Question

Merrill Lynch is a large securities firm which uses the accrual method of accounting in accordance with Generally Accepted Accounting Principles. Merrill Lynch executes stock trades and performs settlement functions. Settlement functions include recording the sale and confirming it with the customer. Trades made on December 28, 2017, until the end of the month are not settled until mid-January of 2018. Merrill Lynch netted $100,000,000 of sales commissions from these trades in late December 2017. Since the security is not credited to the customer’s account until settlement date, Merrill Lynch wants to report the Revenue on their 2017 Income Statement but wants to declare the income on the tax return for 2018 because it coincides with the settlement dates in 2018. Taxpayer does not receive the money until January 2018. Draft a written memo to the client addressing the following research issues: Merrill Lynch contacts you for guidance on this issue. Should the revenue be reported in 2017 or 2018 for financial statement reporting purposes? Why? Please site the specific guidance you followed in response to your research question. The primary issue you should research is whether an accrual basis securities firm has gross income under sec. 451(a) on the trading date or the next year on the settlement date when all the work is performed, payment is due, and money received?

Answer 1

Revenue should be reported in the year 2017 (i.e. the trade date and not the settlement date). The same is because of the revenue recognition principle as follows:-

As per revenue recognition principle under GAAP, revenue should be recorded only when goods has been sold or services has been performed.

For trade and settlement transactions, on the trade date, the broker-dealer fills the trade order by finding and contracting with a counterparty and confirms the trade with the customer. On the settlement date, the cash and security from the respective counterparties are transferred to the respective accounts.  A broker-dealer should determine the point in time at which it transfers control of the trade execution performance obligation to the customer.  Transfer of control of the trade execution performance obligation should be viewed as occurring on the trade date because that is when the underlying financial instrument (for a purchase) or purchaser (for a sale) is identified and the pricing is agreed upon (i.e., the broker-dealer has identified the counterparty and enters into the contract on behalf of the customer). On the trade date, the customer has obtained control of the service in that it can direct the use of, and obtain substantially all of the remaining benefits from the asset that comes from the trade execution performance obligation. For example, in a security purchase transaction, the customer receives the benefits from changes in value of the underlying security on the trade date. In addition, the customer may direct the further sale of a purchased security to a third-party on the trade date. In a security sales transaction, a customer may not direct the use of the sale proceeds to purchase another security until the settlement date when the cash is deposited into their account. However, the customer is no longer subject to the risk of changes in value of the sold security on the trade date and thus has no rights to the underlying security or related risks and rewards once sold on the trade date.

Section 451(a) as per income tax law says the following (The below paragraph is taken form the law itself):-

Section 451(a) provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for in a different period.

In the case of an accrual method taxpayer, § 1.451-1(a) provides that income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.

Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer's method of accounting. Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. Therefore, under such a method of accounting if, in the case of compensation for services, no determination can be made as to the right to such compensation or the amount thereof until the services are completed, the amount of compensation is ordinarily income for the taxable year in which the determination can be made.