The good news? When it comes to revenue recognition, tax law isn’t changing. The bad news? Thanks to new revenue recognition rules, book to tax differences are changing. And because tax prep generally starts with book income, this means that the construction industry, among others, will need to start changing their thinking about tax liability, too.
The goal of the new rules is to establish standards for reporting useful information in financial statements about the nature, amount, timing, and uncertainty of revenue from long-term contracts with customers. The standards aim to clarify the principles for recognizing revenue. You can apply standards consistently across various transactions, industries, and capital markets — in order to improve financial reporting by creating common guidance for U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The core principle is that you should recognize revenue in an amount and at a time that aligns with expectations for the actual amount to be earned when it is actually earned (i.e., when the goods or services are delivered). That’s different from what we do today. Here are some areas affected by the changes:
Under current GAAP, the costs of uninstalled materials, if constructed specifically for the job, are included in the job cost. Under the new GAAP, contractors will recognize the revenue only to the extent of the cost or will capitalize them as inventory—you will recognize profits later. For tax purposes, uninstalled materials are still included in the job cost. You will have to recognize profits for tax purposes sooner than for book purposes.
Multiple performance obligations
Under the new GAAP, you may have to segregate one contract into two or more performance obligations — those revenues are recognized separately. For tax purposes, it is very difficult to segregate a contract (it requires a tax commissioner’s prior written consent) so a contractor might have to show one contract for tax purposes and two or three contracts for book purposes. For example, if you have a contract for a design build project and generally bid separately for the design phase and construction phase of this type of project, you might have to separate this contract into two performance obligations. For tax purposes, you will continue to treat this project as a single contract. These contracts most likely will have different profit margins and you will have to recognize revenue at a different pace.
Under current GAAP, contractors can’t recognize revenue on bonus payments until they are realized, usually at the end of the project. Under the new GAAP, contractors need to gauge the probability of the bonus payments’ being received and may have to include some or all of the bonus payments in the contract price — you will have to recognize revenue sooner. For tax purposes, variable considerations are included in the contract price when contractors can reasonably expect to collect them. The general practice is that tax follows what you record for books for the total contract price. Does this mean that you have to recognize revenue for tax purposes sooner, too? Or will it create a book to tax difference, subject to judgement? The IRS may be issuing some guidance on these issues.
With changes in book to tax differences due to changes in timing of when you recognize profits, there will also be a change in deferred taxes.
After implementing the new GAAP, you will need to segregate items like variable consideration and uninstalled materials. Even if your tax method doesn’t change, will you need to maintain and provide the information needed for tax return purposes? More companies might ask the IRS for permission to make accounting method changes for federal income tax purposes. The IRS may consider allowing an automatic method change in order to help companies conform more easily to the new standards. The IRS will also provide guidance on how the new revenue recognition rules affect tax reporting.
Accounting for GAAP purposes isn’t the same thing as accounting for tax purposes. But when it comes to the new revenue recognition rules, things can get complicated. To learn more about accounting method changes you might need to make, get in touch with your BerryDunn team today and see how the rules may affect your company.