Changes in how revenue is recognized for financial statement purposes under generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) may have significant implications on the tax revenue recognition methods currently used by many taxpayers. Since most taxpayers either follow book revenue recognition methods or determine tax revenue based on book income, changes in how revenue is recognized for financial statement purposes will impact how taxable income is calculated as well as affect other tax and nontax calculations.
On May 28, 2014, new financial accounting standards were issued for recognizing revenue from contracts with customers. They are effective for annual reporting periods beginning after Dec. 15, 2018, for most taxpayers. Publicly traded entities, certain not-for-profit entities and certain employee benefit plans must implement the standards one year earlier (i.e., for annual reporting periods beginning after Dec. 15, 2017).
The new standards require revenue to be recognized when an entity transfers a promised good or service to a customer and the customer takes control. This transfer occurs at either a point in time or over a period of time. Right to payment, transfer of legal title, physical possession and acceptance are all indicators that control has passed from the entity to the customer at a point in time. When performance occurs over a period of time, the timing of recognizing the revenue can be a more complex analysis. In most cases, once the transfer of control takes place, the entity recognizes the associated revenue on the books.
Software, entertainment, manufacturing and construction entities may be particularly affected by the new rules due to the prevalence of business practices and accounting methods, including:
- Percentage-of-completion method
- Income from services
- Revenue from bill and hold sale transactions
- Sales and returns of goods
- Income from sale of warranties
As an example, companies with long-term construction or manufacturing contracts may use the percentage-of-completion method, whereby revenue is recognized for tax purposes based on satisfaction of performance obligations or stages of progress. Under the new revenue recognition standards, these companies may have to recognize revenue on their books when delivery is made or as products are produced, potentially accelerating or decelerating taxable income depending on timing. Furthermore, expenses may be recognized differently from the associated revenue since these new standards are not profit-based. Consequently, additional book-to-tax differences may result.
New IRS guidance
Since issuance, the IRS has been evaluating the impact of these new revenue recognition standards on taxpayer methods of accounting. In proposed guidance released in late March, the IRS appears to be leaning toward providing taxpayers with the ability to make changes using more favorable automatic change procedures, including:
- additional time to file a Form 3115, Application for Change in Accounting Method
- filed by due date of the extended tax return
- no user fee payment required
The guidance would also permit small taxpayers (currently defined as those with $10 million or less in total assets or average annual gross receipts of $10 million or less) to reduce the compliance burden by using a cut-off method. Small taxpayers can apply thresholds at the trade or business level, rather than in the aggregate, which should enable more taxpayers to qualify for the simplified cut-off approach. If finalized in their current form, these favorable procedures will only be available for a limited time (i.e., tax method change(s) must be implemented in the same year the new standards are adopted).
Presumably, taxpayers that failed to file otherwise non-automatic method changes within the prescribed time frame would be required to apply for consent under the more onerous and costly advance consent procedures. Therefore, taxpayers are advised to begin assessing the impact of the new revenue standards on their current tax revenue recognition methods, so they are prepared to implement any necessary accounting method changes within the timeline specified once final guidance is adopted. While the effective dates of the new revenue recognition standard appear far off, the transition process is expected to require significant time to complete given the broad scope and complexity of the new rules.
Taxpayers should act now to coordinate adoption of the new standard with their auditors and tax preparers if they are affected by these new rules. Conversations should include identification of which revenue streams are impacted and at which stage the taxpayer is in the process. Once these discussions have taken place, evaluation of any tax accounting method change(s) should be performed in order to convert to compliant method(s) or to follow the new book accounting method(s).
Please see our dedicated revenue recognition page.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.