Evolving Revenue Recognition Issues: Manufacturers

Editor: Mary Van Leuven, J.D., LL.M.

In May 2014, the International Accounting Standards Board and FASB each released a new accounting standard that addresses when revenue from contracts with customers for goods or services is recognized for financial statement purposes. The new standard replaces much of the existing U.S. GAAP and IFRS guidance with a five-step model for revenue recognition. Public business entities, certain not-for-profit entities, and certain employee benefit plans will be required to use the new guidance for annual reporting periods beginning after Dec. 15, 2017, including interim reporting periods within that reporting period. Earlier application will be permitted only for annual reporting periods beginning after Dec. 15, 2016, including interim reporting periods within that reporting period.

All other entities would apply the new guidance to annual reporting periods beginning after Dec. 15, 2018, and to interim reporting periods within annual reporting periods beginning after Dec. 15, 2019. Application would be permitted earlier only as of an annual reporting period beginning after Dec. 15, 2016, including interim reporting periods within that reporting period, or an annual reporting period beginning after Dec. 15, 2016, and interim reporting periods within annual reporting periods beginning one year after the annual reporting period in which an entity first applies the guidance. Although the effective dates seem a long way off, the new rules may result in retrospective or cumulative catch-up adjustments; time is of the essence for assessing the impact on both financial and tax reporting.

The Five-Step Model

Under the new standard, entities must use a five-step model to determine the amount of revenue to be recognized in a financial reporting period. The steps are:

1. Identify the contract(s) with the 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;

5. Recognize revenue when (or as) the entity satisfies a performance obligation.

The five-step model may result in differences from current GAAP, and its application to manufacturers will generally depend on the company’s type of manufacturing business as well as contracting practices. After applying the guidance in the new standard, a manufacturer will recognize revenue either over time if certain criteria are met, in a manner that reflects performance; or at a point in time, when (or as) it transfers control of the goods to the customer. Thus, any step in the five-step model may cause a significant departure from current financial reporting practices that, as described below, may also have significant income tax implications.

Income Recognition for Tax Purposes

For tax purposes, a company using an accrual method recognizes income using the all-events test, that is, when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy (Regs. Sec. 1.451-1(a)). The courts and the IRS have interpreted the all-events test to mean that income becomes fixed at the earliest of when it is received, due, or earned (see, e.g., Schlude, 372 U.S. 128 (1963)). Thus, if a company receives an advance payment before the goods or services are provided, as a default matter, the payment is included in gross income upon receipt. However, two commonly used exceptions permit a taxpayer to defer the recognition of income from advance payments.

The first, in Rev. Proc. 2004-34, permits deferral for one year of the advance payment to the extent it is not recognized for book purposes in the year of receipt. Rev. Proc. 2004-34 applies to advance payments for services, goods, use of intellectual property, and certain other items. The second exception, in Regs. Sec. 1.451-5, generally permits a two-year deferral of advance payments for goods and in certain cases for longer periods (subject to the limit that tax deferral may not exceed book deferral). Both exceptions provide that income may not be recognized later for tax purposes than for financial statement purposes. As a result, a change in recognition under the new financial reporting standard may also change the timing of revenue recognition for tax purposes. As mentioned below, the IRS views this type of change as a change in method of accounting.

Finally, Sec. 460 and the regulations require the use of the percentage-of-completion method (PCM) for certain long-term manufacturing contracts. Under the PCM, income is recognized on the proportion of costs incurred during the year to total projected costs. The five-step model provides a number of options (e.g., input or output measures for measuring progress) that a taxpayer may use to account for long-term contracts, some of which rely on a cost-to-cost measure but some of which do not. In addition, the new standard does not allow an entity to defer costs when the performance obligation is satisfied over time but, rather, only if certain criteria are met.

While the old GAAP rules used a profit-recognition standard, the new standard focuses only on revenue. If an entity does not use a cost-to-cost measure of progress, then margins may vary. Thus, the five-step model may create new book-tax differences that must be identified and tracked. In addition, the new standard requires a significant number of new disclosures. These disclosures may provide the IRS with additional information about differences in book and tax methods.

How the New Standard May Have an Impact

Incentive payments (variable consideration): Suppose a company enters into a four-year contract to produce 200 widgets per year at $1 each, with an additional $400 bonus paid in year 4 if all widgets are delivered on time; and that the company anticipates it will receive the full $400 bonus and in fact does.

Under present GAAP, the company would recognize $200 each year for widget sales, while it would recognize the incentive payment only in year 4 when the contingency is resolved; this treatment coincides with tax income recognition under the all-events test. Under the new book standard, the incentive payments would be required to be estimated as part of the transaction price and allocated to the performance obligations, and revenue would be recognized to the extent it is probable that a significant reversal in cumulative revenue recognized will not occur. Therefore, the company would recognize $300 in each of the four years, i.e., $200 for widget sales and $100 for each one-quarter of the incentive payment. For tax purposes, revenue recognition would remain the same as before.

Contract manufacturing: Suppose a calendar-year contract manufacturer executes an agreement with a third party in June of year 1 to produce 1,000 circuit boards based on the customer’s design over two years for $1 each. Further assume the contract manufacturer completes and delivers 400 circuit boards in year 1 and has 300 additional circuit boards 50% complete by the end of year 1. Further assume the remaining 600 circuit boards are completed and delivered in year 2.

Under present GAAP, contract manufacturing is generally treated as a product sales arrangement, and revenue is recognized when goods are shipped or delivered. Accordingly, the manufacturer would recognize revenue of $400 in year 1 and $600 in year 2 for both financial statement and tax purposes. Under the new standard, assuming the contract manufacturer cannot sell the products to another customer and has a right to payment for performance to date if the customer cancels the contract, the contract manufacturer would recognize revenue over time as the goods are completed, similar to a service provider. Thus, revenue may be recognized on the work in process in addition to the products delivered in year 1, with the remainder recognized in year 2 (i.e., $550 in year 1 and $450 in year 2). The contract manufacturer would expense costs as incurred rather than carry them in inventory (incremental costs of obtaining the contract and costs to fulfill the contract that meet certain criteria can be deferred). The tax treatment, though, remains as before.

Advance payments: Suppose that in the contract manufacturing example immediately above, the customer paid the entire $1,000 at the outset of the arrangement in year 1. Book recognition under the old and new standards would be expected to be as described, with deferred revenue being present at the end of year 1. The contract manufacturer would, under the tax authorities identified above, have established a method of accounting under which the advance payment is recognized as income upon receipt or, alternatively, is recognized to the extent of book treatment in year 1, with the remainder recognized in year 2. The change in book recognition and corresponding change in tax recognition under the latter deferral method would be treated as a change in method of accounting. Note that, to the extent that there is imputed interest for book purposes because of characterization of the transaction as a significant financing, that treatment may give rise to additional book-tax differences.

In short, it is possible to have several outcomes. If the timing of book revenue changes but the tax treatment remains the same, companies will need to determine the impact on systems needed to retain any necessary information as well as consider the effects of any new book and tax differences. If timing of book revenue does not change and the tax treatment is to follow the financial statement treatment in part or in whole, companies may need to change methods of tax accounting. Other permutations include book revenue recognition remaining the same, or simultaneous yet different changes in book and tax income recognition.

Change in Method of Accounting

If a new tax accounting method is required or desirable upon implementation of the five-step model, Sec. 446(e) requires the entity to obtain permission from the IRS in the first year of the change. The filing procedures and timing vary based on whether the change is automatic; see generally Rev. Proc. 2015-13 for the current procedures for filing the related Form 3115, Application for Change in Accounting Method. On the other hand, the creation of a new book-tax difference arising from a change in the financial statement treatment of an item does not itself require a change in method. If a company wants to change its method of accounting to follow a new book method that is also permitted for tax purposes, a change in method of accounting is generally required. Note that, if the company is using Rev. Proc. 2004-34 to defer advance payments and changes methods for financial statement purposes, the company files a statement (on a cutoff basis) with its tax return for the year in which the financial statement deferral changes (see Rev. Proc. 2015-14, §15.11).

Conclusion

It will be important for the tax department to be an active participant as the accounting function wrestles with the impact of the new revenue recognition standard. As indicated above, potential impacts for federal income tax reporting purposes include changes to the company’s book-tax differences, or even tax accounting method changes. The new revenue recognition standard may also have implications for accounting for income taxes, transfer pricing, foreign tax accounting methods, state income tax apportionment factors, and net-worth or capital-based taxes.

EditorNotes

Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2016 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.