New revenue recognition standards for U.S. and international financial reporting will require careful planning and education to develop an implementation strategy. In addition, the standard affecting U.S. generally accepted accounting principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) may bring about substantial income tax consequences. Historically, many entities found that the financial reporting standards and tax rules regarding revenue recognition ran parallel and produced identical results; under the new standard this may no longer hold true.
A Brief Overview of the New Revenue Recognition Rules
As part of a joint initiative with the International Accounting Standards Board, the Financial Accounting Standards Board (FASB) released the new revenue recognition standard with Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). Entities who report under U.S. GAAP will be required to follow a five-step model to recognize revenue that includes:
- Identifying the contract with a customer;
- Identifying the performance obligations in the contract;
- Determining the transaction price;
- Allocating the transaction price; and
- Recognizing revenue as or when performance obligations are satisfied.
Publicly-traded entities, certain not-for-profit entities, and certain employee benefit plans must adopt the standards for annual periods beginning after Dec. 15, 2017. The new standard applies to nonpublic entities for annual reporting periods beginning after Dec. 15, 2018.
The new revenue recognition accounting model follows a principles-based approach, which may require significantly more judgment on behalf of management. The new standard affects income tax planning as well. For instance, some entities recognized advance payments as revenue using tax rules that allow for a piggyback on the methods used for financial reporting purposes; such tax methods may now be invalidated or undesirable.
Tax Rules for Revenue Recognition
Generally, taxable income is computed using the same method of accounting that is used for financial reporting purposes unless certain items of income or deductions are either required or eligible for another method for tax purposes. When financial reporting methods are inconsistent with tax regulations or guidance, they can cause book-tax differences that must be reconciled on a tax filing and supported with sufficient records upon request.
Under an accrual method of accounting, tax revenue is recognized when all events have occurred to give the taxpayer a fixed right to the revenue and the amount of such revenue is determinable with reasonable accuracy (all events test). All events are determined to occur at the earlier of the time such revenue is due, paid, or earned through required performance. This normally requires revenue earned from the sale of goods to be recognized when the purchaser assumes the benefits and burdens of ownership under the terms of the contract (benefits and burdens test). Revenue earned from the provision of services is recognized ordinarily when the performance of the services, or any element of the services, is considered complete under the terms of the contract (performance test). In either case, revenue must be recognized earlier if it is due or paid from the buyer at an earlier date, unless an exception is available (such as for advance payments).
Timing of Revenue Recognition
For accounting purposes, the seller or provider of services in the contract recognizes revenue when the buyer takes control of the good or service. The timing of this event depends on the nature of the seller’s performance obligation, and whether control is transferred at a single point or over time.
The sale of goods most likely will lead to revenue being recognized at a point in time. Sellers will determine when control transfers by applying judgement to various factors, such as title transfer, possession, customer acceptance, or the buyer accepts the risk and reward of ownership. Some of these criteria may not necessarily align with the benefits and burdens test that will still be used for tax purposes.
Contracts for services will likely qualify for the “over time” method. When revenue is recognized over time, ASC Topic 606 provides that the seller transfers control as progress is made toward satisfying the performance obligation. Conversely, a partially complete project does not produce revenue recognition for tax purposes, unless certain services are “severable” under the terms of the contract.
As a result of the new standard, revenue recognition for financial reporting purposes will involve many scenarios where the timing of revenue recognition will be substantially different than previous guidance. Such differences may result in faster revenue recognition for advance payments. For tax purposes, the timing for revenue recognition involving advance payments is governed by the all events test, which requires, in this case, recognition in the year of receipt.
A widely utilized exception authorizes conformity with the financial reporting methodology, so that revenue can be deferred for tax purposes until the time it is recognized for financial reporting purposes (subject to terms and limitations). Hence, an acceleration of revenue recognition involving advance payments for financial reporting purposes will dictate an identical result for tax purposes.
Certain entities historically have been required to treat bundled contracts of goods and services as a single unit of account under U.S. GAAP, unless specific conditions were met to permit delineation of the contract into its separate elements. In some industries, the conditions required a determination of vendor-specific objective evidence of fair value to enable the separation of the amount and timing of revenue recognition for each element of the contract. Under the new standard, all entities with bundled contracts must allocate consideration among separate performance obligations (described under the new standard as distinct goods or services). Services must be bundled together until they represent a distinct performance obligation. The amount of consideration for each performance obligation would then be determined based on the company’s stand-alone selling prices for such products.
Inconsistencies may arise between accounting and tax reporting for bundled goods and services. The allocation performed for tax purposes defers to the prices for separate elements stated specifically in the contract, which may not be consistent with the dynamic of identified performance obligations or the seller’s stand-alone selling prices associated with those obligations.
Like existing financial reporting standards, the new revenue recognition standards specify that there must be a probable chance of collection in order to recognize any amount of revenue as a threshold matter. Arrangements deemed uncollectible at the beginning of the contract will not default to cash basis recognition; entities will continually reassess the arrangements to determine whether consideration will be collectible at a later date.
Prior to meeting the collectibility requirement, entities may still recognize revenue if certain other criteria are met. An entity can recognize revenue in the amount of consideration received when:
- The entity has transferred control of the goods or services
- The entity has stopped transferring goods or services and has no obligation under the contract to transfer additional goods or services
- The entity has received nonrefundable consideration from the customer
In comparison, the tax rules narrowly define a “doubtful collectibility” exception to revenue recognition that may not dovetail with the collectibility standard and the new financial reporting concepts governing revenue recognition when collection is not probable. Revenue may therefore be recognizable for tax purposes even though it fails to be collectible under the new financial reporting standards.
Fixed price contracts in the new standard should not produce any inconsistencies between financial reporting and tax considerations. Contracts with variable consideration, on the other hand, are a different story. Under ASC Topic 606, entities measure variable consideration using estimates to quantify the amount of revenue expected to be received. Entities use estimates when it is probable that a significant reversal of revenues will not occur upon resolution of the contingencies or uncertainties causing the variable consideration. Situations that might produce variable consideration include the seller’s right to incentives or bonuses, or the seller’s concessions for discounts, credits, rebates, refunds, or penalties.
When the seller estimates variable consideration, the seller may not necessarily have a fixed right to receive the revenue under the benefits and burdens test or under the performance test for tax purposes. Former financial reporting standards did not permit revenue recognition with the existence of contingencies, which comported with tax rules. A fundamental inconsistency is now introduced with the new financial reporting standards.
IRS Permission to Change Accounting Methods
The new accounting standards may precipitate a deluge of applications to change accounting methods for tax purposes. Such changes can be either automatic or require IRS consent (using Form 3115 for either type) before an entity can change its overall tax method of accounting or its tax method of accounting for a material item. The related regulations and guidance would require any entity that experiences a change resulting from the new financial reporting standards to secure IRS consent, where tax conformity is desired. The only instance where this would not be the case is where the underlying facts of the change in recognition occurs, such as a situation where the customer changes the timing or other aspects of the agreement. If an entity has the wherewithal to maintain a tax accounting method that corresponds to the former financial reporting standards (e.g., maintain a second set of books), there is no requirement for conformity as long as the former method continues to result in a clear reflection of income and conforms with the all events test for tax purposes. We suspect that this option would be more burdensome on the taxpayer so we anticipate that many taxpayers will prefer conformity. One instance where this could get a little more complicated is where the taxpayer is deferring income recognition for advance payments (pursuant to Rev. Proc. 2004-34).
On March 28, 2017, the IRS indicated in Notice 2017-17 that applications for changes in accounting methods for ASC Topic 606 may be governed by its so-called “automatic” consent procedures, which would help with timing constraints to make these filings. But implicitly this suggests that a pervasive filing requirement is expected, churning unpleasant memories involving the filing campaign under the tangible property regulations.
As the new standards are implemented for financial reporting purposes, entities should reassess both accounting and tax strategies associated with revenue recognition. They should also plan for a pervasive filing campaign concerning IRS permission to change tax accounting methods. For more information concerning the impact that the new standards will have on your entity, please contact us.
Carl Giardino is a Managing Director in the Tax Group. He can be reached at 617.761.0615 or CGiardino@cbiztofias.com.
Patrick Quinn is a Shareholder in the Accounting and Auditing Group. He can be reached at 401.626.3211 or PQuinn@cbiztofias.com.