What’s your profit? Part 1 — Revenues

Some call it revenues, others income, turnover… Webster dictionary defines it as “ the total income produced by a given source”

Without revenues, there is no business. It seems so simple and yet many companies make errors (naive or fraudulent) in accounting for revenues.

To complicate matters, in the GST act, it alludes to “supplies” and not sales, and yet many have equated the two as one and the same.

Selling is not sales.

To gain a profit, you need to have sales. You can keep selling and not earn any revenues! To attain revenue, your goods or services need to be SOLD.

The key word is “sold”. That’s the base line logic.

Invoicing is not sales.

Invoicing a customer is NOT selling something. You can invoice anyone, but is the other party obligated to pay you anything?

What does the Financial Reporting Standards say?

FRS 18 para 1 deals with the following types of revenue:

(a) the sale of goods; 
(b) the rendering of services; and 
(c ) the use by others of entity assets yielding interest, royalties and dividends.

The definition of revenue in FRS 18 para 7 states that “Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.” FRS 18 para 7

But what is Equity?

FRS 1 (106)(d) requires the following in disclosing equity, for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately disclosing changes resulting from:

(i) profit or loss;

(ii) other comprehensive income; and

(iii) transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control.

So, increase in share capital is NOT revenue. — “other than increases relating to contributions from equity participants” Therefore, pt (iii) is out.

When there are increases in net inflow of profit or loss and other comprehensive income. It would meet the definition of Revenue.

But what are the “gross inflow of economic benefits”?

FRS 18(14)(a) states that revenue from the sale of goods shall be recognised when “…the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;”

It further explains in FRS 18(15) that “In most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer.”

FRS 18(14)(b) — “the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;”

FRS 18(14)(c) — “the amount of revenue can be measured reliably;”

FRS 18(14)(d) — “it is probable that the economic benefits associated with the transaction will flow to the entity;”

Sometimes, there may be issues regarding collectibility of the consideration or uncertainty of remittance from a foreign country. Once uncertainty is removed, revenue can be recognised.

FRS 18(14)(e) — “the costs incurred or to be incurred in respect of the transaction can be measured reliably.”

FRS explains that “revenue cannot be recognised when the expenses cannot be measured reliably; in such circumstances, any consideration already received for the sale of the goods is recognised as a liability.”

Possible situations may be warranty costs, or other costs to be incurred to make the item saleable. If those cannot be measured reliably then the revenue cannot be recognised.

So, how is all that mambo jumbo relevant to a small business owner?

The tax man depends on how you recognise your revenue in order to tax you. The tax man says that you have to follow the financial reporting standards and if you follow it, the tax man will accept (unless in contentious areas) the treatment of revenue recognition.

Example 1,

Let’s assume your year end is 31 December 2017. You made a sale to Mr. X on the 20th of December, you agreed on the pricing and you agreed to deliver the product to him on 31 December. You issued the invoice to Mr. X on 22nd December and he pays you on the 23rd of December.

Your supplier Mr. L(ate), calls you up on 30th Dec and tells you that the product is not ready and it can only be delivered to you on 1st Jan the next year. He will invoice you after he delivers the product to you.

Question

Do you recognise the sale to Mr. X as revenue when you report to the Tax authority for the year 2017?

Have you transferred the risk and rewards of the product to Mr. X? Nope, therefore, no revenue would be recognised and as at 31 Dec, you owe Mr. X the consideration he paid you.

Most businesses would accept the accounting software transaction as correct because the accounting software recognises revenue when you enter the invoice.

Mr. L has probably not invoiced you and if you reported the Sale without recognising the cost of the sale (Mr. L billing you), then you would have already overstated your profit! AND paid overpaid taxes!

Example 2,

Let’s say Mr. L delivers the product to you on the 30th and you delivered it to Mr. X on 31st Dec. Mr. L invoices you on 1st Jan.

Again, there is an overpayment of taxes! Why? Because, FRS 18(14)(e) says that the cost must be able to be measured reliably! Even though you have not received Mr. L’s invoice, you have already agreed on the pricing.

Example 3,

Now assume Mr. X has not paid you yet. You delivered the goods to his premises on the 31st of Dec. All the proper paperwork has been done. He tells you that he will pay you tomorrow on the 1st of Jan 2018. On 15th of Jan, you called his office and you were told that the company is in liquidation and you had to wait for the Liquidator to decide if you can get payment for the goods.

You were casually told that Mr. X’s company owes many creditors and the company is already bankrupt.

Mr. L has invoiced you on the 31st of Dec.

As you can see, the accounting done by the Accounting standard would result in a LOSS and this loss can be offset against other revenue or brought forward to the subsequent year.

Example 4,

Now assume Mr. L delivered the product to you on the 30th of Dec and invoiced as well, you were taken ill and delivered the product on 3rd Jan 2018.

Again, not following the accounting standards DO COST you money!

Conclusion

By ignoring the accounting standard and relying purely on the accounting software or general knowledge, it may lead to over payment of taxes or even paying taxes in an incorrect period.

So, what’s your profit? It is critical to know that profit makes up of many components and each component would determine if you have indeed correctly recognise your profit.

Reference

[1] FRS — Financial reporting standards

One clap, two clap, three clap, forty?

By clapping more or less, you can signal to us which stories really stand out.