Accounting Treatment of the Revenues of Audit Firms... By: Dr. Hussam Addin Ahmad Khalil – IASCA Member

Since the second half of the current Century, the interest in developing accounting rules by professional bodies has been increasing. Back then, in the industrialized countries, practitioners of the accounting profession did not adopt common practical rules; each accounting body set its own rules which they considered suitable for their accounting concepts.

The term generally accepted accounting principles (GAAP), as a technical term used by accountants and auditors, is a concept that includes all the agreed-upon practices in the accountancy discipline that are accepted by firms and organizations, even if such entities used different accounting treatments for the same items.?

?In this context, standards can be defined as models or general guidelines that lead to directing and rationalizing practical practice in accounting and auditing. Therefore, there is a difference between standards and procedures; standards are general guidelines while procedures are the implementation guides of the standards in certain situations.

The growing significance of the accounting and auditing standards drove the professional organizations - in many countries around the world - to set accounting and auditing standards. Since 1939, the American Institute of Certified Public Accountants (AICPA) had developed auditing standards, and in 1973, in the USA, the Financial Accounting Standards Board (FASB) was formed to enhance the GAAP that had been in operation since 1932.

Regarding the attempts to develop standards at the international level, they started at the beginning of the current century with the gigantic economic developments that were accompanied by the emergence of multinational organizations, after the World War II. Those evolving conditions necessitated the development of international standards on which the measurement and recognition of financial transactions and events are based. This led the accounting bodies in many countries to conform to each other by issuing standards that govern the accounting profession.?????

On the other hand, Article 23(A), of the Income Tax Law No. 34 of 2014 and the amendments thereof, stipulates “The taxpayer shall keep the books, records and financial statements needed to determine the due tax provided that such documents shall be developed according to the international accounting standards, audited and certified by a certified public account” .

In addition to this, the International Accounting Standards Board (IASB) issued amendments to the International Financial Reporting Standards (IFRS), among which IFRS 15, revenue from contracts with customers, then IFRS 15 superseded two essential standards, IAS 11, construction contracts, and IAS 18, revenue.

IFRS 15 defines the principles that should be implemented by entities when they report the information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from a contract with a customer. With the adoption of IFRS 15, entities shall recognize revenues to show the transfer of goods and services to the customer with an amount that reflects the firm’s expectations about the consideration for such goods and services. IFRS 15 is not limited to a certain profession or transaction, it applies to all entities that aim at achieving profits and to all contracts with customers, with the following exceptions:???

·???????Leases;

·???????Insurance contracts;

·???????Financial instruments; and

·???????Non-monetary exchanges between entities in the same line of business.

To recognize revenues in accordance with IFRS 15, the entity shall implement the following five stages:

?The First Stage

Determination of Contract (or contracts) with a Customer: a contract is an agreement between two or more parties that creates enforceable rights and obligations; whether such obligations were created, transferred, amended, or terminated. In other words, a contract is an agreement between two parties that creates a legal right, or an agreement between two parties to establish, modify, or terminate a legal relationship.? ?

The revenues arising from a contract, in accordance with IFRS 15, should be treated when the following requirements are met:

1.??????The parties to the contract have approved the contract and are committed to performing their respective obligations;

2.??????The entity can identify each party’s rights regarding the goods or services to be transferred;

3.??????The entity can identify the payment terms for the goods or services to be transferred;

4.??????The contract has commercial substance; and

5.??????It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

Some examples of the above in light of this article:

??1.?????????An assignment letter between the audit firm and the audit client to audit financial statements for the year (...);

??2.?????????Income and/or sales tax consultancy contract with a specific client (individual, company, and/or group of companies);

??3.?????????A contract between the audit firm and a specific client (a special case audit, a special list audit, an audit of the application of a specific standard, and/or a special work as desired by the client).

The Second Stage

Determination of Enforceable Obligations under the Contract: contractual promises to transfer goods and services to customers. ?

At this step, and in order to recognize revenues, the performance obligations can be considered as an accounting unit, the purpose of which is the adoption of IFRS 15.?To do so, we shall define an important term that will eventually lead us to the definition of performance obligation, which is promises. Promises in contracts may be explicit or implicit; they create expectations that the entity will provide the customer/s with goods or services in the context of regular business conduct and in accordance with the applicable policies, terms, or specifications. Therefore, understanding the entity’s policies and practices is important to define promises accurately, for example, promises may include:???

(1)???????????Sale of goods produced by an entity, or resale of goods purchased by an entity;

(2)???????????Arrangements with other parties to transfer goods or services;

(3)???????????Standing ready to provide goods or services prospectively;?

(4)???????????Constructing, manufacturing, or developing an asset on behalf of a customer;

(5)???????????Granting the right to use intangible assets such as intellectual property rights;?

(6)???????????Performing a previously agreed-upon task.

In accordance with IFRS 15, the entity shall identify the promised goods and services in the contract, and shall consider as a performance obligation each promise to transfer to the customer either:??

(1)????????????????A good or service (or a bundle of goods or services) that is distinct; or

(2)????????????????A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Accordingly, each distinct good or service in a contact is considered, per se, as a performance obligation. Alternatively, indistinct goods or services may be considered as an item or a combination in a bundle of indistinct goods or services. Therefore, a bundle of goods or services that includes indistinct items may be considered as a single performance obligation.

?There are some cases where entities provide a series of distinct goods or services during a defined period or on equal intervals, for example, the income and sales tax audit services, and/or the service of filling out private and public sales tax returns; as these goods and services are considered a single performance obligation if they have the same pattern of supply to customers.?

To classify a certain item of goods or services as distinct, some requirements should be met, such as:

(1)????????????????The good or service shall be distinct;

(2)????????????????The item of the goods or services should be separately identifiable in the context of the contract.

For the accounting treatment of the second stage in accordance with IFRS 15, the following should be identified:

1.???????????Determining the transaction price: 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. If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

2.???????????The transaction price shall be allocated to each performance obligation on a relative standalone selling price basis;

3.???????????Recognition of revenues will be carried out after satisfaction of the obligation by transferring an agreed-upon good or service to the customer. The performance obligation may be satisfied in a specified period (typically for promises to transfer goods to a customer), or over time (typically for promises to transfer services to a customer).?Regarding the performance obligations that are satisfied over time, the entity shall identify an appropriate measure to determine the amount of revenue that should be recognized upon the satisfaction of the obligation.

From the above, a promise can be considered as a performance obligation if the item regarding distinct goods or services or a distinct bundle of goods and services is separately identifiable in the contract (a bundle is a group of items of goods and services that may be distinct or not).

The First Requirement: The item for goods or services may be separately identifiable, for example, in the following cases:

·??????????????The customer can benefit from the good or service, on its own, by selling it for an amount that is greater than scrap value;

·??????????????The customer can benefit from the good or service, on its own, by consuming it;

·??????????????The customer can benefit from the good or service, on its own, by using it in a way that creates benefits;

·??????????????The customer can benefit from the good or service, on its own, or in conjunction with other resources, whether readily available for the entity, obtained from others, or previously supplied; or

·??????????????If the good or service is sold as a standalone item in regular circumstances.

The second requirement: The item of goods or services may be separately identifiable in the context of the contract if, for example:?

·???????The good or service is not an input used in the supply or installation of an output specified in the contract;

·???????The good or service is not used in the modification or installation of other goods and services that are specified in the contract; or

·???????The good or service, in its nature, is not significantly related to or associated with other items of goods and services stipulated in the contract.

The above two requirements shall be met together to enable us of assessing the item of goods and services as distinct; therefore, as a performance obligation. If the goods and services were identified as indistinct, this gives evidence that they form a part of a combination or a bundle of indistinct goods and services, that collectively with other items, will form a single obligation performance.??

Finally, we should set a rule; as long as the item of goods or services is indistinct, the entity shall mix or combine such item with other goods or services to form a bundle that can be considered as a single performance obligation in the contract whether the contract includes many obligations, or even if the contract has one single performance obligation.??

The Third Stage

Determining the Transaction Price:

The transaction price is the amount that will be allocated to the performance obligations that were stipulated in the contract. Accordingly, the transaction price is the amount of revenue that will be recognized after the satisfaction of the performance obligations.?In determining the transaction price, the amounts collected on behalf of an external party, such as sales taxes, shall be deducted. On the other hand, the transaction price may be direct, for example, when the contract includes consideration for a fixed amount of goods or services that will be provided in a relatively short time, or it may be complex in some circumstances such as:?

(1)??????When the consideration is variable;

(2)??????When the consideration is non-cash;

(3)??????The existence of a significant financing component; or

(4)??????The existence of consideration payable to a customer.?

The Fourth Stage

Allocation of the Transaction Price to the Items and Components of the Contract: as we have previously mentioned, performance obligations may be treated as an accounting unit, and to complete the above, we need to complete the definition of performance obligations as being nothing more than an accounting unit to which the transaction price shall be allocated.

The transaction price that will be allocated to performance obligation is “the stand-alone selling price”, which is defined as the price for which an entity could sell the goods or services separately to a customer.??

There are other circumstances where the standalone selling price may be determined.?However, there are other cases where the standalone selling price may not be determined. In such cases, we can use more than one entry or manner to determine the standalone selling price, but in this article, we will assume that the standalone selling price will be defined and determined by audit firms according to the circumstances.??

The rule that was stated in IFRS 15 is that “the entity shall allocate a transaction price for each performance obligation on a commensurate basis between the selling prices of goods and services evaluated at the standalone selling price”.??

The Fifth Stage

Recognition of Revenues when the Entity Satisfies its Obligations that are Stipulated in the Contract:

IFRS15 defines two basic methods for recognizing revenue, provided that the second method, i.e., the method of recognizing revenue over a period of time, is to be tested. This means that if any of the requirements for recognizing revenue does not apply over a period of time, the revenue recognition will be, by default, implemented using the recognition of revenues at a certain point in time.

The First Method - Recognition of Revenues at a Single Point of Time:

Recognition of revenues at a single point of time refers to the satisfaction of a performance obligation at a specific point of time, such as the delivery of the ordered goods in one batch. There are many determinants that help professionals determine that the revenue recognition will be carried out at a single point of time:?

(1)??????Transfer of ownership of the asset is accompanied by legal title;

(2)???????The initiation of a payable obligation to the seller;

(3)???????Possession, or physical possession, of the asset;

(4)??????The transfer of the risks and rewards of ownership of an asset to the customer;

(5)??????Acceptance of the asset;

It is worth noting that the General Sales Tax (GST) Law, No. (6) for 1994, and its amendments, instructions, and regulations thereof, Article No. (9) a & b stipulates that: (a) the general and private general sales tax shall be due on the sale of a good if any of the following situations are fulfilled, whichever is sooner: ?1. When the goods are delivered, ?the manager may approve the date of the tax invoice, for the purposes of the tax due, if the invoice is regularly issued or if it is issued by the end of a certain period after the delivery date. 2. When the tax invoice is issued. 3. Upon delivery of the value of the goods, in whole or in part, or in case of post-payment of part of the value, or by any other method of value delivery in accordance with the agreed terms of payment. (b). The tax is due on the sale of the service when any of the following two cases occur, whichever is sooner: 1. When the tax invoice is issued; 2. The delivery of the consideration for the service, partially or totally.

The above addresses the case of the GST law. However, regarding the application of the income tax, Law No 34 for 2014, and the amendments thereof, articles a & b, stipulate that: (a). Subject to any other provision provided for in this Law, the taxpayer’s income shall be computed on the accrual basis of accounting for the purposes of tax; (b). It is permissible for the natural person whose income is generated from employment or profession to compute his tax on the cash basis in accordance with executive instructions issued for this purpose. The law defines taxpayers as every person required to pay, withhold, or remit the tax in accordance with the provisions of this Law.

Here, we should provide a brief explanation of the cash basis and the accrual basis of accounting:-

The Cash Basis: In this accounting basis, revenues and expenses shall be recognized at the time cash is received or paid out, whether such revenues or expenses are for the current period or another period.

Accrual Basis: ?In this accounting basis, revenues shall be recognized when the goods are sold or when the services are provided, whether the value of such goods or services was received from the customer or not, and expenses shall be recognized for the current period, whether incurred or not.

Here, it is worth noting that there are two types of audit firms; firms that are established as sole practitioners, which may adopt the cash basis, and any other types of audit firms, which may not, in accordance with the income tax law, adopt the cash basis, they shall adopt the accrual basis, i.e., apply IFRS 15.????

?.......... Part two – to be continued in the next Issue of the Newsletter