Accounting changes and the meaning of ‘income’

With new standards on the horizon, taxpayers will have to keep their eyes wide open to stay on the compliance ball

Two words usually come to mind when we consider the timing of income recognition. They are “risk” and “reward”. Traditionally, the revenue of a contractor can be recognised once the risk and reward have been passed to the buyer. We are very familiar with this concept as it has been in place for more than a decade. However, changes are in the pipeline.

Earlier this year, the Federation of Accounting Professions (FAP) announced the new accounting standard “IFRS 15: Revenue from Contracts with Customers”. It will replace the existing standard in Jan 2019 for publicly accountable entities.

Accountants are required to recognise revenue earned by following a five-step model. It starts by identifying the existence of the contract with the customer, followed by identifying the performance obligations of the contractor. The contract price is then ascertained and the amount allocated based on the proportion of each obligation performed. Finally, the time of the completion of each obligation is when the revenue under the contract can be recognised.

Under the new standard, the timing of recognition will not be considered only based on the “risk and reward” transferred. The key consideration will be the transfer of control, with risk and reward only one of the factors. The control transferred consists of five elements and whichever one arises first will trigger the recognition of revenue.

The Revenue Department has not yet offered any new guidance regarding this change. Based on current tax law, the accrual basis together with certain specific guidelines apply for corporate income tax computation. Much of the law relating to revenue recognition has been in place for more than a decade. But in a case where there is more than one obligation to be performed — for example, where a sale, warranty and service are included in the same contract — each would be recognised at a different time so the amount will have to be split according to the contract.

As a result, some companies might be able to match the accounting treatment with the tax law, but others may find that they have tax or accounting differences. Critical challenges will emerge on first-time adoption. For example, a retroactive adjustment might be required for comparison between the 2019 and 2018 fiscal periods for an ongoing construction income on a long-term project that started prior to the change.

In such a case, the tax basis initially would have been aligned with the accounting basis for revenue recognition under the percentage of completion (POC) method. After the change, the income stream will not be consistent with what was previously recognised for tax for the same project.

Will the Revenue Department consider this a change in the accounting method that requires its approval before it can be used? Perhaps it is not a change in the method adopted but a transformation of the method to the next level, since the taxpayer will have no choice but to adopt the accounting practice. If the department accepts that POC applies in 2018 and prior years as before, and the new accounting principle should apply from 2019 onward, the total revenue stream for the whole project could be different from the contract amount.

A taxpayer might even face other challenges arising from tax and accounting differences. Apart from the direct impact, the reconciliation of sales in the annual tax return with the monthly VAT returns may be troublesome. The revenue stream might not be from only one source but from multiple sources. Even a trader or manufacturer, who has little difference between the revenue recognised in the accounts and the income in VAT returns, will have to be aware of this change.

One example of this could be the splitting of a performance obligation from only sales of goods to be multiple obligations. Think of a warranty or transport, whereby income is recognised over a period of time while the VAT point is triggered upon the delivery of goods. The issues themselves may not be great but the volume of transactions and the need to keep track of them could be a major task.

Another interesting point is the effect of the change on a company’s transfer pricing reports. Normally, this report is derived from information taken from financial statements. Once the new accounting standard is applied, the performance over several accounting periods could vary as a result of the change in accounting principles.

Moreover, the selected comparable samplings may not be consistent since not all companies will apply this standard. This is one of the challenges faced by a company preparing transfer pricing documentation when first adopting the new standard.

The above issues are some of the examples that are likely to create additional work for the taxpayer. There may be more undiscovered tax and accounting differences that will directly affect corporate income tax computation as well as other tax areas and documentation required. Taxpayers will need to keep their eyes open for any signs from the Revenue Department regarding this change and prepare the necessary internal systems to support compliance.