basic accounting concept and agree with HMRC what the implications are. The first and foremost requirement is to agree the need for a spreading provision to be introduced as soon as possible. I have suggested before that the best way to do this is to introduce a general provision for a spreading framework, which gives the power to make regulations that invoke it in specific circumstances. That could be introduced into the current Finance Bill, leaving agreement on the exact scope of spreading in this instance to be negotiated and implemented by a statutory instrument.
We also need to agree with HMRC the situations in which income does not need to be recognised. UITF 40 itself, in paragraph 19, mentions one of them — where there is a contingency that is not under the control of the seller. 'No win, no fee' cases, for example, are therefore not within ANG, but there may well be several other situations that are covered. But we are unlikely to make any headway on agreeing the exceptions until we can approach HMRC and say that yes, in principle ANG applies to these clients, and therefore there is a need to agree the limits of its application.  

Issue: 4013 / Categories: Comment & Analysis , Companies