1 - background on the new revenue recognition standard · page 4 agenda introduction tax reform...

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Disclaimer

► This presentation is provided solely for the purpose of enhancing knowledge on

tax matters. It does not provide tax advice to any taxpayer because it does not

take into account any specific taxpayer’s facts and circumstances.

► These slides are for educational purposes only and are not intended, and

should not be relied upon, as accounting advice.

► The views expressed by the presenters are not necessarily those of

Ernst & Young LLP.

► This presentation is © 2018 Ernst & Young LLP. All Rights Reserved.

Revenue RecognitionThe immediate tax focus

26 February 2018

Today’s presenters

Alison JonesPrincipal, National Tax

Ernst & Young LLP

[email protected]

P: (202)327-6684

Jamison MeredithPartner

Ernst & Young LLP

[email protected]

P: (214) 969-8119

Revenue Recognition I Quantitative Services

mailto:[email protected]

mailto:[email protected]

Agenda

► Introduction

► Tax reform revisions to Section 451

► The revenue recognition standard

► Key considerations for tax analysis

► Planning and priorities


Tax reform

Revisions to Section 451 in Tax Cuts and Jobs Act

• Accrual basis taxpayers include an amount in income when all events have occurred that fix the right to receive the income and the

amount is determinable with reasonable accuracy (unless an exception applies)

• Cash basis taxpayers include an amount in income when it is actually or constructively received

Previous law (prior to Tax Cuts and Jobs Act)

• Generally requires accrual basis taxpayers to recognize income at the earlier of when recognized for tax purposes under

Section 451 (the “all events test”) or when taken into account in applicable financial statements (effectively requiring tax

recognition at the earlier of earned, due, received or recognized for financial statement purposes)

• Codifies the all events test and specifies the test should be applied to items of gross income

• Applicable to special rules for bonds and other debt instruments in part V of subchapter P, including the original issue discount

rules; however, does not apply to any item of gross income in connection with a mortgage servicing contract

• Other special methods of accounting for reporting gross income (such as the installment method under Section 453 or the long-

term contract method under Section 460) not impacted

• For contracts with multiple performance obligations, the amount allocated to each performance obligation for financial

statement purposes shall be followed for tax

• Codifies the deferral method of accounting for advance payments currently in Rev. Proc. 2004-34 (one-year deferral for certain

advance payments)

• Effective for tax years beginning after December 31, 2017, and implemented as a change in method of accounting

• Retains rules for cash basis taxpayers to include an amount in income when it is actually or constructively received

New enacted Section 451


Summary of tax rules for recognizing incomePrior to tax reform

Tax follows statutory rules for recognizing income:

• Amount can be determined with reasonable accuracy

• Properly accrued on basis of a reasonable estimate

• Differences generally taken into account in year precise determination is made

• Amount is fixed, meaning the earlier of:

• Earned – required performance or events have taken place

• Due to taxpayer (based on contract terms)

• Received by taxpayer

• Advance payments (e.g., follow book deferral for 1-2 years)

• Long-term contracts

• Installment sales

Determinable

Fixed

Special rules

Section 451 and Treas. Reg. § 1.451-1(a)


Tax reform revisions to Section 451New IRC Section 451(b)

• Amount can be determined with reasonable accuracy

• Properly accrued on basis of a reasonable estimate

• Differences generally taken into account in year precise determination is made

• Amount is fixed, meaning the earlier of:

• Earned – required performance or events have taken place

• Due to taxpayer (based on contract terms)

• Received by taxpayer

• Advance payments (new Section 451(c) – follow book deferral for 1 year)

• Long-term contracts

• Installment sales

Determinable

Fixed

Special rules

• Requires taxpayers to recognize income at the earlier of:

• when fixed (above), or

• when taken into account in applicable financial statementsSection 451(b)

Not a book conformity rule, an earlier than rule

Section 451(b) does not provide simple book conformity, but rather requires taxpayers to carefully evaluate both tax rules and financial accounting recognition to determine the appropriate timing for tax income recognition


Revenue recognition standard


Background

► Financial Accounting Standards Board (FASB) Topic Accounting Standards

Codification (ASC) 606/International Financial Reporting Standards (IFRS)

15, Revenue from Contracts with Customers (Topic 606), is effective under

US generally accepted accounting principles (GAAP) for public entities for

annual and interim periods beginning after 15 December 2017.

► This new revenue recognition standard:

► Creates one comprehensive revenue recognition model for all contracts across

virtually all entities and sectors, which replaces current industry- or transaction-

specific guidance

► Provides principles-based revenue guidance based on a five-step model

► Each step requires companies to make judgments about the terms of their contracts and

estimates of the transaction price, as well as to make more disclosures about these

judgments and estimates.

► It is regulatory-driven, mandatory and applicable to all companies, regardless

of industry.

► Virtually all entities deriving revenue under contractual agreements with customers

must evaluate the impact, including adequately scoping out the tax

considerations associated with their Topic 606 implementation.


Core principle: Recognize income at the earlier of when all events have occurred to

earn the revenue or when the revenue is recognized in an applicable financial

statement

Core principle: Recognize revenue to depict the transfer of promised goods or

services to customers in an amount that reflects the consideration to which the entity

expects to be entitled in exchange for those goods or services

Book

Tax

Identify the contract(s) with

a customer

Identify the separate

performance obligations in the contract

Determine the transaction

price

Allocate transaction price to the separate

performance obligations in the contract

Recognize revenue when

or as entity satisfies a

performance obligation

Confirm the amount of

income that can be determined

with reasonable accuracy

Determine when the company

has a fixed right to the income –

either when earned, due, or

received

Consider special rules

Compare when revenue is

recognized for book

Identify income streams and underlying contracts

Step 1 Step 2 Step 3 Step 4 Step 5

Comparison of Topic 606 book and tax revenue recognition models


Key considerations for tax analysis

► Book revenue recognition ≠ IRC Section 451

► Contract terms and fact patterns vary from company to

company

► Any change in current tax treatment requires a tax method

change


Common tax misconceptions

► Company not finished implementing = tax needs to wait?

► Immaterial for book = no tax action needed?

► Section 451(b) = tax now follows book

► “Following book” = proper tax method of accounting


Example

Taxpayer (TP) enters into a 4-year contract which provides it a $40 performance

bonus in year 4 if certain conditions are satisfied, and a $40 commission is paid

to the TP’s employee upon the sale of the contract.

Potential Topic 606 treatment Tax treatment

• $40 performance bonus may be recognized

ratably over the contract period

• $40 commission may be capitalized and

recognized ratably over contract period

• Section 451(b) requires recognition of the

performance bonus at the earlier of:

when the all events test is met (in Year 4

if conditions are met), or

when recognized in revenues in an

applicable financial statement ($10 in

Years 1-4)

• Entire commission expense should be recognized

in year 1

F/S result: potential $0 impact Tax result: An acceleration of income; Schedule M

adjustment for expense

x

Operational considerations

It is important to look for items presented on a “net change” basis as there may be offsetting items of income and expense that need to be considered for tax purposes.


Qualitative Example Facts

► Manufacturer sells widgets to customers

► The standard contract for widget sales includes a 3-year

warranty and free accessories

► The new revenue recognition standard* requires the

manufacturer to analyze the contractual obligations associated

with the sale of widgets

► For this manufacturer, the analysis results in identifying three

distinct performance obligations in its contract to sell widgets to

customers

► Currently the manufacturer does not separately identify or

allocate part of the sales price to these performance obligations

► The tax department has historically “followed book”

*FASB Topic ASC 606/IFRS 15, Revenue from Contracts with Customers

Qualitative Example

Book method pre-

adoption:

Sale of Goods

New Revenue Recognition Standard:

Identify performance obligations

Recognize revenue from

the sale of:

Recognize revenue from the sale of:

1 bundled revenue stream =

1 tax method of accounting

“follows book”

3 distinct performance obligations =

3 new considerations for tax

methods of accounting/book-tax differences?

widgets

the widget “free” accessories

warranty


Qualitative ExampleTax questions

1. Does Taxpayer (TP) have the sale of one item or three items?

2. What is the current book treatment for the Widget revenue?

3. What is the new book treatment for the three identified

performance obligations?

4. How is TP’s “follow book” tax accounting method impacted?

5. Are there other tax considerations to be examined?

6. How are TP’s systems and processes impacted?


Quantitative Example – Bundled Contract Steps 1 and 2: Identify contract

Contract with customer

► Contract signed 1 July 2018

► $3,000 bundle of equipment,

software and service agreement

► Three-year service maintenance

period

One contract Four performance obligations

Equipment

Software

Service agreementThis contract was signed during

a promotional period that included a

free six-month term license

subscription.

Performance obligations

Subscription license

Step 1:

Identify the

contract

Step 2:

Identify

performance

obligations

Step 3: Determine

transaction price

Step 4: Allocate

transaction price

Step 5:

Recognize

revenue


Quantitative Example – Bundled ContractStep 3: Determine the transaction price

Is there variable consideration?

What is the stated transaction price?

What is the total transaction price?

Equipment, software and service $3,000

Free subscription $0

$3,000

This contract was signed during

a promotional period that included a

free six-month term license

subscription.

Step 1:

Identify the

contract

Step 2:

Identify

performance

obligations

Step 3: Determine

transaction price

Step 4: Allocate

transaction price

Step 5:

Recognize

revenue

Contract with customer

► Contract signed 1 July 2018

► $3,000 bundle of equipment,

software and service agreement

► Three-year service maintenance

period


Quantitative Example – Bundled Contract Step 4: Allocate the transaction price

List price per

written contract

Estimated

SSP*

% of relative

selling price

% of transaction

price

Allocation of

transaction price

Equipment $300 $600 12% 12% * $3,000 $360

Software $1,800 $2,500 50% 50% * $3,000 $1,500

Service agreement $900 $1,500 30% 30% * $3,000 $900

Subscription $0 $400 8% 8% * $3,000 $240

Total $3,000 $5,000 100% $3,000

Stated transaction price

Equipment, software and service $3,000

Free subscription $0

$3,000

How much relates to

the equipment? to the

service? software?

subscription?

Company determines each list

price based off SKU’s bill of

materials:

Equipment – 10%

Software – 60%

Service agreement – 30%

Step 1:

Identify the

contract

Step 2:

Identify

performance

obligations

Step 3: Determine

transaction price

Step 4: Allocate

transaction price

Step 5

Recognize

revenue

*Standalone selling price


Quantitative Example – Bundled ContractStep 5: Recognize revenue

2018 2019 2020 2021 Total

Current book accounting $500 $1,000 $1,000 $500 $3,000

Future revenue pattern

Equipment $360 $360

Software $1,500 $1,500

Service $150 $300 $300 $150 $900

Subscription $200 $40 $240

Total revenue $2,210 $340 $300 $150 $3,000

Difference ($1,710) $660 $700 $350 $0

Equipment

Software

Three years of service maintenance, beginning on date of contract

Performance obligations When does control transfer?

Point in time

Over time

What is the appropriate measure of progress?

Delivery

Passage of time

Assess new criteria for when control transfers

Six month subscription, activated 1 Aug 2018

Step 1:

Identify the

contract

Step 2:

Identify

performance

obligations

Step 3: Determine

transaction price

Step 4: Allocate

transaction price

Step 5:

Recognize

revenue


Complexities and Government Guidance

► Sections 451(b) and (c)

► Procedural guidance

► Substantive guidance

► Recent ABA discussion

► ASC 606

► Public Company Accounting Oversight Board (PCAOB) indicated

that adoption of the standard will be a major focus of regulators’

inspections

► Comment letters and guidance


Planning and priorities

Actions for tax to take now on revenue recognition…

1

2

3

4

5

6

Solidify federal tax return treatmentDetermine applicability and timing for filing of Form(s)

3115, compute new / modified Schedule M

adjustments and update tax processes, systems and

controls

Assess other tax implicationsState and local taxes; transfer pricing; compensation and benefits

1

2

3

4

5

6

Identify current book and tax methodsOrganize by revenue stream, identify current GL accounts, and

confirm current book and tax methods for recognizing revenue

Assess changes to financial statement revenue

recognition methodsConsider changes in timing of revenue recognition as well as the

identification of additional performance obligations or revisions

impacting the allocation of transaction price

Document and assess changes to current tax

methods and tax reform impactsIdentify any required or optional tax method changes and the related

procedural rules for making a change. For tax methods that will not

change consider data requirements for computing taxable income.

Compute deferred tax impactWill need to obtain supporting schedules that include data organized

by jurisdiction, revenue stream and performance obligation to assess

new, or remeasure existing, temporary differences


Thank You!


Thank You!

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