U.S. tax and FASB’s new paradigm for revenue recognition

Review the tax implications of this sweeping new standard.
By Marshall K. Pitman, CPA, Ph.D.; Linda Campbell, CPA, CGMA, Ph.D.; and Kasey Martin, CPA, Ph.D.

U.S. tax and FASB’s new paradigm for revenue recognition
Photo by eugenesergeev/iStock

In May 2014, FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers (Topic 606), arguably the most comprehensive change to accounting principles ever amassed. Almost every company applying U.S. GAAP will be affected in some way by the required changes of this standard. All companies with tax compliance responsibilities (federal, state, and sales tax) should be considering potential issues relevant to tax planning and reporting.

The current effective date for FASB Accounting Standards Codification (ASC) Topic 606 for public entities, certain not-for-profit organizations, and certain employee benefit plans is for annual and interim periods beginning after Dec. 15, 2017; and all other entities for annual periods in fiscal years beginning after Dec. 15, 2018, and for interim periods in fiscal years beginning after Dec. 15, 2019. Early adoption is allowed for reporting periods beginning after Dec. 15, 2016; however, technical corrections continued through late 2016. Companies and financial statement users will experience firsthand a single, principles-based revenue standard in which FASB aspires to:

  • Streamline statement preparation and reduce essential guidance;
  • Provide enhanced disclosure to users;
  • Offer a more robust revenue framework;
  • Improve comparability across entities, industries, capital markets, and jurisdictions; and
  • Remove inconsistencies and weaknesses in the prior revenue standards.

While FASB consistently promotes the positive effects that it anticipates occurring with full implementation of the standard (including clarifications), accountants and other financial professionals are expressing interest and concern about issues FASB has left unaddressed. The profession is discussing the challenges of implementation and indirect issues such as upcoming changes to the leasing model. Beyond a short list of "hot" GAAP-related issues such as revenue recognition changes, effects on earnings quality, deferred taxes, management compensation, and earnings management, scant guidance on these indirect issues is being laid out for management's immediate consideration.

This may partially be due to the possibility that many unanticipated roadblocks have yet to be encountered, as companies may actually be further behind on their path to implementation than they are willing to admit. Even guidelines thought to be firmly in place (by both companies and FASB) have been addressed and altered in recent months as implementation of Topic 606 progresses. Corporate managers and tax professionals need to keep a constant watch on a long list of paramount issues seemingly unrelated to this new standard (e.g., the new leasing standard, dramatic changes in information technology (IT) systems, modifications in internal controls, and, especially, resulting tax implications).

STAKEHOLDERS SEEK CLARIFICATION

Even before adoption, the standard is generating concern among personnel charged with its implementation—leading to numerous FASB clarifications in certain areas such as the distinction between revenue from licenses of intellectual property (IP) that represent a promise to deliver a good or service over time (symbolic IP) versus a promise to be satisfied at a point in time (functional IP). The distinction is important among media companies, which must determine whether license revenue from syndicated television shows, the use of sports logos, or other sources must be accounted for all at once or in increments over time.

FASB, responding to requested feedback on several issues that have arisen, has released numerous, extensive clarifications. In 2015, FASB issued a clarification concerning the effective date. In 2016, four clarifications were released: (1) ASU No. 2016-08, addressing principal versus agent considerations; (2) ASU No. 2016-10, identifying performance obligations and licensing; (3) ASU No. 2016-12, a clarification of narrow scope improvements and practical expedients (directed at items such as the reporting of noncash consideration, contract modification and completed contracts at transition, collectibility matters, and other concerns); and (4) ASU No. 2016-20, 13 specific corrections and/or improvements on an array of issues, including loan guarantees, contract costs—impairment testing, and provision for losses on construction-type and production-type contracts. Stakeholders are encouraged to keep abreast of possible future updates.

A SINGLE SOURCE OF REVENUE GUIDANCE

Overall, the standard is anticipated to erase a profusion of individual, industry-specific revenue guidance by providing a multistep evaluation model directing an entity to recognize revenue in an amount that reflects the transfer of goods and services to customers that corresponds to the consideration it expects to be entitled to in exchange for those goods and services. Judgment will be paramount in reviewing the stated and implied terms of each contract and in implementing the model outlined in the guidance. These steps are:

  1. Identify the contract with a customer;
  2. Identify performance obligations of the contract;
  3. Determine the transaction price;
  4. Allocate the transaction price to the appropriate performance obligations of the contract; and
  5. Recognize revenue when (or as) the performance obligations are satisfied.

There is no shortage of resource information to guide financial reporting efforts. Various firms, organizations, and publishers are hosting webinars, seminars, self-study courses, etc., for all interested parties. Additionally, a joint IASB/FASB Transition Research Group was formed in 2014 and to date has met numerous times and discussed over 55 implementation issues. Its last meeting was in November 2016. This group has been directed to:

  • Solicit, analyze, and discuss stakeholder issues arising from implementation of the guidance;
  • Inform FASB and the IASB about those implementation issues, which will help the boards determine what, if any, action will be needed to address those issues; and,
  • Provide a forum for stakeholders to learn about the new guidance from others involved with implementation.

POTENTIAL TAX-RELATED ISSUES

The standard relates to any revenue arising from contracts to provide goods and/or services to an entity's customers (unless the contract is within the scope of another specified standard such as FASB's new leasing standard). The standard also addresses some items not previously considered (e.g., costs associated with obtaining and fulfilling a contract). There is new gross versus net revenue guidance that may change the gross/net analysis for some entities (see the sidebar "All Events").

To comply with the basic principle of the standard, an entity must "recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services" (ASU No. 2014-09, p. 2). The standard may create an unexpected issue for taxpayers, as they will be required to use more judgment and estimates (such as identifying performance obligations and the value of variable consideration) than under previous authoritative guidance (e.g., advance payment revenue recognition rules are an area of potential significant impact on an entity's cash tax position). Under Regs. Sec. 1.451-5 or Rev. Proc. 2004-34, revenue recognition of certain advance payments for tax purposes depends on revenue recognition for financial accounting purposes.

AREAS OF CAUTION

The areas of caution continue to grow as the implementation deadline nears. The standard requires that the transaction price be allocated to each performance obligation based on relative stand-alone selling prices. One result of this guidance is that revenue recognition for certain software contracts is expected to accelerate under the new standard. Consider that under the current standard, software contracts that contained multiple element deliverables were treated as a single unit of accounting unless vendor-specific objective evidence (VSOE) of the fair value of the undelivered elements was available. Under the new guidance, software companies are not required to have VSOE of the fair value of the undelivered elements to separate the undelivered elements from the delivered software license. Rather, an entity will allocate transaction price based on stand-alone selling price without regard to VSOE. This will likely accelerate the recognition of revenue for both financial reporting and tax purposes.

Included in Step 1 of the model is a collectibility consideration. If collectibility of substantially all of the consideration to which the entity expects to be entitled is not probable, an entity will not recognize revenue until it concludes that collectibility is probable. Under tax principles, an entity's rights to income are not fixed until all material contingencies on the receipt of income are removed. In the past, the allowance for doubtful accounts in financial reporting preceded the actual write-off for tax purposes and could result in a deferred tax asset. The book-tax difference may actually decrease in this area if entities treat the new guidance more similarly to the tax guidance in the area of collectibility.

The determination of separate performance obligations (Step 2) and allocation of consideration between those obligations (Step 4) is another potential area of concern for standard adopters. Consider a cellphone sold at a discount or given free when bundled with a service contract and warranty. The guidance may change the categorization of this revenue as well as when it is recognized (i.e., product revenue versus service revenue and recognized at a point versus over time). Additionally, items not previously identified as a separate performance obligation may now be considered one under the guidance (e.g., free installation or haul-away of an old appliance).

Foreign subsidiaries of U.S. companies may face additional federal income tax considerations if the reportable taxable distributions are affected by changes caused by the standard. If the foreign subsidiary is subject to IFRS, further complications may arise. Repatriated earnings will need to be fully considered to accurately determine taxable distributions and/or Subpart F inclusion per Secs. 951—965. Changes to foreign tax credits, state and local tax apportionment, and the presentation of taxes not based on income (e.g., sales, excise, or value-added taxes) may result from implementing the standard.

Accelerated recognition of revenue from the sale of goods in certain circumstances (e.g., certain software contracts) may result, as it will now be necessary to recognize revenue when control of goods is transferred, rather than the previous consideration focusing on the transfer of risks and rewards. Additionally, the seller's price is no longer required to be fixed or determinable for financial accounting purposes. Variable consideration (i.e., incentives, discounts, royalties, credits, performance bonuses, penalties, and refund rights) must be included in the transaction price if it is probable that the amount will not result in a significant revenue reversal when the uncertainty is resolved. For federal tax purposes, an entity generally reports income in the period in which the right to the income becomes fixed and the amount becomes determinable. This change may increase book-tax differences.

The standard addresses whether taxes collected from customers and remitted to governmental authorities should be presented gross versus net on the income statement. Special consideration should be noted, as sales tax will be treated differently than production tax. The key consideration in ASC Subtopic 606-45, Revenue Recognition—Principal Agent Considerations, is whether the entity is acting as a principal or agent on behalf of the government.

Additionally, a change in sales or excise tax may occur because revenue previously considered product revenue may now be considered service revenue (and vice versa). Other areas of potential caution include uninstalled products, customer change orders, warranties and claims, transfer-of-control issues, measuring the progress of a contract, and tax accounting methods. Many of these concerns apply to all industries, some just to a few. Many of the final determinations of applicability will be judgment-based. Adding another component of consideration, under ASU No. 2016-12, an entity, as an accounting policy election, is permitted to exclude amounts collected from customers for all sales (and other similar) taxes from the transaction price.

ACTIVATING A CHANGE IN TAX ACCOUNTING METHOD

It is highly probable that while implementing the standard for financial accounting purposes, companies may complicate matters by triggering a required (or desirable) change in their tax accounting method. Several revenue issues are topics of concern, as changes to these specific revenue areas could have a significant impact on a company's cash tax position and the timing of recognition. These include advance payments, percentage of completion, licenses of intangible property, and sales of inventory. Changes in these areas will most likely accelerate the recognition of income for financial accounting purposes and potentially lead to accelerated income recognition for tax purposes.

The IRS must approve changes in tax accounting methods. The federal income tax definition of a change in accounting method can be found in Sec. 446. As previously mentioned, taxable income is computed on the basis by which the taxpayer regularly computes financial accounting records. The company's tax method comprises both an overall plan of accounting for gross income or deductions (cash, accrual, or hybrid) and the treatment of any specific items used in the overall plan (e.g., inventory methods) (see the sidebar "Tax Accounting Changes").

Companies seeking IRS approval generally must file Form 3115, Application for Change in Accounting Method. The IRS grants some changes on an automatic consent basis, while other changes may require the Service's advance consent. Since the IRS treats a change in the timing of the recognition of revenue as a change in method of accounting, the standard implementation and its inherent timing changes are of considerable interest to tax professionals. One change in tax method may trigger additional changes, as multiple alterations to previously used tax methods may be required to bring revenue recognition under both methods into desired alignment.

The IRS has not specifically addressed guidance related to the upcoming FASB changes, but the task of compliance could be significant. Companies should take note that the rules of handling and filing Form 3115 are fluid, as the IRS has lengthened the list of automatic changes and released additional procedural notices numerous times in recent years. The most current guidance is available in Rev. Proc. 2015-13.

In May 2015, the IRS issued Notice 2015-40 to seek public comments on how the new standards will affect accounting for income taxes. Receiving few comments, the IRS again requested comments in March 2017 with Notice 2017-17. Until guidance is developed, companies may feel they are still in the dark concerning issues such as:

  • Whether these new FASB standards are "permissible" methods under the Internal Revenue Code;
  • The types of accounting method change requests the IRS will act on; and
  • Whether the IRS will eventually amend its current procedures for consenting to a change of method of accounting requests.

With adoption of the standard, entities should anticipate necessary adjustments to the financial accounting of income taxes. Temporary differences have always been a challenging component of financial accounting, and new regulations will require existing timing differences to be reviewed to address possible current and future changes and to capture all required documentation. This may lead to substantial changes in deferred tax assets and liabilities as revenue recognition components are reevaluated under the new revenue rules (see the sidebar "Temporary Differences").

PLANNING AHEAD

Taxes will be affected in many ways due to the changes in financial reporting as a result not only of the revenue standard but also other upcoming standards. For example, though FASB's new leasing standard, ASU No. 2016-02, Leases (Topic 842), does not go into effect until a year after Topic 606, many lessors will need to apply upcoming lessor accounting model changes (such as the new sales and leaseback guidance for evaluating the "sale") right along with implementation of Topic 606.

In summary, taxable income may be accelerated, temporary differences in accounting for financial reporting and accounting for income taxes may arise or change, and sales or excise tax may change because revenue previously considered product revenue may now be considered service revenue (and vice versa). As companies implement the standard, many new policies, systems, internal controls, and processes will need to be put in place. Compensation plans, benefit plans, and bonus and incentive plans should be reviewed for potential impact. Other issues that must be considered are changes in forecasting, licenses, performance fees, vendor protection clauses, budgeting, contracting, sales procedures and organization, and IT functions. Some industries will be affected more than others.

On the positive side, many of the changes initiated by the standard will likely only affect the computation of a book-tax difference and the related deferred taxes. On the negative side, this may greatly complicate the previously established revenue recognition patterns used to determine book-tax differences. Companies should be well underway examining possible changes to their business model; opportunities in altering pricing strategies; training options for their employees, investors, analysts, lenders, and creditors; and initiating new financial and tax reporting processes—all in preparation for the magnitude of tax planning and recognition changes headed their way.


All events

Under U.S. taxation rules, an entity must recognize revenue for tax purposes under the "all events" test when the following items are concluded:

  • The entity has a fixed right to receive the revenue. To determine whether a fixed right has been established, the entity must consider the presence and conclusion of any conditions that must occur before the right to income is satisfied. Revenue resulting from the sale of goods generally is earned for tax purposes when the benefits and burdens of ownership pass to the customer; and
  • With reasonable accuracy, the revenue amount must be determinable. If not determinable during the tax year, the revenue amount is not reportable until the proper amount is established.

Tax accounting changes

In general, any accounting method used for tax reporting purposes must satisfy three criteria: consistent treatment, timing, and materiality (Regs. Sec. 1.446-1(e)(2)(ii)(a); Regs. Sec. 1.481-1(a)(1); Rev. Rul. 90-38).

  • The treatment of a material item in the same way in determining the gross income or deductions in two or more consecutively filed tax returns (without regard to any change in status of the method as permissible or impermissible) represents consistent treatment of that item.
  • With regard to timing, Rev. Proc. 2015-13, citing Rev. Proc. 91-31, states: "In determining whether a taxpayer's accounting practice for an item involves timing, generally the relevant question is whether the practice permanently changes the amount of the taxpayer's lifetime taxable income. If the practice does not permanently affect the taxpayer's lifetime taxable income, but does or could change the taxable year(s) in which the item is taken into account, it involves timing and is therefore a method of accounting."
  • A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

Temporary differences

Common areas of concern for temporary differences caused by the new financial accounting standard include:

  • Changes in variable consideration (such as rebates, financing components, and rights of return) may lead to differences with tax reporting of the ultimate transaction price.
  • Changes in contract costs required by the new capitalization rules effective in certain circumstances.
  • Changes in how an entity is to distinguish between implied price concessions versus customer credit risk in its determination of the transaction price.
  • Changes to, and/or an establishment of a valuation allowance for, taxable temporary differences may be required.

About the authors

Marshall K. Pitman (marshall.pitman@utsa.edu) is an accounting faculty member at the University of Texas at San Antonio. Linda Campbell (linda.campbell@txstate.edu) and Kasey Martin (kasey.martin@txstate.edu) are both accounting faculty members of the McCoy College of Business Administration at Texas State University in San Marcos, Texas.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.


AICPA resources

Publication

  • Revenue Recognition—Audit & Accounting Guide (#AAGREV16P, text; #WAR-XX, online access)

CPE self-study

  • Interpreting the New Revenue Recognition Standard: What All CPAs Need to Know (#158062, online access; #GT-CL4INRR, group training)
  • Revenue Recognition: Mastering the New FASB Requirements (#746321, text; #164241, online access; #GT-INRR, group training)

Conference

  • National Advanced Accounting and Auditing Technical Symposium at AICPA ENGAGE, June 12—14, Las Vegas

Specialized product page

For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.

The Tax Adviser and Tax Section

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