• Sep 2010
• 
• about asa
• 
• advertise
• 
• subscribe
• 
• Xl Magazine
• 
• contact us
• 
• search

SETTLEMENT DISCOUNTS LINKING IFRS WITH TAXATION

The aim of this article is to highlight the accounting treatment of settlement discounts from the perspective of the seller as prescribed by the IFRIC, taking into consideration value-added tax (VAT) and income tax consequences. The deferred tax consequences are also addressed. This article considers only settlement discounts and none of the other issues addressed by Circular 9/2006.

The IFRS requirements for revenue and trade receivables

IAS 18 (AC 111), Revenue, determines that revenue should be measured at the fair value of the consideration received or receivable. In most cases, the consideration takes the form of cash or cash equivalents and the amount of revenue is the amount of the cash or cash equivalents received or receivable. If goods are sold on credit, the corresponding debit entry goes to trade receivables, which is a financial asset, as it represents a contractual right to receive cash. In accordance with IAS 39 (AC 133), Financial Instruments: Recognition and Measurement, financial assets should initially be measured at their fair value, which is normally the transaction price (i.e. the fair value of the consideration received).

The measurement of fair value entails two issues, estimating the future cash flows receivable and discounting those cash flows using an appropriate discount rate. As this article assumes that the effect of discounting short-term receivables is immaterial, only the first issue is considered.

If an entity offers an early settlement discount, the likelihood that the debtor will exercise the option to settle early should be taken into account in the estimate of future cash inflows. If it is probable that the debtor will settle the account early, the estimate of future cash inflows must be reduced and the revenue and trade receivables must therefore be accounted for at the reduced amount. The inverse also applies – in other words, if it is probable that the debtor will not settle the account early, the estimate of future cash inflows will exclude any settlement discount. This initial assessment of the future cash flows affects both the measurement of revenue and the initial measurement of trade receivables. Any changes in these initial estimates should be accounted for in terms of IAS 8 (AC 103), Accounting Policies, Changes in Accounting Estimates and Errors.

The VAT treatment

Section 7(1)(a) of the Value-Added Tax Act No. 89 of 1991 (the VAT Act) provides that VAT must be levied on the value of any supply of goods or services by a vendor in carrying on an enterprise. In determining the VAT treatment of settlement discounts from the seller's perspective, two key aspects must be considered:

• the time of supply, as this determines the time at which VAT must be raised on a particular transaction; and

• the value of the supply, as this determines the amount of VAT that must be raised.

The time of supply

VAT must be raised in the tax period in which a supply is made. According to section 9(1) of the VAT Act, the time of supply is the earlier of the invoice date or the time at which any payment of the consideration is received by the seller.

The value of a supply

The amount of VAT that must be raised is based on the value of a supply, which, in terms of sections 10(2) and 10(3) of the VAT Act, includes the amount of any discount included in the selling price.

If a settlement discount is subsequently granted, the output tax charged by the vendor at the time of supply must be adjusted in the tax period in which the discount is granted (section 21 of the VAT Act).

The VAT treatment described above is relevant only for vendors that account for VAT on the invoice basis. A vendor registered on the payments basis would account for VAT only to the extent that payment for a supply has been received in each tax period, and would deduct input tax only to the extent that payment has been made for a supply. In practice, the vast majority of vendors are registered on the invoice basis, because the permissible range of vendors eligible for the payments basis is very limited. Consequently, this article will assume that the vendors account for VAT on the invoice basis.

The income tax treatment

In order to determine how a sales transaction with an early settlement discount should be treated in the calculation of the seller's taxable income, it is necessary to determine whether the settlement discount portion of the transaction would be included in the seller's "gross income" as defined in section 1 of the Income Tax Act No. 58 of 1962 (the Act) for the year of assessment in question.

The definition of "gross income" includes all amounts, in cash or otherwise, received by or accrued to the taxpayer during the year of assessment. Of particular concern in this context is whether the settlement discount is regarded as having accrued to the seller at the time of the sale.

"Accrued" means that the seller is legally entitled to recover the amount in question, that is, the seller has a right of recovery, even if that right is not immediately enforceable.

This principle of accrual was established in the judgment of Lategan v CIR and it was later confirmed in CIR v People's Stores (Walvis Bay)(Pty) Ltd.

The People's Stores judgment triggered the introduction of the proviso to the definition of "gross income", which states that –

"...where during any year of assessment the taxpayer has become entitled to any amount, which is payable on a date or dates falling after the last day of such year, there shall be deemed to have accrued to him during such year… such amount."

In other words, if the seller becomes entitled to an amount in a particular year of assessment, it must include the full amount in its gross income in that year of assessment even if the right to recovery is not immediately enforceable.

Where a settlement discount is concerned, the question is whether the settlement discount portion of the selling price accrues at the time of the sale, or whether the accrual arises only at the end of the discount period if the buyer does not meet the conditions for the discount.

In practice, the timing and amount of an accrual will depend on the specific terms and conditions of the relevant contract. If the contract specifies that the seller's entitlement to an amount is contingent upon the happening of a future event, such as delivery by the seller, the amount does not accrue to the taxpayer until the happening of the contingent event.

For many years, there has been a general practice (apparently also accepted by SARS) of excluding settlement discounts from the taxpayer's gross income. The argument for this approach is that a seller is regarded as being entitled to an amount if it is able to sue the purchaser for recovery of that amount, but where the seller has offered the purchaser a settlement discount, it would not, initially, be able to sue for payment of the full selling price. If the purchaser does immediately settle the amount due, such payment would be reduced by the amount of the settlement discount and the seller's entitlement at that stage would therefore only be for the invoice price reduced by the settlement discount. This approach was supported by a 1944 case cited as ITC 563, in which it was held that the value of the accrual effectively excluded the settlement discount portion.

Silke supports this view and states the following in this regard:

"… in circumstances in which goods are sold on credit subject to a discount if payment is made within a specified period the amount accruing is not the full selling price but the value of the resulting debt in the light of the discount available. In this way a provision for discounts created for accounting purposes may be taken into account in the determination of taxable income. SARS accepts this view in practice. It is submitted that … this practice is correct."

Recent developments in the Courts, however, indicate that SARS may no longer support this approach.

ITC 1669 dealt with prompt payment rebates rather than a settlement discount, but the principle is nonetheless useful in the context of settlement discounts. The taxpayer in the case granted rebates to customers that paid their invoices within an agreed settlement period. The taxpayer sought to include only the net amount of the invoice (excluding the rebate) in its gross income and argued that the right to the rebate portion of the invoice was contingent upon the fulfilment of a condition that the customer settled the full invoice amount within the agreed rebate period. The court held that the full invoice amount accrued initially, notwithstanding the fact that the subsequent timeous settlement of the invoice amount gave rise to the obligation to grant the rebate; all that was conditional was the customer's right to receive a rebate, which depended on the requirement that the customer fulfilled the condition of paying the invoiced amount before the predetermined date. The subsequent payment of the rebate would then give rise to a deductible expense, but this did not affect the initial accrual.

In a more recent case, ITC 1815, the taxpayer allowed customers to withhold a settlement discount from payments made within a specified period and included only the net invoice amount (after deducting the settlement discount) in gross income. The taxpayer contended that it did not have an immediate right to recover the discount portion of the selling price, as -

"(w)hether the purchaser pays on due date or not is an uncertain event and entitlement to the additional element of the purchase price, the discount, arises only then."

The court held that the full purchase price accrued when the invoice was issued and the full amount therefore had to be included in gross income. This judgment was however overturned on appeal. In the decision of the Natal High Court (not yet reported), it was held that the seller only became entitled to the full invoice price if the creditor failed to pay the amount by the specified date. Indeed, the settlement discount was regarded not so much as a discount, but rather as a penalty for tardy payment. It remains to be seen whether SARS takes this judgment on appeal.

Examples

A company sells goods for R114 000 (including VAT) to a customer on 31 December 2006. The customer is offered a settlement discount of 2% if the account is settled within 10 days. Normal credit terms are 30 days.

Scenario 1: Initially, it is estimated that the customer will settle the account early and this estimate proves to be correct. See table 1 below.

For disclosure purposes, the trade receivable should be reflected at R111 720 (R114 000 x 98%). This amount is calculated as the net balance between the gross receivable (R114 000) and the allowance account for settlement discount (R2 280). The allowance account is therefore used as a mechanism to keep track of the expected settlement discounts that have not yet been claimed. The revenue should be measured net of VAT and the settlement discount, therefore it should be R98 000 (R114 000 x 100/114 x 98%). For the purposes of the first journal entry, it should be noted that the debtor owes the amount inclusive of VAT, as the VAT component is also contractually due to the entity. The recognition of the output VAT adjustment of R280 that will be legally claimable from SARS in future if the debt is settled early (first journal entry), needs to be considered in terms of the normal accounting recognition criteria, which are probability and measurability. As the estimates used in the accounting treatment suggest that the amount will be settled early, one could argue that it is probable that the related output VAT adjustment will be recoverable from SARS when early settlement takes place. The amount of the settlement discount is also known, and the output VAT adjustment is therefore measurable. The recognition of an asset of R280 is therefore appropriate.

If there is a reporting date between the sales transaction and the payment and assuming that the full amount (i.e. including the settlement discount) is taxable on the date of sale, the following represents the deferred tax calculation: See table 2.

1. IAS 12 (AC 102), Income Taxes, defines the tax base of an asset as the amount that can be deducted for tax purposes against any taxable economic benefits that flow to an entity when it recovers the carrying amount of the asset. If those economic benefits are not taxable, the tax base of the asset is equal to its carrying amount. Because the full amount of R100 000 has been included in gross income on the date of the sales transaction and because the output VAT included in the gross trade receivable is not taxable, the future economic benefits are not taxable. The tax base therefore equals the carrying amount.

2. The definition of the tax base of a liability in terms of IAS 12 (AC 102) should be applied in this case. The tax base of a liability is defined as its carrying amount less the amount that will be deductible in future. In future, the entity will be able to deduct R2 000 for tax purposes if the debtor settles the account early. The VAT component of R280 will not be deductible for normal income tax purposes in future. The tax base is therefore R280 (2 280 – 2 000).
   
   If there is a reporting date between the sales transaction and the payment, and assuming that the net amount (i.e. excluding the settlement discount) is taxable on the date of sale, the following represents the deferred tax calculation: See table 3.

1. The tax base of an asset is the amount that can be deducted for tax purposes against any taxable economic benefits that flow to an entity when it recovers the carrying amount of the asset. If those economic benefits are not taxable, the tax base of the asset is equal to its carrying amount. The tax base equals the carrying amount as:
    

   • the amount of R98 000 that has been included in gross income on the date of the sales transaction is not taxable in future;

   • it is expected that the R2 000 will not be taxable in future as the buyer will settle the account early (i.e. no further accrual is expected for tax purposes in future); and

   • the output VAT included in the gross trade receivable is not taxable. 

2. The definition of the tax base of a liability in terms of IAS 12 (AC 102) should be applied in this case. The tax base of a liability is defined as its carrying amount less the amount that will be deductible in future. In future, the entity will not be able to deduct anything for tax purposes, as only the net amount was taxed on the initial sales transaction.

Scenario 2: Initially it is estimated that the customer will settle the account early and this estimate proves to be incorrect. See table 4.

The R2 000 adjustment against revenue upon the settlement of the debt must be disclosed as a change in estimate of the originally anticipated cash flows.

If there is a reporting date between the sales transaction and the payment, the deferred tax consequences on the reporting date are the same as for Scenario 1.

Scenario 3: Initially, it is estimated that the customer will not settle the account early and this estimate proves to be correct. See table 5 below.

If there is a reporting date between the sales transaction and the payment and assuming that the full amount (i.e. including the settlement discount) is taxable on the date of sale, the following represents the deferred tax calculation: See table 6 below.

1. The tax base of an asset is the amount that can be deducted for tax purposes against any taxable economic benefits that flow to an entity when it recovers the carrying amount of the asset. If those economic benefits are not taxable, the tax base of the asset is equal to its carrying amount. Because the full amount of R100 000 has been included in gross income on the date of the sales transaction and because the output VAT included in the gross trade receivable is not taxable, the future economic benefits are not taxable. The tax base therefore equals the carrying amount.

If there is a reporting date between the sales transaction and the payment, and assuming that the net amount (i.e. excluding the settlement discount) is taxable on the date of sale, the following represents the deferred tax calculation: See table 7 below.

1. The tax base of an asset is the amount that can be deducted for tax purposes against any taxable economic benefits that flow to an entity when it recovers the carrying amount of the asset. If those economic benefits are not taxable, the tax base of the asset is equal to its carrying amount. The tax base is determined as follows:

• The amount of R98 000 that has been included in gross income on the date of the sales transaction is not taxable in future (the tax base for this portion is therefore R98 000);

• It is expected that the R2 000 will be taxable in future as the buyer will not settle the account early and the entity will have to accrue the additional amount for tax purposes at that stage (the tax base for this portion is Rnil, as there are no future deductions available); and

• the output VAT included in the gross trade receivable is not taxable (the tax base for this portion is therefore R14 000).
  The tax base is therefore R112 000 (R98 000 + R0 + R14 000)

Scenario 4: Initially it is estimated that the customer will not settle the account early and this estimate proves to be incorrect. See table 8 below.

The R2 000 adjustment against revenue upon the settlement of the debt must be disclosed as a change in the estimate of the originally anticipated cash flows.

If there is a reporting date between the sales transaction and the payment, the deferred tax consequences on the reporting date are the same as for Scenario 3

Concluding remarks

It is evident from this article that the way that settlement discounts are treated for IFRS purposes is not necessarily the same as the way they are treated for VAT and income tax purposes. The preparers of financial statements need to consider these differences and should indicate how the treatment of these differences should be incorporated into the systems and reporting of the entity.

Jackie Arendse CA(SA), Tax Specialist and Associate Professor at the University of the Witwatersrand and part-time Lecturer at the KPMG Academy, and Elmar Venter CA(SA), Manager: KPMG Academy.

Submit a comment
First Name:	*
Comment:	*
	Items with * are required.
Anti-Spam Policy
To complete your post please type in the words that you see in the image below. (Note: The image is case sensitive.)  Generate new Code

Comment(s)

• No comments have been made.

• CPD Verifiable Articles
• No items available

• Additional CPD Articles
• No items available

• Latest Comments
• i'm currently studying for a corporate law diploma and had to do an essay on the strenghts and weaknesses of business rescue. the article has been of great help since I didn't have enough time to do research due to my work overload and keeping my 18 month old boy happy. I got 82% on the essay. thanx a million
  read more
• I would like to be part of the learnership for accounting for next year i am available at any time convinient to you.
  read more
• A warranty on a repaired item becoming void if it is abused or if normal wear and tear is determined should apply to new items as well and not just repaired items
  read more
• Awesome article, this has been very helpful!
  read more
• The argument blaming directors of insider trading based on the fact that share prices traded lower after the directors hedged their shares does not hold water. Correlation does not automatically imply causation. A likely reason for the share performance drop is the signalling effect of the act of the director hedging their shares. This action would lead investors to be sceptical about the prospects of the shares and hence those shares would trade lower.
  read more

• Latest What to Watch