INCOME RECOGNITION. In essence, income should be recognised when the following three conditions are met:

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1 INCOME RECOGNITION This guidance note considers the income recognition principles that relate to entitlement it considers the issues of performance related grants and when it is appropriate to recognise an asset by way of WIP or a debtor for funding which has not been received for work that has been carried out. It does not consider aspects of legacy and subscription recognition although the key principles are the same Charities may have missed the impact of an amendment to FRS 5 Reporting the substance of Transactions. Application Note G Revenue Recognition which came into force for accounting periods ending on or after 23 December 2003 lays down for the first time rules for revenue recognition. It sets out basic principles to be applied in all cases, and also provides specific guidance for certain areas. The Application Note purports to codify existing good practice but it can have a significant impact on some organisations and may result in some charities having to rethink the way they account for income received from funders. The FRS defines recognition as: "The process of incorporating an item into the primary financial statements under the appropriate headings. It involves depiction of the item in words and by a monetary amount and inclusion of the amount in the statement totals." The principles in the Revenue Recognition Application Note have also been reinforced for charities and other non profit bodies in the Accounting Standards Board's (ASB s) Exposure Draft: Statement of Principles for Financial reporting Proposed interpretation for Public Benefit entities as well as the new Charity SORP (SORP 2005). The FRS focuses on a supplier s right to consideration and care is needed with this key concept which may be easily misinterpreted. As defined in the Application Note, this right is a direct reflection of contractual performance and is not affected by arrangements that may or may not exist for stage payments or an agreed invoicing schedule. The General Principles In essence, income should be recognised when the following three conditions are met: i) entitlement the charity should have entitlement to the income; ii) certainty there should be reasonable certainty of receipt; and iii) measurement the item should be measurable at a monetary amount with reasonable certainty These three criteria have been reemphasised in the SORP. With contracts, service level agreements and performance related grants entitlement will not usually be until the charity has earned the income. Grant Income There are two kinds of grants to consider ordinary grants and performance related grants. As with all income the key issue is does the charity have entitlement? The issues of grants recognition are explained in paras 104 et seq of the SORP. In particular note paragraph 110.which explains that grants should not be deferred simply because the expenditure has not been made or the services have not been provided (unless they are performance related grants see section below) It is also important to consider the issue of time restrictions. This is where the donor specifies when the funding can be used and it is not within the charities discretion to make use of the funds at an earlier stage. Simply because the charity decides it can not start a funded project until a later accounting period does not mean that the income should be deferred (See SORP paragraph 108 quoted below).. There continues to be uncertainly as to the criteria for the recognition of grant income where payment has been promised but not been received, particularly where the promise contains payment terms that may be perceived to amount to a condition. For example, a donor may 1

2 specify a gift and indicate that payments will be made on particular staged dates, or that payment will be made on the presentation of a report or certification of expenditure or on presentation of an architects certificate when the gift is for the construction of a building. In such circumstances the three tests of discussed above should still be applied. The key paragraphs from the SORP are reproduced below (I have marked up areas that are often overlooked in bold) 104 A pre-requisite of recognition of a promised grant or donation is evidence of entitlement. Evidence will normally exist when the grant is formally expressed in writing. Where entitlement is demonstrable, and no conditions are attached, such promises should be recognised as incoming resources once the criteria of certainty and measurability are met. 105 Charities often receive grants or donations with conditions attached that must be fhulfilled before the entity has unconditional entitlement (control) of the resources. Meeting such conditions may be either within the recipient charity's control or reliant on external factors outside its control. Where meeting such conditions is within the charity's control and there is sufficient evidence that the conditions will be met, then the incoming resource should be recognised. Where uncertainty exists as to whether the recipient charity can meet conditions within its control, the incoming resource should not be recognised but deferred as a liability until certainty exists that the conditions imposed can be met. 106 For example, a grant may be conditional on a charity obtaining matched funding, or subject to a successful planning consent. Meeting the conditions attaching to such grants would not be either certain or wholly within the control of the recipient charity. The charity would not therefore have unconditional entitlement (control) of the incoming resource until these conditions were met. The incoming resource and corresponding asset should not be recognised until the conditions set have been met. 107 Conditions such as the submission of accounts or certification of expenditure can be seen as simply an administrative requirement as opposed to a condition that might prevent the recognition of incoming resources. 108 Incoming resources may also be subject to donor imposed conditions that specify the time period in which the expenditure of resources can take place. Such a precondition for use limits the charity's ability to expend the resource until the time condition is met. For example, the receipt in advance of a grant for expenditure that must take place in a future accounting period should be accounted for as deferred income and recognised as a liability until the accounting period in which the recipient charity is allowed by the condition to expend the resource. 109 Where the existence of a condition prevents the recognition of an incoming resource, a contingent asset should be disclosed where it is probable (but not virtually certain) that the condition will be met in the future (see paragraphs 340 to 348) 110 Charities are normally entitled to incoming resources when they are receivable. Recognition of a grant or donation without pre-conditions should not be deferred (Glossary GL 15) even if the resources are received in advance of the expenditure on the activity funded by the grant or donation. In such cases the charity has entitlement to the resource with the timing of the expenditure being within the discretion of the charity. Such incoming resources cannot be deferred simply because the related expenditure has not been incurred. Similarly, a condition that allows for the recovery by the donor of any unexpended part of a grant does not prevent recognition. A liability for any repayment is recognised when repayment becomes probable. Performance related grants The existing Charity SORP (SORP 2000) emphasises that income should be recorded when it meets the income recognition principles of entitlement, certainty and measurement. The clarification focuses on the entitlement criteria for contracts or grants that are performance 2

3 related and SORP 2005 introduces the term performance related grant. This is where the terms of the grant require the performance of a specified service and where the grant is conditional on specified outputs and deliverables. In such cases the income should only be recognised when the charity has performed and earned entitlement to the income. SORP 2005 defines a performance related grant in the glossary: The term performance-related grant is used to describe a grant that has the characteristics of a contract in that: (a) the terms of the grant require the performance of a specified service that furthers the objectives of the grant maker and (b) where payment of the grant receivable is conditional on a specified output being provided by the grant recipient. It is important to note that there are two prongs to the definition and that both aspects have to be considered when deciding on whether a grant is a performances related grant. But why is this important? The SORP clarifies that all income should be recognised as soon as it meets the criteria for recognition. This treatment should be followed regardless of the source of the income or the purpose to which it is to be or has been put. It is important to recognise that often contracts and much funding from institutional donors will be performance related and in such cases the income is either accrued or deferred in line with performance.. However, where the funder simply identifies some targets or desirable outcomes that are not a requisite to earn the income then it is unlikely that the funding will be performance related. Therefore if a funder provides funds to dig wells then the income is simply restricted income that would be recognised when receivable. Paragraph 110 of SORP 2005 quoted above is key to this thinking. On the other hand if the funding was to dig ten wells then this is most likely a performance related grant that would need to be recognised in line with performance. On the face of it this might seem to be a fairly innocuous and intuitive change but the implications merit careful attention. Most charities have accounted for income in line with the payments schedule agreed in the grant offer or contract terms. Alternatively, they may have recognised income when they have finished the work or submitted a claim. When explaining the right to consideration FRS 5 states that, this right does not necessarily correspond to amounts falling due in accordance with a schedule of stage payments which may be specified in a contractual arrangement. Whilst stage payments will often be timed to coincide with performance, they may not correspond exactly. Stage payments reflect only the agreed timing of payment, whereas a right to consideration arises through the seller's performance. This means that the charity must have systems to record and monitor the work actually completed. In my experience this information is sometimes not adequately reported by the field and those producing the financial statements do not have evidence of the work performed at the year end date. At the time the Exposure Draft of SORP 2005 was prepared there was confusion amongst readers which led them to think that all restricted income was performance related this is not the case and clarification is provided in Paragrphs 99 et seq of the SORP. Certain grant funding arrangements may contain conditions that closely specify the service to be performed by the charity. The terms of such funding may be set out in a service level agreement where the conditions for payment are linked to the performance of a particular level of service or units of output delivered, for example, number of meals provided or the opening hours of a facility used by beneficiaries. Entitlement to the incoming resources derived from such performance-related grants may be conditional upon the delivery of the specified level of service and in such circumstances should be recognised as incoming resources to the extent that the charity has provided the services or goods. Simply because a grant is restricted to a particular purpose of the recipient charity does not mean it should necessarily be recognised as a performance related grant. For a performance 3

4 related grant entitlement to the incoming resource only arises with the performance of a specific output identified as a condition for the grant. Entitlement to the grant in such cases only arises as the performance conditions are met. This can be contrasted with a restriction that whilst limiting how a charity may expend funds to particular purposes does not require a specific and measurable output to be delivered by the recipient charity as a condition of a charity s entitlement to the funds.such restricted grants are recognised on the basis set out in paragraphs 104 to 111. (quoted above in the section on general grants) Therefore, when considering when and how to recognise income those preparing and auditing charity accounts will have to first understand the funding terms to decide whether they are performance related and then consider what level of performance has been achieved at the accounting reference date. This may be easier said then done particularly where the charity is using agents or partners to fulfil some or all of the work. In my experience this information is sometimes not adequately reported by the field and those producing the financial statements do not have evidence of the work performed at the year end date Partial performance There are additional complications where there are different deliverables which may have achieved different levels of performance. For example a funder might require the charity to sign up a specified number of people to a scheme and then deliver a certain level of training. At the year end date it might have signed up 70% of the people and delivered 40% of the training what is the level of consideration that it has earned? The FRS explains that a seller ( the charity providing the goods or services) may obtain a right to consideration when some, but not all, of its contractual obligations have been fulfilled. Where a seller has partially performed its contractual obligations, it must recognise revenue to the extent that it has obtained the right to consideration through its performance. This will require a view to be taken on the level of consideration that can be recognised for part completion of different components. Work in Progress Both the FRS 5 and SORP 2005 reiterate the relevance and need to follow the provisions of Statement of Standard Accounting Practice Number 9 (SSAP 9) Stock and long term contracts. SSAP9 defines a long term contract as : a contract entered into for the design, manufacture or construction of a single substantial asset or the provision of a service (or of a combination of assets or services which together constitute a single project) where the time take substantially to complete the contract is such that the contract activity falls into different accounting periods It goes on to explain that, although a long-term contract usually extends for a period exceeding one year., a duration exceeding one year is not an essential feature of a long-term contract. Some contracts with a shorter duration than one year should be accounted for as long-term contracts if they are sufficiently material to the activity of the period that not to record turnover and attributable profit would lead to a distortion of the period's turnover and results such that the financial statements would not give a true and fair view. The thinking is that owing to the length of time taken to complete such contracts, to defer recording turnover and taking profit into account until completion may result the accounts reflecting not so much a fair view of the results of the activity during the year but rather the results relating to contracts that have been completed in the year. It is therefore appropriate to take credit for ascertainable turnover and profit while contracts are in progress in certain cases. Charities will therefore need to record income and related costs as contract activity progresses. Income should be ascertained in a manner appropriated to the stage of completion of the contract. There will be contracts where costs incurred to date do reflect the work performed and in such circumstances it would be appropriate to use the proportion of costs incurred in comparison with total expenditure in measuring revenue; however, this will not always be the case. The incurrence of costs by the charity, does not, in itself, justify the recognition of revenue. The 4

5 Application Note therefore re-emphasises the principles of SSAP 9 and explains that the key principle in recognising revenue is the performance of contractual obligations. Where it is considered that the outcome of a long-term contract can be assessed with reasonable certainty before its conclusion, the prudently calculated attributable profit or surplus should be recognised as the difference between the reported turnover and related costs for the contract. In all cases it is important to remember that income should be recognised when the charity has entitlement, the amount can be measured and there is reasonable certainty of receipt Paragraph 103 of the 2005 SORP explains Application Note G to FRS 5 provides specific guidance on revenue recognition under long-term contractual arrangements. A charity should recognise incoming resources in respect of its performance under a long-term contract when, and to the extent that, it obtains entitlement to consideration. This should be derived from an assessment of the fair value of the goods or services provided to its reporting date as a proportion of the total fair value of the contract. There will be contracts where costs incurred to date reflect the work performed and in such circumstances it would be appropriate to calculate incoming resources recognised at the balance sheet date based on the proportion of costs incurred to date in comparison with total expenditure. In the case of services, it may be appropriate to use the time spent as a proportion of the total time to be spent to fulfil the contract where this provides a reasonable estimate of a charity s performance and therefore entitlement. The incurrence of costs by the charity, does not, in itself, justify the recognition of revenue. Compliance will only be possible if the individuals responsible for preparing the accounts have information about the nature and requirements of the funding agreements and also of the performance achieved at the year end. In any case, this is important not just to comply with Financial Reporting Standards but also to ensure proper monitoring of work against funding. This is particularly relevant when working with agents / partners on projects that have been funded by institutional and other donors since it is the charity that carries the risk and rewards of the relationship with funders based on the deliverables from the agents or partners. In conclusion: The key considerations are entitlement, certainty and measurement Income recognition should not be deferred simply because there is a restriction or because the related expenditure has not been incurred Where the income is received under arrangements that are analogous to a performance related grant then the recognition should be in line with the performance Where the income is in exchange for the provision of goods or services the delivery of which spans the year end and the amounts involved are material there is a need to record income and related costs as activity progresses. Income should be ascertained in a manner appropriated to the stage of completion of the contract. If there is a time restriction relating to when the expenditure is to be incurred imposed by the donor then the recognition should be in line this Note that this is not the same as the recipient of the funding stating that the project has not started or the expenditure for which the income has been received has not been incurred. Pesh Framjee Updated 15 April 2006 Pesh Framjee is the Head of the Unit serving Non profit Organisations at Deloitte & Touche LLP, the lead provider of audit and related services to charities. He is also the Special Advisor to the Charity Finance Directors Group, a member of the Accounting Standards Boards Committee for Accounting for Public Benefit Entities and of the Charity SORP Committee. He is joint author of Charities the law and practice. This paper is written in general terms and is not intended to be comprehensive. Before taking any decisions on the basis of the suggestions and indications given in this note you should consult your professional advisers For a list of our guidance notes and useful frequently asked questions see 5