The tax implications of the new revenue recognition standard
Last year, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The new standard, which takes effect in 2018 for privately held companies (2017 for public companies), creates a single, comprehensive revenue recognition model to replace today’s industry-specific — and often inconsistent — rules.
As you prepare to implement the new standard, don’t overlook the potential tax implications. In some cases, the new rules may accelerate taxable income or create book-tax differences that you’ll need to track and report.
A quick recap
The new standard prescribes a five-step model for recognizing revenue: 1) Identify the contract, 2) identify performance obligations, 3) determine the transaction price, 4) allocate the price among the performance obligations, and 5) recognize revenue when (or as) performance obligations are satisfied.
Today, contractors usually treat a contract as a single performance obligation. Under the new standard, however, certain contracts may be split into two or more distinct performance obligations. Suppose, for example, that a contract calls for you to construct a building and to supply and install certain equipment. Depending on the facts and circumstances, the contract may be divided into two performance obligations, requiring you to allocate the price between construction and equipment installation and to recognize revenue from each separately.
The new standard may also affect accounting for long-term contracts. Typically, contractors use the percentage-of-completion method to recognize revenue over the life of a project. Under the new standard, revenue is recognized when control of a good or service is transferred to the customer. Depending on several factors, control may be transferred when the contract is complete or it may be transferred gradually over the life of a contract.
Other areas potentially affected by the new standard include change orders, uninstalled materials, and claims and warranties.
Impact on tax planning
The new revenue recognition standard may affect taxes and tax planning in several ways. Here are a few examples:
Acceleration of taxable income. Under certain circumstances, revenue recognition for tax purposes is required to align with its treatment for financial reporting purposes. So, if application of the new standard accelerates revenue recognition for financial reporting purposes, it may also accelerate recognition of taxable income. Suppose, for example, that your contracts call for advance payments. Generally, for tax purposes, advance payments are included in taxable income in the year they’re received. But there’s a limited exception, which allows you to defer tax on advance payments for goods and services for one year, to the extent they are deferred in your audited financial statements.
In some cases, the new standard’s “transfer of control” model may require you to accelerate revenue from advance payments into the year they’re received. If this happens, taxable income related to those payments will similarly be accelerated.
Percentage-of-completion method. With certain exceptions, the tax code requires contractors to account for long-term contracts using the percentage-of-completion method. But the new standard may require adjustments to that treatment for financial reporting purposes. (See the sidebar “Measuring progress on a contract.”)
If the tax and financial reporting treatments diverge, applying the new standard may create a book vs. tax income difference (or alter an existing book-tax difference) that must be tracked and reported on your tax returns.
Changes in tax accounting methods. If the new standard requires you to change an accounting method for financial reporting purposes, it may be necessary or desirable to make a similar change to the corresponding tax accounting method. Changing a tax accounting method requires you to file Form 3115, “Application for Change in Accounting Method.” Depending on the nature of the change, approval may be automatic, or it may require advance consent from the IRS.
System changes. As just described, adoption of the new revenue recognition standard may cause you to change your tax accounting methods, or it may create (or alter) differences between book and tax income. Either way, you must ensure that you have updated systems, policies, processes and controls in place in order to gather the data you need for both financial and tax reporting and to track any book-tax differences.
Start planning now
Even though the new revenue recognition standard won’t take effect for two or three years, it’s a good idea to begin planning for the change sooner rather than later. As you prepare, be sure to consider the potential impact on your tax returns as well as your financial statements.