Revenue Recognition. The immediate tax focus. 26 February 2018

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1 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. EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms, of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. Page 1

2 Revenue Recognition The immediate tax focus 26 February 2018

3 Today s presenters Jamison Meredith Partner Ernst & Young LLP Jamison.Meredith@ey.com P: (214) Alison Jones Principal, National Tax Ernst & Young LLP Alison.Jones@ey.com P: (202) Page 3

4 Agenda Introduction Tax reform revisions to Section 451 The revenue recognition standard Key considerations for tax analysis Planning and priorities Page 4

5 Tax reform Page 5

6 Revisions to Section 451 in Tax Cuts and Jobs Act Previous law (prior to 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 New enacted Section 451 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 longterm 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 (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 Page 6

7 Summary of tax rules for recognizing income Prior to tax reform Tax follows statutory rules for recognizing income: Determinable 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 Fixed 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 Special rules Advance payments (e.g., follow book deferral for 1-2 years) Long-term contracts Installment sales Section 451 and Treas. Reg (a) Page 7

8 Tax reform revisions to Section 451 New IRC Section 451(b) Determinable Fixed Section 451(b) Special rules 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 Requires taxpayers to recognize income at the earlier of: when fixed (above), or when taken into account in applicable financial statements Advance payments (new Section 451(c) follow book deferral for 1 year) Long-term contracts Installment sales 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 Page 8

9 Revenue recognition standard Page 9

10 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 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 transactionspecific 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. Page 10

11 Comparison of Topic 606 book and tax revenue recognition models 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 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 Step 1 Step 2 Step 3 Step 4 Step 5 Tax Identify income streams and underlying contracts 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 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 Page 11

12 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 Page 12

13 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 Page 13

14 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 $40 performance bonus may be recognized ratably over the contract period $40 commission may be capitalized and recognized ratably over contract period Tax treatment 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 x 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 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. Page 14

15 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 Page 15

16 Qualitative Example Book method preadoption: Sale of Goods Recognize revenue from the sale of: New Revenue Recognition Standard: Identify performance obligations Recognize revenue from the sale of: the widget free accessories widgets warranty 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? Page 16

17 Qualitative Example Tax 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? Page 17

18 Quantitative Example Bundled Contract Steps 1 and 2: Identify contract 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 This contract was signed during a promotional period that included a free six-month term license subscription. Performance obligations Equipment Software Service agreement Subscription license One contract Four performance obligations Page 18

19 Quantitative Example Bundled Contract Step 3: Determine the transaction price 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 This contract was signed during a promotional period that included a free six-month term license subscription. What is the stated transaction price? Is there variable consideration? What is the total transaction price? Equipment, software and service $3,000 Free subscription $0 $3,000 Page 19

20 Quantitative Example Bundled Contract Step 4: Allocate the transaction price Step 1: Identify the contract Step 2: Identify performance obligations Step 3: Determine transaction price Step 4: Allocate transaction price Step 5 Recognize revenue 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% 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, % $3,000 *Standalone selling price Page 20

21 Quantitative Example Bundled Contract Step 5: Recognize revenue Step 1: Identify the contract Step 2: Identify performance obligations Step 3: Determine transaction price Step 4: Allocate transaction price Step 5: Recognize revenue Performance obligations Equipment Software Three years of service maintenance, beginning on date of contract Six month subscription, activated 1 Aug 2018 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 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 Page 21

22 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 Page 22

23 Planning and priorities Page 23

24 Actions for tax to take now on revenue recognition 1 Identify current book and tax methods Organize by revenue stream, identify current GL accounts, and confirm current book and tax methods for recognizing revenue Assess changes to financial statement revenue recognition methods Consider 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 impacts Identify 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 impact Will need to obtain supporting schedules that include data organized by jurisdiction, revenue stream and performance obligation to assess new, or remeasure existing, temporary differences Solidify federal tax return treatment Determine applicability and timing for filing of Form(s) 3115, compute new / modified Schedule M adjustments and update tax processes, systems and controls 6 Assess other tax implications State and local taxes; transfer pricing; compensation and benefits Page 24

25 Thank You! Thank You! Page 25