FASB Changes Revenue Recognition Rules:
Will your Company Need to File for a Tax Accounting Method Change

New guidance was issued that will change the methodology and timing for recognizing revenue under multi-element products.

These newly adopted accounting policies may also impact a company's tax accounting methods. This article provides a summary of the changes in the book guidance for revenue recognition and also provides some insights into the impact of these changes from a tax perspective.

Overview of the GAAP Changes

In October 2009, the Financial Accounting Standards Board (FASB) finalized and issued new revenue recognition rules on Multiple-Deliverable Revenue Arrangements in Accounting Standard Updates ASU No. 2009-13 (EITF 08-1) and on Certain Revenue Arrangements That Include Software Elements in ASU No. 2009-14 (EITF 09-3). These new rules are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15th 2010, unless entities elect to adopt it retrospectively. If an entity elects to apply these rules in an earlier interim period, the company will need to apply the guidance retrospectively from the beginning of the fiscal year.

Under prior guidance, entities selling hardware and software bundled with a service contract had to provide objective and reliable evidence of the fair value of each item sold under the contracts in order to recognize revenue separately; otherwise, they had to account for the sale as a single unit of accounting and defer the revenue until all items had been delivered, or over the term of the service contracts. The guidance of the previous revenue recognition on multiple deliverables was provided in the Emerging Issues Task Force (EITF) issue 00-21.

Comparison of the Previous and New Guidance

The key changes between the previous and new rules are outlined below.

• Under the new rules, entities are required to use a selling price hierarchy when allocating consideration to the deliverables in the multiple-element arrangement. If neither vendor specific objective evidence (VSOE) nor third party evidence (TPE) exists for the deliverables, entities then need to determine the best estimated selling price (ESP) for the deliverable. Under the previous rules, entities were required to demonstrate VSOE or TPE in order to treat the deliverables as separate units of accounting for revenue recognition purposes. Often, entities had difficulty in proving VSOE or TPE, or the fair value of each item of the deliverables.
• Under the new rules, the term "fair value" is replaced by "selling price" in order to clarify that the selling-price measure in the new rules is not a market-participant measure as required by Financial Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures. Under the previous rules, the total price of an arrangement was allocated to each unit of accounting based on their relative fair values.
• Under the new rules, the residual method has been eliminated. Once entities have determined the selling price of each item of an arrangement, the total consideration is allocated to the items based on their relative selling prices. Under the previous rules, if there was VSOE or TPE for the undelivered item within the arrangement, but not for the delivered item, the residual method was used to allocate the selling price to the delivered item.
• Under the new rules, entities are subject to much higher levels of disclosure requirements, including the nature of its multiple-deliverable arrangements; the significant deliverables within the arrangements; the general timing of delivery or performance of service; a discussion of the factors, inputs, assumptions, and methods used to develop the selling prices, and the general timing of revenue recognition. Under the previous rules, entities just needed to disclose the description and nature of the revenue arrangements and their policy for revenue recognition.
• ASU No. 2009-14 amends the scope of SOP 97-2 (ASC 450-10-60, ASC 985-605) to exclude tangible products containing software and non-software components that operate jointly to deliver the tangible product's essential functionality. If a company sells a joint hardware/software product that meets the criteria under ASU No. 2009-14, it will now be subject to the revenue recognition rules under ASU No. 2009-13.

Overview of Tax Accounting Method Changes

From a tax perspective, a change in an accounting method for financial reporting purposes may result in a similar change in the accounting method for federal income tax purposes. In general, when an entity determines that the tax accounting method change is required due to a change in the book accounting method, they must obtain the permission from the Internal Revenue Service (IRS) National Office to change a tax accounting method by filing a Form 3115, Application for Change in Accounting Method. The filing procedures and timing vary depending on whether the change is automatic or subject to advance consent.

An automatic method change requires that entities send a copy of Form 3115 to the IRS National Office and also attach the original form to a timely filed federal income tax return (including extensions) for the year of change pursuant to Rev. Proc. 2008-52 and Rev. Proc. 2009-39. An advance consent method change requires that entities file a Form 3115 with the IRS National Office by the last day of the year of change and obtain advance IRS consent pursuant to Rev. Proc. 97-27 before applying the proposed accounting method to the taxable income computation. These voluntary changes in a tax accounting method generally result in an adjustment under Internal Revenue Code (IRC) Sec. 481(a). The Sec. 481(a) adjustment is computed as of the beginning of the year of change. The adjustment represents the cumulative difference between the present and proposed methods. The adjustment will either decrease (a favorable adjustment) the taxable income in the year of change or increase the taxable income (an unfavorable adjustment). Unfavorable adjustments are generally taken into account ratably over a four-year period starting with the year of change.

By filing the Form 3115, an entity receives audit protection to prevent IRS from raising the same issue for a tax year prior to the year of change. In addition, in case an entity is under IRS audit, the Form 3115 must either be filed with the permission of the examining agent or be filed within a "90-day window period" (i.e., the first 90 days of any tax year if the entity has been under audit for at least 12 consecutive months as of the first day of the tax year) or a "120-day window period" (i.e., the first 120 days following the date an audit ends regardless of whether a subsequent audit has commenced).

The Implications of Revenue Recognition Changes on Tax Accounting Methods

Under the U.S. tax law, IRC Sec. 451(a) provides that income is recognized in the tax year in which received by the taxpayer, unless under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period. The Treasury Regulations in Reg. Sec. 1.451-1(a) also provide that under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy. As such, a taxpayer receiving advance payments should include payments as income in the year of receipt; this is known as the "full inclusion" method. Alternatively, taxpayers may elect to use the deferral method under Rev. Proc. 2004-34. Under the deferral method, the taxpayer must include advance payments in gross income for the year of receipt to the extent recognized in revenue in the same year's financial statements; the remaining amount of advance payments must be included in income in the following tax year. A change to the deferral method from the full inclusion method is typically made under the automatic consent procedures.

In a recent Chief Counsel Advise (CCA) memorandum 201011009, the IRS Office of Associate Chief Counsel (Income Tax & Accounting) considered whether a taxpayer that had elected to defer advance payments under Rev. Proc. 2004-34 was required to obtain consent under IRC Sec. 446(e) if the taxpayer subsequently changed its applicable book method for deferred advance payments. The taxpayer asserted that the use of the new book method for purposes of Rev. Proc. 2004-34 should not be treated as a change in method of accounting because any omission or duplication could be avoided by making the adjustment on a cut-off basis. However, IRS concluded that the change in accounting method for advance payments for book purposes would result in a change in accounting method for income tax purposes when a taxpayer accounts for advance payments under the deferral method. The conclusion was partly based on the IRS position that the use of the cut-off method is premised on the existence of a change in method of accounting under IRC Sec. 446(e). In addition, the required method change was determined to be non-automatic, which requires that the taxpayer obtain advance consent from the IRS National Office prior to changing its method.

This conclusion by IRS presents companies who are in the process of adopting this new revenue recognition guidance with a decision. Should the company come off of the deferral method (not a desirable answer) or change to the new book method?

Either answer to this question will result in the need to file for a tax accounting method change. Therefore, for planning purposes, entities that recognize revenue under the deferral method should file a Form 3115 and obtain consent from the IRS National Office in the year that the new accounting guidance (ASU No. 2009-13 and ASU No. 2009-14) is adopted. Because this application is due before the end of the taxable year in which the financial accounting change has been made, timely filing requires careful communication and coordination between financial personnel and tax personnel at affected companies.

Because the financial accounting change generally accelerates income recognition and results in an unfavorable tax accounting method change, the resulting Sec. 481(a) adjustment (i.e., the income inclusion catch-up adjustment that is the difference between the tax accounting on the old method and new method as of the beginning of the year of change) will qualify to be spread over four years. This treatment will create a favorable timing difference that could be material for many large companies.

Practitioners complained to IRS that the requirement of filing for an advance consent method change that includes computation of a Sec. 481(a) is unnecessarily burdensome. IRS indicates it is considering other alternatives for addressing this change in method. Because the advance consent method changes are due by the end of the company's tax year, companies with this method change should be prepared to file a Form 3115 before year-end to secure advance consent to utilize the new book method for tax purposes.

Conclusion

The new accounting guidance, to the extent that it is favorable for financial reporting purposes, will be unfavorable for tax purposes. Failing to request advance consent for this change in method results in exposure that deferred income will be accelerated for tax purposes. By properly requesting advance consent, companies avoid this exposure and receive the benefit of the four-year spread for the catch-up adjustment. IRS may relax this requirement through future guidance. In the absence of such relief, companies should be prepared to file Form 3115 before year-end to reflect this change in financial accounting for tax purposes.