Failure to prepare accounts according to Generally Accepted Acccounting Practices (GAAP) for tax purposes led to an expensive discovery claim for the taxpayer and allegation of negligence for his acccountant.

In Mark Smith v HMRC [2012] TC02321 Mr Smith traded as a sole trader carrying out groundwork for construction clients. He worked on fixed price contracts that lasted between one month and a year. As is common practice in construction, he would make one or more requests payment on account of work completed from his customer as work progressed. 

Applications for payment were calculated on the basis of an assessment of works completed by his in-house quantity surveyor. Upon receipt of an application for payment the main contractor would send out its own surveyor to inspect the work and he would issue a valuation certificate.  It would release payment shortly after. There was a gap of two to three weeks between the date that the application for payment was made and the date on which the valuation certificate was issued.

Mr Smith’s accountant recognised his income on the later date: that on which the valuation certificate was issued. He did this on the basis that this was the date on which the debt became due. This had a material effect on the profits shown in the accounts, albeit only a timing difference. It was significant in terms of tax payment dates and interest. 

The business was subsequently incorporated. 

HMRC opened an enquiry into Mr Smith’s 2001/02 accounts. Its officer decided that his income should be recognised when the payment application was made and not at the later certification point. It alledged that Mr Smith’s income was not being recognised in accordance with generally accepted accounting practice (GAAP). HMRC subsequently made enquiries into the new company’s accounts and then made discovery assessments for earlier years 1994/95, 1995/96 and 1996/97. The taxpayer appealed. 

The case came before the First Tier Tribunal its members were both Chartered Accountants. They considered whether the income from the businesses had been recognised according to GAAP. 

The Financial Reporting Council published Financial Reporting Standard 5 in 1994, it deals with Reporting the Substance of Transactions. The concern at that time was that too many financial institutions were resorting to off-balance sheet financing and this was distorting accounts. Application note G to FRS 5 was published in 2003 this dealt with Revenue Recognition. The principle of FRS 5 was that revenue should be recognised in accordance with performance by the seller.

Further guidance on this topic was provided by the Urgent Issues Task Force who issued Abstract 40 (UITF 40) in 2005. 

UITF 40 was controversial for accountants in that it also recommended that revenue on service contracts should be recognised while the seller performed the contract, rather than when it has a right to receive consideration for the work on completion. By way of example, for an accountant UITF 40 broadly means that if an audit was half complete at the year end, he would need to accrue half of the income receivable for that job in his accounts for that year, instead of carrying forward any associated costs in work in progress and recognising the full fee for the return in the following accounting period. This hit many professional firms hard because many had not recognised partners time in work in progress (WIP) and under UITF 40 they were being forced into recognising the full sale value of that part of the work performed at the year end. 

In Mr Smith’s case, he employed a surveyor, he was able to measure with some accuracy how much of any construction contract was performed at any given time. The First Tier Tribunal had little difficulty in agreeing with HMRC. It found that Mr Smith’s accountant’s conduct had been negligent in ignoring FRS 5. He had not applied GAAP and as a result HMRC’s discovery was permitted. 

The tax payer made a further appeal to the Upper Tier Tribunal (UTT) on a number of grounds all of which were dismissed. One of these was whether there was negligent conduct on behalf of the taxpayer. If there was not then there could be no discovery. 

The Tribunal decided that negligent conduct by Mr Smith’s accountant did not necessarily amount to professional negligence.

  • An accountant’s conduct should be judged by reference to the standard of the ordinarily competent accountant.
  • It was possible to make that judgment even when the accountant was not party to the proceedings.
  • In this case the accountant gave evidence and the matter was decided by the FTT, the members of which were themselves qualified accountants. Who better to decide whether or not there was negligent conduct?

Revenue recognition 

Where you are required to recognise revenue on a contract before it is billed in accordance with UITF 40: 

Dr Debtor – accrued income

          Cr Sales/turnover 

Having recognised revenue, the accruals concept dictates that you must match your costs against your revenue, so costs relating to the income accrued are written off in the same period and not carried forward in WIP.

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