The Tax Cuts and Jobs Act (TCJA) contains a provision that ties revenue recognition for book purposes to income reporting for tax purposes, for tax years starting in 2018. This law could have a major impact on industries dealing with contracts, such as construction, especially as companies implement the updated revenue recognition standard under U.S. Generally Accepted Accounting Principles (GAAP).
This accounting rule will cause some companies with complex, long-term contracts to recognize revenue earlier than in the past. All construction companies that report their financial statements under GAAP will need to implement the new standard within the accounting function affecting their internal controls, systems and processes. It may require advance payments to be taxed before they’re recognized on the financial statements. The net effect of these accounting rule and tax law changes could be substantially accelerated tax bills.
Revenue Recognition Under GAAP
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, went into effect for public companies for periods beginning after December 15, 2017; it will go into effect for private companies for periods beginning after December 15, 2018. The updated standard requires businesses to all use a single model for calculating the top line in their income statements under GAAP, as opposed to following various industry-specific models.
The standard doesn’t change the underlying economics of a business’s revenue streams; however, it may change the timing of when companies record revenue in their financial statements. The standard introduces the concept of “performance obligations” in contracts with customers and allows revenue to be recorded only when these obligations are satisfied. It could mean revenue is recorded right away or in increments over time, depending on the underlying contract. The changes will likely affect complex, long-term contracts.
Advance Payments Under TCJA
Starting in 2018, the TCJA modifies Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it’s recognized for financial reporting purposes. Under Section 451(b), taxpayers that use the accrual method of accounting will meet the “all events test” no later than the taxable year in which the item is considered as revenue in a taxpayer’s “applicable financial statement.” Section 451 also requires that taxpayers allocate a contract’s transaction price among the performance obligations consistent with how it is allocated for GAAP purposes.
The TCJA also added Section 451(c), referred to as the “rule for advance payments.” At a high level, the rule can require businesses to recognize taxable income even earlier than when it’s recognized for book purposes if the company receives a so-called “advance payment.”
Some companies delivering complex products can receive payments from customers years before they build and deliver the product. Under ASU 2014-09, a business can’t recognize revenue until it’s completed its performance obligations in the contract, even if an amount has been paid in advance. However, under Sec. 451(c), companies may be taxed before they recognize revenue on their financial statements from contracts that call for advance payments.
Revenue Recognition Rule Changes Could Affect You
Changes in the TCJA, combined with the new revenue recognition rules under GAAP, will cause some companies to recognize taxable income sooner than in the past. In some industries, this could mean significantly accelerated tax bills. However, others won’t experience any noticeable differences. We can help you evaluate how the accounting rule and tax law changes will affect your company, based on its unique circumstances.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.