Determining when revenue is considered income

Sometimes the accounting rules and the tax laws are logical and equitable. Sometimes they aren’t. However, one question always seems to surface: When is an aggregate operation’s revenue considered “income”? Although it’s not unusual that there is specific time to include revenue — or secure deductions — until now, the time to claim income and deductions is dictated by rules or laws, not the aggregate producer’s opinion.

Accounting rules recently issued by the Financial Accounting Standards Board (FASB) offer new guidelines for determining how and when revenue should be recorded on the operation’s books, financial statements and tax returns. Most businesses must now depict the transfer of goods or services to customers for the revenue they “expect” to collect.

After deleting about 120 pieces of industry-specific guidance in the Generally Accepted Accounting Principles (GAAP) and establishing broad guidelines for calculating revenue, implementing the FASB’s extemsive new guidelines could be difficult.

However, with the 2018 effective date for the new revenue recognition standards just months away, the FASB advises all businesses to start preparing for the sweeping changes as soon as possible.

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 every operation’s tax bill, revenue may also affect, among other things, a crushed stone or sand operation’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 and stock-based compensation. Anticipated revenue may also influence an aggregates operation’s tax-planning strategies.

With the cash basis method of accounting used by most of us in our personal lives, revenue is recognized when cash is received regardless of when goods or services were sold. Under the accrual method of accounting, revenue is recognized when it is either realized or realizable and is earned (usually when goods are transferred or services rendered), no matter when cash is actually received.

The so-called “revenue recognition” principle is a cornerstone of the accrual method of accounting that, with the so-called “matching principle,” determine 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 GAAP, published “Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers” in May 2014.

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

The new standards call for the use of 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, finally, recognize revenue once the performance obligation has been satisfied. What could be clearer?

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

Going one step further, the new guidelines recognize cash can be received in either an earlier or later period than when a contract’s 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 aggregate operation’s income.

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

Compensation ‘ifs’

Because many businesses have compensation plans for managers, sales personnel, shareholder/employees, executives or others that are tied to the operation’s revenue, compensation arrangements are 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 Dec. 15, 2017, the new standard could result in earlier recognition of revenue that, in turn, could lead to higher commissions or bonuses. In other words, for some aggregate operations, the standard will change the timing of when revenue will be recognised and therefore may change the way compensation is awarded under existing profit-sharing arrangements.

The recognizing revenue principle

As mentioned, the cornerstone of the accrual method of accounting is the so-called “revenue recognition” principle. That principle dictates when revenue and expenses are recognized for both tax and accounting purposes.

Thanks to the new guidelines, the aggregate business records revenue only when it has substantially completed a revenue generation process; in other words, when it has been earned.

To illustrate, an aggregate business completes a job for its standard fee of $1,000. It can recognize the revenue immediately upon completion of the job, even if payment is not expected from the customer for several weeks. A variation on the example is when the same business is paid $10,000 in advance to provide sand, gravel or crushed stone during a four-month period. In this case, the business should recognize an increment of the advance payment in each of the four months covered by the agreement reflecting the pace at which it is actually earning the payment.

Of course, if there is substantial doubt that any payment will be received, then the aggregate producer should not recognize any revenue until a payment is received.

If a sand, gravel or crushed stone business receives payment in advance, it is recorded as a liability, not as revenue. Only after all work has been completed can the payment be recognized as revenue.

Ground rules for deductions and income

Nearly all aggregate mining businesses will be affected by the expanded financial disclosures required under the new revenue recognition guidelines. When claiming deductions or write-offs and timing the receipt of income under the new guidelines, there are a number of crucial steps every aggregate operation and business should take:

◾ File a valid tax return. There are options such as filing an amended return, but there could be problems if the aggregate operation’s tax returns are not filed or not filed on time. Obviously, 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) but the operation has unrestricted use of the money, it must be reported as income and a deduction taken in the year paid the transaction is completed.

◾ Theft loss. As under our current accounting guidelines and tax laws, deductions for theft losses can be claimed only in the year the theft is discovered.

◾ Casualty loss. As with theft losses, an accounting or tax deduction is only allowed in the year of the loss. Naturally, losses can’t be taken if an insurance reimbursement is anticipated.

◾ Bad debts and worthless stock. These losses can only be taken in the year either the debt or stock becomes worthless. Obviously, determining the year of worthlessness can be tricky.

◾ Timing. While the effective date for public companies is not until 2018, the new guidelines permit sand, gravel and crushed stone businesses to either apply the requirements retrospectively to all prior periods or to apply the requirements in the year of adoption. Addressing some areas of the new guidelines may require longer lead-time, particularly when it comes to revenue or billing systems where separation and/or allocation changes may be required.

It goes without saying that the bigger the numbers, the more important it is to use the services of a qualified professional. And, since the guidelines are extremely complex, don’t assume that 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.

Thus, a good strategy involves making a list of any unusual issues during the year to discuss with the 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.

With the effective dates for these guidelines approaching when all quarries and sand and gravel plants or businesses will be required to report revenue following hundreds of pages of new accounting guidance, seeking the all-so-necessary professional help in complying is an important first step for avoiding last minute panic.

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Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the past 25 years.