The Tax Cuts and Jobs Act (TCJA) lowered corporate income taxes overall and established new categories for foreign income subject to taxation. But the fine print also contains a narrow section that U.S. companies should pay attention to — a provision requiring them to recognize revenue for tax purposes no later than when it’s recognized for financial reporting purposes.
If your company follows U.S. Generally Accepted Accounting Principles (GAAP), your accounting method might result in higher-than-expected tax obligations — especially as you implement the new revenue recognition rules. Here are the details.
The TCJA modified Section 451 of the Internal Revenue Code so that a business must recognize revenue for tax purposes no later than when it is recognized for financial reporting purposes. The revision to Sec. 451 says that, for taxpayers who use the accrual method of accounting, the “all events test” is met no later than the taxable year in which the item is taken into account as revenue in a taxpayer’s “applicable financial statement.”
The change’s significance can’t be overstated. For tax purposes, companies want to minimize taxable income, and defer it when possible, so they owe less tax in the current year. But the TCJA provision is intended to help the federal government collect tax revenue sooner rather than later.
For accounting purposes, companies want to maximize earnings — within the limits of GAAP — to present financial results in the best possible light to investors and lenders. The Financial Accounting Standards Board (FASB) implements rules to ensure operational results are presented fairly and accurately.
Updated revenue recognition guidance under GAAP
The TCJA revenue recognition change is amplified by the changes to financial reporting under FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers. The updated revenue recognition guidance went into effect for public companies this year and will go into effect in 2019 for privately held businesses.
The updated standard erases reams of industry-specific revenue guidance from GAAP and calls for a single model for businesses to calculate the top line in their income statements. However, it doesn’t change the underlying economics of a business’s revenue stream. Rather, in many cases, it changes the timing as to when companies record revenue in their financial statements.
The revenue recognition standard introduces the concept of performance obligations in contracts with customers, and it allows revenue to be recorded only when these performance obligations are satisfied. This could mean revenue is recorded right away or in increments over time, depending on the transaction.
For example, when a customer buys a $5 sandwich from a deli and gets $0.25 worth of loyalty points, the store would previously have recognized $5 at the time of sale. Under the new standard, when a customer orders the same $5 sandwich, the transaction might be carved into two separate performance obligations: 1) $4.75 recognized for the point-in-time purchase, and 2) $0.25 recognized over time for the loyalty points redeemable in the future.
With the TCJA changes to the tax code, this new revenue pattern will likely have tax implications. The changes will be most apparent for complex, long-term deals, when the timing of revenue recognition could change significantly. In some industries, this could mean accelerated tax bills. For instance, most software companies expect to record revenues in their financial statements earlier than they did under the old accounting.
The TCJA also added a rule for advance payments under Sec. 451. At a high level, the rule requires businesses to recognize taxable income even earlier than when the income is picked up for financial reporting purposes if the company receives a so-called “advance payment.”
Some companies delivering complex products to customers, such as an aerospace parts supplier making a custom component, may receive payments from customers years before they build and deliver the product. According to ASC Topic 606, a business can’t recognize revenue until it has completed all of its performance obligations in the contract, even if it has been paid in advance.
Under current law, you might need to revise your tax planning strategies. Contact B&V tax and accounting advisors to discuss how the TCJA will affect your company’s accounting for financial reporting and tax purposes.
Cash vs. accrual accounting methods
Companies following U.S. Generally Accepted Accounting Principles (GAAP) are required to use the accrual method of accounting for financial reporting purposes. The accrual method generally matches revenue to the period in which it’s earned and expenses to the period in which they’re incurred (regardless of cash inflows and outflows).
Private companies aren’t required to follow GAAP for financial reporting purposes, but many do so to promote consistency and accommodate stakeholders’ preferences. On the flipside, eligible companies often prefer to use the cash method of accounting for tax purposes, because it allows greater flexibility in tax planning.
The Tax Cuts and Jobs Act (TCJA) expands the threshold for companies that are eligible for the simplified cash method of accounting for tax purposes. Under the TCJA, for tax years beginning after 2017, businesses can use the cash method if their average annual gross receipts for the three previous tax years didn’t exceed $25 million. The cash method is allowed even if the purchase, production or sale of merchandise is an income-producing factor for these taxpayers.
In general, the cash method may allow smaller businesses to defer tax obligations. For example, under the cash method, they may defer income into the next tax year by holding off on mailing invoices. Or they might prepay expenses to accelerate expenses claimed in the current tax year.
Although many more businesses are eligible for the cash method under the TCJA, changes to Internal Revenue Code Section 451 (see main article) also require them to recognize revenue for tax purposes no later than when it’s recognized for financial reporting purposes. So, businesses that use the accrual method for financial reporting purposes may not be eligible to use the cash method to recognize income for tax purposes.
The changes to Sec. 451 could limit the availability of these cash-method tax planning strategies. What’s worked for you in the past might not be the right choice under the TCJA. Contact B&V tax and accounting advisors, at 713-667-9147 or firstname.lastname@example.org, to determine which method of accounting is right for your business.