April 18, 2017
New revenue recognition standards for financial reporting require careful planning and education to develop an implementation strategy. They may bring about substantial income tax consequences as well. Historically, many businesses found that the financial reporting standards and tax rules ran parallel and produced identical results; under the new standard this may no longer hold true.
A Brief History of Revenue Recognition Changes
The Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) unveiled new revenue recognition standards on May 28, 2014. The new standards were published concurrently as FASB Update No. 2014-09 (Topic 606) and IASB International Financial Reporting Standard 15. 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 standards apply to all other entities for annual reporting periods beginning after Dec. 15, 2018. It is assumed that a business will adopt the new standards both for purposes of keeping its internal books and for financial reporting purposes.
Although much of the focus on revenue recognition has been on implementing the financial reporting changes, the new standards affect income tax planning as well. For instance, some businesses recognized advance payments as revenue using tax rules that authorize a piggyback on the methods used for financial reporting purposes; such tax methods may now be invalidated or undesirable.
The new standards may also precipitate a deluge of applications to change accounting methods for tax purposes. On March 28, 2017, the IRS indicated in Notice 2017-17 that such applications 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.
A comparison of the significant components of the new standards to existing tax rules will help to demonstrate these concerns.
Revenue Recognition Rules for Tax Purposes
Taxable income must be computed using the same method of accounting that is used for financial reporting purposes, except where items are required or permitted to be computed under another method for tax purposes. To the extent financial reporting methods are inconsistent with specific 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 as the performance 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).
New Financial Reporting Rules – Probable Collection
Like existing financial reporting standards, the new standards specify that there must be a probable chance of collection in order to recognize any amount of revenue as a threshold matter. However, the new standards provide that an entity will not default to cash basis recognition when collection is not probable.
In comparison, the tax rules narrowly define a "doubtful collectability" exception to revenue recognition that may not dovetail with the probability standard and the new financial reporting concepts governing revenue recognition when probability does not exist. Revenue may therefore be recognizable for tax purposes even though it fails to be probable under the new financial reporting standards.
New Financial Reporting Rules – Bundled Contracts
Businesses historically have been required to treat bundled contracts of goods and services as a single unit of account under financial reporting standards, unless certain conditions were met to permit delineation of the contract into its separate elements.
In certain 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 standards, all businesses must now allocate sales price among performance obligations (distinct goods and services) based on the company's stand-alone selling prices for such products. 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.
New Financial Reporting Rules – Variable Consideration
The new standards do not deviate from existing tax rules when measuring the contracted amount of revenues for fixed price contracts. On the other hand, contracts with variable consideration call for revenue measurement based on expectations that are developed using estimates to quantify the amount of revenue. Such estimates are appropriate when it is probable that a significant reversal of revenues will not occur upon resolution of the contingencies or uncertainties. Variable revenues might include the seller's right to incentives or bonuses, or the seller's concessions for discounts, credits, rebates, refunds, or penalties.
When variable consideration is estimated under the new standards, 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.
New Financial Reporting Rules – Timing
The new standards also specify that a given amount of revenue is recognized 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 conferred at a single point or over time. When revenue is recognized at a point in time, such as with the sale of many goods, the determination of when control transfers is made by applying judgement to various factors, such as title transfer, possession, customer acceptance, or the buyer's 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. When revenue is recognized over time, such as with the sale of many services, the new standards provide 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 these new standards, revenue recognition for financial reporting purposes will involve many scenarios where the timing of revenue recognition will be substantially different. Such differences will often result in faster revenue recognition for advanced payments, particularly with cases involving variable consideration and bundled contracts. 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.
IRS Permission to Change Accounting Methods
IRS consent is required (using Form 3115) before a business can change its overall tax method of accounting or its tax method of accounting for a material item. Under regulations, a change in the method of accounting that is employed in keeping internal books requires IRS consent before the same method can be employed for tax purposes. These regulations would seem to require any business that experiences a change resulting from the new financial reporting standards to secure IRS consent, where tax conformity is desired. If a business 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. However, this tactic would disqualify the special tax method that is available to defer income recognition for advance payments.
Businesses that defer revenue recognition for tax purposes under the previously discussed exception for advance payments will also need to secure IRS consent to change tax accounting methods, in situations when there is a change to timing of recognition (including acceleration) when adopting the new financial reporting standards. This is so even when the intent is to continue utilizing the exception concerning advance payments for tax purposes.
The IRS request for comments in Notice 2017-17 builds upon a previous request for comments in Notice 2015-40 that was issued June 15, 2015. The IRS is soliciting feedback on procedures it is considering for businesses to obtain consent to change accounting methods as a result of the new financial reporting standards. The IRS also is soliciting feedback to identify areas where the new financial reporting standards are inconsistent with existing tax rules (such as issues now created with variable consideration and partially complete service contracts).
As the new standards are implemented for financial reporting purposes, businesses must reassess tax strategies associated with revenue recognition, and plan for a pervasive filing campaign that appears to be necessary concerning IRS permission to change tax accounting methods. For more information concerning the effect that the new standards will have on your business, please contact us.