Since the new revenue recognition standards were released, accounting departments have been spending countless hours working to understand and implement the new rules. But what effect will the new standard have on tax returns and taxable income? This blog summarizes how the changes under the new revenue recognition standard (ASC 606) may impact tax filing and compliance. Most companies will be affected in some way by this standard, so knowledge of the tax implications is crucial!
Tax laws can be complicated! Certain types of transactions are subject to rules that do not always match the U.S. GAAP accounting treatment. To the extent that the tax accounting is similar to the rules used for financial reporting purposes, the taxpayers can employ the same methods. When considering the new revenue recognition standard, changes in the amount and timing of revenue recognition for book purposes may also affect taxable income, as the timing may differ from the allowable recognition under federal income tax rules.
Under U.S. federal income tax principles, an accrual based taxpayer reports taxable income in the year which:
- The right to receive revenue becomes fixed (Criteria #1), and
- The amount can be determined with reasonable accuracy (Criterion #2)
First of all, when does the “right to receive revenue become fixed?” An amount is considered fixed at the earliest of when:
- Payment is made,
- Payment is due, or
- Performance has occurred
These criteria are clearly different from the 5-step model introduced by ASC 606. If the new standards are impacting the amount or timing of revenue, an evaluation must be performed to determine if that same methodology is acceptable under tax laws. Say a company has always followed book methods for tax purposes. If ASC 606 is changing how revenue is recognized, they cannot simply change their tax method to follow the new book method! An in-depth study must be performed. If it is determined that the new book method of accounting does not qualify under the criteria above, there will be a new temporary difference! If there was already a temporary difference between book and tax revenues, then any new differences must be evaluated.
Below we identify the potential differences between book at tax for each step:
Under ASC 606, collectability of the transaction price (the amount to which the entity expects to be entitled in exchange for the promised goods or services) must be probable or no revenue is recognized until certain criteria are met. Under the U.S. tax code, there is no requirement to meet a “probable” collectability threshold before recognizing revenue. Instead, the revenue must be fixed and determined with reasonable accuracy. There may be a contract for which collection is not “probable” for book purposes, therefore no revenue would be recognized. In making the decision not to recognize revenue for tax purposes, must prove that there is reasonable doubt and uncertainty regarding collectability. This “doubtful collectability exception” is likely different in application that the “probable” collectability threshold under U.S GAAP.
Performance obligations are promises to a customer under ASC 606. At contract inception, an entity should assess the goods or services promised. To be categorized as a performance obligation, each promise to transfer to the customer must be: 1) a good or service that is distinct, or 2) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. On the other hand, tax laws generally place emphasis on the basis of the form of a contract. How performance obligations are bundled for book purposes under Step 2 may be different! If the wording in a contract and the Step 2 evaluations result in different conclusions, there could be timing differences in when and how much revenue is recognized.
Under ASC 606, entities must include variable consideration in its determination of the transaction price (subject, of course, to the revenue constraint). The transaction price is the amount the entity expects to be entitled in exchange for the transfer of goods or services to a customer. U.S. federal income tax principles do not recognize revenue until the amounts are fixed and determinable. The concept of variable or contingent revenue does not apply under tax law. Therefore, the amount of revenue recognized under each set of rules could differ.
Again, tax law requires that the form of a contract be followed. Therefore, if a contract allocates the transaction price to various elements within the contract, that allocation would be followed. However, Step 4 of ASC 606 requires the transaction price to be allocated to each distinct performance obligation based on the relative stand-alone selling price. The timing and amounts included as revenue for tax purposes may not match revenues determined in step 4.
Revenue may be recognized for books at a point in time or over a time period. ASC 606 states that the asset is transferred when the customer obtains “control.” This would occur when the customer can either: 1) direct the use of, and obtain substantially all the benefits from, an asset, or 2) prevent other entities from directing the use of, and obtaining benefits from, an asset. Tax law requires that income be reported in the year in which the revenue is fixed and determinable. In addition, there are special rules within the tax law for certain types of transactions (e.g. advanced payments, long-term construction contracts, installment sales, etc.), which may also cause differences.
An in-depth evaluation of revenue recognition methods for both book and tax must be completed! Are there any new temporary differences? Maybe there are changes to existing temporary differences. Is the implementation of ASC 606 standards permissible for income tax purposes? After the assessment is complete, the taxpayer must determine if there is a change in tax accounting methods as a result of the implementation of the new revenue recognition standard.
If there is a change in tax accounting method, Form 3115, Application for Change in Accounting Method must be filed with the IRS. There are certain accounting method changes that are considered automatic, but the form still needs to be filed. If the change in accounting method is not specifically categorized as automatic, advance consent from the IRS is required!
We hope this blog helped with your understanding of the upcoming tax impacts due to ASC 606! As always, feel free to contact us with any questions!
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