The Financial Accounting Standards Board (FASB) recently finalized a new standard for revenue recognition that moves away from a rules-based approach to a much broader principals-based approach. Nonpublic companies are required to implement the new standard on financial statements for periods beginning after December 15, 2018.
The new standard represents a major change in financial accounting. Because almost all businesses start with book income to determine taxable income, this shift will likely have a significant ripple effect on tax return preparation as well. Despite the fact that the final effective date is still a few years away, planning should be in process now for any entity that issues GAAP financial statements. In order to have a successful implementation, businesses should ensure that tax considerations are included in each step of the process.
A quick look at the new standard
The new standard requires a business to look at each customer contract to determine how to recognize revenue. The analysis is a five-step process:
A refresher on tax revenue recognition
Generally, revenue is recognized for income tax purposes when it’s received, when it’s due, or when it‘s earned — whichever comes first. There are many exceptions to this rule for transactions including long-term contracts, installment sales, and advance payments.
Even if the book method changes, the previous tax method may still have to be used for income tax purposes. This may acquire additional reporting…
There are three general scenarios for businesses to consider when it comes to the tax accounting impact of the new financial standard:
- Book revenue recognition methods change, but tax revenue
recognition methods don’t change.
Tax revenue recognition methods are determined under the Internal Revenue Code and can’t change unless the IRC changes. So even if the book method changes, the previous tax method may still have to be used for income tax purposes. This may require additional reporting to be available within the accounting system or may require the accounting system to maintain two different revenue recognition models for each transaction. The new standard requires a business to look at each customer contract to determine how to recognize revenue.
- Both book and tax revenue recognition methods change.
Tax revenue recognition rules may not always provide a clear black and white answer. In these cases, it’s possible that the new book method may be used for tax purposes as well. However, tax law generally requires that a taxpayer maintains consistency in its tax methods of accounting from year to year. If taxpayers want to change their tax method of accounting, they’re required to apply for a change with the IRS. This application requires time and effort and can often require a substantial cash outlay.
- The tax revenue recognition method directly refers to the financial
Some tax revenue recognition methods directly incorporate financial accounting methods. For instance, several tax methods of accounting that permit a taxpayer to defer the recognition of advance payments into revenue require financial accounting conformity. If a taxpayer changes the way they account for these items for financial accounting purposes, they must also change the way they account for them for income tax purposes. In these cases, the IRS will still expect the taxpayer to file for a change in method of tax accounting.
Many questions remain unanswered
The implementation of the new financial standard is an ongoing process. FASB, accountants, and businesses continue to identify new issues and develop solutions to make the transition as smooth as possible. The IRS has also sought input from taxpayers on these issues in an effort to understand if tax rules may need to change to provide more flexibility. However, given the complexities surrounding financial accounting, we likely won’t see any changes to tax rules in the immediate future.
As with most significant changes, there are still many questions that must be asked and answered. As businesses prepare for the new revenue recognition rules from a book accounting perspective, they shouldn’t forget about the tax implications of those changes. Overlooking tax issues during the transition may result in missed opportunities or future surprises.