IRS Issues Taxpayer Favorable Change of Accounting Method Procedures to Align with New Revenue Recognition Standards
By Jeff Borchers and Lynn Loden
On May 28, 2014, FASB and IASB jointly announced new financial accounting standards for revenue recognition, titled “Revenue from Contracts with Customers (Topic 606).” For publicly-traded entities, Topic 606 was required to be adopted for annual accounting periods beginning after December 15, 2017 and all other entities beginning after December 15, 2018.
The IRS recently issued Rev. Proc. 2018-29, which went into effect on May 10, 2018. Rev. Proc. 2018-29 provides new procedures for taxpayers that have adopted Topic 606 for changing their method of recognizing revenue for federal income tax purposes.
Rev. Proc. 2018-29 specifically excludes, among other items set forth under section 3.01, (1) any requests for changes in method of accounting for amendments to IRC §451 concerning certain book-conformity requirements for filers of “applicable financial statements” and (2) advanced payments in connection with the Tax Cuts and Jobs Act signed into law on December 22, 2017 (“TCJA”). The IRS will publish guidance on amendments to IRC §451 at a later date.
Topic 606 vs. Tax Law - Financial Statement Impact
Under Topic 606, an entity will recognize revenue for promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services based on the following sequential steps: (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; and (5) recognize revenue as the entity satisfies a performance obligation.
In contrast, the “all events test” under IRC §451 primarily governed the recognition of income for federal income tax purposes before the TCJA. The “all events test” is met with respect to any item of gross income if all the events have occurred which fix the right to receive such income and the amount of such income can be determined with reasonable accuracy. All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due, or (3) payment is made, whichever happens first. Schlude v. Commissioner, 372 U.S. 128, 133 (1963); Rev. Rul. 84-31, 1984-1 C.B. 127; Rev. Rul. 80-308, 1980-2 C.B. 162.
There were differences in revenue recognition for financial and tax reporting purposes for items such as advanced payments, treatment of long-term contracts, accounting for sales and returns of goods and earning income from warranties before Topic 606. These book and tax differences created deferred tax assets or liabilities recorded in the balance sheet of the financial statements. Upon implementation of Topic 606, the deferred balances in the financial statements potentially change with the recognition or de-recognition of assets and liabilities unless the taxpayer changes its method of accounting for federal income tax purposes to another permissible method in accordance with IRC §451 which aligns with the changes made under Topic 606.
Making the Change
Accounting method changes under Rev. Proc. 2018-29 only apply to taxpayers that want to change its method of accounting for the recognition of income for federal income tax purposes to a new method under Topic 606 for (1) identifying performance obligations, (2) allocating transaction price to performance obligations, and/or (3) considering performance obligations satisfied. A taxpayer may request a change only if the taxpayer’s new method of accounting is otherwise permissible for federal income tax purposes and the change in method of accounting is made for the taxable year in which the taxpayer adopts Topic 606. Rev. Proc. 2018-29 does not apply to (among other items in Section 3.01) a change in the manner which the taxpayer identifies contracts or determines the transaction price, including the inclusion and exclusion of variable consideration in the transaction price under Topic 606 or to long-term contracts under IRC §460(e)(1).
A change in method of accounting is filed by completing Form 3115, and Rev. Proc. 2018-29 only requires certain sections to be completed which streamlines the process. The tax accounting method change is “automatic” and does not need to be approved by the Commissioner of the IRS (although it is not a determination by the Commissioner that the new method is a permissible method of tax accounting) and is filed with the taxpayer’s return for the year of the change in accounting method with a duplicate copy sent to the IRS.
The taxpayer can implement the tax accounting change with either a §481 adjustment (generally spread over four years for unfavorable adjustments) or implement the change using the “cut-off” method. Under the “cut-off” method, only items arising on or after the beginning of the year of change are accounted for under the new method of accounting. Any items arising before the year of change continue to be accounted for under the taxpayer’s former method of accounting.
One of the primary benefits of a change in tax accounting method is administrative convenience, especially in cases where companies have multiple forms of contracts delivering both goods and services. Aligning book and tax methods of accounting should reduce the amount of time of determining the differences between the two methods, which may offset the time value of money from selecting a more beneficial tax accounting method. Aligning both methods may also reduce the risk of misstatement of deferred balances in financial statements. Other than easing administrative burden, there could be opportunities for cash tax benefit if the taxpayer was required to recognize income for tax purposes before recognizing revenue for financial accounting purposes.
About the Authors:
Jeff Borchers a Managing Director with Opportune’s Tax practice in Houston. Jeff has over 20 years of tax, treasury, accounting and legal experience serving clients in various segments of the energy sector. He has extensive experience in partnership and corporate tax law, tax accounting and tax compliance. Prior to Opportune, Jeff was with KPMG where he led the firm’s Alternative Investments practice serving private equity firms and portfolio companies in all facets of taxation. Jeff also signed off on large public company tax provisions. Prior to KPMG, he served as Vice President – Tax/Assistant Treasurer at Willbros Group Inc. where he re-domiciled and restructured the company, reducing its overall effective tax rate, promoted tax compliance across all business units in multiple U.S. and international tax jurisdictions, settled U.S. and international tax disputes, participated in buy-side due diligence and managed Willbros’ cash and covenants under its credit facility during challenging times. Jeff holds a Bachelor of Science degree in Accounting from DePaul University and a Juris Doctor (J.D.) degree from the John Marshall Law School.
Lynn Loden is a Managing Director at Opportune with responsibilities in the Transaction Services and Tax practice areas. Lynn has over 30 years of business experience, ultimately becoming an M&A partner at Arthur Andersen LLP, and then Deloitte Tax. While in public practice, he served clients in numerous transaction support roles including planning, structuring and execution assistance, and financial reporting of income taxes. He provided firm wide technical support in SFAS No. 109/ASC 740 matters, Subchapter C (corporate) events, and lease and structured financings arrangements. He was a panelist before the FIN 48 working group of the FASB, and has represented clients and provided testimony before the Internal Revenue Service national office. Lynn’s practice currently focuses on the application of this experience to Opportune’s energy-focused clients in support of the Firm’s business lines. Lynn is a licensed CPA in the State of Texas.