New GAAP Revenue Recognition Rules: Is Your Tax Department Ready?

The FASB’s new revenue recognition rules are required to be implemented for years beginning after December 15, 2017 for public companies and after December 15, 2018 for private companies.

The new rules are fundamentally different than current revenue recognition standards, which until now have been more aligned with tax revenue recognition principles. The new rules may result in significant differences in the amount of revenue recognized from one period to the next for some companies. However, even if the difference is small, accounting processes and financial reporting will change. This presents a challenge for the tax executive who relies on financial statement reports for tax reporting.

New Five-Step Recognition Model

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued the new revenue recognition standard ASU No. 2014-09, Revenue From Contracts With Customers (Topic 606). The new standard supersedes nearly all existing revenue recognition guidance under U.S. GAAP and International Financial Reporting Standards.   

With some exceptions, the new revenue recognition standard applies to all contracts with customers. Under the new standard, revenue related to the transfer of promised goods and services to customers is recognized in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods and services. The new standard provides the following five-step model for determining the timing and amount of revenue recognized for contracts:

  1. Identify the contracts with a customer;
  2. Identify the performance obligations in the contract;
  3. Determine the transaction price;
  4. Allocate the transaction price to the performance obligations in the contract; and
  5. Recognize revenue when (or as) the business satisfies a performance obligation.

The new standard is to be implemented with either a full retrospective approach for all periods presented in the period of adoption (generally three years) or a modified retrospective approach with the cumulative effect adjustment to retained earnings as of the date of adoption. 

Practical Implications of the New Standard

Existing contracts must be analyzed and the accounting processes may need to be revised. Companies will need to exercise more judgment and make more estimates as compared with prior guidance where income was generally recognized based on the terms under the contract. Management judgments and estimates may also require periodic updating. In addition, business processes and IT systems may need to be developed or updated to capture and monitor management’s judgments and subsequent changes.

Very importantly, changes in the timing and amounts of revenue and expenses recognized for financial reporting purposes may prompt changes in tax accounting methods and processes. The tax department and outside tax advisors should be involved in the early stages of making the assessment.

Tax Implications of the New Standard

A company using an accrual method of accounting recognizes revenue for tax purposes when the right to receive the revenue is fixed and the amount can be determined with reasonable accuracy. For sale of goods, revenue is earned when the benefits and burdens of ownership pass to the customer. For services, revenue is recognized when the performance of services is complete.

When a taxpayer changes a method for financial accounting purposes it must either request permission from IRS to change to the new method for tax purposes, or reconcile from the new financial accounting treatment to the old tax accounting method that is continued. IRS generally treats a change for financial reporting purposes as a method change for tax purposes. If a new tax accounting method is required or more advantageous as a result of the book treatment under the new standard, Form 3115, Application for Change in Accounting Method, should be filed with IRS. The filing procedures and timing vary based on whether the change can be filed under the automatic consent procedures or whether advance consent from IRS is required. 

Under the new standard, a company may be required to recognize revenue for financial reporting purposes under a method that is not a proper method for tax purposes. For example, the transaction price of a contract is not required to be fixed or determinable to recognize revenue under the new standard. This change may result in timing differences between book and tax because revenue may be recognized for book purposes before it is fixed, determinable and recognized for tax purposes. When this occurs, dual records will need to be maintained to support the tax methodology.

The new revenue recognition standard will also have implications for the accounting for income taxes. The cumulative adjustment required upon adopting the new standard may result in changes to deferred tax assets and liabilities. New temporary differences may arise. For some companies, changes in taxable temporary differences arising from the application of the new standard may also have effects on the evaluation of a valuation allowance. Businesses should expect new complexities in the transition period as well as on an on-going basis. 

Additional guidance from IRS will be necessary to address inconsistencies between the new standard and the tax rules, and to streamline the process of implementing changes from a tax perspective. The Treasury Department and IRS have requested public comments on these issues, but no guidance has been issued thus far. Tax executives should begin to prepare for these upcoming changes as soon as possible.