Canada: The Elimination Of Billed-Basis Accounting For Professionals

Work in progress (WIP), work performed but not yet billed, is a ubiquitous aspect of business for professionals. Under the Income Tax Act, WIP is deemed to be inventory. Since inventory is carried at the lesser of cost or fair market value (FMV), businesses typically carry WIP at cost on their balance sheets.

Professionals, such as accountants, dentists, doctors, veterinarians and others, can deduct the WIP in calculating their income for tax purposes. Budget 2017 proposes to change that.

Typically, professionals account for WIP on their balance sheets in two basic ways:

  1. No recognition – WIP is not recognized on the year-end balance sheet of the professional.
  2. Recognition at FMV – WIP is carried on a professional's balance sheet at FMV.

Given the ability of these professionals to deduct their WIP as incurred, many simply do not track their WIP. Whether the professional does not track WIP or deducts the value of WIP carried at year-end, WIP is essentially carried at $nil for tax purposes.

Budget 2017 proposes to eliminate the ability of professionals to use billed-basis accounting by eliminating the deduction of WIP by professionals in calculating income for tax purposes. Once fully phased in, these changes will require professionals to include the value of WIP as inventory at year-end at the lesser of cost or FMV. The inability to deduct their WIP for tax purposes will increase the income of the professionals during the phase-in period. Since professionals will no longer be able to deduct costs associated with WIP as incurred, they must defer the deduction of expenses on professional work until revenue is realized on that work.

Professionals who do not currently carry WIP on their balance sheets will now need to account for their WIP at year-end and include this amount in their income for tax purposes at the lesser of cost or FMV. Professionals who carry a value for WIP on their balance sheets at FMV will need to determine the lesser of cost or FMV of their WIP at year-end. Cost of WIP for a professional firm will exclude any profit component in WIP, including time incurred by partners and mark-up on staff wages. Cost will include staff wages at cost and other direct costs associated with ongoing projects.

The budget proposal will be phased in over two years, for taxation years commencing after March 22, 2017, requiring professionals to include 50 per cent of their WIP in their income in the first year of the transition and 100 per cent in the second and subsequent taxation years.

Consider this example for the effect of the change on a professional's income:

  • The FMV of WIP at a given year-end is approximately $140,000.
  • The annual cost of WIP is approximately $60,000.
  • Income is approximately $350,000.

For professionals who do not track their WIP and therefore do not recognize WIP on their balance sheets at year-end, or who deduct their full WIP and therefore value their WIP at a nominal amount for tax purposes, the phased-in changes will cause these results:

  2017 2018 2019 2020
Income before WIP inclusion $350,000 $350,000 $350,000 $350,000
Opening WIP inventory - - (30,000) (60,000)
Closing WIP inventory* - 30,000 60,000 60,000
Taxable income $350,000 $380,000 $380,000 $350,000
Additional income during transition years   $30,000 $30,000 -

50 per cent of WIP at lesser of cost FMV in 2018

Professionals who carry WIP at FMV will need to adjust the value of WIP for accounting purposes to the lesser of cost or FMV for tax purposes in their annual income tax return. In the example above, this adjustment would reduce the value of WIP, for income tax purposes, from FMV of $140,000 to its cost of $30,000 in 2018, and $60,000 thereafter.   

Since WIP will be valued at the lesser of cost or FMV, sole practitioners who bill based on their own time and have minimal direct costs associated with their client work may not be significantly impacted by these changes.

Professional firms that have significant infrastructure or that leverage the efforts of their staff (for example, legal/accounting associates or dental hygienists) will need to quantify the costs invested in ongoing work at year-end in valuing their WIP. 

Professionals who perform contingency services will likely feel the greatest impact from the changes since they often incur significant up-front expenses in pursuing claims, and may need to carry those costs for several years before realizing any revenues. The inability to deduct expenses as incurred may have a significant impact on these professionals. However, given the uncertain nature of the outcome of many contingency cases, the FMV of some cases may be below the cost invested at year-end.

We have based the above discussion on the assumption that professionals will be able to value their WIP at the lesser of cost and FMV as stated in the budget plan. However, firms currently carrying WIP at FMV for accounting purposes may need to request permission from the Minister to change WIP valuation methodologies from FMV to cost. We expect in the coming months that the government will clarify if any request regarding WIP valuation will be required and, if required, whether the Minister will automatically grant these requests.  

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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