The Tax Cuts and Jobs Act (TCJA) introduced an additional test for when sales, gross receipts, and other items of income (collectively, sales) are recognized. The new test may cause significant changes to the timing of when incomes taxes are due and the amount of deferred taxes included in financial statements.
In December 2018, the Joint Committee on Taxation published its explanation of tax law (aka “Blue Book”) that clarifies when sales should be recognized for income tax purposes. Under the TCJA, an entity that has an applicable financial statement (typically an audited financial statement prepared under U.S. Generally Accepted Accounting Principles (US GAAP)) and that applies the all events test to determine when sales are recognized for tax purposes must, in taxable years beginning after Dec. 31, 2017, recognize a sale generally at the earlier of when the all events test is met or when the sale is recognized in the applicable financial statement. Entities that apply a special method of accounting instead of the all events test would not be subject to the earlier of test.
When preparing US GAAP financial statements, entities must determine whether the new earlier of test will result in income taxes payable or deferred income taxes in the financial statements. Complicating the analysis the new revenue recognition guidance under ASC Topic 606 may accelerate financial statement revenue recognition.
For federal income tax purposes, an entity first determines if gross income is clearly realized, and the Blue Book clarifies that this historical requirement is unchanged. If gross income is clearly realized, then the entity proceeds to the next step of the historical requirements to determine when it should be recognized. The new earlier of test affects the timing of when gross income is recognized for tax purposes. This can lead to different conclusions on the need for a deferred tax asset or liability based on why financial statement revenue is earlier. The following summarizes two of the illustrative examples in the Blue Book.
Over Time Revenue Recognition
Assume an entity manufactures a custom machine that qualifies for over time revenue recognition under ASC Topic 606. Manufacturing of the machine begins in year one and the machine is delivered in year two. Payment of $50,000 is due upon delivery. Under ASC Topic 606, the manufacturer determines $30,000 of revenue should be recognized in year one and the remaining $20,000 in year two. Under the TCJA, the manufacturer would apply the earlier of test and recognize the sale for tax purposes at the same time as its applicable financial statement. Prior to the earlier of test, the manufacturer would not have recognized any sales in year one for income tax purposes and would have had a deferred tax liability.
Assume an entity enters into a three-year contract to provide services to a customer. The contract provides for a $4,500 bonus if certain conditions are met at the end of the three years. Under ASC Topic 606, the entity concludes in year one that it expects to receive the bonus and should include the bonus as part of the transaction price, recognizing $1,500 of the bonus in each year. For federal income tax purposes, the bonus has not been realized until all the necessary material conditions are met, and the earlier of test does not change this result. Even though the revenue was recognized in an applicable financial statement, the entity defers recognition of the bonus for income tax purposes until year three. As a result, the year one and year two financial statements of the entity include a deferred tax liability related to the bonus.
Keep in mind that although the interpretations included in the Blue Book are helpful in interpreting tax law, they do not constitute official legislative history.
There May Be More Impact on Income Tax Accounting
The above illustrates just one change related to the TCJA that impacts the accounting for income taxes. There are other changes that may also impact the accounting for income taxes, including areas without interpretive guidance. For instance, the TCJA introduced a requirement to allocate revenue to performance obligations in the same manner as done in an applicable financial statement, and there has not yet been guidance provided for how to apply that rule to free goods and services or renewals recognized as performance obligations under ASC Topic 606.
As a result of the interaction of the TCJA and Topic 606, the accounting for income taxes is likely to be one of the more challenging and evolving areas of US GAAP. When accounting for income taxes and preparing financial statements it will be important to be aware of interpretations and changes occurring to ensure all relevant considerations are made.
Published on March 19, 2019