4 S.Ac.L.J. Part II
Recognition of Income
249
RECOGNITION OF INCOME —
THE CHOICE BETWEEN THE EARNINGS OR CASH BASIS
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
1 [1978] 1 All E.R. 754 at p. 756. See also Lord Reid in Duple Motor Bodies Ltd v. I.R.C.
[1961] 1 W.L.R. 739 at p. 751
2 For an excellent illustration of the effect of timing on the set off of losses see Parkside
Leasing Ltd v. Smith [1985] S.T.C. 63. See also Butterworths U.K. Tax Guide 1991–92
paragraph 2:11 for other reasons why the issue of timing is important, at least in the U.K.
context.
3 For a judicial description of these two modes of tax accounting, see Lord Clyde L.P. in
I.R.C. v. Morrison (1932) 17 T.C. 325 at p. 330.
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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
4 One problem is that the courts have not effectively defined the meaning of receipt. See
Dunmore v. McGowan [1978] S.T.C. 217, MacPherson v. Bond [1985] S.T.C. 678, and
Peracha v. Miley [1990] S.T.C. 512, U.K. cases which concerned the taxability of interest
income earned from money deposits charged as security to banks. Even though the
taxpayer’s account was frozen in that he was not allowed under the terms of the charge to
withdraw monies from the account, interest accruing on the deposit monies may on the
facts be received by the taxpayer for tax purposes. See also Tiley [1982] B.T.R. 22 and
[1986] B.T.R 152 and Butterworths U.K. Tax Guide 1991–92 paragraph 2:12.
5 In Australia, sums are due when they are legally recoverable i.e. when a right of action to
recover the debt has arisen. For authority on this proposition see Barwick C.J. in
Henderson v. F. C. T. (1970) 1 A.T. R. 596 at p. 601 but see also Walsh J. in Rowe v. F. C. T.
(1970) 2 A.T.R. 121 at p. 131, McInerney J. in F.C.T. v. Firstenburg 6 A.I.T.R. 297 at p.
308 and [1972] Australian Tax Review 219 for doubts and contrary views. The U.K. courts
have not articulated any test for determining when income is earned under the earnings
basis but it would appear that legal recoverability is too strict/narrow a criterion. Lord
Jauncy in Eckel v. Board of Inland Revenue [1989] S.T.C. 304 at p. 310 said,
“. . .money will only be treated as being notionally in hand and hence as a trade debt
when the trader has done all that is required of him to earn it. Delivery of goods or
completion of services to rendered are examples of events which may give rise to taxation
in a fiscal year in which they occur, albeit payment is not made until a subsequent year.”
See also Viscount Simon L.C. in I.R.C. v. Gardner, Mountain & D’Ambrumenil Ltd.
(1947) 29 T.C. 69 at p. 93.
6 S. A.S. 16, paragraph 23 suggests that income is recognised when the seller has transferred
to the buyer all “significant risks and rewards of ownership in that all significant acts have
been completed and the seller retains no continuing managerial involvement in, or
effective control of , the goods transferred to a degree usually associated with
ownership. . .”. The position would be different for sales on credit terms — see Rowe v.
F.C.T., supra, note 5.
4 S.Ac.L.J. Part II
Recognition of Income
251
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
7 Singapore Master Tax Guide 1992 paragraph 703.
8 per Cooper, L.P. in D. & G. R. Rankine v. C.I.R. (1952) 32 T.C. 520 at p. 527. Note
however that this comment was made as regards accountancy practice and not tax law.
9 Australian Income Tax Law and Practice, E.F. Mannix and D.W.Harris, eds., paragraph
25/1035.
10 See infra, note 39.
11 1 A.I.T.R. 416 at p. 442.
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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
12
13
14
15
Ibid., at p. 442. Emphasis added.
Supra, note 11 at p. 444.
Supra, note 11 at p. 440.
Dixon J. supra, note 11 at p. 442 stated, “Unless in the statute itself some definite
direction is discoverable, I think the admissibility of the [accounting] method. . .must
depend upon its actual appropriateness.” ‘Appropriateness’ is a term which has yet to be
defined. The U.K. courts do not recognise such a concept; rather the anaylsis in U.K.
cases appears to be directed as to whether income is earned.
4 S.Ac.L.J. Part II
Recognition of Income
253
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 advertising costs of goods are but two
such components. However income is only reported for tax and accounting
purposes as earned at one point in the income earning process. In
Singapore, accounts are normally prepared to show income earned from 1
January to 31st December of every year and the profitability of a business
enterprise is normally measured as at 31st December. This is necessarily an
arbitrary process. There is no universal test or method for determining
when income is said to arise. According to one accounting text therefore,
“The measurement of periodical revenue is thus a case of arbitrary
allocation, in the sense that no single allocation method can be justified as
the only proper allocation method.”16 Hence the accountancy profession
has created the cash and earnings basis to measure and allocate income
within arbitrary periods of time. The courts will therefore have to consider
accountancy practice in determining if a certain basis of income recognition
is appropriate.
The courts do in fact take cognisance of prevailing commercial accountancy practice in its recognition of the profits of a taxpayer.17 This is in part
16 p. 155, R. Matthews and R. Ma, The Accounting Framework, A Contemporary Emphasis
(1980).
17 See for example Pennycuick V.C. in Odeon Associated Theatres Ltd v. Jones 48 T.C. 257
who said, “In. . .ascertaining the true profit of a trade the court applies the correct
principles of the prevailing system of commercial accountancy. . .the court must
determine what is the correct principle of commercial accountancy to be applied. Having
done so, it will ascertain the true profit of the trade according to that principle, and the
profit so ascertained is the subject of taxation.” See also Dixon J. in Carden’s case supra
note 11 at p. 441.
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because “The thing to be taxed is the amount of profits or gains. The word
‘profits’, I think, is to be understood in its’ natural and proper sense — in a
sense which no commercial man could misunderstand.”18 Accountants
would be the best persons to state the views of commercial men on whether
something is a profit or not. The House of Lords has gone as far as stating
that a question of law as to whether something is a profit or a gain will only
arise where a statute applies (e.g. where statute holds that certain gains are
taxable) or where, in unclear situations, a presumption has to be invoked
to fill in the gap.19 In all other situations, the question is to be ascertained
from ordinary business conceptions where it is submitted that accounting
practice becomes crucial evidence.
One point which immediately follows from this is that ordinary business
and accounting practices change from time to time. The law however
evolves more slowly. When a court therefore rules that the cash basis is the
more appropriate basis of accounting in a certain situation this inevitably
lends to development in the law itself. For instance if the Courts were to
rule the cash basis was appropriate for say, a law firm of five lawyers then
this ruling would be a precedent for law firms of five lawyers or less to
prepare their tax accounts on a cash basis. Dixon J. in Carden’s case
recognised this when he observed, “. . .under our system of precedent, a
decision adopting or resorting to any given accounting principle or
application of principle is almost bound to settle for the future the rule to
be observed and the rule thus comes to look very like a proposition of
law.”20 What can be said therefore is that since accountancy practice
changes/develops more rapidly that the law, older cases deciding on the
applicability of a certain tax accounting method to certain trades or
enterprises will have less of a precedent value than more recent ones. So
will foreign cases since accounting practice and perceptions abroad may be
different.
To summarise the above submissions, first, recognition of income for tax
purposes is an arbitrary process. Secondly, the cash and the earnings bases
are two such arbitrary methods developed by accountants to recognise
income. Thirdly, the courts take cognisance of accountancy practice in
deciding if the cash or earnings basis is appropriate in a particular business
situation. Fourthly, a ruling by the courts on the appropriateness of a
particular method of tax accounting to a particular business situation will
invariably create a precedent for others in similar business situations to
18
19
20
21
per Lord Halsbury L.C. in Gresham Life Assurance Society v. Styles 18 T.C. 185 at p. 188.
See Viscount Haldane in Sun Insurance Office v. Clark [1912] A.C. 443 at p. 455.
Supra, note 11 at p. 442.
See Whiteraan on Income Tax, paragraph 5–24, and Lord Clyde in C.I.R. v. Morrison
supra, note 3.
4 S.Ac.L.J. Part II
Recognition of Income
255
follow. The precedent value of these court decisions is limited since
accountancy practice can change faster than the law. With these comments
in mind let us examine some factors influencing the choice for the cash or
earnings basis.
B. Trading Businesses — Sale and Purchase of Trading Stock
Australian case authorities suggest that the more appropriate basis of tax
accounting in a business where goods are bought and sold is the earnings
basis. This appears to be the U.K. position as well21.
An Australian case illustrating the appropriateness of the earnings basis to
the business of buying and selling of goods is J. Rowe & Sons Pty. Ltd. v.
F.C. T.22 In that case, the taxpayer sold goods on a credit basis — the total
sum paid by the purchaser was the cash sale price of an article plus a
furthur amount (a term charge) which varied, depending on the length of
the term over which the repayments were to be made. The Commissioner
of Taxation assessed the taxpayer on the basis that the cash sale price was
the income which was assessable at the time a sale was made, and the term
charge was assessable over the term of the repayments (an assessment akin
to that under the earnings basis). The taxpayer contended that he should
be assessed on a cash basis or alternatively that profits from sales, together
with the term charges should be estimated and brought to charge
proportionately over the period of repayment on a profits emerging basis23.
The Australian High Court (Full Court) held that the appropriate basis was
the earnings basis. Menzies J., who gave the leading judgement observed
that the trading stock provisions in the Australian Income Tax Assessment
Act indicated that “the proceeds of any sale of stock in the ordinary course
of business will be brought into account in the year in which it was sold.”
He then observed,
“In a system of annual accounting, ordinary business considerations
would indicate that what becomes owing to a company for trading stock
sold during a year should, in some way, be brought into account to
balance the reduction of trading stock which the transaction effects
. . .the taxpayer’s system of accounting produces the odd result that, as
turnover increases by the sale of more and more trading stock, income
falls, because, when regard is had to receipts only, then but a small
22 (1970) 2 A.T.R. 121 (High Court), (1971) 2 A.T.R. 497 (Full High Court). There is no
U.K. authority on the appropriateness of the earnings basis to the business of buying and
selling of goods.
23 On this basis the profit element of any instalment would be included in the assessable
income of the year in which the instalment is received by the taxpayer. This basis was
rejected by the majority of the Full High Court in Rowe. New Zealand courts are also
similarly inclined — see I.R.C. v. Farmer’s Trading Co. Ltd. (1982) 13 A.T.R. 335.
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proportion of the proceeds of each sale on terms is brought into account
in the year of sale.”24.
To furthur support the view that income of a trading business should be
computed on an earnings basis, Menzies J. observed that there was a
provision in the Australian Income Tax Assessment Act allowing for the
write off of bad debts which have been brought into account as assessable
income25. The presence therefore of such a bad debt provision meant that
income from the sale of stock would have to be recognised even before
receipt and then written off as a bad debt. The existence therefore of bad
debts would only be due to the fact that the amounts were prepared on an
earnings basis.
It is noteworthy that Paragraph 6 of S.A.S. 23 states that income from the
sale of goods is recognised inter alia when “the seller has transferred to the
buyer the significant risks and rewards of ownership, in that all significant
acts have been completed and the seller retains no continuing managerial
involvement in, or effective control of the goods transferred to a degree
usually associated with ownership.”
Conversely, in a business other than the business of buying and selling
trading stock, it is arguable that the cash basis is more appropriate. For
example, where income earned cannot be accurately matched with
expenditure incurred in the production of income, then the cash basis is
more appropriate. Examples of these situations include income earned by
writers, composers and artists. Expenditure incurred by writers for
example cannot accurately be matched to their earnings. In fact a writer’s
income is disproportionate to expenditure. Income from year to year will
depend on when a writer’s works are published, and the extent and success
of the marketing of the writer’s books. The same may be said of a
solicitor’s practice. Expenditure incurred by say, two one-man law firms
may be similar, yet one firm may be several times more profitable than the
other. It is a question of matching the profits with the relevant expenditure
incurred to produce that profit; in some businesses it is just not possible or
feasible to match profit with expenditure since the financial picture
presented by accounts would be just as distorted as if no matching had
taken place. Dixon J. in Carden’s case observed,
“Where there is nothing analogous to a stock of vendible articles to be
acquired or produced and carried by the taxpayer, where outstandings
24 Supra, note 22, at p. 499. This reasoning is consistent with the idea that trading stock is
circulating capital.
25 Singapore’s equivalent is Section 14(1)(d) of the Income Tax Act, Cap. 134, 1985 Rev.
Ed.
4 S.Ac.L.J. Part II
Recognition of Income
257
on the expenditure side do not correspond to, and are not naturally
connected with, the outstandings on the earnings side, and where there
is no fund of circulating capital from which income or profit must be
detached for actual enjoyment, but where on the contrary, the receipts
represent in substance a reward for professional skill and personal work
to which expenditure on the other side of the account contributes only in
a subsidiary or minor degree, then I think according to ordinary
conceptions the receipts basis forms a fair and appropriate foundation
for estimating professional income. But this is subject to one qualification. There must be continuity in the practice of the profession.”26
Taxpayers engaged exclusively in professional work and advice may
therefore have a better case for being assessed on a cash basis.
C. Size of Organisation — Professionals
Generally, in a smaller organisation, it may be easier for a taxpayer to
argue that the cash basis is the appropriate basis of accounting. Conversely, a larger organisation will have more difficulty convincing the
Revenue authorities that the cash basis is the appropriate basis of tax
accounting. The reasons for this has not been articulated by the courts but
it is submitted that in a smaller organisation it may be more difficult to
match expenses incurred with income earned. The amount for provision of
bad debts may be less consistent and predictable in smaller organisations.
To take a simple example, in a large legal practice one more bad debt
incurred in the course of lawyer A’s work may be ‘compensated’ by one
less bad debt incurred by another colleague in the same firm. But the
incurring of just one additional bad debt by a lawyer in a sole practice may
involve a larger fluctuation in profits of the firm. This makes the matching
of income earned with expenses incurred much more difficult. Since
matching of income forms the crux of the earnings basis, in a situation
where matching is often not possible or feasible the cash basis becomes
more appropriate. These propositions above may be supported by two
Australian cases dealing with taxpayers who were practising accountants.
In Henderson v. F.C.T.27, the taxpayer was a partner of an accounting
partnership which employed a total of 295 persons of whom 150 were
qualified accountants. It was found that the accounting partnership was
one of the largest in Australia and the largest in Western Australia. The
partnership and the taxpayer had originally filed its accounts on a cash
basis, but from July 1965, owing to changes in the nature of work done, the
26 Supra note 11 at pp. 444–445. U.K. cases are not so forthright in stating the distinction
though it was recognised by Lord Clyde in I.R.C. v. Morrison, supra note 3 at p. 330.
27 1 A.T.R. 133 (High Court), 1 A.T.R. 596 (Full High Court).
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partnership lodged its accounts with the Commissioner of Taxation on an
earnings basis. The taxpayer’s personal returns were also filed on an
earnings basis. The Commisioner took the view that the cash basis was
more appropriate and assessed the taxpayer on that basis.
The High Court (Full Court) held that the earnings basis was the more
appropriate basis. Barwick C.J. who delivered the judgement of the Court,
examined the structure of the taxpayer’s accounting practice and stated,
“It is apparent in my opinion that what such a business earns in a year
will represent its’ income derived in that year for the purposes of the
Act. The circumstances which led the majority of the Court to conclude
in Carden’s case that a cash basis was appropriate to determine the
income of the professional practice carried on by the taxpayer personally
are not present in this case.”28
Unfortunately the Court did not say exactly what were the circumstances in
the case which determined that the earnings basis was the appropriate basis
of tax. The obvious difference on the facts between Carden’s case and
Henderson’s case is the size of the profit making structure — a difference
between a one man practice and a large accounting practice.
This distinction was also brought up in the case of F.C.T. v. Firstenburg
where McInerney J. stated,
“It is apparent, from a review of the cases cited that the concept of
‘income derived’ is one which will often take it’s content from the
context in which it has to be applied, and that it may have very different
content and significance when applied to the financial operations of a
huge multi-national corporation, or a large trading company or business,
or a large professional partnership respectively than it would in the case
of a one-man professional practitioner. . .[I]n the case of a one-man
professional practitioner the essential feature of income ‘derived’ is
receipt and that ‘receivability without receipt’ is nothing.”29
His Lordship suggested that the tax position of a sole practitioner
professional was akin to that of a salaried man/wage earner who would
“ordinarily be understood as having derived only the income which he had
received in his hands or which he had under his control.” He gave the
example of junior barristers in their first few years at the Bar who had
often to “wait a long time before they received payment of fees earned and
entered into their fee books.”30 Such a junior barrister who may have
28 Ibid, at p. 598.
29 Supra, note 5 at p. 310.
30 Supra, note 5 at p. 313.
4 S.Ac.L.J. Part II
Recognition of Income
259
entered $500 in his fee books for work done but only received $90 would be
surprised to receive a tax assessment on $500 instead of $90.
However in F. C.T. v. Dunn31 it was held that there is no principle of law or
binding authority to the effect that a sole practitioner is to be assessed on a
cash basis. In this case, the taxpayer was a chartered accountant who
carried on business as a sole practitioner in a small town. He had some
employees and also employed his wife and daughter-in-law on a part-time
basis. However he did not employ a part-time accountant and took
responsibility for all work. The taxpayer had from 1970 lodged his tax
returns on an earnings basis but from 1977 — 1980 lodged his returns on a
cash basis. The Commissioner of Taxation contended that the earnings
basis was appropriate. The Administrative Appeals Tribunal held, on the
authority of F.C.T. v. Firstenburg32 that the cash basis was more
appropriate. The Commissioner appealed to the Federal Court.
The Court held that it was an overstatement to say that “the effect of
Firstenburg’s case is that sole practitioners are assessed on a ‘cash receipts’
basis”33. The matter depended upon the nature and incidents of the income
earning enterprise, and upon current perceptions in the field in which the
taxpayer gains his income. The court affirmed the Tribunal’s decision and
dismissed the Commissioner’s appeal on the grounds that the Tribunal had
directed itself correctly and had given proper consideration to the
taxpayer’s case. It is therefore entirely a question of fact for the courts to
decide whether the cash or earnings basis is appropriate.
To suggest that size of an organisation is an important factor would
necessarily lead to the next question — how large must an organisation be
before it can be said with some certainty that the earnings basis rather than
the cash basis is appropriate? There is no answer to this and it must be a
question of fact. However, it is this writer’s submission that the cash basis
is more suitable for smaller or at least one-man organisations.
D.
Bad Debts and Irregular Flow of Income
Where the taxpayer’s income earning operations involve a greater fluctuation of bad debts or an irregular flow of income it may be more
appropriate to use the cash basis. Lord Clyde in I.R.C. v. Morrison34
observed that the cash basis “has the merit of avoiding all the trouble
which the [earnings basis] imposes on the taxpayer in calculating the
31 89 A.T.C. 4141.
32 Supra, note 5.
33 Ibid, note 31 at p. 4151.
34 Supra, note 2.
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‘outstandings’ on current jobs.” Since accurate calculation of outstandings
becomes difficult when the amount of bad debts fluctuate in such cases
from year to year or there is an irregular flow of income the cash basis is
more appropriate.35
This becomes apparent when one examines the bad debt requirements in
Singapore’s Income Tax Act. Section 14(1)(d) allows a deduction for bad
debts incurred in a taxpayer’s trade, business, profession or vocation
(Section 10(1)(a) income). Each bad debt claimed must be a trading
receipt brought into account in a previous accounting period and must turn
bad for the first time during the period in which the deduction is claimed.
The onus is on the taxpayer to claim that a debt has turned bad for the first
time. This is a judgement which involves considerations of timing and
creditworthiness. The taxpayer must satisfy the Revenue that a debt has
turned bad. Normally, the Revenue will be satisfied of the irrecoverability
of the debt if the debtor has been wound-up or made a bankrupt and the
debt continues to remain outstanding. However these requirements import
a degree of subjectiveness and can potentially create a lot of administrative
inconvenience, all the more so if it is inherent in the taxpayer’s income
earning operations that bad debts often fluctuate. Under these situations it
is submitted that the cash basis is more appropriate. In fact if the earnings
basis were to be adopted in a business where bad debts often fluctuate, the
accounts would have to be adjusted every year in order to represent an
accurate picture of profitability of the business. This would clearly not be
acceptable.
E.
Commercial Accounting Practice
It has been suggested earlier on that the courts take notice of normal
commercial accounting practice in determining whether the cash or
earnings basis is more appropriate for tax purposes. This is because income
tax is a tax on ‘profits’ in a commercial (and hence accounting) sense.
However the emphasis in financial accounting practice is for the accounts
to give a true and fair view of the enterprise’s financial position and not for
the accounts to be suitable for tax purposes.36 It will also be recalled that it
is ultimately for the courts to determine whether income is recognised for
tax purposes; accounting practice is but only one factor that a court has to
consider. Where accounting practice and the law conflict therefore, it must
be the law which prevails. It is with these principles in mind when one
35 Though “it does not follow that a light incidence of bad debts makes the earnings basis
appropriate.” per McInerney J. in F.C.T. v. Firstenburg, supra, note 5 at p. 312.
36 It is a statutory requirement for companies to prepare their profit and loss accounts and
balance sheets so as to give a true and fair view of the financial position of the company.
See Sections 210(1) and 210(3) Companies Act (Cap 50).
4 S.Ac.L.J. Part II
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261
considers current accounting practice and accounting standards followed
by the accounting profession,
1. Current Accounting Practice
Current accounting practice in Singapore favours the earnings basis over
the cash basis of accounting. Paragraph 16 of S.A.S. 1 specifies the accruals
(or earnings basis) concept as a fundamental accounting assumption which
underlies the preparation of financial statements. It goes on to state,
“. . .if a fundamental accounting assumption is not followed that fact
should be disclosed together with the reasons.” This is because the
earnings basis is consistent with the ‘matching principle’ in accounting
theory. Under the ‘matching principle’, income is as far as possible to be
matched with the relevant expenditure to produce that income. However
not all expenditure can be matched with income. For example, in
advertising costs, it is not possible to tell whether it gives rise to a particular
profit or loss. In this sense the use of the earnings basis may face serious
problems in practice.
The cash basis on the other hand is not generally followed by accountants
in preparing a taxpayer’s accounts. One main disadvantage of the cash
basis is that a taxpayer can arrange his cash flow so that income monies
received can be conveniently set-off against deductible costs in a manner to
minimize tax payable. Another defect is that cash receipts of other periods
may be treated as income of the period when the cash flow occurs.37
However in some situations the use of both the cash and the earnings basis
to recognise income would equally be unsuitable. Take for example, a
property development construction contract. The date at which contract
activity commences and the date at which the activity is completed are not
likely to be within the same accounting period. The problem is therefore
how receipts and expenses are to be allocated over the duration of the
contract. In such situations, the accounting profession has developed other
accounting methods to more appropriately recognise income. These
methods and their use have been promulgated in the profession’s
accounting standards. We shall now briefly examine the authority of these
accounting standards.
2.
The Authority of Accounting Standards
The I.C.P.A.S. is a member of the International Accounting Standards
Committee (I.A.S.C.), an international accounting body which issues
International Accounting Standards. The International Accounting
Standards are meant to provide basic standards for ‘worldwide acceptance
37 See supra, note 7 at p. 1561 for other reasons why the cash basis is defective.
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and observance’ and for improvement and harmonisation of regulations,
accounting standards and procedures relating to presentation of financial
statements’38. The I.C.P.A.S.’s accounting standards committee considers
all the standards issued by the I.A.S.C. and amends them to suit local
circumstances before recommending them for adoption by the profession
in Singapore as Statements of Accounting Standards. (S.A.S.)
Once adopted the Council of the I.C.P.A.S. (‘the Council’) expects
members of the I.C.P.A.S. (who include all the practising accountants in
Singapore) to comply with them. A member must ‘exercise extreme care
and caution before he concurs with the adoption of any accounting policy
which does not comply with the S.A.S. . .39 In the event of a departure
from the S.A.S. an auditor should disclose the departure and if the auditor
feels that the financial statements do not give a true and fair view of an
enterprises’ financial position this should also be disclosed.
S.A.S. 16 is the General Accounting Standard dealing with Income
Recognition. S.A.S. 16 deals with income arising from sale of goods,
rendering of services and interest, royalty and dividend income. There are
other accounting standards which deal with income arising from construction contracts (S.A.S. 11) and leases (S.A.S. 15). S.A.S. 16 and 11
recognise two other methods of accounting - the completed contract
method40 and the percentage of completion method41 in determining how
income is to be recognised. In fact these two methods are recommended by
S.A.S. 16 whenever one seeks to recognise income from the provision of
services. It is submitted that in the absence of any contractual stipulation,
the completed contract method should apply since under general contract
law no fee will be payable until services are performed.42 Since the fees are
not payable they cannot be said to be earned for tax purposes under the
earnings basis.
How authoritative are the S.A.S. accounting standards? In a Singapore
38 Paragraph 2, preface to Statements of Accounting Practice.
39 See the Preface to the S.A.S. paragraph 11.
40 For a judicial definition, see Lord Templeman in [1984] S.T.C. 251 at p. 254B. Under this
method, income is not recognised and costs and expenses not brought into account until a
contract has been completed/performed. This method of income recognition is suitable for
indivisible contracts and has been recognised by the Privy Council as being appropriate for
property development business but only if it is properly applied. See Thomson Hill Ltd. v.
C.I.T. [1984] S.T.C. 251, a Privy Council decision emanating from Singapore. For a
commentary on the lower court decisions see generally Shue Tily, “The Resolution of Tax
Disputes Over The Taxpayer’s Choice Of Accounting Method” (1982) 24 Mal. L.R. 48.
41 Paragraph 4 of S.A.S. 16 defines this as a “method of accounting which recognises
revenue in the income statement proportionately with the degree of completion of goods
or services under a contract.” This method is probably more suitable for severable as
opposed to indivisible contracts.
42 Cutter v. Powell (1795) 6 Term Rep. 320, see also McInerney J. in F.C.T. v. Firstenburg
supra, note 5 at p. 307.
4 S.Ac.L.J. Part II
Recognition of Income
263
case, Thomson Hill Ltd. v. C.I. T.43 the taxpayer carried on the business of
real estate developers. Its’ accounts were prepared under the completed
contract method under which, it will be recalled, expenses directly related
to the earning of income (Income expenses’) would only be taken
into account on completion of the development. General expenses not
directly attributable to any development site, like stationary, office
equipment and maintenance of company vehicles which could not be
apportioned to any particular development were taken into account for tax
purposes every year. These general expenses were therefore deductible
from gross income earned every year. The taxpayer did not initially treat
property tax as a general expense between 1970 and 1973. Subsequently
the taxpayer changed its practice and treated property tax as a general
expense. This had the effect of reducing the net profit subject to tax from
1975, an effect which was desirable since the taxpayer had started selling
completed property units (and hence realising its profits) from 1974. The
Revenue disallowed the property tax deduction of $253,979.92 claimed by
the taxpayer and insisted that property tax should, under the completed
contract method be treated as an Income instead of a general expense. The
taxpayer appealed and argued inter alia before the Privy Council that
Section 35(1) of the Income Tax Act required that computation of income
required that all expenses, including property tax, be deducted from
income receipts.
The Privy Council held that under the completed contract method property
tax was an Income Expense and should therefore be taken into account
when the development was completed. It was not proper, inspite of Section
35(1), to deduct property tax annually from income receipts. In so deciding
the Privy Council affirmed the correctness of applying the completed
contract method to construction contracts and dismissed the taxpayer’s
appeal. Lord Templeman stated that “[The completed contract method] is
accepted by the Comptroller of Income Tax and by the company and its
advisers and was approved by the Statement of Standard Accounting
Practice No. 9 issued by the Institute of Chartered Accountants of England
and Wales and by the International Accounting Exposure Draft No. 12
issued by the International Accounting Standards Committee.”44
This statement is interesting because it suggests that the courts will go as
far as interpreting the Act in the light of established accounting methods. It
may be said that if a particular accounting method is recommended for a
particular income recognition situation by the I.A.S.C. it is likely that it
will be correct to use that method for income recognition. It is submitted
43 [1984] S.T.C. 251.
44 Ibid., at p. 255. U.K.’s Statements of Standard Accounting Practice is the U.K. equivalent
of Singapore’s S.A.S..
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therefore that the courts will in deciding if income is recognised, follow
recommended accounting methods of income recognition set out in the
S.A.S. especially if they originate from the International Accounting
Standards Committee.45
To summarise my submissions at this juncture; first, that for tax purposes
accounting practice favours the earnings over the cash basis. Secondly,
accounting practice recognises that the earnings and cash basis may both be
unsuitable for recognising income in certain situations (e.g. income from
construction contracts). In these situations, income is recognised under
other methods (e.g. the completed contract method as applied to
construction contracts). Thirdly, these alternative methods of accounting,
if recommended by the I.A.S.C. and if accepted by the parties concerned
will be the appropriate methods of income recognition.
Change of Method When A Business is Continuing
One situation which will often arise is where the circumstances of a
taxpayer’s business changes such that it may be more appropriate for the
taxpayer’s tax accounting methods to change as well. The taxpayer may for
example have a more irregular flow of income due to an increase of bad
debts. Or his income earning operations may take a slant towards the
provision of services instead of the buying and selling of goods on credit. In
such a situation a taxpayer who is preparing his accounts on an earnings
basis will be required to prepare, under the appropriateness concept, his
accounts on a cash rather than earnings basis. What if there are two or
more appropriate methods of tax accounting? (The assumption being that
there can be more than one appropriate method of tax accounting in a
given fact situation; and more than one way of drawing up accounts to give
a ‘substantially correct reflex of the taxpayer’s true income.’).
Two issues arise; first, whether the Revenue or the taxpayer has the
initiative in determining the choice of accounting method and secondly, the
consequences of change from one method to another. We shall now turn to
a discussion of these issues.
A.
The Initiative for Change
The U.K. position on which party has the initiative in determining the
choice of accounting method has been extensively discussed by Ms Shue
45 Subject of course to the principle that “neither profit nor loss may be anticipated. A trader
may have made such a good contract in year one that it is virtually certain to produce a
large profit in year two. But he cannot be required to pay tax on that profit until it actually
accrues.” per Lord Reid in B.S.C. Footwear Ltd. v. Ridgeway [1971] 2 All E.R. 534 at p.
536.
4 S.Ac.L.J. Part II
Recognition of Income
265
Tily.46 The learned author observed that “The cases show that the English
courts proceed on the reasonable premise that the choice of accounting
method is primarily the taxpayer’s and that the only legitimate interest that
the Revenue has in the taxpayer’s accounting methods is in the accuracy of
the resulting records for the purposes of ascertaining tax liability.”47 It is
respectfully submitted that this should represent the position in Singapore
as well. Indeed, as the requirement of appropriateness is a legal requirement48; the taxpayer’s or the Revenue’s preference should not factor in the
choice of accounting method. However, where there are two or more
methods of tax accounting accepted as being equally accurate and
appropriate for tax purposes (as is possible where for example one wishes
to recognise income from construction contracts) then it is submitted that
the taxpayer should be allowed his choice of any of these methods on the
preparation of his accounts and submission of returns. Aside from the
various U.K. case law authorities discussed by the learned author it is
submitted that it is innate in our system of income tax (and probably in all
other systems of income taxation in the Commonwealth) that the amount
of tax payable is based on the tax return submitted by the taxpayer. It has
been argued that the tax system is, in a sense, one of self assessment, the
taxpayer declaring items of income and claiming available deductions.49 If
an accurate return is submitted on an appropriate basis of tax accounting
there should not be any reason for the Revenue to require tax to be
assessed on another equally proper though preferable basis of tax
accounting.
B. Consequences of Change
On a change of accounting method from cash basis to earnings basis there
may be items of income for goods and services rendered in the last years
when the cash basis was in operation but in respect of which payment was
made only after the changeover to the earnings basis. These sums would
therefore escape tax when the earnings basis is used. Conversely, on a
change from earnings to cash basis, sums due in the last years when the
earnings basis was in operation and received after the changeover to cash
basis would be subject to tax twice over. There are no provisions in the
Income Tax Act governing these changeover situations50. In practice the
Singapore Revenue authorities do not accept computation of income on a
46 See supra, note 40.
47 Based on Section 67 of the Income Tax Act which requires persons exercising a trade,
profession, business or vocation to keep proper records of his income.
48 See Dixon J. in Carden’s case supra, note 11 at p. 440 and Barwick C.J. in Henderson’s
case supra note 27 at p. 599.
49 See Parsons, Income Taxation: An Institution in Decay 13 Syd. L.R. 435.
50 In the U.K., Section 104 of the U.K. Income and Corporation Taxes Act 1988 (c.1.)
effectively charges to tax income not taxed where a changeover from the cash to earnings
basis occurs. There is no corresponding provision covering changeovers from earnings to
cash basis..
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cash basis so any issues arising from changeover is purely academic.51
However U.K. and Australian case authority52 have ruled that on a
changeover from the earnings to cash basis, the income would be
effectively taxed twice over. This is inequitable but in strict legal theory is
correct. This is because income tax is charged on annual profits and gains
and the amount of income computed under whichever basis applied by the
taxpayer is merely a ‘factor in ascertaining the profits and gains’53 of a tax
year.
Conclusion and Submissions
The writer has argued that there is room for more than one basis of income
recognition in Singapore. It has been recognised both in the U.K. and
Australia54 that there is a place for assessment of income on cash basis. It
may be said that generally, as long as the nature and incidents of a business
enterprise does not change frequently any basis of tax accounting would
yield the same amount of income receipts. This may be a reason why the
Revenue will not accept computation of income tax on accounts prepared
on a cash basis. The Australian authorities cited above however suggest
that income tax should be based on income figures which give a true
reflection of a taxpayer’s earnings in a given year of assessment. It is
submitted that this should be the position because it would be fairer and
more consistent with the layman’s understanding of a tax on income since a
layman would understand income tax to be imposed on income actually
received. Unfortunately ‘appropriateness’ is another legal term which has
not, at this juncture in time, been not adequately developed or defined by
the courts. A recent Australian case, F. C. T. v. Dunn55 has held that regard
must be had to “the nature and particular circumstances of the taxpayer’s
income and enterprise” to determine the appropriateness of accounting
method.56 Perhaps the time has come for the relevant authorities to give
the cash basis a second look.
LIU HERN KUAN*
51 Supra, note 7.
52 U.K. — I.R.C. v. Morrison supra, note 3; Australia—Carden’s case supra, note 11.
53 per Lord Sands in I.R.C. v. Morrison supra, note 3 at p. 331. See also Dixon J. in Carden’s
case, supra, note 11 at p. 443.
54 For U.K. authority see generally Whiteman on Income Tax, paragraph 5–24, for
Australian authorities see Carden’s case, supra note 11, and F.C.T. v. Firstenburg, supra,
note 5.
55 Supra, note 31.
56 Ibid, at p. 4147.
* LL.B.(Hons.)(S’pore), LL.M.(Cantab), Advocate & Solicitor(S’pore), Lecturer, Faculty
of Law, National University of Singapore. I wish to thank my colleagues Terence Tan and
Ho Hock Lai for their comments. I remain responsible for all errors and omissions.