RECOGNITION OF INCOME — THE CHOICE BETWEEN THE EARNINGS OR CASH BASIS

• Citation: (1992) 4 SAcLJ 249
• Date: 01 December 1992
• Published date: 01 December 1992

Lord Salmon in Willingale v. International Commercial Bank stated a cardinal principle of income taxation when he said, “…a profit may not be taxed until it is realised. This does not mean until it has been received in cash but it does mean until it has been ascertained and earned…”1.

It is necessary, for tax to be chargeable on income, for the income to be recognised as ascertained and earned income. Income recognition, as stated in paragraph five of the Institute of Certified Public Accountants of Singapore (I.C.P.A.S.) Statement of Accounting Standard No. 16 (S.A.S. 16), “is mainly concerned with when revenue is recognised in the income statement of an enterprise.” Income recognition poses a legal question — when is a receipt or gain recognised as income? Income recognition is also connected with timing issues, i.e., when will an income receipt be subject to tax? Generally, timing issues are important because the rates of income may differ from year to year.2 For example, income recognised in a year of assessment when the tax rate is 10% will attract less tax than income recognised in another year of assessment when the rate is 15%. It will be noted at the outset that recognition of income depends on how a taxpayer files his tax accounts — whether on an earnings or on a cash basis. How this is so will be apparent in the discussion on the two bases of tax accounting which follows later. In addition for income to be recognised and accounts prepared, income must be capable of measurement; where uncertainties exist (as for example where the expenses of producing income are not known) then net income cannot be recognised.

This article attempts to introduce and examine generally the taxpayer’s choice between the two basic ways of income recognition for the purposes of tax accounting (the preparation of accounts for tax purposes). This discussion will only be confined to the two basic methods of income recognition on the revenue side — the earnings and cash basis of tax accounting, leaving aside tax issues relating to the incurring of expenditure and methods of tax accounting used to recognise income where there is work in progress. In Singapore taxpayers are assessed on an earnings basis and the Revenue does not recognise computation of income on a cash

basis. However, there are no local cases touching on this point. This article will examine whether there is a place for computation of income on a cash basis in some businesses.

The Earnings and Cash Basiss3

These are the two main bases of income recognition. In the cash basis mode, tax is chargeable on income actually received by the taxpayer4. Under the earnings basis, tax is chargeable on sums once they are due5, irrespective of whether they have been received. As an illustration of the difference between the two bases of income recognition, take the example of a trader who agrees to sell goods to a buyer and who delivers the goods to the buyer. Under the earnings basis, income would be recognised when the goods are delivered since this would be when the trader performs all his obligations required to earn income.6 Under the cash basis income would be recognised when payment for the goods is received by the trader. When payment is received will depend on agreement between the parties. Where the sale is on credit terms then income will be received and hence recognised some time after goods are delivered. It will be observed that the difference between the two bases is a matter of timing — it is a difference between the dates when income is received as opposed to when it is due.

For financial accounting purposes, the earnings basis is the preferred of the

two bases since it gives a better reflection of a taxpayer’s financial position. For example a taxpayer may sell goods in year one on terms that he is to be paid in year two. On the cash basis of computation, he would suffer a loss in year one and profit in year two, since he would have incurred expenses and costs of providing the goods or services (and received no profit) in year one and received profit (and not incur any expenses) in year two. On the earnings basis of computation, the profit to be received in year two would be brought into account in year one. Both profit and loss would be taken to be ‘matched’ in the same year. Net profit of the sale can then be easily computed. Under the cash basis, there would not be a matching of costs and expenses incurred with income earned in any tax year of assessment where there is a time lapse between when goods and services are rendered and when they are paid for. This problem would not arise under the earnings basis. Indeed it has been stated that the Revenue “does not accept the computation of income for a year of assessment on a cash basis.”7 In Singapore most taxpayers are assessed on an earnings basis. The Scottish Court of Session has also stated that “from the standpoint of strict accountancy practice [there is] no doubt that the earnings basis is always the theoretically ideal method of computing the profits and gains of any business, vocation or enterprise…”8

However financial accounting must be distinguished from tax accounting (or accounting for tax purposes). ‘Financial accounting practices are designed for purposes other than tax accounting, for example, profit forecasting and credit assessment. ‘9 Financial accounts are prepared to give the public and shareholders a ‘true and fair’ view of the financial position of an enterprise.10 On this criterion alone the earnings basis would certainly be more suitable. In financial accounting practice the amount of tax payable is merely subsidiary to this end. However in tax accounting, where the object is to ascertain the profits of a taxpayer, it is submitted that the criterion must be whether the chosen basis of tax accounting will provide an accurate reflection of the taxpayer’s income position. Dixon J. in C.O.T. v. Executor Trustee & Agency Company of South Australia Ltd. (Carden’s case)11 said that, “the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer’s true income.” The learned judge, with whom the majority of the Australian Full High Court agreed, then observed:

“we are so accustomed to commercial accounts of manufacturing or

trading operations, where the object is to show the gain upon a comparison of the respective positions at the beginning and end of a period of production or trading, that it is easy to forget the reasons which underlie the application of such a method of accounting to the purpose of ascertaining taxable income…Speaking generally in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.”12

In Carden’s case C who was a medical practitioner in sole proprietorship passed away on 15 Nov 1935. C’s executor, following C’s practice of preparing his accounts on a cash basis, lodged a return in respect of the final year of assessment before his death, on a cash basis. The Commissioner of Taxes increased the gross income by 2,119 pounds, the book debts outstanding at the date of C’s death created in the final year of assessment before C’s death and issued amended assessments in respect of the 1934 and 1935 tax years of assessment which included as part of the taxable income of C amounts which ultimately would be realised by collection of book debts. The issue was whether the Commissioner of Taxes could re-open and amend the assessments in this manner and this turned on whether the cash or earnings basis was the appropriate basis of preparing accounts on the facts of the case. The High Court (Full Court) held that the appropriate basis was the cash basis. Dixon J. (with whom Rich and McTiernan JJ. agreed but with Latham C. J. dissenting) held that the earnings basis was not “not plainly applicable to every pursuit by which income is earned.” and that the Income Tax Act did not “intend to fix [the earnings basis] upon every business and vocation which involves the giving of credit.”13 In the absence of any statutory requirement, “the question whether one method of accounting or another should be employed in assessing taxable income derived from a given pursuit is one the decision of which falls within the province of the Courts of law possessing jurisdiction to hear appeals from assessments. It is, moreover, a question which must be decided according to legal principles.”14

The writer submits, pursuant to Carden’s case that taxpayers should not automatically prepare and submit their tax accounts on an earnings basis since the question whether a cash or earnings basis is suitable is one of appropriateness.15 The legal issue is what income has ‘come home’ to the

taxpayer in an income period. This income and only this income should be subject to tax. In tax accounting the cash and earnings basis are but two methods used to determine the ‘coming home’ of income and hence taxability of that income. In the absence of any legislative provision directing that accounts should be prepared under a certain basis of tax accounting, it is for the courts to decide which method is the appropriate one since appropriateness is a question of law. But on what criteria will the courts decide whether the cash or earnings basis is appropriate?

When Will The Cash Or Earnings Basis Apply?

A. Origins — Accountancy Practice

Before we examine the criteria for the choice between the cash and earnings basis it must first be recognised that the earning of income is a process attributable to all stages in the operating cycle of an enterprise. Many components that make up the profits from manufacture and sale of goods contribute to the profit generated from the sale of the goods. For example, the sourcing of and negotiations for raw materials for manufacture of the goods, and marketing and...