Tax Consequences of Revenue Recognition Rules Under ASC 606
It’s year-end and while everyone is focusing on tax reform, a topic that should not be overlooked is the financial statement impact of the new revenue recognition standard ASC 606 Revenue from Contracts with Customers. The standard is effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2017, for public companies, and after December 15, 2018, for nonpublic companies.
From a revenue recognition perspective, there are five steps that have been identified by the FASB that need to be considered while implementing this new standard. It is imperative that companies are considering the impact that any identified adjustments may have on overall tax expense within the income statement or balance sheet through deferred tax assets and deferred tax liabilities. While the tax guidance on revenue recognition rules has not changed since Rev. Proc. 2004-34 was introduced in 2004, the recently enacted Tax Cuts and Jobs Act (“the Act”) has made some notable changes. An accrual-basis taxpayer reports income in the taxable year in which (1) the right to the revenue becomes fixed and (2) the amount of revenue can be determined with reasonable accuracy. The amount is considered fixed at the earliest of when payment is made, payment is due or performance has occurred. The amount is determinable with reasonable accuracy when an amount is reasonable ascertainable. Under the Act, revenue cannot be recognized for tax purposes in a period later than revenue is reported in the applicable financial statements with few exceptions.
Current and Future Revenue
Under ASC 606, revenue may be recognized in different amounts and/or periods than under historical GAAP (ASC 605). In addition, similar to current requirements, revenue may be recognized prior to the receipt of cash. If companies have elected Rev. Proc. 2004-34 which allows tax to follow book for the initial year of a multi-year contract, this election may no longer be beneficial if revenue is being recognized earlier for book purposes. Therefore, it may be beneficial to change the company’s tax method for revenue recognition. If the company decides to maintain the deferral method for tax purposes, and the way that the company recognizes revenue for financial reporting purposes changes, the company is deemed to have a change in tax accounting method.
Example: A company enters into a two-year contract which includes a warranty provision with a customer. The service was provided and operational and cash exchanged hands on the date the contract was signed. Historically, under ASC 605, the full amount of revenue would be recognized ratably over the life of the contract. However, under ASC 606, the service is valued separately from the warranty, as separate performance obligations. The value of the warranty may be recognized into revenue at a point in time and the service revenue will be recognized over the contract period. As such, the timing of revenue recognized will change depending on when the value of the warranty is recognized separately for financial reporting.
Prior Period Revenue Recognition
In addition, upon the adoption date, companies will be reviewing their existing contracts and revenue streams to determine if an opening adjustment to retained earnings is necessary upon adoption that would result in revenues being moved between two different prior tax periods. If this occurs, then companies may reverse the deferred revenue on the adoption date with an offset to retained earnings. These retained earnings adjustments must be analyzed to determine if there are any deferred tax assets recorded on the balance sheet related to deferred revenue that should also be reversed.
Example: Assume a company issued a five-year contract where all of the cash was received in year one ($100,000), and under legacy GAAP the revenue was recognized on a straight-line basis over the five-year period ($20,000/year). If the company did not elect Rev. Proc. 2004-34 in year one, a deferred tax asset of $28,000 [($100,000 - $20,000)*35%] was created as the full amount received of $100,000 was included in taxable revenue and financial reporting revenue was $20,000. Under ASC 606, it is determined that in year one $45,000 of revenue should have been recognized. This results in a variance of revenue that should have been recorded of $25,000. The company would record the $25,000 through as a credit to retained earnings and the deferred tax asset balance should now be $19,250 [($100,000-$45,000)*35%]. The $25,000 adjustment to prior revenue will decrease the deferred tax asset and the tax effect of $8,750 is also recorded as an adjustment to retained earnings.
Not only is the timing of recognizing revenue changing, but the related reserve (contra-asset) accounts will be effected as well. By recognizing revenue at an earlier date with less certainty, the likely result will be an increase in return reserves. Under the old standard, more often than not, when a reserve is recorded, there is a related expense recorded in the income statement. Therefore, to determine the non-deductible expense recorded through the income statement for tax purposes, one could look at the fluctuation of the opening and closing balance sheet accounts. Under the new guidance, estimated product returns must be recorded gross on an entity’s balance sheet (i.e., an asset is recorded for the recovery of the product and a liability is recorded for the refund that will be due to the customer). Accordingly, the tax department will need to work closely with the accounting department to understand the financial reporting changes to recording reserves and develop a process to continue monitoring such changes.
Example: Historically, the entry to book the reserve would have been:
Dr. Reserves (contra-revenue)
Cr. Return Reserve (contra-asset)
Under ASC 606, when a return reserve is recorded, the entry will be:
Dr. Inventory (asset)
Dr. Reserves (contra-revenue)
Cr. Return Reserve (contra-asset)
Change in Accounting Method and Other Considerations
With revenue recognition changes and tax reform occurring simultaneously, it is the perfect time to consider changes in accounting method(s). If a change of accounting method is made, generally, a Form 3115 Application for Change in Accounting Method needs to be completed and filed. If the change that is being applied for is considered an automatic change, the impact of the change should be reflected within the financial statements when the company commits to making the tax accounting method change. For changes that are not automatic, a Form 3115 must be mailed to the IRS national office and a consent letter will be sent to the taxpayer when approved. The company should consider the recognition and measurement provisions of ASC 740 to determine when the change of accounting method should be reflected. When making a change in method, a cumulative catch-up adjustment should be calculated which would be equal to the difference between the use of the companies’ old and new methods of accounting as of the first day of the taxable year of the change (IRC Section 481(a) adjustment). If the adjustment will result in a decrease of taxable income, then the adjustment can be recognized entirely in the year of the change. If the adjustment will result in an increase in taxable income, the adjustment can generally be recognized ratably over a four-year period. However, due to the decrease in the corporate tax rate (from 35% to 21%) under the Act, such accounting method changes and timing of revenue recognition must be revisited.
Note that a Form 3115 is not required to be filed if a company historically followed the deferral method for advance payments under Rev. Proc. 2004-34 and is now required to change its accounting method due to the adoption of ASC 606 (see Section 16.10 of Rev. Proc. 2017-30). In this instance, attaching a statement to the annual tax return is all that is required. The change is made on a cut-off basis and only applies to advance payments received on or after the beginning of the year of change.
In the interim periods during 2017 prior to adoption of ASC 606, most public companies have been disclosing the date adoption is required and a brief description of the new standard with the method of adoption. For calendar-year public companies, it is expected that their 2017 Form 10-K will disclose the numerical potential impact of ASC 606 including the related tax impact discussed in the income tax footnote.
Upon adoption of ASC 606, the disclosures required depend on the method of adoption – full retrospective method or modified retrospective method. Under the full retrospective method, the impact of adoption on any effected financial statement line item for the historical periods being retrospectively adjusted must be disclosed. The modified retrospective method requires companies to keep two sets of books and disclose the amount by which each financial statement line item is affected in the year of initial application.
In summary, all companies are required to analyze all of their revenue streams to fully understand the impact of ASC 606. There is a chance that even an immaterial change may result in current period income; however, analyzing the retrospective changes may reveal a more consequential effect. Your professionals advisors can help analyze how this standard will impact your financial reporting of revenue and related tax consequences, develop the appropriate internal processes and controls for both revenue and income taxes, and assist with layering the recently enacted tax legislation to the overall consideration of tax positions and accounting method elections.
Further information regarding ASC 606 Revenue Implementation is available.