Changes in how revenue is recognized for financial statement purposes under US 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 affect not only how taxable income is calculated, but also potentially other tax and nontax calculations.
As further explained below, the IRS is evaluating the impact of the new standards on taxpayers’ methods of accounting and is expected to issue procedural guidance to implement such method changes. Software, entertainment, life sciences, manufacturing, and construction industry businesses are likely to be particularly affected by the new guidance, which makes significant changes to revenue methods commonly employed in these industries for items such as:
- Percentage of completion method
- Income from services
- Revenue from bill and hold sale transactions
- Sales and returns of goods
- Income from sale of warranties
New accounting standard
Generally effective for nonpublic entities for years beginning after Dec. 15, 2018 (Dec. 15, 2017, for public entities, certain nonprofit entities, and certain employee benefit plans), the Accounting Standards Update (ASU) applies a five-step analysis to all contracts with customers to transfer goods and services (other than leases, insurance, financial instruments, guarantees, and nonmonetary exchanges between entities in the same line of business). See Baker Tilly's Assurance Services page for further details and resources on the five-step analysis and the revenue recognition accounting standard.
Current tax requirements
Under federal tax principles, revenue is generally recognized using the “all-events” test under IRC section 451 where the taxpayer has (1) a fixed right to receive the revenue (usually the earlier of when the revenue is due, received, or earned) and (2) the amount can be determined with reasonable accuracy. In some circumstances, certain advance payments received from the provision of goods, services, and other eligible sources may be deferred for one to two tax years. Changing how revenue and/or advance payments are recognized for tax purposes generally constitutes a change in accounting method that requires IRS consent to implement (i.e., by filing Form 3115, Application for Change in Accounting Method).
In Notice 2015-40, the IRS raised multiple questions, including whether these new standards are permissible for federal tax purposes, what types of accounting method change requests will be required from adopting the new standards, and whether current IRS procedures can accommodate such requests. Specific issues raised include:
- To what extent do the new standards deviate from the requirements of section 451? How do they affect deferral of income?
- What types of changes in methods of accounting do taxpayers anticipate requesting?
- Should taxpayers be required to use the automatic consent accounting method change procedures or the advance consent procedures to request permission to change a method of accounting and why?
- Will advance or automatic consent procedures or other procedural guidance (such as Rev. Proc. 2004-34) need to be modified and, if so, how?
- What transition procedures may be helpful?
- What related accounting method changes do taxpayers anticipate requesting that may be appropriately made on a single Form 3115?
While the new standards do not take effect until tax years beginning after Dec. 15, 2018, for many businesses, a review of current and proposed book and tax accounting methods and revenue recognition is important in order to plan now for the repercussions and evaluate whether tax accounting method change(s) are necessary or desired to change to compliant method(s) or to follow the new book accounting method(s) or, alternatively, whether the client tracks the necessary data to continue using the current revenue recognition method(s). National tax resources are available to assist in this process. Public companies will need to accelerate this process as the new revenue recognition rules go into effect one year earlier for these entities and because income tax provisions of public companies may need to include the impact of new standards prior to actual adoption.
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.