The Financial Accounting Standards Board’s Emerging Issues Task Force (EITF) recently updated guidance regarding recognition of revenue for multiple deliverable arrangements, which is intended to better reflect the underlying economics of such arrangements. In most situations, the new guidance will result in earlier revenue recognition for financial reporting purposes.
As a result, taxpayers that for tax purposes follow their financial accounting revenue recognition method for multiple deliverable arrangements could face a change in method of accounting that would require IRS consent. Similarly, taxpayers that defer advance payments related to multiple deliverable arrangements under Rev. Proc. 2004-34 should file a request to change their accounting method if their underlying method of recognizing those advance payments for financial reporting purposes changes due to the adoption of the new revenue recognition guidance.
The new EITF guidance is expected to have a significant impact on industries that have multiple deliverable arrangements, including the software, technology, pharmaceutical, and biotechnology sectors.
New Financial Accounting Guidance
Vendors often provide multiple deliverables to their customers as part of a single arrangement or contract. Special accounting rules govern recognition of revenue from such arrangements due to the difficulty of determining value for each separate deliverable. The EITF has issued EITF Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables” (superseding EITF Issue No. 00-21), and EITF Issue No. 09-3, “Applicability of AICPA Statement of Position 97-2 to Certain Arrangements That Include Software Elements” (modifying the scope of AICPA Statement of Position (SOP) 97-2). Both EITF issues are effective for new or materially modified contracts in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The new revenue recognition guidance has been incorporated in ASC 605-25, “Revenue Recognition—Multiple Element Arrangements,” and ASC 985, “Software.”
EITF Issue No. 08-1
Under EITF Issue No. 00-21, companies generally had been required to recognize revenue from multiple deliverable arrangements on a single unit of accounting basis absent vendor-specific objective evidence (VSOE) or third-party evidence (formerly known as vendor objective evidence) of the fair value of the undelivered items. As a single unit of accounting, revenue generally was recognized using a proportional performance model. In contrast, if the company recognized the arrangement on a separate unit of accounting basis, it could recognize the revenue attributable to each element as it was delivered. Critics of EITF 00-21 argued that the requirement to establish fair value of the undelivered items often resulted in recognition of revenue on a single unit of accounting basis, creating a deferral of revenue that did not accurately reflect the underlying economics of the transactions.
EITF Issue No. 08-1 now allows use of the best estimate of selling price when VSOE or third-party evidence (TPE) of the fair value of undelivered items is not available. In many cases, the ability of companies to use their best estimates of selling price when VSOE or TPE of the fair value of undelivered items is not available will allow companies to recognize multiple deliverable arrangements on a separate unit of accounting basis, thereby accelerating revenue recognition for financial reporting purposes.
EITF Issue No. 09-3
EITF Issue No. 09-3 modifies the scope of SOP 97-2 to exclude tangible products containing software elements and nonsoftware components that function together to deliver the tangible product’s essential functionality. SOP 97-2 provides guidance on recognition of revenue derived from licensing, selling, leasing, or otherwise marketing computer software. It requires a company to establish VSOE of the fair value of undelivered items (such as software maintenance and upgrades) in order to avoid treating the arrangement as a single unit of accounting. As a result of EITF Issue No. 09-3, more multiple deliverable arrangements that involve nonsoftware and software elements will now be subject to EITF Issue No. 08-1 rather than SOP 97-2.
Nonadvance Payment Arrangements
For tax purposes, taxpayers generally should recognize multiple deliverable arrangements that do not involve advance payments as each element is delivered, consistent with the separate unit of accounting approach discussed above. Accordingly, such a taxpayer generally should not follow its financial statement method of revenue recognition under EITF Issue No. 00-21 for arrangements that the taxpayer treats as a single unit of accounting, and the changes made by EITF Issue No. 08-1 should not affect tax accounting methods. Rather, EITF 08-1 should merely reduce or eliminate the book-tax difference associated with the recognition of revenue from multiple deliverable arrangements.
However, taxpayers that were inadvertently following their financial accounting revenue recognition method under which multiple deliverable arrangements were treated as a single unit of accounting should consider filing a Form 3115, Application for Change in Accounting Method, to change to a permissible tax method and obtain audit protection for prior years. Note that the IRS will not provide consent to a taxpayer seeking to change a tax accounting method for revenue recognition to match the method used for financial statement purposes, unless the method used for financial statement purposes is a proper tax method.
Advance Payment Arrangements
With respect to multiple deliverable arrangements involving advance payments, any financial accounting changes resulting from the new EITF Issues likely will affect taxpayers that currently recognize deferred revenue under the deferral method prescribed in Rev. Proc. 2004-34. Under the deferral method, taxpayers follow the financial statement recognition of an advance payment in the year of receipt and recognize the remaining amount of the advance payment in the year following the year of receipt. The deferral method presumes that the recognition of advance payments for financial statement purposes is an appropriate measure of the revenue earned for tax purposes in year 1. As a result, if a taxpayer’s recognition of advance payments in year 1 is consistent with current accounting standards (EITF Issue No. 00-21, SOP 97-2) or new accounting standards (EITF Issue Nos. 08-1 and 09-3, SOP 97-2), the recognition of advance payments in year 1 would be appropriate for tax purposes.
To the extent a taxpayer adopts the new revenue recognition standards to account for advance payments in multiple deliverable arrangements for financial statement purposes, its method of revenue recognition for tax purposes under the deferral method would also change. In general, a taxpayer must secure IRS consent in order to change its method of accounting for federal income tax purposes. Previously, practitioners believed that under Rev. Proc. 2004-34, any change in the financial statement recognition method would be viewed as a change in fact, as opposed to a change in accounting method, because the taxpayer’s “method” continued to be the deferral method. However, in Rev. Proc. 2009-39, the IRS expressly provided that a change in method of accounting under Rev. Proc. 2004-34 includes a change in how a taxpayer recognizes advance payments in revenues in its applicable financial statements.
As a result, a taxpayer changing its method of recognizing deferred revenue for financial accounting purposes must file a Form 3115 to obtain IRS consent if the taxpayer’s current method is the deferral method. This accounting method change is eligible for automatic consent under Rev. Proc. 2008-52, as modified by Rev. Proc. 2009-39. Taxpayers filing a Form 3115 to change their accounting method for the new revenue recognition standards would be eligible to defer the tax impact of such a change over a four-year period under Sec. 481(a) as opposed to absorbing the impact in a single year, which would be the result if the financial statement change in recognition of advance payments was treated as a change in fact.
In comparison to prior guidance on multiple deliverable arrangements, EITFs 08-1 and 09-3 generally provide for an earlier recognition of revenue for financial statement purposes. These pronouncements theoretically should not affect the recognition of nonadvance payment arrangements for tax purposes unless the taxpayer was inadvertently following its book method. With respect to advance payments, however, taxpayers that defer the recognition of advance payments associated with multiple deliverable arrangements under the Rev. Proc. 2004-34 deferral method could face an acceleration of the recognition of those advance payments if the taxpayer’s underlying method of recognizing the advance payments changes for financial statement purposes. In addition, as a result of Rev. Proc. 2009-39, such taxpayers using the deferral method likely will be required to file a request to change their method of accounting. This accounting method change may be filed using the automatic consent procedures under Rev. Proc. 2008-52, as modified by Rev. Proc. 2009-39, and taxpayers filing this change would be eligible to defer the tax impact of the change over a four-year period under Sec. 481(a).
Editor: Annette B. Smith, CPA
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.