Revenue Recognition and the Deferred Tax Question at Orchard Analytics
Orchard Analytics Ltd sells a three-year data subscription for Tk 360,000, invoiced and collected in full at the start of year one. The contract includes setup and configuration work, which Orchard performs in the first month and which has a standalone selling price of Tk 60,000; the remaining Tk 300,000 relates to ongoing access. Orchard's accountant has recorded the entire Tk 360,000 as revenue in year one because 'the cash is in the bank and the contract is signed'. Separately, Orchard bought equipment for Tk 500,000 on 1 January of year one. Accounting depreciation is Tk 100,000 a year on a straight-line basis over five years with no residual value; tax depreciation is Tk 200,000 in year one. The tax rate is 25%. Profit before depreciation and tax is Tk 900,000 each year. The finance director is preparing year-one statements and wants to know whether the accountant's treatment is defensible and what the deferred tax position is.
1. Assess the accountant's revenue treatment and compute the revenue and profit before tax that should be reported in year one.
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The treatment is not defensible. Receipt of cash is not the criterion for recognising revenue. Revenue arises when control of the promised goods or services transfers to the customer, in an amount reflecting the consideration to which the entity expects to be entitled.
Step 1: identify performance obligations. There are two distinct promises: (a) setup and configuration, a service delivered in month one; and (b) ongoing access over three years. They are distinct because the customer can benefit from the access only once configured, but the configuration service is separately identifiable and has its own observable standalone price.
Step 2: allocate the transaction price. Total consideration is Tk 360,000. Standalone prices are Tk 60,000 and Tk 300,000, totalling Tk 360,000, so the allocation is exactly proportional: Tk 60,000 to setup and Tk 300,000 to access.
Step 3: recognise each obligation as it is satisfied. Setup is complete in year one, so Tk 60,000 is recognised. Access is satisfied over time, so Tk 100,000 (Tk 300,000 / 3) is recognised in year one. Year-one revenue is therefore Tk 160,000, and Tk 200,000 is a contract liability (deferred revenue) at the year-end.
Step 4: profit before tax. Profit before depreciation and tax is Tk 900,000. Accounting depreciation is Tk 100,000, so profit before tax is Tk 900,000 - Tk 100,000 = Tk 800,000.
The accountant's figure of Tk 900,000 revenue overstates year-one revenue by Tk 740,000 and overstates profit before tax by the same amount. The error reverses over years two and three, so cumulative profit is unaffected, but each individual year is materially misstated.
2. Compute the deferred tax balance at the end of year one and explain what it represents and how it will move.
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Step 1: carrying amount of the equipment. Cost Tk 500,000 less accounting depreciation Tk 100,000 = Tk 400,000.
Step 2: tax base. Cost Tk 500,000 less tax depreciation Tk 200,000 = Tk 300,000.
Step 3: temporary difference. Carrying amount exceeds tax base by Tk 400,000 - Tk 300,000 = Tk 100,000. This is a taxable temporary difference, because future taxable profits will be higher than future accounting profits: tax deductions have been taken early, so less deduction remains for later years.
Step 4: deferred tax liability. Tk 100,000 x 25% = Tk 25,000, presented as a non-current liability.
What it represents. It is not a tax payable now. It is the tax that will become payable in future periods because the tax authority has allowed depreciation faster than the accounts have charged it. The tax written-down value is lower, so future tax deductions will be smaller than future accounting charges.
How it moves. In year two, accounting depreciation is Tk 100,000 and tax depreciation is Tk 200,000 again, so the difference grows by a further Tk 100,000 and the liability rises to Tk 50,000. From year three, tax depreciation falls to nil while accounting depreciation continues at Tk 100,000, so the difference reverses and the liability unwinds to nil by the end of year five, when both carrying amount and tax base are zero.
Judgement point. The deferred tax figure is a presentational and analytical issue, not a cash issue. A reader comparing Orchard with a competitor that claims full capital allowances immediately would see a large deferred tax liability but identical cash tax paid over the asset's life, so the liability should be explained rather than treated as a hidden debt.
3. The finance director asks whether correcting the revenue error changes the deferred tax calculation. Explain the interaction.
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It does not change the deferred tax on the equipment, but it creates a second, separate deferred tax effect.
The equipment calculation depends only on the carrying amount and tax base of the asset, which are unaffected by revenue recognition. So the Tk 25,000 liability on the equipment stands.
The new item is the contract liability. Recognising Tk 200,000 of deferred revenue creates a liability in the statement of financial position. The tax authority has already taxed the Tk 360,000 as cash received, so the tax base of the contract liability is nil: there is no future tax deduction for delivering the access. A liability with a nil tax base against a carrying amount of Tk 200,000 gives a deductible temporary difference of Tk 200,000.
Recognition test. A deferred tax asset of Tk 200,000 x 25% = Tk 50,000 is recognised only if sufficient future taxable profit is probable to use the deduction. Orchard's profit before tax of Tk 800,000 in year one and similar expectations in years two and three make this comfortably probable, so the asset is recognised.
Net position at end of year one. Deferred tax liability on equipment Tk 25,000, less deferred tax asset on the contract liability Tk 50,000, giving a net deferred tax asset of Tk 25,000, subject to offset rules where the balances relate to the same tax authority.
Why this matters. The accountant's error understated profit in later years and overstated it in year one, but it also concealed a real asset: tax has been paid in advance on revenue not yet earned. The correction therefore improves the balance sheet presentation in two directions at once. The broader lesson is that revenue timing and tax timing are separate questions, and a correction to one must be traced through to the other.