The new revenue recognition standards under Generally Accepted Accounting Principles (GAAP) became effective for private companies for annual reporting periods beginning after December 15, 2018. As such, many private companies with calendar year annual reporting periods are now facing what that means for both financial statement reporting and its impact on federal taxes.
As part of tax reform, the Tax Cuts and Jobs Act added new Internal Revenue Code (IRC) §451(b) to address the timing for accrual basis taxpayers to recognize revenue when they have an Applicable Financial Statement (AFS) that is now using the new accounting standards.
Timing for Revenue Recognition Taxpayers with an “AFS”
New IRC §451(b) requires an accrual basis taxpayer with an AFS to take revenue into account for tax purposes no later than the financial statement takes revenue into account for financial reporting purposes.
- This is a no later than rule meaning that, if under another IRC section, the all-events-test was met at an earlier date, the taxpayer would have to use the earlier date to recognize the revenue for tax purposes. This is a revenue acceleration rule and does not create a deferral.
Transaction Price
The new financial reporting standards may impact how a taxpayer defines transaction price for the purpose of an AFS. The tax reporting standard doesn’t necessarily define the transaction price the same way. IRC §451(b) starts with the gross consideration in the AFS, but excludes from the definition of transaction price:
- Amounts collected on behalf of third parties
- Increases in consideration which are contingent on the occurrence or nonoccurrence of a future event, for example, bonuses contingent on performance. Amounts are not presumed to be contingent on a future event if included in an AFS, however, this presumption is rebuttable (see the auto parts manufacturer example below)
- Reductions for allowances, adjustments, rebates, chargebacks, refunds, rewards, and amounts included in costs of goods sold that are not deductible under the normal rules to deduct accrual basis expenses under IRC §461
Bonus Revenue & Expected Return Example:
An automobile parts manufacturer has a contract to sell 1,000 parts. The parts sell for $10/per part, plus a 2% bonus if the parts are delivered by February 1st. Traditionally 5% of the sold parts are returned. The manufacturer is a calendar year taxpayer and 500 parts were delivered on December 31st. The remaining 500 parts were scheduled for delivery on January 4th. Assume that for AFS purposes revenue is $4,850 (Part sales 500 x $10= $ 5,000 + $100 bonus (5,000 x 2%) – $250 expected returns ($5,000 x 5%).
The amount that is included for tax is $5,000. The manufacturer had no right to the bonus at December 31st, so even though the AFS included it in revenue, it was rebuttable. The 5% returned part estimate does not meet the all-events test, therefore it cannot be deducted for tax reporting at December 31st.
Chargeback Example
Taxpayer F, a manufacturer of pharmaceuticals, is a calendar-year accrual method taxpayer with an AFS. In addition to billing the wholesaler for the sale of the pharmaceutical at the wholesale acquisition cost under the contract, F generally credits or pays wholesalers a chargeback of 40% of the wholesale acquisition cost for sales made by those wholesalers to qualifying customers. In 2018, F enters into a contract to sell 1,000 units to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 × $10 = $10,000). The contract also provides that F will issue a 40% chargeback for sales by W to certain qualifying customers. F delivers 600 units to W on December 31, 2018, and bills W $6,000 under the contract. For AFS purposes, F adjusts its revenue by 40% for all sales to W for anticipated chargebacks. As such, in its 2018 AFS, F reports $3,600 ($6,000 – $2,400 = $3,600) of revenue from the contract with W, decreasing revenue by $2,400 (40% × $6,000 = $2,400) for anticipated chargeback claims. For Federal income tax purposes, F’s 2018 revenue is $6,000 because F’s revenue is not reduced for anticipated chargebacks.
Allocation of Transaction Price
IRC §451(b)(4) provides that when a contract contains multiple performance obligations, the transaction price will be allocated in the manner that the AFS allocates the transaction price.
AFS Defined
The definition of AFS includes audited GAAP and IFRS statements, statements filed with the SEC or similar foreign regulatory agency, audited statements prepared for a substantial non-tax purpose or a certified financial statement filed with a non-taxing governmental agency. It does not include compilations or reviews. If a taxpayer’s financial results are included on an AFS for a group of entities, it will be treated as an AFS for the taxpayer, proposed regulations provide the rules of priority when a taxpayer’s financial results are reported as part of a group AFS and also as in a separate AFS.
What if my business is not covered by an AFS?
While IRC §451(b) does not apply to taxpayers without an AFS, if you have financial statements that are prepared, compiled or reviewed under GAAP/IFRS standards that resulted in a change in the way revenue is recognized, you will need to consider how financial statement revenue may need to be adjusted for tax reporting purposes so it does not result in an unintended change in accounting method. Alternatively, you may consider applying for a change in accounting method, keeping in mind the differences between financial statement reporting and tax reporting discussed above.
Next Steps
If you are covered under an AFS and there has been a change to the way you have recognized revenue in the past, you will need to determine how these rules apply to you. As with all tax rules and procedures there are exceptions to the general rules, each taxpayer’s particular fact pattern needs to be considered in order to apply the rules correctly. If your method of accounting for revenue has changed, it is likely that you will need to file Form 3115, Application for Change in Accounting Method. The IRS has published guidance for automatic changes that may be available. We will continue to monitor the IRS guidance in this area, currently, the regulations are only in the proposed form and have not been finalized.
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[1] Proposed Treas. Reg. §1.451-3(c)(6)(ii) amounts included in AFS are presumed to not be contingent on the occurrence or nonoccurrence of a future event, unless on the examination of the all the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event.
[2] Proposed Treas. Reg. §1.451-3(m)(6) –Example 6.
[3] Proposed Treas. Reg. §1.451-3(m)(6) –Example 7
[4] IRC §451(b)(3)
[5] IRC §451(b)(5)
[6] Proposed Treas. Reg. §1.451-3-(h)
