RSM INSIGHT ARTICLE — January 27, 2017 — RSM is an IMA member company . . .
As companies begin preparing to implement the new revenue recognition guidance in their financial statements, they may not be focused on the tax implications. As part of the adoption of the guidance, companies should consider whether new book to tax differences will arise or if they will need to prepare a Form 3115 (or multiple forms) for federal income tax purposes.
The effective date for the new revenue recognition guidance (ASU 2014-09 included in ASC Topic 606) is fast approaching. Public entities (i.e., public business entities and certain not-for-profit entities and employee benefit plans) must apply the new guidance in annual reporting periods beginning after Dec. 15, 2017 and the interim periods within that year. For all other entities, the guidance is effective for annual periods beginning after Dec. 15, 2018. Implementing the updated guidance can be a labor and task intensive process as companies review the guidance, assess its impact, and adjust their systems and processes accordingly. In our experience to date, we believe the implementation process for public entities should be well underway and private entities should also be focused on assembling the necessary resources to implement. As companies determine how to best transition from legacy GAAP to the new guidance, the tax implications of the implementation must also be considered.
The core principle underlying the new guidance is to 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. Companies must follow a five-step model when applying the core principle to revenue-generating transactions:
Identify the contract with a customer
Identify the performance obligations in the contract
Determine the transaction price
Allocate the transaction price to the performance obligations
Recognize revenue when (or as) each performance obligation is satisfied.
Even though the tax rules for revenue recognition have not changed, a change in book recognition could create a change in the tax method of accounting. In addition, companies can take a deeper dive into their revenue recognition process and determine if there are previous book/tax differences that should have been accounted for and make accounting method changes to correct any items of concern.
Items of revenue are to be included in taxable income in the year in which the taxpayer has the fixed right to receive income and the amount can be determined with reasonable accuracy. In straightforward terms, revenue is recognized when it is due, paid, or earned. However, tax provisions allow taxpayers to defer certain revenue to the extent deferred in an entity’s audited financial statements (with limitations). An example of this would be the deferral of recognition for payments received in advance of delivering goods or performing services. The new revenue recognition guidance states that an entity must identify the performance obligations in a contract and recognize revenue as the entity satisfies each of those performance obligations. In certain situations this could change the timing of revenue recognition under the new guidance compared to legacy GAAP. Consequently, this change in timing for financial statement purposes could lead to a change in the timing of recognition for tax purposes when the entity receives advance payments.
Other potential areas of tax concern are the collectibility threshold where the new guidance could result in a delay in the recognition of revenue even when there has been nonrefundable cash collected. Under legacy GAAP when it is not probable/reasonably assured that an entity will collect the stated contract price or the price is not fixed or determinable, revenue is generally deferred until cash is collected. Under the new guidance, the amount to which an entity is entitled to must be evaluated to determine whether collectibility is probable. If collectibility is not probable, in certain cases the entity would not recognize revenue even if cash if collected for a portion of the transaction price and the payment is nonrefundable. We will discuss collectibility and price concessions in a later blog post.
The impact of a significant financing component applied to both deferred and advance payments could also have an impact on book/tax accounting. The existence of extended payment terms or advance payment terms need to be assessed for the existence of a significant financing component, which has the potential to create a book/tax timing difference.
Finally, the allocation of the transaction price to performance obligations could create or change a book/tax difference. The new guidance requires allocations based on standalone selling prices, which may differ in some cases from legacy GAAP. The allocation of the transaction price would need to be reviewed to determine if it is appropriate for tax purposes.