Tax Accounting
FASB and the International Accounting Standards Board (IASB) jointly issued a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance under U.S. GAAP and International Financial Reporting Standards (IFRS). FASB Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers, creates a single source of revenue guidance for all companies. This is a significant change from prior guidance, which contains many pieces of industry- or transaction-specific literature.
The new standard is more principles-based than previous revenue guidance and lacks some of the complexity and specificity of the previous guidance. The lack of bright lines will result in the need for increased judgment. The standard will likely affect an entity's financial statements, business processes, and internal control over financial reporting. It is effective under U.S. GAAP for public entities for annual and interim periods beginning after Dec. 15, 2016. There is a one-year deferral for nonpublic entities that do not fall under FASB's new definition of a public business entity. Early adoption is not permitted under U.S. GAAP for public entities, but nonpublic entities may adopt the new standard as of the public-entity effective date. The standard is effective under IFRS for all entities beginning on or after Jan. 1, 2017. Early adoption is permitted under IFRS.
New Revenue Accounting Principles
The new standard provides accounting guidance for revenue arising from contracts with customers and affects all entities that enter into contracts to provide goods or services to their customers (unless the contracts are in the scope of other U.S. GAAP standards, such as leasing contracts). The guidance also provides a model for the measurement and recognition of gains and losses on certain sales of nonfinancial assets, such as property, plant, and equipment and real estate. It also addresses the accounting for some items not typically thought of as revenue, such as certain costs associated with obtaining and fulfilling a contract.
The standard's core principle is that a company will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under today's guidance in U.S. GAAP. These judgments include those relating to identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price, and allocating the transaction price to each separate performance obligation.
The five-step model: The guidance outlines the principles an entity must apply to measure and recognize revenue and the related cash flows.
The principles in the new standard will be applied using the following five steps:
- Identify the contract(s) with a customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price to the performance obligations in the contract; and
- Recognize revenue when (or as) the entity satisfies a performance obligation.
An entity will need to exercise judgment when considering the terms of the contract(s) and all of the facts and circumstances, including implied contract terms. An entity also will have to apply the requirements of the new standard consistently to contracts with similar characteristics and in similar circumstances.
Transition: Companies must adopt the new guidance using either a full retrospective approach for all periods presented in the period of adoption (with some limited relief provided) or a modified retrospective approach. Each approach requires a company to determine a cumulative effect adjustment at the date of initial application, including the income tax effects of the cumulative effect adjustment.
U.S. GAAP and IFRS differences: While the boards actually issued two separate standards (ASU No. 2014-09, which has been codified primarily in FASB's Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers, and IFRS 15), this item refers to them as a single standard. The standards under U.S. GAAP and IFRS are identical except for these areas: (1) The boards used the term "probable" to describe the level of confidence needed when assessing collectibility to identify contracts with customers, which will result in a lower threshold under IFRS than U.S. GAAP (The term "probable" under IFRS means "more likely than not"; however, under U.S. GAAP, it means "likely to occur."); (2) FASB required more interim disclosures than the IASB; (3) the IASB allows early adoption; (4) FASB does not allow reversals of impairment losses, and the IASB does; and (5) FASB provides relief for nonpublic entities relating to specific disclosure requirements, the effective date, and transition, while the IASB does not.
Tax Technical Considerations
U.S. tax principles governing the recognition of revenue: Generally, under U.S. tax principles, a taxpayer must recognize revenue for tax purposes under the "all events" test when (1) it has a fixed right to receive the revenue (which generally occurs on the earliest of when the revenue is due, received, or earned) and (2) the amount can be determined with reasonable accuracy. When analyzing the satisfaction or nonsatisfaction of the fixed-right-to-receive-income portion of the all-events test, consideration must be given to the existence of a condition precedent, which is a condition that must occur before the right to income arises and subsequently bars the accrual of income by a taxpayer until the condition is fulfilled.
If the means of ascertaining the proper amount of reportable income is not determinable within the tax year, the income is not reportable until some means for establishing the proper amount is established. For purposes of performing this analysis, consideration must be given to the use and degree of estimates employed in determining reportable income.
Revenue derived from the sale of goods generally is earned when the benefits and burdens of ownership pass to the customer. Revenue derived from the provision of services generally is considered recognized when the performance of the services is complete. While rare, certain tax rules require consideration of amounts reported for financial reporting purposes.
The special federal income tax rules that permit taxpayers to defer revenue recognition of certain advance payments received from the provision of goods, services, and other eligible sources under Regs. Sec. 1.451-5 or Rev. Proc. 2004-34 constitute one example of a tax rule that considers amounts reported for financial reporting purposes. For taxpayers applying a deferral method, the amounts deferred for tax purposes are determined by reference to the amounts deferred for financial statement purposes. If the financial reporting for advance payments changes under the new revenue recognition standard, taxpayers following a deferral method for tax for those advance payments may be required to file an application for a change in tax method of accounting (Form 3115, Application for Change in Accounting Method) or other filings as provided by the IRS (i.e., statement with the taxpayer's income tax return in lieu of a Form 3115).
Additionally, a taxpayer may change other tax methods of accounting for recognizing revenue to align with the recognition of revenue for financial reporting purposes, provided the financial reporting method also is a permissible method for tax purposes. A taxpayer seeking to change a tax method of accounting is required to file an application for the change in tax method of accounting (i.e., file a Form 3115) with the IRS National Office. Further, a discretionary change in tax method (i.e., one made at the company's election) may be required to be approved by the taxing authority.
State income tax implications: Many states require apportionment of federal taxable income to the states in which a company operates. Federal taxable income is typically apportioned based on the sales, payroll costs, and assets located in each state. To the extent that revenue for tax purposes is changed, a company may need to review its methodology for compiling sales apportionment data to determine if an alternate or additional data stream may now be required.
Indirect taxes: In addition to federal tax consequences, state and local indirect taxes may be affected by the change in the revenue recognition standard. This is because, in certain jurisdictions, the tax will be computed based on amounts reported for financial reporting purposes. In particular, companies should specifically review provisions of states that impose indirect taxes on gross receipts or revenue to understand the implications for those taxes. In addition, affected entities should evaluate the potential effect on other indirect taxes, including state net-worth taxes, as the cumulative effect of adopting the new standard will be recorded to retained earnings.
International subsidiaries: A U.S. company with foreign subsidiaries may have additional federal income tax considerations. To the extent that the foreign subsidiary's earnings are repatriated or are included on a federal tax return (i.e., application of Secs. 951—965, commonly known as subpart F), the amount of a distribution taxable as a dividend or the amount of a subpart F inclusion depends on the underlying earnings and profits of the foreign subsidiary for U.S. tax purposes. Careful consideration of the effect of adopting the revenue recognition standard is necessary to determine if a foreign subsidiary's tax earnings and profits are affected. In addition, foreign tax credits associated with a foreign subsidiary may be affected to the extent that a foreign subsidiary's local tax changes. Further, the information included on certain U.S. information returns may change as well.
In certain international jurisdictions, a foreign subsidiary's local tax liability is based on the subsidiary's statutory financial statements. In jurisdictions where local statutory financial statements are prepared in accordance with IFRS, the statutory financial statements may change with the adoption of the standard in that jurisdiction. Taxpayers will need to determine when and how any such change in statutory financial reporting is recognized for tax purposes.
Transfer pricing: Companies may need to review transfer-pricing policies and related documentation as a result of adopting the revenue recognition standard for financial reporting purposes. For example, transfer pricing may be based on the revenue or profit measures reported in the financial statements. Changes to these measures because of the adoption of the revenue recognition standard may affect intercompany prices, transfer-pricing policies, and related documentation.
Also, in developing and documenting its transfer-pricing policies, a company may look to comparable products or services sold by other companies and the related financial statement reporting. A company should consider the effect on its transfer-pricing policies and related documentation when these other companies experience changes in revenue recognized for financial reporting purposes for the comparable products or services.
Income Tax Accounting Considerations
Changes to temporary differences: When a company adopts the new accounting standard, the accounting policies related to revenue may not be consistent with the U.S. federal income tax rules. That is, the timing of when revenue is recognized for financial reporting purposes may not align with the timing of when revenue is recognized for U.S. federal tax purposes. Taxpayers may have new temporary differences or be required to compute an existing temporary difference in a different manner. Companies may need to revise their processes and data collection tools to capture any new temporary differences for tax reporting purposes. The following items are examples that may result in differences between the timing of revenue recognition for financial reporting purposes and the timing of revenue recognition for tax purposes:
- Performance obligations may differ due to the identification of sales incentives in the form of free goods or services, customer award credits or loyalty programs, or options for additional goods or services in the future (including renewals). To the extent that there are different identified performance obligations for financial reporting and tax, the pattern of revenue recognition may differ, as well as the amount of revenue recognized for each performance obligation.
- Transaction price may differ due to items such as variable consideration (including rebates, price concessions, performance bonuses, and rights of return), noncash consideration, consideration payable to a customer, and significant financing components. A different transaction price for financial reporting and tax purposes may result in a temporary difference because of a different pattern of revenue recognition and different amounts of revenue recognized for financial reporting purposes and tax purposes.
- The new standard requires significant judgment in distinguishing between customer credit risk (i.e., bad debt) and implied price concessions (i.e., transaction price). Due to the financial reporting treatment for the allowance for doubtful accounts and price concessions, a taxpayer will need to revisit the related temporary difference calculations.
- Contract costs may differ because the new revenue standard requires capitalization in certain circumstances. A different cost capitalization policy for financial reporting purposes and tax purposes will result in a different pattern of expense recognition for financial reporting purposes and tax purposes.
Additional considerations: Adoption of the new standard will likely result in a cumulative effect adjustment. The current and deferred tax consequences associated with the cumulative effect adjustment should be reported in the period of adoption and may require careful consideration of the income tax accounting effect of individual items that are included in the cumulative effect adjustment.
A multinational company also will have to consider the effects of changes in revenue recognition for financial reporting purposes on foreign subsidiaries. A jurisdiction-by-jurisdiction analysis is necessary to assess whether the change in revenue recognized for financial reporting purposes results in temporary differences due to differences in timing and amount of revenue recognized for financial reporting and tax purposes.
Changes in revenue recognition for financial reporting purposes also may result in changes to deferred tax assets, as well as expectations of future taxable income that arise as a result of the reversal of existing temporary differences. That is, the taxable and deductible temporary differences that arise from the application of the new revenue recognition standard likely result in different deferred tax assets and liabilities from those reported under the current revenue recognition guidance. As a result, a company should evaluate whether deferred tax assets that arise in the application of the new revenue recognition standard are realizable.
Future reversals of existing taxable temporary differences are a source of taxable income to be considered in determining whether a valuation allowance is required. Changes in taxable temporary differences as a result of the application of the new revenue standard may result in a change in the reversal pattern of temporary differences. Additionally, a change to revenue recognition may result in a change to the expectations of future taxable income (i.e., revenue is accelerated or deferred).
Further, to the extent that a company changes an accounting method for tax purposes, it is important to understand in which period the change in tax method is considered for financial reporting purposes.
EditorNotes
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
