Private ruling: Accruals basis of accounting
Published: July 2013
Ruling period: Year ended 30 June 2013
Date scheme commenced: 1 July 2012

Ruling: Q1: Does trade debtors and recoverable work in progress at 30th June 2012 need to be included in the assessable income of the company when changing from cash to accruals accounting in the 2013 income year? | A1: Yes

Relevant facts and circumstances: · The company is a private company. · The company carries on a business of providing services to clients. · The company is managed by one person and initially employed no staff relying on sub-contractors when needed. · The company's business has grown over the years and now utilises a service trust to provide employees to the company. The employees are majority professional persons and the fees of the company are substantial. · Due to the growth in the company, it will change over from a cash basis of accounting to an accruals basis for the year ended 30 June 2013. · There are outstanding trade debtors and work in progress at 30 June 2012. · Company policy treats work in progress as recoverable debts immediately and is recorded daily. · Invoices are issued by the company at the end of a specific job.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 6-1(1) | Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 subsection 118-20(1)

Reasons for decision: Summary: Subsection 6-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that your 'assessable income' consists of 'ordinary income' and 'statutory income'. Section 6-5 of the ITAA 1997 states: 1. Your assessable income includes income according to ordinary concepts, which is called ordinary income. 2. If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year. 3. If you are not an Australian resident, your assessable income includes: (a) the ordinary income you derived directly or indirectly from all Australian sources during the income year; and (b) other ordinary income that a provision includes in your assessable income for the income year on some basis other than having an Australian source. 4. In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.' When income is earned in one year but received in another, the adoption of an appropriate method to determine when the income is derived under subsections 6-5(2) and (3) in a relevant year of income is an issue of practical concern to taxpayers | Detailed Reasoning - Accounting Methods: Taxation Ruling TR 98/1: Income tax: determination of income; receipts versus earnings (TR 98/1) provides guidance on the two commonly used methods of determining when income is derived in a relevant year of income. These methods are the receipts method and the earnings method. Paragraphs 8 and 9 define the two systems of accounting as follows: | Detailed Reasoning - Receipts method: 8. The 'receipts' method is sometimes called the 'cash received' basis or the 'cash' basis. Under the receipts method, income is derived when it is received, either actually or constructively, under subsection 6-5(4) of the ITAA 1997. The effect of that subsection is that income is taken to have been derived by a person although it is not actually paid over, but is dealt with on his/her behalf or as he/she directs. | Detailed Reasoning - Earnings method: 9. The 'earnings' method is often referred to as the 'accruals' method or the 'cash and credit' method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created. | Detailed Reasoning - Which method is appropriate?: A taxpayer determines when income is derived by adopting a method of accounting for income. When accounting for income, for tax purposes, a taxpayer must adopt a method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives a "substantially correct reflex" of that income. This is the principle established in The Commissioner of Taxes (South Australia) v The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108 (Carden's case). Whether a method gives a "substantially correct reflex" and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It should also be noted that only one method of accounting is appropriate to any one item of income, there is no choice available. Berwick J, at page 4018, in Barratt & Ors v FCT, 92 ATC 4275, said: "There cannot in fact be alternative figures for such assessable income" Paragraph 18 of TR 98/1 provides that the receipts method of accounting is likely to be appropriate to determine: · income derived by an employee · non-business income derived from the provision of knowledge or the exercise of skill possessed by the taxpayer · business income where the income is derived from the provision of knowledge or the service of skill possessed by the taxpayer in the provision of services (subject to the qualifications listed at paragraph 45 for an individual taxpayer) Paragraph 39 of TR 98/1 states that a substantially correct reflux of a company's business would be given by the earning method except where that method was as 'artificial, unreal and unreasonably burdensome method of arriving at the income derived'. The factors that weigh against the receipts method and in favour of the earnings method are: · the commercial and accounting principles and practices governing accounts kept by companies generally require the accruals (earnings) method of bookkeeping; and · a company generally relies upon employees; it is not able to provide personal services. The company carries on a business of providing services to clients. It initially employed no staff and engaged sub-contractors when needed. The company's business has grown over the years and now utilises a service trust to provide employees to the company. The employees are majority professional persons and the fees of the company are substantial. Given that the business has expanded, is in a company structure and now relies upon employees, it is considered that the accruals basis of accounting will give a substantially correct reflex of the company's true income. | Detailed Reasoning - Transition between methods: Tax law does not contain a specific provision permitting the Commissioner to make adjustments of assessable income to deal with the consequences of the application of an incorrect method of accounting, nor for changing between methods of computation of gross income. In TR 98/1 the Commissioner considers that a taxpayer who accounts for items of income should continue to adopt that method until it is no longer appropriate. Accordingly, when the taxpayer's circumstances show that a different method is more appropriate then the taxpayer may change between methods. The High Court case of Henderson v FC of T (1970) 119 CLR 612 at 649; 70 ATC 4016 ( Henderson's case ) illustrates the results of a change in the accounting method. In that case, the taxpayer was a partner in a large accounting firm and for the 1964-65 year switched from cash to accruals, thinking accruals to be a more appropriate basis on which to regulate the internal relationships of the partnership. An effect of the change was that some $179,000 in fees, earned in the last cash basis year (1963-64) but not paid until the first accruals basis year (1964-65), escaped tax altogether. The Commissioner assessed the taxpayer's income from the partnership on a cash basis. Both Windeyer J at first instance ((1969) 1 ATR 133) and the Full High Court accepted that the accruals method was the appropriate basis for assessing the partnership income from 1964-65. An argument that the Commissioner could choose any basis of accounting not inconsistent with the terms of the Assessment Act was firmly rejected. In Henderson v FCT, Windeyer J at first instance had held that when a taxpayer moved from a cash to an accruals basis, an adjustment needed to be made to bring to account, as earnings at the time the new basis of accounting began, all debts then collectable (all debts due and payable except bad debts). The Full High Court rejected this view on appeal. Barwick CJ said at 4019: There cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the results of more than one year in order to obtain the assessable income for a particular year of tax. Of course the experience of a prior year may be reflected in the opening figures of the relevant year but they become and are figures of that year and not figures of two years in combination. Once it is decided that the...income derived in the year in question will be the net amount of its earnings of that year, it is in my opinion, only the earnings of that year which can be included in the computation' On the authority of the above-mentioned cases, trade debtors on hand at the end of the immediately preceding cash basis year (2012) is not assessable as ordinary income in the later accruals basis year (2013) when the income is received. Applying the principle that a change in basis should be strictly adhered to and income calculated should be arrived at by proper and regular application of the accruals basis that the taxpayer adopted, trade debtors are not to be included in the computation of taxable income in the changeover year (2013) because the amounts would not have been earned in that year. Trade debtors would not have been taxable in the cash basis year (2012) as receipt of income had not taken place. In regards to 'work in progress', Barwick CJ said in Henderson's case at 4020: '..only fees which have matured into recoverable debts should be included as earnings. In presenting figures before his Honour, allowance was made for what was termed "work in progress"….When the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned, then it or they will be income derived in the period of time in which it or they have become recoverable. But until that time had arrived, there is, in my opinion, no basis, when determining the income derived in a period, for estimating the value of services so far performed but for which payment cannot properly be demanded, and treating that value as part of the earnings of the professional practice…' Therefore, in general, nothing is required to be brought to account in respect of incomplete work or work in progress. The test laid down by Barwick CJ in Henderson's case is that a fee will have been earned and income derived in the period of time in which it has become recoverable. Paragraph 10 of TR 98/1 provides further guidance on when a recoverable debt arises: 10. The term 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task. A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt. In addition, paragraphs 5 to 7 of Taxation Ruling TR 93/11 Income tax: assessability of income on an accruals basis: when professional fees are derived, provides the Commissioner's view as to when a recoverable debt arises: | Detailed Reasoning - Recoverable debt only on billing client: 5. The proper construction of the particular contract or arrangement may be that a recoverable debt for the professional work done is created only when the professional person bills the client. This is the most common arrangement for professional work, particularly if the terms of the contract or arrangement are not in writing. In these circumstances, the fee income is derived in the income year in which the professional person presents the bill to the client. This is so even if the bill allows additional time for payment. | Detailed Reasoning - Recoverable debt when work wholly completed (including quantum meruit): 6. Under the contract or arrangement a recoverable debt may be created, with the professional person not needing to bill the client, once the work is wholly completed. If this is the case, the fee income is derived in the income year in which the work is in fact wholly completed. However, if the professional work is terminated prematurely (for instance, because of the dismissal or resignation of the professional person), he or she may have an action in quantum meruit for the work already done. The professional person in these circumstances derives the fee income (being the amount of the quantum meruit claim) in the income year in which the professional work ended early. | Detailed Reasoning - Recoverable debts arising progressively: 7. The legal effect of the contract or arrangement may be that recoverable debts arise, with the professional person not needing to bill the client, for work completed by the end of particular (say, three month) periods or on the happening of some specifically nominated actions or events. In these cases, the professional person derives the fee income in the income year or years in which each of the particular periods ends or in which each of the specifically nominated actions or events happens. | Detailed Reasoning - Receipt of fee in advance of work done: 8. A professional person will sometimes receive fee income in advance of the work to which it relates. If the contract or arrangement requires that the fee be paid in advance, the fee income is derived in the income year in which the professional person completes the work (or the part of the work) to which the fee relates. On the other hand, if the client simply pays early, the fee income is derived when a recoverable debt arises or would have arisen if the client had not paid early (see paragraphs 5 to 7 above). The company's policy towards classifying work in progress as recoverable debts is to consider it as recoverable immediately. The time is added to the client's work in progress on a daily basis. Invoices are subsequently issued at the end of a specific job. The work in progress amounts are not considered to be recoverable debts. A recoverable debt arises when the taxpayer is not obliged to take any further steps before becoming entitled to a payment. When recoverable debts arise progressively, it is as a result of a specified event or action or at the end of a period. It is the company's policy is to categorise work in progress as recoverable immediately and therefore it cannot be said that a specified action or event has occurred as per paragraph 7 of TR 93/11 or that a period has ended. By the time the specific job is completed an invoice is issued by the company and this would be classified as a trade debtor amount. Therefore, the work in progress amounts are not derived in the 2012 year. They would be derived in the 2013 year, or when such a recoverable debt arises. Consequently, they will be brought into account as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Capital gains tax implications: Under section 102-5 of the ITAA 1997, your assessable income includes your net capital gain. A capital gain or loss is made if a CGT event happens. For most CGT events, the capital gain is the difference between the capital proceeds and the cost basis of the CGT asset. A capital loss is made if the reduced cost base of the CGT asset is greater than the capital proceeds. Section 108-5 of the ITAA 1997 states a CGT asset includes any kind of property of a legal or equitable right that is not property. The note under subsection 108-5(2) of the ITAA 1997 states that debts owed to you are CGT assets. A debt owed to you is an intangible CGT asset. CGT event C2 under section 104-25 of the ITAA 1997 happens when the ownership of an intangible asset ends by the asset being satisfied or discharged. The time of the event is when you enter into the contract or if there is no contract, when the asset ends. In ATO Interpretive Decision ATOID 2008/110 Income Tax: Capital Gains Tax: debt arising from the provision of services - whether same amount can be both ordinary income and a capital gain , a taxpayer carried on a business of providing services to clients. The taxpayer's income was assessed on the accruals basis and debts arose from the provision of services to clients. Those debts were later discharged. In that case, CGT event C2 occurred when the taxpayers' ownership of the debt was discharged, upon payment of those debts. Subsection 118-20(1) of the ITAA 1997 will apply to reduce the capital gain where an amount of the debt that was taken into account in working out the capital gain was included in assessable or exempt income under a provision of the ITAA 1997 (apart from Part 3-1). This is to prevent any double taxation from occurring. When the company converted to an accruals basis of accounting there were outstanding debts owed to the company at the beginning of the 2013 income year. According to ATO Interpretive Decision ATO ID 2005/211 Income Tax: Capital Gains tax- cost base/reduced cost base- debt, the cost base of the asset at the time is nil, as no money was paid to acquire the debt and the market value substitution rule does not apply as a result of subparagraph 112-20(1)(a)(ii) of the ITAA 1997 been satisfied. The consideration received on the asset ending, is the amounts paid to you by the debtors. Trade debtor amounts will not be included as ordinary income in the 2013 income year as the income was derived in the 2012 income year. However, the receipt of any amounts in relation to trade debtors in the 2013 income year is considered to trigger a CGT event and thus the amounts will be included in assessable income and subject to capital gains tax. The amount of the capital gain is not reduced by subsection 118-20(1) of the ITAA 1997, as the amount was not included in assessable income in another provision of the ITAA 1997.