By now, most companies are aware that FASB issued an Accounting Standards Update (ASU) for revenue recognition related to contracts with customers in May 2014 (ASU 2014-09, Revenue From Contracts With Customers (Topic 606)). Some companies may have already started planning the implementation for financial statement purposes. However, the effect of this change in financial accounting hits more than just the financial statements—significant changes could also be in store for tax purposes.
When FASB voted in July 2015 to delay the implementation of the ASU by one year, all companies likely breathed a sigh of relief. Originally, implementation was scheduled for January 2017. Recently, the effective date was changed to 2018 (years beginning after Dec. 15, 2017) for public entities, certain nonprofit entities, and certain employee benefit plans, and 2019 (years beginning after Dec. 15, 2018) for nonpublic entities, with an option to adopt early.
Even though implementation was pushed back, companies should get a jump on analyzing its effects and evaluating tax methods. Companies waiting until the last minute to understand the tax implications of the change may be at a disadvantage due to a change in information flow or timing for making crucial accounting method changes.
When FASB issued ASU No. 2014-09, the International Accounting Standards Board (IASB) simultaneously released IFRS 15, Revenue From Contracts With Customers. By doing so, FASB and the IASB have essentially achieved convergence of these standards, with only minor differences. The goal was to remove inconsistencies, not only between U.S. GAAP and IFRS, but throughout different industries, and to provide a more robust framework for analyzing revenue. Replacing industry-specific guidance, the ASU focuses on a new five-step analysis to be applied to all contracts with customers to transfer goods or services (other than leases, insurance, financial instruments, guarantees, and nonmonetary exchanges between entities in the same line of business). These steps include:
1. Identify the contract(s) with a customer;
2. Identify the performance obligations in the contract;
3. Determine the transaction price;
4. Allocate the transaction price to the performance obligations in the contract; and
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
The model indicates that revenue should be recognized when (or as) an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled. Depending on whether certain criteria are met, revenue is recognized either over time, in a manner that demonstrates the entity's performance, or at a point when control of the goods or services is transferred to the customer.
Practically all companies will be affected to some extent either by a change in timing of recognizing revenue or by the significant increase in required disclosures. In addition to increased disclosures, the impact on companies will vary depending on industry and current accounting practices. Companies will need to consider changes that might be necessary to information technology systems, processes, and internal controls to capture new data and address changes in financial reporting.
Although these standards relate to financial accounting principles, companies should use this opportunity to take a closer look at their tax methods related to revenue recognition. In many cases, companies will simply follow the book method of revenue recognition without much further analysis. The book method may or may not be a permissible method for tax purposes. In other cases, companies are following the book method to the extent allowed for tax, in which case changes to the book timing will affect the tax timing of recognition. Understanding whether the current method for tax purposes is permissible or optimal (in the case of multiple permissible methods) is an important first step in evaluating the tax effect of any book changes that will result from implementation of the new standard.
Additionally, a company cannot simply change its tax method of accounting for revenue recognition without requesting IRS consent on Form 3115, Application for Change in Accounting Method. In instances where the current tax method is permissible, financial accounting changes as a result of the new standard could affect or create new book-tax differences and deferred taxes related to revenue recognition. Companies also need to consider what information they need to compute these book-tax differences and whether the information will be available after the change for financial statement purposes.
General Tax Rules for Revenue Recognition
Under general tax principles of Sec. 451, a taxpayer must recognize revenue when it has a fixed right to receive the revenue, which generally occurs the earlier of when it is due (payable), paid, or earned, and the amount can be determined with reasonable accuracy. Revenue generated from the sale of goods generally is earned upon the sale when the benefits and burdens of ownership of the goods pass to the customer, which could occur upon shipment, delivery, acceptance, or title passage. Revenue generated from the provision of services generally is earned when performance of the required services (or divisible services) is complete. Revenue generated from licenses is generally earned over the term of the customer's use.
Although these are the general rules, the IRS does provide certain exceptions for amounts that are due or paid before they are earned (known as advance payments), which may be deferred for tax purposes under Regs. Sec. 1.451-5 for goods and Rev. Proc. 2004-34 for goods, services, use of certain intellectual property, and other eligible payments, both of which allow limited deferral that cannot exceed the financial accounting deferral. Taxpayers must be using one of these provisions to permissibly defer revenue beyond the year of receipt; thus, taxpayers simply following the book deferral are likely using an impermissible accounting method for tax purposes.
The deferral method under Rev. Proc. 2004-34 is more commonly used due to its broader applicability. It provides for a one-year deferral of any amounts deferred for financial statement purposes. Taxpayers using one of the deferral provisions for tax purposes will need to consider the impact that an acceleration of book revenue may have on their cash taxes. Additionally, the IRS considers a change in the underlying book method to be a method change for which consent is required; however, for those taxpayers using Rev. Proc. 2004-34, consent may be obtained automatically under Rev. Proc. 2015-14, Section 15.11. Other exceptions to the general revenue recognition rules of Sec. 451 are special provisions for installment sales (Sec. 453), long-term contracts (Sec. 460), nonaccrual-experience method (Sec. 448(d)(5)), and interest accruals (Regs. Sec. 1.448-2).
A "long-term contract" under Sec. 460 is any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the tax year it was entered into, and in most cases requires use of the percentage-of-completion method to recognize revenue. Companies typically follow their financial accounting treatment for long-term contracts, which may also use a percentage-of-completion method, whether or not it complies with the tax rules.
Companies that currently follow the financial accounting treatment and recognize revenue on a percentage-of-completion basis for tax purposes can consider two alternatives:
1. The company should determine whether its long-term contracts meet the definition in Sec. 460. If a company is not required to use the percentage-of-completion method for tax purposes (e.g., a manufacturer of a nonunique item that takes less than 12 months to complete), it is permitted to change its tax method of accounting to recognize revenue on an accrual basis (i.e., shipment, delivery, or transfer of title), which may result in the deferral of revenue for tax purposes.
2. If the company is required to use the percentage-of-completion method under Sec. 460, the second consideration is whether the specific method being used complies with the regulations. Generally, certain aspects of the percentage-of-completion method for financial statements differ from the required tax method and will continue to diverge from the tax rules under ASU No. 2014-09. If the taxpayer is currently following the financial accounting method to recognize revenue and that method is not permissible for tax purposes, it should change to a permissible method of accounting under Sec. 460, which would create a book-tax difference related to revenue recognition.
Tax Accounting Method Considerations
It is important to understand that if a company's tax method has been following financial accounting and the company changes its book method, it cannot simply change its tax method to follow the new book method. Rather, it needs to evaluate whether applying the tax rules would result in the same answer as the new book method, and if so, the company will have to file a Form 3115 to change its tax method to implement it on its tax return.
If a taxpayer wants to change its tax method of accounting for an item, it must do so by filing Form 3115 to request consent from the IRS. For certain changes enumerated in Rev. Proc. 2015-14, IRS consent is automatic if the taxpayer meets certain eligibility requirements. All other changes require advance consent. An automatic method change is due by the extended due date of the federal income tax return, and an advance consent method change is due by the last day of the tax year of change. For automatic changes, the IRS will permit the taxpayer to use the new method of accounting upon the filing of Form 3115. For advance consent changes, the IRS will permit the taxpayer to use the method only after consent has been granted and the taxpayer has accepted the terms and conditions required to make the change.
Tax Procedural Rules: Rev. Proc. 2015-13 and Rev. Proc. 2015-14
In January 2015, the IRS issued two revenue procedures (Rev. Proc. 2015-13 and Rev. Proc. 2015-14) that update the procedural rules to change a method of accounting for federal income tax purposes. Rev. Proc. 2015-13 updates and revises the general procedures under Sec. 446(e) to obtain IRS consent. Furthermore, Rev. Proc. 2015-13 combines the procedures to obtain the advance consent and automatic consent into a single revenue procedure, replacing Rev. Proc. 97-27 and Rev. Proc. 2011-14. The accounting method changes required to be filed under the automatic consent procedures are separately listed in Rev. Proc. 2015-14. A company should refer to these revenue procedures when evaluating the need to change its tax method. Most changes related to revenue recognition are not currently included on the list of automatic changes, so companies should plan ahead for the additional effort and earlier deadline required to file an advance consent change.
However, ASU No. 2014-09 has not gone unnoticed by the IRS. In May 2015, the IRS issued Notice 2015-40, requesting comments regarding the possible effects of the new revenue recognition standard on a taxpayer's tax accounting methods. The IRS requested comments about how the new standard deviates from the tax revenue recognition rules, how taxpayers will be affected by the change, and what types of method changes, if any, would arise for tax purposes. The IRS is evaluating comments that have been submitted; however, it is too early to determine what specific guidance will be issued. Many taxpayers hope that additional automatic method changes related to revenue recognition will be included in the guidance.
Looking at revenue recognition methods sooner, rather than later, will put companies at an advantage and make the implementation process smoother. It is important to make sure that tax considerations are part of the upfront discussion and not an afterthought. Taking a fresh look at the tax methods around revenue recognition will be key in understanding the effect of any book changes.
Taxpayers will want to thoroughly assess all of their revenue streams and assess the proper tax methods for each to plan the appropriate actions for a successful implementation. The new standard presents a unique opportunity for taxpayers to revisit their tax methods for revenue recognition to not only ensure compliance with the tax rules, but also to take advantage of tax opportunities and planning around revenue recognition.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.