On the long list of issues companies will need to address as they adopt the new revenue recognition standard, tax consequences are—or more accurately, should be—gaining more attention.
The Internal Revenue Service is even contemplating how extensive and potentially burdensome the tax consequences could become, both for taxpayers and for itself. The IRS put out a notice in July expressing its concerns and asking for public comment on whether some change in tax policy or administrative procedures might be warranted.
“I don’t think a lot of companies are yet aware of the tax implications here,” says Eric Lucas, principal in KPMG’s national tax practice. “As a firm, we’re trying to advise as many of our clients as we can of the concerns. I’m not sure a lot of tax departments are that focused on it just yet.”
The Financial Accounting Standards Board and the International Accounting Standards Board adopted new standards that require a five-step method for determining when and in what amounts companies should recognize revenue in financial statements. In order, companies are required to: identify each contract with customers; define the performance obligations contained in each contract; determine the transaction price; allocate that price across those performance obligations; and then recognize revenue as each performance obligation is satisfied.
That five-step method for bookkeeping purposes is not synchronized with tax rules on when companies should recognize income for tax purposes. Tax law focuses on the “all events” test, Lucas says. It is a requirement that all events involved in a taxpayer’s right to incur income or expense must occur before a taxpayer can report an item into income or expense. “In any of the five steps, there could be areas where tax is not able to follow what book is doing,” Lucas says.
Variable consideration, for example, is a critical concept in the recognition of revenue for financial statement purposes, where companies will be required to use estimates and judgments to determine when to recognize revenue for certain performance obligations. Tax rules, however, do not allow taxpayers to recognize income if there are any material contingencies on the income, Lucas says. “This is where the most significant change is going to occur,” he says.
Even under existing accounting rules, companies track and manage differences in when they recognize revenue for book versus tax purposes, but those differences are likely to change and grow under the new standard. It will be especially tricky for revenue that will be deferred under the new accounting rules, but can’t be deferred under tax rules, says A.J. Schiavone, director in the tax group at Crowe Horwath. “Tax rules provide for only limited deferrals for advance payments,” he says. Companies will need systems and controls to track such differences and assure they are reported properly.
Some companies will be affected more than others, Schiavone says. Just as companies in certain sectors are most likely to see big changes in how they recognize revenue, companies in those same industries are likely to see the biggest tax consequences. That might include media and entertainment, software, telecommunications, aerospace, construction, and real estate, he says. “It’s certainly going to depend on the nature and complexity of transactions,” he says.
“[The IRS’s] main objective is to increase revenues from taxes. This is contrary to that. They’re going to have to contemplate whether this is an acceptable change for their purposes.”
Peter Bible, Partner, EisnerAmper
The IRS notice says companies that are likely to see the biggest differences are those currently following the percentage-of-completion method to recognize revenue (common in the construction sector) and those who earn income by providing services. Others likely to feel the pinch include those companies that engage in bill-and-hold transactions for the sale of goods, those accounting for sales and returns of goods, and those earning income from warranties.
Don’t Forget the Filing Headaches
Beyond preparing to track those differences in revenue recognition timing, companies also will face complexities in IRS filing requirements when they change their method of book accounting. The IRS requires companies to ask for permission to change their accounting methods for tax purposes, either by an advance consent procedure or an automatic procedure. The IRS is wondering just how many companies are going to file such consent requests, and what the administrative burden of managing all those requests will be like.
TAX FACTS & IMPACTS
Below, KPMG outlines significant changes under the new revenue standard and how the standard will affect taxes.
Under the new revenue recognition standard entities may be required to change the timing or amount of revenue reported in financial statements for a variety of reasons, including the following.
The seller’s price is no longer required to be fixed or determinable.
Software companies are not required to have vendor-specific objective evidence (VSOE) of the fair value of undelivered items to separate the undelivered items from the delivered software license.
Revenue may be recognized over time or at a point in time depending on the circumstances and terms of the contract. In some cases, entities that currently recognize revenue upon delivery may recognize revenue over time while some entities currently recognizing revenue over time may recognize revenue at a point in time.
There are new requirements for capitalizing costs of obtaining or fulfilling a contract.
There is new gross versus net revenue guidance that may change the gross/net analysis for some entities.
Changes in financial reporting for revenue may affect taxes by:
Accelerating taxable income because tax accounting methods change;
Creating or changing existing temporary differences in accounting for income taxes for financial reporting purposes;
Requiring revisions to transfer pricing strategies and documentation;
Requiring updated policies, systems, processes, and controls surrounding income tax accounting and financial accounting; and
Changing sales or excise taxes because revenue may be recharacterized between product and service revenue.
Automatic consent requests can be filed with a tax return that is under extension, Schiavone says, giving companies more time to deal with the issues. Advance consents need to be filed before the end of the tax year. “That could put pressure on taxpayers to address issues much earlier than they intended,” he says.
April Little, national partner in charge of tax accounting and financial reporting at Grant Thornton, says companies need to assure their tax departments are involved in any implementation effort so they can prepare for any differences ahead. “They will have income tax, sales and use tax, internal controls, IT and data management issues to worry about,” she says. By now most companies are well aware of the accounting changes in store for them, but may not yet be focused on tax changes. “There’s a lot of work to be done. In general, companies are not as prepared as they’d like to be.”
Companies should also start assessing whether timing differences between book and tax rules might accelerate or decelerate their tax obligations, Lucas says. “It’s hard to generalize if it’s going to be tax-beneficial or not,” he says. “A lot of companies are doing the analysis now. I don’t know if anyone really knows unless they’ve done that analysis internally.”
Peter Bible, a partner with audit firm EisnerAmper, believes the new standard will slow the recognition of revenue to some degree. It remains to be seen, he says, whether the IRS will provide or seek any kind of policy change as it considers the effect of the new accounting standard.
“Their main objective is to increase revenues from taxes,” he says. “This is contrary to that. They’re going to have to contemplate whether this is an acceptable change for their purposes. I think there’s going to be a lot of pressure to not view it as an acceptable change.”
Lucas points out tax departments should also tune in to the disclosure requirements of the new accounting standard. “Under the new model, the disclosures are going to be much more detailed,” he says. “That will be more transparent for the IRS exam teams. If they can get information from financial reporting on where the book-tax differences are and how they are handling them for book, that will be more transparent.”