Transitory items are an important part of accounting that are fundamentally different from ordinary revenues and expenses. This article explains what transitory items are, including their main characteristics, and it provides a practical example to illustrate the concept.

What’s in this article?

• What are transitory items?
  
• What are the criteria for transitory items?
  
• Examples of transitory items
  
• What are the benefits of transitory items?
  
• How are transitory items handled in bookkeeping?
  
• An example of the correct way to handle transitory items
  
• Common errors when processing transitory items
  

What are transitory items?

Transitory items are amounts of money that a company either receives on behalf of a third party or that it forwards to a third party. These items are not considered the company’s own revenues or expenses. The funds are placed in a clearing account, which is an account for holding temporary amounts that are later transferred to the rightful party. A typical example of a transitory item would be an advance payment made for deliveries, or services that a company carries out on behalf of a customer or business partner. And because these types of payments are not attributable to the company’s own operations, they do not need to be included on its income statement as operating income or expenses.

Another example of transitory items would be taxes that a tax consulting firm pays on behalf of its clients. These amounts would be economically attributable to the client and therefore recorded initially in a separate account. Later, the bill for the amounts would be passed on to the client.

What are the criteria for transitory items?

For funds to be considered transitory items, the following conditions must be met:

• A company is acting on behalf of or in the name of a third party: The business must act solely as an intermediary (also called an agent or trustee) and have no economic interest in the funds.

• The company does not dispose of the funds: The company cannot freely dispose of the amounts, and it is required to forward them directly.

• Separate accounting occurs: Funds must be shown as transitory items in the company’s accounting records and must not be included in the company’s sales or operating expenses.

• There is clear labelling: Transitory items must be clearly identifiable in the accounting records to avoid tax problems.

Examples of transitory items

Typical transitory items include taxes and duties, third-party fees, and other external expenses. Below are common examples in each of these categories.

Taxes and duties

• Value-added tax (VAT), which a company collects from its customers and forwards to the tax office
  
• Vehicle tax, which a car rental company pays on behalf of customers when they rent vehicles
  

Third-party fees and external expenses

• Court costs that a law firm pays in advance on behalf of its clients
  
• Shipping costs that a customer pays to a retailer and the retailer passes on to the shipping business
  
• A travel agency pays hotel or flight costs directly and then charges them to its clientele
  
• A notary’s office pays fees for journal entries and then passes those fees on to the client
  

What are the benefits of transitory items?

Transitory items have some advantages in both accounting and tax law. This is due to their special treatment, as they are not considered operating income or expenses. Here are some of the most important benefits of transitory items:

• Lack of tax burden: A company does not pay taxes on funds that are identified as transitory items so long as those funds do not contribute to the success of its business.
  
• Efficient processing of third-party costs and transparent accounting: Classifying amounts that a company pays on behalf of a third party (e.g. fees, taxes, shipping costs) as “transitory items” enables the company to efficiently process those amounts. And because the funds are recognised separately from the company’s regular income and expenses, accounting is kept clean and transparent.
  
• Improved cash planning: Because transitory items are not considered operating expenses, the company’s financial metrics – such as cash and operating income – remain unchanged. This means the balance sheet is never distorted by including funds that are not the company’s own, but rather a third party’s.
  
• Clear customer billing: When a company reports transitory items separately (e.g. on invoices), it provides transparency to its customer base. It makes it clear what costs are being incurred for services and what amounts the company is simply passing on.
  

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How are transitory items handled in bookkeeping?

As transitory items do not affect operating profits, they are not subject to VAT. Accordingly, they have no effect on the cash-basis accounting method (EÜR). However, you need to prove to the tax authorities that the entries in question are in fact transitory items.

The following information is important for proving that funds are transitory items:

• Total amount
  
• Date of receipt
  
• Date of outgoing transfer
  
• Purpose
  
• Name and address of the person or company the money is being moved on behalf of
  

Transitory items on the balance sheet

To ensure the correct recording of assets and liabilities, transitory items must be recorded in a separate account. On the balance sheet itself, transitory items appear in identical amounts on both the assets and liabilities sides. The use of unique identifiers can help to avoid misclassification. Further, if amounts are still outstanding on the balance sheet date, a receivable must be recorded in the balance sheet. This prevents premature recognition of profits.

An example of the correct way to handle transitory items

Let’s look at a real-world example to illustrate the proper handling of transitory items.

The scenario

In this example, let’s say an online retailer sells a product to a customer. The online retailer hires a shipping company to make the delivery to the customer, and the retailer receives an invoice for the shipping charge. The online retailer then bills the customer for the shipping charge that it had to pay on the customer’s behalf.

Why is the shipping cost a transitory item in this case?

• No direct performance: The online retailer does not provide a direct service by passing on the shipping cost to the customer. It merely acts as an intermediary between the customer and the shipping company.
  
• Third-party invoicing: The invoice for the shipping cost is in the name of the online retailer. However, the customer is the actual debtor (i.e. the party that owes the money).
  
• Specific transfer: The shipping cost is passed on to the customer immediately and in full. No profit is made by the online retailer on the transfer.
  

The accounting treatment

Accounting for this transitory item should look like this:

• Separate account: The online retailer should set up a separate clearing account for the shipping cost.
  
• Bookings:
  
  • Debit of the clearing account: When paying the shipping cost to the shipping company, the clearing account will be debited.
    
  • Debit to the customer account: The amount of the shipping cost will then be charged to the customer account.
    
• Value-added tax: The VAT included in the shipping cost can be claimed as input tax if the online sale is subject to VAT. With Stripe Tax, businesses can stay on top of their taxes for both domestic and international transactions. Tax gives you a complete view of all your tax obligations and can help you with important things like tax filing.
  

Recognition in the balance sheet

Because the shipping cost in this scenario is considered a transitory item, it would not have a direct impact on the online retailer’s balance sheet. This is because transitory items appear in equal amounts on both sides of the balance sheet – i.e., assets and liabilities – effectively cancelling each other out.

Common errors when processing transitory items

Incorrect reporting

A typical error associated with transitory items occurs in accounting, when the funds are incorrectly reported as operating income or expenses. This distorts the company’s profits or revenues, which can lead to incorrect tax calculations.

Poor differentiation

Another error is lack of differentiation between transitory items and regular income or expenses, which makes accounting difficult and can lead to confusion both internally and externally.

Incorrect allocation

Incorrect allocation is also a common mistake. In this situation, funds are treated as transitory items even though the company itself benefits from them financially (e.g. shipping costs with a profit margin). Such errors can lead to additional claims or even penalties during audits.

Missing receipts

Difficulties can arise from missing or insufficient supporting receipts, as well. Without them, a company cannot prove that it was merely acting as an intermediary, which is problematic during audits.

Incorrect VAT calculation

VAT is also often calculated incorrectly. Transitory items are not tax-relevant, and incorrectly applying tax can lead to unnecessary tax payments and incorrect information on invoices.

Low transparency for the customer

Equally problematic is when transitory items are not separately identified for the customer and rather appear as regular costs. This can give the impression that additional fees have been charged.

Lack of knowledge of the legal basis

In addition, if a business lacks a clear understanding of certain legal principles, such as a business acting in the name of or on behalf of a third party, it can lead to the misclassification of funds as transitory items.

Gaps in documentation

Forgotten or unrecorded transitory items can also damage trust in a company and lead to legal claims by customers or third parties.

Improper use of funds

An error with potentially serious consequences is the improper use of transitory items. If these funds are used for internal purposes, this violates the principles of proper accounting and might result in legal consequences.

Missed deadlines

Finally, failure to meet deadlines for transitory items can result in payment reminders, interest on late payments, or litigation.