The Tax Impacts You Need to Consider with Revenue Recognition

January 31, 2020 | Article

The effective date for this accounting standard has been potentially delayed due to the COVID-19 outbreak.

The Tax Impacts You Need to Consider with Revenue Recognition
The release of ASC 606 – Revenue from Contracts with Customers by FASB provided substantial changes to standards governing revenue recognition for financial statement purposes. Ever since the standards were released in 2014, businesses and organizations alike have been working to see just how these new standards will affect their financial statement and tax preparation.

What Is ASC 606?
ASC 606, also known as revenue recognition, overhauls accounting for revenue and related financial statement disclosures. The standard affects almost every type of entity that produces financial statements. Specifically, ASC 606 lays out a five-step analysis process to determine the amount and timing of revenue recognition for financial accounting purposes. 

Ready to learn more about ASC 606 and revenue recognition? We’ve developed a resource to walk you through the five steps to implementation of the new standard.

When Does ASC 606 Take Effect?
Publicly-traded entities, certain nonprofit entities, and certain employee benefit plans were required to adopt the new standards for annual reporting periods beginning after December 15, 2017. All other entities were required to adopt the new standards for annual reporting periods beginning after December 15, 2018.

What Are the Tax Implications for Revenue Recognition?
While ASC 606 may significantly affect revenue recognition methods used for financial statement purposes, it does not change the revenue recognition rules for tax purposes. However, taxpayers may find that the new financial reporting standards impact their tax reporting in a number of ways, including:

  • Tax accounting method changes
  • Book-tax differences
  • Deferred taxes
  • Sales & use or indirect taxes
  • International tax planning & reporting

What Are Next Steps When It Comes to Tax Accounting Method Changes and ASC 606?
There are several steps organizations can consider when it comes to the tax implications of ASC 606.

  1. Understand the financial reporting changes.The first step in understanding the potential tax implications of ASC 606 is understanding the financial reporting changes being made in connection with implementing ASC 606. The specific changes to be made will depend on the details of each taxpayer’s business arrangements and customer contracts. And, these items will vary from taxpayer to taxpayer, even among taxpayers in the same business or industry.

  2. Identify certain types of contracts and arrangements that are more likely to be impacted by the new standard.
    For example, taxpayers that sell “bundled” goods and services for a single price may find that they will now have two separate obligations under the contract and will be forced to split the contract price and revenue recognition among the separate obligations.

    Additionally, taxpayers whose contract price includes discounts, rebates, bonuses, chargebacks or other types of price adjustments must adjust the amount of revenue recognized to reflect the amount of revenue they expect to collect after considering the impact of these price adjustments. Other taxpayers may find that they are now required to recognize more revenue over a period of time rather than at a single point in time.

  3. Address the tax implications of the changes.
    The first task is determining whether the new financial reporting methods are permissible for tax purposes. The IRS has provided some guidance in this regard, but many questions remain unanswered.

    Generally, if taxpayers find that the new ASC 606 revenue recognition methodology is permissible for tax purposes, and they wish to use that method for tax purposes, they will need to request an accounting method change by filing Form 3115, Application for Change in Accounting Method.

    If the new ASC 606 methodology is not permissible for tax purposes, taxpayers will need to remain on their current revenue recognition methods for tax purposes and will be required to make a new book-tax adjustment.

The Impact of Tax Reform on Revenue Recognition
ASC 606 is not the only regulation or legislation to impact revenue recognition. The Tax Cuts and Jobs Act (commonly known as tax reform) has also made significant changes to tax side of revenue recognition. Specifically, tax reform has impacted book-tax conformity and advance payments.

Book-tax Conformity and 451(b)
Section 451(b)(1) generally provides that an accrual method taxpayer with an applicable financial statement (AFS) or other specified financial statement is required to recognize revenue for tax purposes no later than when such revenue has been recognized as revenue in an AFS or other specified financial statement.

The rule of section 451(b)—commonly referred to as the “AFS inclusion rule” —operates as a one-way book tax conformity provision prohibiting the deferral of revenue for tax purposes after the date the revenue is recognized for financial statement purposes. Although the rule appears to be fairly straight-forward, the application of the rule, and related exceptions, can be quite complex.

Section 451(b) produces unfavorable tax outcomes as taxpayers are required to accelerate the recognition of income for tax purposes to match the timing of recognition of the amounts for financial statement purposes. But, section 451(b) cannot be used to defer recognition of income for tax purposes, it only accelerates recognition. As a result, many taxpayers are focused on understanding the exceptions and limitations of section 451(b) to make sure they are only applying the AFS inclusion rule where required.

The good news is that section 451(b) and the related income inclusion rule do not apply to all taxpayers. Section 451(b) applies only to taxpayers that have an AFS or other financial statement. An AFS includes an audited financial statement that is filed with the SEC or used for a non-tax business purpose such as reporting to owners, creditors or other parties. Additionally, taxpayers who file financial statements with the federal government, a federal agency, state government, state agency or self-regulatory organization are subject to section 451(b).  

However, even if a taxpayer is subject to section 451(b), not all types of income and transactions are subject to the rules. The AFS income inclusion rule does not apply to income for which the taxpayer uses a special method of accounting, such as the long-term contract rules under section 460 or the installment method under section 453. Additionally, section 451(b) does not result in the reclassification of transactions for tax purposes, such as sale or lease transactions, or the recognition of income on a transaction otherwise eligible for non-recognition.

Section 451(b) also does not require taxpayers to accelerate the recognition of revenue that is contingent on the occurrence or non-occurrence of a future event. However, determining whether an amount is truly contingent can be complex and depends on the terms of the taxpayer’s agreement as well as the taxpayer’s rights to payment if the contract is terminated prior to completion.

Tax Reform is here to stay!
Check out seven reasons why you still need to care about tax reform.

Revenue Recognition for Advance Payments and Section 451(c)
The IRS also issued proposed regulations under section 451(c), which was enacted by the Tax Cuts and Jobs Act. Specifically, 451(c) addresses the scope and application of the deferral method for advance payments.

Accrual method taxpayers are generally required to recognize income on the earliest of when the income is earned, due or received. As a result, taxpayers using an accrual method of accounting are subject to tax when income is received prior to being earned, unless they are eligible for deferral. Under pre-Tax Cuts and Jobs Act law, several deferral provisions were available to taxpayers who received advance payments from customers for goods, services or other items to be provided in the future. Section 451(c) was intended to consolidate and codify these deferral methods.

Section 451(c) applies to both taxpayers that maintain an AFS and taxpayers that do not maintain an AFS. An AFS includes an audited financial statement that is filed with the SEC or used for a non-tax business purpose such as reporting to owners, creditors or other parties as well as financial statements that are filed with the federal government, a federal agency, state government, state agency or self-regulatory organization.

Section 451(c) provides a one-year deferral method. Under the one-year deferral method, taxpayers with an AFS are required to recognize the payment in income in the year of receipt to the extent recognized in the taxpayer’s AFS and recognize any remainder in the following year. Taxpayers without an AFS are required to recognize the payment in income in the year of receipt to the extent earned and recognize any remainder in the following year.

The one-year deferral provided by Section 451(c) is not consistent with the two-year deferral that was previously provided by Treas. Reg. § 1.451-5. Taxpayers currently utilizing this two-year deferral method are required to file a Form 3115, Application for Change in Accounting Method, to change their method of accounting to adopt the one-year deferral method. Additionally, taxpayers who are currently recognizing advance payments in income on receipt, or under a method that does not comply with section 451(c), may be eligible to file a Form 3115 to adopt a one-year deferral method that is consistent with section 451(c).

The Next Steps with Tax and Revenue Recognition
Revenue recognition is complex. With many new standards and legislation affecting how revenue is recognized across a sweeping number of businesses, now is the time to review and plan for these changes.

Unsure where to begin?
We have developed multiple resources on the impacts of revenue recognition.

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