Ritson Smith hot topic: Revenue recognition for professional firms and others

 
The following article has been prepared by Jean Main, partner with Aberdeen-based accountancy practice Ritson Smith.

 
New rules have been set out by the Accounting Standards Board (ASB) which may change the method of recognition for income and profit, and, as a consequence, affect, amongst others, professional practices like lawyers, surveyors, architects, and others.

The new rules will be effective for accounting periods ending on or after 22 June 2005 at the earliest, and have been published by the ASB’s Urgent Issues Task Force (UITF) as Abstract 40 to answer queries on ASB Application Note G on Revenue Recognition. Abstract 40 gives guidance on the recognition of income derived from contracts for professional and other services. and this final abstract differs quite substantially from the draft abstract issued at the end of 2005.

It is particularly important for accountants to be up-to-date with these latest rules as UITF Abstract 40 may not only change the way they calculate their own profits, but may also affect many of their clients.

The key principle is set out in paragraph 26 of the Abstract:

 “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 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.”

In other words, revenue will have to be recognised as the contract progresses and not at the point of completion, delivery or invoice as in the past; firms will now have to account for accrued income, including the profit element.  The change may result in a one-off large increase in profits with the resulting increase in tax liabilities and adverse effect on cash flow.  January 2007 is the first date that will possibly cause cash flow difficulties for a lot of businesses.

Planning for tax liability

The advice to professional firms and others who believe they may be affected by the new standard is to treat this issue as urgent and to start acting now.  Businesses need to start thinking about how they should be calculating income and profits (possibly on a contract by contract basis) and perhaps planning how they are going to meet the resulting tax liability.

The potential impact on businesses is currently being addressed by the Institute of Chartered Accountants of Scotland who are carrying out surveys to establish how much the new rules are going to affect business with a view to supplying this information to government.  The purpose is to try and persuade the Inland Revenue to allow some sort of relief, such as a deferral of tax payment, in order to soften the blow.

Whether a relief is going to be granted or not, the issue is not going away; firms still need to weigh up how the new regulations are going to affect their business and consider new ways of assessing profits.

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