In 2014, a new accounting standard on how to recognize revenue from contracts was issued by the Financial Accounting Standards Board (FASB). Now the IRS is allowing a new automatic change in accounting method for businesses to use to conform with the new financial accounting standard. This will allow for more book-tax conformity and facilitate accounting method change requests associated with adopting the new standard.
New Accounting Rules
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, goes into effect in 2018 for public companies and 2019 for private ones. The new revenue recognition standard requires entities following U.S. Generally Accepted Accounting Principles (GAAP) to recognize contract revenue for promised goods and services to customers based on the following five 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.
5. Recognize revenue as the entity satisfies a performance obligation.
The new revenue recognition standard is a significant change from current accounting practices, particularly for technology firms, construction contractors and service providers with warranty and repair service contracts. However, the recognition rules for tax purposes remain unchanged.
Under the tax rules, businesses that follow the accrual method of accounting accrue income when the right to receive income is fixed and the amount can be determined with reasonable accuracy. This is known as the “all events” test.
IRS Change of Accounting Method
Your business can apply for a change in accounting method by filing IRS Form 3115 and submitting detailed information about the change. To alleviate the administrative burden, the IRS created a list of “automatic” method changes whereby a business is deemed to have the consent of the IRS to change its accounting method if it’s within the scope of a revenue procedure and any related guidance for the specific method change.
When a business changes its accounting method for tax purposes, adjustments are generally required to be made to prevent items from being duplicated or omitted. Sometimes, the IRS allows a “cutoff” method instead, where only the items arising on or after the beginning of the year of change are accounted for under the new accounting method.
Syncing GAAP Revenue and Taxable Income
Most entities would prefer to use the same method of recognizing revenue under GAAP as they do for reporting taxable income to the IRS. The new IRS guidance provides procedures to obtain automatic IRS consent to change to an otherwise permissible accounting method under ASU 2014-07, if such method change is otherwise permissible for federal income tax purposes and is made for the tax year in which a business adopts the new accounting standard.
Specifically, Revenue Procedure 2018-29 applies small business exception rules to more businesses and gives taxpayers the option of implementing the accounting method change either with an adjustment or on a cutoff basis. If needed, the IRS may issue additional guidance as the IRS and businesses obtain more experience with the interaction of the new standard with federal income tax accounting methods.
We Can Help
The new IRS guidance simplifies the procedures needed to align your taxable income with the amount of revenue reported on your financial statements. Contact us for answers to your questions about how to implement the changes.