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When to count income

January 1st, 2017 / By: / Business, Sustainability

Get ready for new guidelines on ‘revenue recognition.’

Sometimes accounting rules and the tax law are logical and equitable; sometimes they aren’t. One question always seems to surface: When is a business’s revenue considered “income”? The time to claim income and deductions is dictated by rules or laws, not by a business owner’s opinion.

Accounting rules recently issued by the Financial Accounting Standards Board (FASB) offer new guidelines for determining how and when to acknowledge the receipt of revenue for bookkeeping and accounting purposes. Most businesses must recognize the transfer of goods or services to customers for the revenue they “expect” to collect.

REVENUE = INCOME … SOMETIMES

Revenue is an important financial measure for every business. Owners, managers, shareholders, lenders, analysts, investors and regulators all use revenue to monitor an operation’s financial performance and its general financial health.

In addition to its impact on an operation’s tax bill, revenue may also affect, among other things, the company’s ability to borrow money or attract investors. It is also often used as a basis for determining certain employee compensation and benefits such as commissions, bonuses andstock-based compensation. Anticipated revenue may alsoinfluence abusiness’s tax-planning strategies.

With the cash basis method of accounting used by most people in their personal lives, revenue is recognized when cash is received, regardless of when goods are sold or services provided. Under the accrual method of accounting, revenue is recognized when it is either realizedorrealizable, andisearned(usuallywhengoodsaretransferredorservicesrendered), no matter when cash is actually received.

The so-called “revenue recognition” principle is a cornerstone of the accrual method of accounting which, with the so-called “matching principle,” determines the time when revenue and expenses are recognized.

NEW RULES RULE

After more than a decade of debate and decisions about how businesses worldwide should report income, the FASB, the folks responsible for the U.S. Generally Accepted Accounting Principles (GAAP), in May 2014 published Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers.

These standards replace reams of industry-specific accounting guidance contained in the U.S. GAAP with a broad, principles-based method that almost all businesses worldwide must use to account for revenue. Public companies must comply with the new guidance in 2018, while private companies and not-for-profit groups have an extra year.

The standards call for five steps to calculate the final income amount: identify the contract, identify the performance obligations or promises necessary to fulfill the contract, determine the transaction price, allocate the transaction price to the promises in the contract and recognize revenue once the performance obligation is satisfied. What could be clearer?

In general, the new revenue recognition principle states that businesses using the accrual basis of accounting should only record revenue when it has substantially completed the revenue generation process. In other words, revenue is to be recorded when it has been earned.

Going one step further, the new guidelines state that cash can be treated as received in either an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized. Naturally, all revenue realized during an accounting period is included in the operation’s income.

If there is any doubt whether payment will be received from a customer, the seller should recognize an allowance for doubtful accounts for the amount it is expected the customer will renege. If there is substantial doubt that any payment will be received, the business should not recognize any revenue until a payment is actually received.

COMPENSATION QUESTIONS

Because many businesses have plans for managers, sales personnel, shareholder/employees, executives or others that are tied to revenue, compensation arrangements are emerging as a big concern under the new revenue recognition standard. In fact, many of those working to implement the new revenue recognition standard are already encountering challenges with compensation policies.

Although the effective date for public companies is annual reporting periods beginning after December 15, 2017, the new standard could result in earlier recognition of revenue which, in turn, could lead to higher

commissions or bonuses. In other words, for some operations the new standards change the timing for recognizing revenue, possibly changing the way compensation is awarded under existing profit-sharing arrangements.

SALES TAXES

Under the new revenue guidelines, the transaction price is the “amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.” Questions about whether sales and similar taxes should be excluded from the transaction price of a business have risen and remain confusing despite the latest guidelines.

The new revenue guidelines provide guidance on assessing whether a business is consideredtobeaprincipaloranagent in a given transactionandwhethersalestaxesshouldbe included intheoperation’s gross income ormore suitedtoreportingas “net” withinrevenue. This analysisisfurthercomplicatedbythesalestaxin eachtaxjurisdiction, especiallyfor businesses operatinginmorethanonetaxingjurisdiction.

The new accounting guidelines permit professionals to ignore all sales taxes that areassessedbyagovernmentauthorityand that are “imposed on and concurrent with a specificrevenue-producingtransactionand collected by the business.”T he new guidelines don’t, however, apply to taxes assessed on “an entity’s total gross receipts or imposed duringtheinventoryprocurementprocess.”

DEDUCTIONS AND INCOME

When claiming deductions or write-offs and timing the receipt of income under the new guidelines, there are a number of crucial steps every business should take:

• File a valid tax return. There are options such as filing an amended return, but there could be problems if the operation’s tax returns are not filed or not filed on time. Elections to take a deduction or defer income do exist; however, it is usually only with a timely-filed return (either by the due date or, if with an extension, the extended due date).

• Claim of right. If the business receives an amount that is not really income (e.g., a deposit) buttheoperationhasunrestricted use of the money, it must be reported as income and a deduction taken in the year the transaction is completed.

• Theft loss. As under current accounting guidelines and tax laws, deductions for theftlossescanbeclaimedonlyintheyear the theft is discovered.

• Casualty loss. As with theft losses, an accountingortaxdeductionisonlyallowed intheyearoftheloss. Naturally, lossescan’t be taken if an insurance reimbursement is anticipated.

• Bad debts and worthless stock. These losses can only be taken in the year when eitherthedebtorstockbecomesworthless. Determining the year of worthlessness can be tricky.

• Timing. While the effective date for public companies is not until 2018, the new guidelines permit specialty businesses to eitherapplytherequirementsretrospectively to all prior periods or to apply the requirements in the year of adoption.

Itgoeswithoutsayingthatthebiggerthe numbers, the more important it is to use the servicesofaqualifiedaccountingprofessional. And, since the guidelines are extremely complex, don’t assume that a professional will catch everything. It’s more than likely he or she will ask questions about large or unusual items, but the true nature of the item could be disguised.

A good strategy involves making a list of anyunusual issuesduringtheyearto discuss with the accounting professional before any financial statements or tax returns are prepared. Better yet, do so during the year or before the transaction is complete. There could be big savings.

After deleting about 120 pieces of industry-specific guidance in the GAAP and establishing broad guidelines for calculating revenue, implementing the FASB’s extensive new guidelines could be difficult. Although the 2018 effective date for the new revenue recognition standards is a year away, theFASB is advising all businesses to start preparing for the sweeping changes as soon as possible.

For many businesses, seeking early advice to comply with these voluminous changes is an important first step toa void last minute panic.

Mark E. Battersby writes extensively on business, financial and tax-related topics.

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