On 10 March 2005, the Urgent Issues Task Force (UITF) of the
Accounting Standards Board published UITF 40 Abstract 40 Revenue
recognition and service contracts (UITF 40). UITF 40 applies to
accounting periods ending on or after 22 June 2005.
On 27 April 2006, the Institute of Chartered Accountants in
England & Wales (ICAEW) published a three part guidance note on
UITF 40. This was developed out of an earlier guidance note
prepared by the Association of Tax Technicians and the Association
of Accounting Technicians in conjunction with the ICAEW’s
Practice Society. This earlier guidance note was, with some
amendments, adopted as Part 2 of the ICAEW’s guidance on 27
April.
Although the guidance is designed primarily to assist small
businesses, it applies to all service providers who are affected by
UITF 40. The guidance applies to UITF 40 only and does not address
the application of comparable requirements in either the FRSSE or
in International Financial Reporting Standards.
Following discussions between some members of the CCAB bodies
and HM Revenue and Customs about the impact of UITF 40, the
importance of having consistent guidance on UITF 40 that received
the general support of the accountancy profession was recognised.
Accordingly, it was agreed that the ICAEW would approach its fellow
members and seek their approval to adopting the guidance published
on 27 April 2006, with the result that the guidance would be
published under the auspices of the CCAB.
Following a ratification process, the guidance has been
adopted by all the six members of the CCAB and is accordingly now
published as CCAB guidance. For ease of reference the guidance note
has been retained in the form published on 27 April 2006, including
the reference in Part 2 to the Practice Society’s guidance
note. The CCAB bodies wish to emphasise, however, that although the
guidance note is in three parts, the guidance must be read as a
whole and each part is equally important: no one part of the note
should be taken in isolation.
In this respect service contracts are treated in the same way as long-term contracts for goods. Thus, a mixed contract – services and goods, e.g. a plumbing contract – is accounted for in the same way as a service contract.
Practice Society Guidance on the application of UITF 40 “Revenue recognition and service contracts”
The Practice Society of ICAEW has been liaising with the
Accounting Standards Board (ASB), jointly with the Association of
Accounting Technicians and the Association of Taxation Technicians,
to provide further guidance for the benefit of Members and their
clients on the accounting treatment of Work in Progress in service
entities. The discussions have centred on those small businesses
that would otherwise normally rely on the FRSSE exemptions.
The issue of AN G in November 2003 and the further guidance
provided by UITF Abstract 40 issued 10 March 2005 is intended to
assist in the interpretation of FRS 5 ‘Reporting the
substance of transactions’. This relates to the accounting
treatment of revenue arising from contracts to provide services
with the main point at issue being when revenue from such contracts
should be recognised.
It is understood from ASB that this is an area that has been
inconsistently treated in practice giving rise to early or late
reporting of revenue. We agree that the same standard should apply
to all entities leading to consistent reporting on a valid basis by
all entities.
AN G and Abstract 40 do not directly address the basis of
valuation of stock and work in progress (WIP), nor the valuation of
debtors. Their purpose is to provide a framework within which a
decision can be made as to the time at which revenue should be
recognised.
In producing AN G and Abstract 40 it was not possible for the
ASB to give precise rules for every situation because of the wide
variety of service contracts in use, both now and in the future.
Instead, the documents set out a framework within which a compiler
can prepare accounts on a true and fair basis. The compiler is also
required to apply materiality, practicality, common sense and
professional judgement to the preparation of the accounts.
When considering the problem of when to recognise revenue for
service entities, it will be necessary to review the contracts in
existence at the year-end. Sometimes it will be appropriate to look
at each individual contract, and sometimes it will be necessary to
consider parts of a contract separately, such as when the contract
has distinguishable phases. On other occasions it will be possible
to review all contracts of a similar nature, or to take a common
approach to all contracts, in determining when to recognise revenue
at the year-end.
In order to recognise revenue from a contract, as compared
with treating contract performance as part of WIP, it is necessary
for the selling entity to have reached a point within the contract
where there is a right to consideration in respect of the work done
to date.
Under the general approach (basing the accounting on when
‘the seller obtains a right to consideration in exchange for
its performance’), it will generally be the case that revenue
is recognised as contract activity progresses.
However, this will not always be the case, and it will be
necessary, in considering whether a right to consideration has been
established, to consider:
(a) the nature of the contract
(b) whether there are any ‘milestones’ within the
contract. For example, it might be clear that a right to
consideration is established only when certain milestones are
reached.
(c) its materiality. For example, in the case of a task
lasting a few hours or days it is most likely that the contract
will not be sufficiently long that to apply the percentage of
completion method would materially change the numbers.
The issue of, or failure to issue, an invoice, or the date of
payment, do not determine the timing of recognition of revenue.
The starting point in assessing quantum is the amount that could
be charged for the work done. That will normally be the
consideration due for the performance completed, but the value
should be reduced to take into account the likely amount that the
customer would accept for the work done, by the credit risk and by
other uncertainties. The value should be recognised as a debtor,
although it may be better practice to show the amount separately in
current assets as ‘Accrued Income’.
It follows from the above, that an entity that provides only
services and where the seller has a right to bill for actual time
spent on completion of every time unit, will not have any WIP. All
time spent under such contracts must be either billed debtors or
accrued income (reduced to the value that the client will accept
for the service provided).
However, in some cases there may be no right to receive
consideration (see UITF 40, para 5) (note that we say above that
invoicing date, as such, is not a sound basis) until the immediate
task is complete. In those circumstances, the part completed work
for which there is no right to receive consideration at the
year-end will continue to be valued as WIP. This is important
because under SSAP 9, stock (which includes WIP) should be valued
at the lower of cost or its net realisable value. The principle
here is to match that cost with the revenue it will generate when
sold. Thus WIP is valued at cost, being the direct costs of the fee
earners engaged on that work plus any attributable overheads. To
the extent that a partner or proprietor’s time is included in
WIP, there would be no addition for their cost, as there is none.
The situation will be different in a limited company to the extent
that there will be a cost of owner/manager’s time.
All unbilled, completed work must be included as accrued
income at a realisable invoice value.
For certain assignments, typically but not exclusively longer
contracts, ‘milestones’ will occur at intervals. These
must be identified and the right to consideration arising from the
part performance quantified. Thus the work to the previous
‘milestone’ will be valued as accrued income at
realisable value, and work since that ‘milestone’ (if
there is no right to receive consideration in relation to it) as
WIP at the lower of cost or its net realisable value.
If the right to consideration does not arise until the
occurrence of a critical event then revenue is not recognised until
that event occurs. The incomplete assignment is then valued as WIP
at the lower of cost or its net realisable value.
In all cases, the policy to be adopted must be applied consistently. The policy must be practical.
Q1 – TV personality
A TV personality does a show for a fee of £20,000. He is
also entitled to a repeat fee of £10,000 if the show is
rebroadcast and £5,000 for each subsequent broadcast, if any.
There are no costs other than the proprietor’s own
labour. In the past the monies were recognised as each became
contractually due. Is it the case that under UITF 40 the
personality has to assess the likelihood of the show being
repeated, and recognise the probable repeat fees once he has
completed filming the show? Would this not result in recognising
fictional income?
The TV personality does not have any ‘right to
consideration’ in respect of the rebroadcast until the
rebroadcast occurs and should not recognise any rebroadcast fees
until that time. So if he were to recognise an estimate of the
rebroadcast fee and then it doesn’t occur, he would have
recognised fictional income, which would not be
appropriate.
Q2 – Songwriter
A songwriter composes six compositions. He thinks it likely
that at least one will be covered by a major artist and that will
generate income of £100,000 some time during the next three
years. This is a contingency that is outside his control, so no
income need be recognised until a song is actually recorded. When
it is recorded the songwriter will become entitled to several
separate royalty flows (a recording royalty and a performance
royalty). Is it the case that once the song has been recorded and
the record containing it released, he has to estimate his likely
income, which in this case could well arise over a 10-year period,
and recognise the entire figure immediately? Again, the songwriter
has no costs other than his own labour and in the past would have
recognised the royalties as and when they became contractually due.
It is agreed that no income should be recognised until a
song is actually recorded. This service does not fall within the
scope of SSAP 9, as there is no contract in place (had the
songwriter written a bespoke song to order, the situation would be
different). Prior to a contract being signed for the
‘sale’ of the song, although the songwriter had
performed (the song is written) there is no right to consideration.
When the song is recorded the recording royalty should be
recognised. Performance royalties, however, should not be
recognised until each performance occurs, as there is no
‘right to consideration’ until then. That is, revenue
on future performances should not be anticipated.
Q3 – Tax accountant
John is half way through completing Sam’s tax return at
the end of June. Does he accrue the right to 50% of the
consideration that Sam has agreed to pay for the tax return?
Commonsense would suggest not. Sam has no use for half a tax
return. Indeed, one could argue that 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.
It is true that a half-completed tax return is of little
practical use. But the working assumption is that contracts will
progress to completion. In general, John will complete the tax
returns that he is working on. (If that is not the case for a
significant number of John’s assignments, the accounting
treatment might well be different.)
From a technical perspective, UITF 40.11 pushes John into
SSAP 9 for accounting for this contract, the completion of a tax
return being a single project. SSAP 9.29 requires that, where the
outcome of the contract can be determined revenue is ascertained in
a manner appropriate to the stage of completion.
This is entirely consistent with FRS 5 AN G, which requires
that revenue is recognised by reference to performance and the
right to consideration. The only circumstance under which it would
not be appropriate for John to recognise any revenue would be if
his right to consideration was contingent on a specific trigger
event, the outcome of which he cannot control (as outlined in UITF
40.19). The stage of completion is not necessarily determined on a
straight-line, time incurred, basis but is influenced by the value
to the client of the work done to date.
Q4 – Accountant doing advisory work
John very rarely works for an agreed fee. He tells clients
his charge out rate and those of his staff and decides what to
charge only when the job is complete.
Suppose that John is asked to advise on whether and how to
merge two companies. At his year-end he has £4,000 of time on
the clock of which £2,200 is staff time whose cost was
£1,700 and £1,800 is his own time. He assesses that the
client is likely to accept a fee of £20,000. He expects to
incur a further £6,000 of time. However he has not yet
considered stamp taxes and has a gut feeling that they could create
a problem. If they do and he cannot find a solution, the merger
idea will be dropped. In those circumstances he thinks it unlikely
that he will be able to recover all of the time on the clock.
How much income should he recognise at his year-end? Past
practice was to recognise nothing until he completed the job and
was in a position to raise a fee note.
Again, UITF 40.11 directs us towards SSAP 9 and the
"percentage of completion" method.
Given that there are no milestones in the contract, it may
be appropriate to measure the stage of completion by reference to
the costs incurred to date compared with the total estimated costs
of completing the project. John has incurred 40% of the costs, so
should recognise 40% of the revenue, or £8,000 of
revenue.
SSAP 9.24 requires the application of a certain degree of
prudence. It requires that no profit should be recognised "until
the outcome of a contract can be reasonably foreseen" and that, of
the profit that can, in light of all circumstances, be reasonably
foreseen, the amount earned should reflect a prudent estimate of
the work performed to date. SSAP 9.28 notes that the estimated
outcome of a contract may vary over its life.
If, at the end of year 1, having incurred 40% of the costs,
he is concerned about the stamp duty issue and is not "reasonably
certain" of billing more than the amount on the clock when the
merger is abandoned, he should recognise only £4,000 of
revenue (or such lower figure as he estimates he will be able to
recover) and no profit.
But if, at the outset, he is reasonably certain of
receiving the full £20,000 and accumulates £4,000 of the
£10,000 of costs in year 1, he would recognise £8,000 of
revenue. If, however, in year 2, he incurred no further costs but
noted that the stamp duty issue jeopardised the outcome of the
contract (and making any profit is no longer reasonably certain),
then the revenue recognised to date would be limited to £3,500
(being the cost of the time incurred) and he would debit revenue
£4,500. This last entry – reversing revenue already
recognised – would arise only in rare circumstances when he
initially genuinely believed that full recovery was reasonably
certain, but events later proved him wrong.
In practice, unless the accounts are finalised very quickly
after the year end, one would have a good idea, when finalising
them, of the impact of adjusting post-balance sheet events.
If the fee arrangement is that the whole of John’s
fee is contingent on completion of the merger, UITF 40.27 precludes
him from recognising any revenue whatsoever until the occurrence of
this trigger event (which is outside his control).
Q5 – Accountancy work and resignation
Firm X starts to prepare accounts for a client. It has
£1,000 on the clock at the year-end and expects it will take a
further £2,000 to finish the job, when it will be able to bill
£3,000. After the year-end Firm X discovers that the client
has charged a large amount to the business that does not relate to
the business. The client refuses to exclude the sum from the
accounts. Firm X says it will resign if he does not do so. He says
that if the firm does resign, it cannot expect to be paid for the
work done so far. Firm X resigns and writes off the time.
It appears that the dispute with the client is a
non-adjusting event under FRS 21. Accordingly under UITF 40 Firm X
needs to recognise £1,000 of income that it knows is never
going to be received and write it off next year. In a way that is
logical, as the firm had done the work in year 1 and the result of
the dispute in year 2 was to lose it the ability to recover the fee
for that work. But is recognising ‘fictional’ income in
year 1 true and fair?
Although the dispute was after the year end, it indicated
that, of the amount receivable recognised at the year end
(£1,000), none was recoverable. So although Firm X would
recognise revenue of £1,000 (on the basis that, when the work
was performed it was performed in good faith of being paid), it
would recognise a specific bad debt provision as an adjusting post
balance sheet event under FRS 21 para 9(b).
Q6 – Barrister – “no win, no fee”
A barrister works on a “no win, no fee” basis.
How should this be accounted for?
Revenue should not be recognised until a case has been won.
Only at that stage does the barrister have a right to
consideration. (UITF 40, para 27)
Q7 – Barrister – “pay at end”
A barrister works on a “pay at end” basis. The
fee is not agreed in advance, nor will the rate be fixed. The
consideration is negotiated at the conclusion of the case. The
difference from ‘no win, no fee’ is that a fee will
always be due. Currently this is included as soon as the fee is
negotiated.
There is significant uncertainty about the amount of the
fee at an accounting date prior to the end of the case.
Nevertheless, it is clear that the relevant fee is not nil. There
are two possible arguments:
Q8 – Barrister – fixed fee cases
A barrister works on certain types of public funded cases
(“cost assessed”, “graduated fee” and
“prosecution”). These cases are done for a fixed fee.
Currently, revenue is recognised on completion of the case. Is it
right to say that UITF 40 can be read to give the same result?
Another view appears to be that every case should be examined and
part of the consideration accrued to the year-end date be included,
even though there is no right to consideration. A further reason
why one might argue that this is incorrect is that if the barrister
who has prepared the case is unable to present the case in court
then the presenting barrister receives the whole of the fee.
The appropriate accounting here is a matter of professional
judgement depending on the facts of the situation. Where, for
example, it is reasonably clear what a typical case involves (say
two client meetings, one day’s preparation and one day in
court for an aggregate fee of £5,000), it will be possible to
assess, for each case, how far through the case one is at the year
end. If the barrister is half way through the case, he would
recognise half the fee, or perhaps somewhat less if there were
genuine uncertainties about the time to complete. On the other
hand, if the fee was agreed but the amount of remaining work and
therefore time was open ended and therefore very difficult to
predict, one would either (a) recognise some revenue but on the
basis of a very conservative estimate or (b) argue that no reliable
estimate can be made until the case is further progressed.
As to the point about potentially losing the fee if the
barrister cannot appear in court, the effect of this point on the
accounting depends on the substance. If losing the fee due to being
unable to present the case in court is rare, one would either
disregard it or make an overall reduction of a few percentage
points in the overall revenue figure to allow for the rare case in
that category. On the other hand, if it is common that a barrister
prepares a case and is not able to present it, thereby losing the
fee, it may be that there is not sufficient certainty to justify
recognition of revenue until the barrister does present the case in
court and is thereby assured of earning the fee. Events after the
balance sheet date (appearing or not being able to appear) may of
course reduce the uncertainty in some cases.
Q9 – Barrister – Legal aid cases
Legal aid in some cases is not agreed until after the matter
has been settled. In lengthy cases payments on accounts are made.
This is a long and protracted procedure that can take many years.
Often the payments on account will be for a greater amount than the
eventually agreed fee and the barrister has to return the excess.
It has been agreed with HMRC that the relevant tax point is
payment, normally a payment on account, or the agreement of the
fee, whichever comes first.
Again, professional judgement has to be applied here and
the accounting treatment will depend on the degree of uncertainty.
In principle, revenue should be recognised according to the work
done to date, rather than according to progress payments received.
If a reasonable estimate can be made of the revenue that has been
earned as a result of the work done to date, then that should be
recognised. Prudence should be built in to that estimate in
response to uncertainty. It may be that the level of uncertainty is
so high that no reliable estimate can be made until either later in
the process or until the case is completed and the fee agreed.
Finally, a barrister should not recognise all the progress payments
received as revenue, even if they do bear a close relationship to
the work done to date, if it is likely that some of the amounts
received will have to be refunded.
Q10 – Joiner
A joiner contracts to create fitted bookcases in an office
for a total price of £15,000. He purchases the timber
(materials cost £6,000) and builds the doors in his workshop.
He also prepares the timber for the rest of the structure in his
workshop. He then builds the skeleton of the bookcases on the
customer’s premises and attaches thereto the timber that he
has already prepared in his workshop. What is the accounts
treatment if his year end occurs after he has prepared the timber
and the doors but before he has gone to the customer’s
premises to build the skeleton and fit them?
The contract is a single contract and the joiner should
recognise revenue according to the stage of completion of the work.
It is not relevant whether the work is done at his workshop or at
the client’s premises. Neither is it relevant that part of
the contract can be regarded as ‘goods’ and part as
‘services’: both are treated in the same way for
accounting purposes.
Let us assume the joiner assesses that he has done 1/3 of
the work by the year end and he has used half of the timber and
other materials. The calculation would be: total price £15,000
less materials at cost (£6,000) leaves £9,000. Assuming
the profit attaches only to the labour, accrued income is
£3,000 (1/3 complete) plus materials at cost of £3,000 (
a half used), a total of £6,000. The remaining half of the
total cost of the materials (£3,000) is work in progress.
These figures should then be adjusted to reflect any likely losses,
discounts, delay in payment or cost of difficulties expected to
arise in completing the contract. Any progress payments received
should be treated as creditors in accordance with SSAP
9.
