Chapter 6 - Revenue recognition
6.1 Current taxation rules governing the derivation of income are complex, although a number of guidelines on how and when income is derived have been established by case law. The income derivation rules in taxation are based primarily on normal accounting principles and commercial practice.
6.2 With the adoption of IFRS, the accounting principles on revenue recognition are formalised in NZ IAS 18. The standards provide that revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. These revenue recognition criteria are substantially similar to the principles in the New Zealand Statement of Concepts, which preceded IFRS. As such, the new standards should continue to be appropriate for taxation purposes.
6.3 We do not suggest introducing any legislative change to the revenue recognition principles for taxation purposes at this stage. Inland Revenue is monitoring the application and interpretation of NZ IAS 18 for taxation purposes, and further legislative changes may be considered at a later stage.
6.4 In general, the recognition of expenditure for taxation purposes is governed mostly by statutory provisions in the Act. As such, the adoption of IFRS is not expected to have a similar impact on the treatment of expenditure for taxation purposes.
Treatment of warranties
6.5 In CIR v Mitsubishi Motors NZ Ltd,[14] the Privy Council held that “[a]s the term “profits or gains” is not defined, these words must therefore bear their ordinary meaning as understood by a businessman or accountant”, but an expenditure may be deducted only if it has been incurred. Further, estimated warranty costs were held to be deductible at the time of sale because the defects that manifested themselves within the warranty period were presumed to be present at the time of sale and are not a contingency.
6.6 Under NZ IAS 18, any identifiable service fees included in the price of a product must be deferred and recognised as revenue over the period during which the service is performed. The amount of revenue deferred will include the expected costs of the services and a reasonable profit on those services.
6.7 As such, any fees and profits associated with a warranty contract provided together with a sale must be recognised over the term of the warranty. This new method of recognising warranty income is broadly consistent with the approach taken by the Court of Appeal in Mitsubishi Motors New Zealand Limited (1994) 16 NZTC 11,099.
6.8 We see the recognition of warranty income as a separate revenue stream and the spreading of warranty income over the term of the warranty contract under NZ IAS 18 to be an appropriate approach for taxation purposes.
6.9 The adoption of NZ IAS 18 appears to have modified the principles of revenue recognition that underpin CIR v Mitsubishi Motors NZ Ltd. In CIR v Mitsubishi Motors NZ Ltd, the Court held that provisions for warranty costs should be deductible for taxation purposes at the time of sale on the presumption that warranty revenue had been recognised. As NZ IAS 18 requires the deferral of warranty income, and if this approach is accepted for taxation purposes, then provisions for warranty costs should not be deductible at the time of sale.
6.10 Legislative amendment may be required to ensure that provisions for warranty costs, which could arguably still be deductible in accordance with the principles established in CIR v Mitsubishi Motors NZ Ltd, are not deductible at the time of sale if the recognition of revenue from warranty contract is deferred under NZ IAS 18.
Revenue recognition during transition to IFRS
6.11 Financial reporting entities are required to restate their financial statements in the year of transition from the old accounting standards to IFRS. For example, a company that moves to IFRS for its 2008 year will have to prepare the 2008 financial statements using IFRS and restate the 2007 financial statements. The “change” from old to new accounting standards is dealt with by way of adjustments directly to shareholders’ funds.
6.12 If a stream of income had been recognised under the old accounting practice in 2007 but IFRS requires that income to be recognised in 2008, the income which would have been reported in 2007 and subjected to tax then could be reported again in 2008 as an adjustment in the year of transition. This income should not be subject to tax again in 2008, and section BD 3(6) of the core provisions of the Income Tax Act 2004 ensures that does not occur.
6.13 The opposite problem could also happen during the transition year. If an income stream that would have been recognised in 2008 under the old accounting practice is now recognised in 2007 under IFRS, the income stream is simply not recognised as income by the company in either 2007 or 2008. This amount will be recorded directly in the shareholders’ funds as part of the transitional adjustment. This income should be taxable in the year of the transition.
6.14 Even though the revenue recognition for taxation purposes continues to follow the accounting approach generally, legislative amendments will be necessary to recognise as income the amount of previously unrecognised income recorded directly in the shareholders’ funds as part of the transition year.
Summary of suggested changes
- Revenue recognition for taxation purposes should continue to follow the accounting practice, which has been formalised in NZ IAS 18, although Inland Revenue should monitor the interpretation and application of the standards for taxation purposes.
- The recognition of warranty income as a separate revenue stream and the spreading of warranty income over the term of the warranty under NZ IAS 18 is an appropriate revenue recognition approach for taxation purposes.
- Legislative amendment may be required to ensure that provisions for warranty costs, which could arguably still be deductible in accordance with the principles established in CIR v Mitsubishi Motors NZ Ltd,[15] are not deductible at the time of sale if the revenue from warranty contract is deferred under NZ IAS 18.
- Legislative amendment will be necessary to recognise as income the amount of previously unrecognised income that has been recorded directly to the shareholders’ funds as part of the transition year.