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.