Valuation of Work in Progress – Background

On 10 March 2005 the Accounting Standards Board (ASB) issued UITF (Urgent Issues Task Force) Abstract 40 (UITF 40) which is effective for accounting periods ending on or after 22 June 2005.

Accountants will be well aware that, in respect of service contracts, the generally accepted method of accounting for them was as follows:

• Revenue on completed work would be recognised in full, even if it had not been billed at the year end.
• Uncompleted work would be recognised as work in progress (WIP), represented by the costs incurred to date but not recognising any revenue (or prospective profit) at the year end.

UITF 40 sets out further rules for accounting for revenue from service contracts. The purpose of this note is to comment on the tax consequences which might arise where it is appropriate that these new rules are to be followed. It is outside the scope of this note to comment on the circumstances in which the new rules must be applied.¹

One result of adopting UITF 40 can be a one-off uplift in declared profits in the period covered by the change in accounting basis. It could conceivably also result in a one-off decrease in declared profits.

Tax Implications

Corporation Tax

UITF 40 will be an element of Generally Accepted Accounting Practice as defined in TCA97 s. 4 for companies with accounting periods ending on or after 22 June 2005. Because, for CT purposes, TCA97 s. 76A (1) requires that the profits or gains of a company are computed in accordance with GAAP, there will be a corresponding impact on the assessable profits.

Income Tax

Individuals and non-incorporated partnerships are not obliged to prepare accounts to GAAP standards for tax purposes. The so-called “earnings basis”, as defined in TCA97 s91 (5) (a) is regarded by Revenue as the legal basis for drawing up accounts for income tax purposes.

A Revenue Statement of Practice SP-IT 02/92 has been relevant in this regard for several years. SP-IT 02/92 describes an alternative “conventional basis” on which accounts may be drawn up for tax purposes in the case of an individual or partnership carrying on a profession (other than a profession as a barrister).

Neither the earnings basis nor the conventional basis necessarily constitutes GAAP. However, where individuals or partnerships prepare accounts to GAAP standards, the tax issues arising from UITF 40 which apply to companies would also apply to such individuals and partnerships. ICAI is clear in its support for the preparation of accounts to GAAP standards.

Existing Revenue Statements of Approach

SP-IT 02/92 as already mentioned deals with the position of individuals and partnerships. It is not a requirement for tax purposes to prepare accounts to GAAP standards, and individual businesses may elect not to do so. SP-IT 02/92 does not apply to companies.

A Revenue Memorandum G9, which dates back to 1975 and was published on the introduction of the then SSAP 9 standard, addresses changes in valuation methods for stocks and WIP. Memorandum G9 did offer a favourable tax treatment of the consequences of an uplift in certain stock values which followed from the change in accounting practice. ICAI is hesitant to recommend reliance on this Memorandum in the current circumstances. This is because, as it is not apparent at present in the Revenue Rules and Procedures published as required under s16 of the Freedom of Information Act, its continued operation cannot be assumed. Further, even if it remains in effect, it is unclear as to whether it offers any measure of relief for increased liabilities arising as a consequence of a change in the valuation of professional WIP on certain contracts.

Current Action

ICAI, in association with CCAB-I, has been in correspondence with both Revenue and the Department of Finance over the last three months to obtain clarifications on the issues which UITF 40 has raised. We are clear that no taxpayer should be prejudiced because they apply the best and most current accounting principles in the conduct of their affairs. Equally, if any outcome as expressed in current tax law does result in bringing forward profits into the charge to tax, relief must be made available in these circumstances. In our submissions we have highlighted the precedent established for the move to IFRS in the 2005 Finance Act, whereby the impact of tax uplifts as a consequence of accounting policy changes is spread over five years.

We understand a proposal in this regard has been brought to the attention of the Minister for Finance.

Preliminary Tax

Because many taxpayers will have to make payments of preliminary tax before the Minister's decision on the matter becomes known, we suggest that, where possible for PT purposes, payments based on 100% of the previous year's liability be made to avoid interest charges. The same method should be used in cases of doubt for “small companies”, that is to say companies whose CT liability in the preceding chargeable period has been €50,000 or less.

ICAI will continue to keep its members informed of developments as they arise.

1. FURTHER BACKGROUND

In November 2003, the Accounting Standards Board (ASB) issued Application Note G: Revenue Recognition (ANG), as a clarification of how Financial Reporting Standard (FRS) 5'Reporting the Substance of Transactions’ applies to issues of revenue recognition. Until ANG was issued, the Ireland & the UK did not have an accounting standard in this area, whereas International Accounting Standard (IAS) 18'Revenue' deals with such issues. Unfortunately, ANG gave rise to considerable concern about the correct way to account for revenue from contracts to provide services. As a result of these concerns, the ASB asked the UITF to consider the matter.

On 10 March 2005 the UITF issued Abstract 40 which is effective for accounting periods ending on or after 22 June 2005. Abstract 40 seeks to clarify the rules for accounting for revenue (i.e. turnover) from contracts to provide services and applies not only to professional service firms but to all other providers of services. The impact of UITF 40 on existing accounting practice is not clear cut, but many believe it will cause the value of previously unrecognized WIP at the balance sheet date to be included in the balance sheet and thus, consequently, in the income statement. Further guidance is being developed to assist practitioners on the practical effects of UITF 40.