Just as tax is the last thing to happen in a financial statement close, it seems to be the last thing happening in preparing for the new revenue recognition requirements as well.
“People are scrambling,” says Mike Mathieson, a senior advisor at Valuation Research Corp. “People are going to mobilize and turn it into a crusade at this point.”
Tax rules are not changing, but the new five-step method that public companies must begin to follow in 2018 changes the accounting method for recognizing revenue in financial statements. That means companies may be facing method changes for tax purposes as well, and that raises huge tax compliance and reporting implications.
“A lot of people forgot about that until now,” says Mathieson. “They are scrambling like crazy.”
Accounting for financial reporting purposes and accounting for tax purposes are two different animals. For financial reporting purposes, or book purposes, companies follow GAAP rules established by the Financial Accounting Standards Board and enforced by the Securities and Exchange Commission. But for tax purposes, they follow tax rules under the U.S. Treasury and the Internal Revenue Service.
Income in the income statement is not necessarily income on the tax return—at least not always at the same time. Differences in the two sets of rules often lead to differences in timing for when income appears in financial statements and when it becomes income for tax reporting purposes. Tax experts refer to them as book rules and tax rules.
The IRS requires companies to follow an established method for recognizing income for tax purposes, and it requires companies to ask for permission to change their method. If they will be following one of a number of pre-approved methods, the “automatic consent procedure” is fairly straightforward, says Sheryl VanderBaan, a partner in the tax services group at Crowe Horwath. They can simply fill out an extra form and attach it to the next tax return that employs the new method.
If their intended new method varies from any pre-approved methods, however, companies must seek advance consent from the IRS. That means a costly filing, an analysis by the IRS, and an approval that must be secured before the return incorporating that method can be filed.
“I’m seeing a lot of tax people that have not focused on this yet at all. It’s not surprising, in all honesty, because you have to wait until the book people figure out what they are going to do.”
Sheryl VanderBaan, Partner, Tax Services, Crowe Horwath
While many companies put off consideration of the new revenue recognition rules both for book and tax purposes, the Internal Revenue Service certainly took notice when the Financial Accounting Standards Board approved its sweeping new standard in 2014 for how to recognize revenue in financial statements. If companies would be changing their book accounting for income, that meant they might likely need to change their tax accounting method, the IRS recognized.
Anticipating the potential onslaught of requests that might arise due to the accounting change, the IRS issued a request for comment on whether it should revise its procedures for granting permission to method changes. In its 2015 notice asking for input, the IRS notes the new accounting standards for book purposes raise a number of big issues for the IRS, including whether the new standards produce permissible methods of accounting for federal income tax purposes, or whether a huge tranche of companies would be in a position of needing to ask for permission to make method changes.
The IRS notes the new accounting standard may affect the timing of income for tax accounting purposes, especially for entities using the percentage of completion method, deriving income by providing services, using bill-and-hold transactions for the sale of goods, accounting for sales and returns of goods, and earning income from warranties.
Hearing little feedback on its 2015 request for comment, the IRS moved forward with a proposal in 2017 to revise its permission procedure to make it easier for companies to change their methods. But that’s a small bit of good news among a mountain of work that still must be done as companies begin to face compressed timelines to complete it.
“I’m seeing a lot of tax people that have not focused on this yet at all,” says VanderBaan. “It’s not surprising, in all honesty, because you have to wait until the book people figure out what they are going to do.”
Mathieson says he sees companies still in “phase one” of the transition from a tax standpoint. “What is changing from an accounting perspective? Then in phase two you need to analyze what that means from a tax perspective. People scrambling now is indicative of the whole process companies have gone through.”
IRS REQUEST FOR COMMENTS
This notice sets forth proposed procedures for obtaining IRS consent to a qualifying same-year method change. In connection with this notice, the Treasury Department and the IRS request comments on all aspects of the proposed procedures and on the specific method change issues identified in Notice 2015-40. Comments are specifically requested on the following issues:
1. Is the exception for small businesses in paragraph 5.02(2) of the proposed revenue procedure appropriate?
2. What types of changes in methods of accounting do taxpayers anticipate requesting?
3. Do taxpayers anticipate requesting changes in methods of accounting prior to the effective dates of the new standards?
4. Which procedures should taxpayers be required to use to request permission for a qualifying same-year method change, the automatic accounting method change procedures or the advance consent procedures?
5. What changes, other than those described in Section 5 of the proposed revenue procedure, do taxpayers expect will be requested in the year the taxpayer adopts the new financial standards, and should they be allowed as automatic changes?
6. What related accounting method changes do taxpayers anticipate requesting that may appropriately be made on a single Form 3115?
7. If multiple changes are requested on a single Form 3115, should the taxpayer report a separate § 481 adjustment for each change and should those adjustments be netted and a single spread period applied?
8. What alternatives to filing a Form 3115 would reduce the burden of compliance?
9. What transition procedures may be helpful?
10. What additional procedural changes would be appropriate and helpful?
WHERE TO SEND COMMENTS
Comments must be submitted by July 24, 2017. Comments, identified by Notice 2017-17, may be submitted using one of the following methodsBy Mail:
Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2017-17)
P.O. Box 7602
Ben Franklin Station
Washington, D.C. 20044By Hand or Courier Delivery: Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: Courier’s Desk
Internal Revenue Service
1111 Constitution Avenue, N.W. Washington, D.C. 20224Electronic: Alternatively, persons may submit comments electronically to Notice.Comments@irscounsel.treas.gov. Please include “Notice 2017-17” in the subject line of any electronic communications.
By a number of indicators, companies did not use the extended lead time FASB allowed companies to adopt the standard to actually prepare for implementation. Many companies have said they will not see a material effect from the standard, and experts say many companies dismissed the significance of the process change that would be necessary to follow the new method.
Mathieson concedes in a former role as an assistant corporate controller, he too believed the effect would not be particularly dramatic. “It’s not that people are not capable or it’s too complicated,” he says. “It was a function of focus for a long time. We never really thought about tax consequences.”
Greg Bocchino, a partner and tax lead for revenue recognition at KPMG, says he’s observing companies really ratcheting up efforts to design processes for the financial accounting side of the new standard. “We’re observing there’s definitely an acknowledgment now that there are significant tax considerations and impacts as it relates to a standard as far reaching as revenue recognition,” he says.
While many companies are still working on developing the new accounting processes, Bocchino believes tax people probably have enough information at least directionally at many companies to get tax preparations under way. “This is going to happen so quickly as we get closer to Q1 of 18, if the tax function doesn’t start to assess, there’s a risk the tax function is going to be doing a lot of work at the eleventh hour,” he says.
In terms of establishing an accounting method for reporting income for tax purposes, companies will have to take whatever accounting conclusions are reached to comply with the new accounting requirements and determine whether they can follow the same method for tax purposes. Depending on how that works out, they may or may not need to seek IRS permission for a method change.
If tax departments determine they need a different method or tweaks to the book accounting method for tax purposes, that suggests there will be timing differences in when book rules and tax rules recognize income, which could lead to deferred tax issues that need to be tracked closely. “It sounds easy, but if financial accounting is no longer a user of historic data because they are accounting for things differently, then tax needs to be there to say we were a user of this old system that may be unplugged,” says Bocchino. Tax needs to speak up to be sure that data remains available.
The year of transition to the new revenue recognition method also carries big tax consequences, because many companies adopting the new accounting on a modified retrospective basis will be computing cumulative catch-up adjustments, which may flow into retained earnings instead of income. “For tax purposes, cumulative adjustment is a problem,” says VanderBaan. “If it goes into retained earnings and doesn’t go into income, that’s a tax problem.”
Christian Wood, a principal in the Washington national tax practice at audit firm RSM, says the new accounting will enable the acceleration of revenue recognition for certain types of performance obligations compared with how it would be recognized for tax, especially for certain intellectual property agreements. Companies will have to decide if they want conformity across book and tax, or if they might realize a tax benefit by deferring the income for tax purposes. That’s a tax planning decision they need to make as they determine the accounting and tax reporting they will follow, he says.
Companies should especially consider their tax accounting methods in light of the potential for tax reform, which seeks to lower corporate tax rates, says Ellen Martin, a partner in Grant Thornton’s Washington national tax office. “If you’re reviewing revenue recognition for book, it’s also a really good time to review it for tax purposes,” she says. “Maybe you have a method that was set up years ago. Maybe things have changed. Especially with tax reform on the horizon, if there’s a rate cut, deferring revenue into later years would create a permanent benefit.”