“The tax reviewer told me that I should declare as income all collections received during the year which we consistently applied over the years. But now, I am told my income is incorrect for the current year,” quipped a seemingly clueless business owner in one of the public seminars where was a speaker. His concern, I believe, is quite common among small and medium enterprises. Improper recording of revenue due to lack of tax and accounting knowledge may lead to problems.
How much and when do I record revenue?
I have encountered many misconceptions about the meaning of revenue that can lead to problems for the management and the owners. In any financial statements and income tax returns, revenue is the most important item as it drives profit, performance bonuses and sales incentives. Understanding the fundamental principles will help the management, business owners, and all stakeholders to assess the true performance of their business and make informed decisions. Below are some of the common questions relevant to owners of small and medium enterprises:
a) Does cash collection means income or revenue?
Some companies report income based merely on cash collection. Is this correct? Let us examine a typical cash on delivery (CoD) arrangement for the sale of goods. Company A delivers a unit of equipment to Company B at a fixed price of Php100. Upon receipt, Company B accepts the equipment and takes full control and possession. It can use the unit upon delivery. Without any other condition, revenue is measured at cash price and has to be recorded upon acceptance of goods by Company B.
Now let us use the same facts (still CoD), but the unit delivered needs to be installed by a qualified technician, which under the contract can only be provided by the seller. The unit will not function as designed and Company B will not be able to use until the unit is installed and tested. Here, Company A has delivered the unit but the installation and testing will happen only 15 days after delivery.
In the second case, the cash collected upon delivery is not yet a revenue, but a mere deposit (or advance). Why is this so? The accounting rules are explicit, stating that the seller can only record a revenue when, along among other criteria, risk and rewards over assets sold have been transferred to the buyer. This means that Company B has to take full control and enjoy the risks and rewards of ownership, that is, the company can use the assets purchased as intended to generate economic benefit. Under this scenario, revenue will only be recorded when installation and testing are completed 15 days later and accepted by Company B.
In short, there is no such thing as cash basis accounting. Accounting is more focused on the delivery of what you sold and not how much you have collected.
b) Do the promises you made preclude you from recording income?
When you watch TV advertisements, you will hear promises like, “if you are not entirely satisfied, return the product and we will refund you”, “money back guarantee”, etc.
In the sale of consumer goods, some salesmen, in order to meet volume target and earn incentives, enter into a verbal deal with their customers, say a distributor of their products, not to pay until the same products are sold to ultimate buyers. These are just a few examples of promises, generally verbal, that may bind the seller and may pose serious accounting issues. Moreover, it may lead to erroneous sales reporting which serves as basis for sales incentives. Let me explain the matter further by providing some of the common promises typically given by companies and their accounting consequences:
Right of return: The goods may have been delivered, paid and used by the customers. But, when you promised customers that they can return the product within 60 days and you will grant refunds, this promise may preclude you from recording revenue until the right of return expires.
This is not absolute because accounting rules allow an entity to book sales even if there is right of refund so long that the seller can reasonably estimate the expected return. In this case, if the seller estimates that five percent will be returned, 95 percent of the sales value upon delivery may be recorded while the remaining five percent will be deferred until the right of return expires. But, there is another question. How can we say that the estimate is objective and reasonable?
This is what makes accounting interesting because it allows management to use estimates. To answer this question, we can apply some industry practices or conventions. For instance, it is acceptable to use historical average percentage of sales returns over the past 2 years for the same product such that historical experience is used to justify a current year estimate. But what if the product is new to the market, and hence, there is no way to make a reliable estimate of returns? In this case, the seller cannot record any revenue until the right of return expires and all collections will be accounted as deposits from customers (which is a liability account).
Extended credit term: Revenue, being the main lifeblood of any business, attracts readers and users of the financial statements, such as key management, shareholders, suppliers and all other stakeholders. When a listed entity announces a possible decline of future revenue, it is reasonable to expect that its share price will also decline. In order to generate sales, some salesmen, eager to meet sales target, would offer a deal or promise to extend the credit term beyond the normal. The underlying motive is, generally, for sales incentives or bonus. This usually happens during the last months of the calendar or fiscal year when sales volumes are monitored for incentives purposes. While I think these promises are made in good faith, it is prone to abuse and may provide opportunity to create artificial sales, strictly in the context of accounting. In technical accounting, we call this trade loading or artificial sales, in simple terms.
I remember a CEO frowning after learning that he paid bonuses based on sales figures that turned out to be partially artificial. Some invoices remained uncollected for more than six months. The distributor would not pay because the goods remained unsold to ultimate customers; hence, these were just kept in the warehouse. When his company tried to initiate legal actions to enforce collections, the distributor justified there was a promise or a deal, albeit made verbally, made by the sales agent not to collect until it is able to collect from ultimate buyers of the goods, usually the retailers.
In the example above, recording of revenue or sales on the date of delivery of goods may not be allowed under the accounting rules because collection is contingent upon the ultimate sale of goods to another party. Accounting requires that “collection must be probable” at the date when sales are recorded. Just because the goods are delivered and invoiced does not mean there is a legitimate sale.
In summary, accounting takes into consideration the substance (or intentions) of both the seller and the buyer. In determining the substance, promises made, either verbal or in writing, will influence the over-all intent of the seller and the buyer. Mere delivery of goods, invoicing and cash collection arrangements will not necessarily define your revenue or income.
What is the benefit of proper accounting?
Among the many substantial benefits of proper recognition of revenue is the credible and reliable information for decision-making purposes. It gives management the true and fair view of the financial condition and profit generated by the company.
What about taxation? Well, tax generally follows accounting; so a compliant financial reporting generally results in compliant tax reporting, except under a few circumstances where taxation differ from accounting. One example is collection of advanced rent, which is taxed upon collection but does not represent revenue under accounting rules until earned/used by the lessee.
So there you go, dear readers. I hope I have given you some practical insights about the meaning of revenue, which I hope will help you manage your business. With proper knowledge and consistent correct application, you will be more confident even in responding to questions raised by tax authorities. Or shall I say, you will have peace of mind, which unfortunately, cannot be measured by accounting because it is priceless!
Roderick M. Danao is the vice chairman, Assurance Managing Partner and Markets Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.