A combination of recent changes in accounting and tax rules has created some potentially nasty traps that many companies risk falling into by the end of 2019.
The problems revolve around the tricky area of revenue recognition and the disconnect that these changes have created between accounting standards and tax rules. Many companies don’t realize the importance of recent book revenue recognition changes when it comes to taxes and aren’t planning early enough to be prepared for the impact.
New GAAP accounting standards took effect for public companies in 2018 and for private companies this year. New tax revenue recognition standards were introduced as part of the Tax Cuts and Jobs Act, effective for 2018. The combination of those two changes together has made tax situations a lot more complicated, with the potential to create serious costs and cash-flow problems that could take years to resolve.
Companies, especially mid-sized firms in manufacturing, distribution, and services that are likely to be most affected need to get on top of this now to minimize any tax hit in 2019.
The new GAAP rules essentially threw out the different industry standards of the old system and replaced them with a single, principles-based approach for all companies. The new approach may get you to the same numerical answer as the old one despite taking a different path to get there, but not always. For example, under the new rules, a manufacturer supplying widgets may end up being treated more like a service provider and having to recognize revenue as it’s making items rather than when they are delivered.
Despite this change, it’s important to realize that bookkeeping and tax planning are entirely different things. Just because something changed for bookkeeping absolutely does not mean it has to change for tax purposes, too. It becomes crucial to examine the tax rules, which have been built up over the past hundred years to make sure that what you are doing is appropriate.
However companies adapt to the changes, there will be headaches. Companies may have to adopt two parallel bookkeeping systems — one for the new GAAP rules and the other for tax purposes. While this isn’t the end of the world, it may create a lot of pain if you have already revamped your bookkeeping systems to meet the new standards and now have to somehow reverse engineer that for taxes.
Another path is to change your tax system to follow the new bookkeeping standards if tax law permits. In that case, companies must formally apply to the IRS for a change in their method of accounting. This approach at least means you can align your tax reporting with your book reporting, but a lot of homework needs to be done to make sure the new accounting method is appropriate for tax purposes.
Getting this right isn’t easy and the cost of making mistakes can be high, depending on the magnitude. The risk is that by understating revenue in one period and overstating it in another, you may be liable for penalties both for underreporting income and for underpaying estimated taxes.
Things get even more perilous when you take into account new tax rules on revenue recognition acceleration that came into effect in 2018. These rules, which only apply to companies that have audited financial statements, have generally made it mandatory to recognize revenue for tax purposes no later than for bookkeeping purposes. But the same doesn’t apply for expenses, meaning that companies risk getting slammed with taxes on revenue this year without being able to deduct the expenses until the following year.
This can cause some ugly problems, illustrated by the following example. An auto-parts maker plans to sell inventory in 2020 for $1 million that cost $900,000 to make. Under the old rules, they would have recorded both in 2020. Under the new accounting rules, however, they may have to record a substantial amount of that $1 million in revenue in 2019 but the expenses have to stay in 2020.
Even though the profit on the transaction was only $100,000, the company is on the hook to pay taxes on most of the $1 million this year. Worse still, changes to rules on net operating losses mean that you can no longer take the loss from next year and offset it with the prior year’s taxable income. What appears on the surface to be just a timing issue can result in far more severe implications.
So what should companies be doing to avoid these pitfalls? Here are four steps that could help.
1. Make sure that someone at the company is paying attention and has a full understanding of where the company stands in relation to the new GAAP rules and whether it is already behind the curve. With 2019 already three-quarters old, the company in the example above could already be facing hefty penalties for underpayment of estimated taxes.
2. Since the new GAAP rules are based on principles, there is inherent flexibility in how they can be interpreted. There may, for example, be arguments you can make to use a different revenue recognition pattern for a transaction that results in a better tax answer. Even if you can’t, you may need to determine how to properly track revenue for income tax purposes before abandoning old methodologies. At a minimum, you may want to change the way in which transactions are recorded on your general ledger to make it easier to identify tax significant items when preparing tax returns.
3. Changing the way your contracts with customers are written may allow you to avoid pulling revenue forward and avoid the tax problem in the future.
4. Since the revenue recognition acceleration rules only apply to companies with audited financial statements, switching to another system such as reviewed financial statements could be a way out.
It’s quite possible to be in a scenario where none of these last three options provide a viable escape route. For example, your bank may rule out a shift to reviewed financial accounts. But if you don’t start to examine the possibilities now, it may soon be too late to even try.
Kurt Piwko is a partner at Plante Moran’s National Tax Office.
