ASC 740 implications of accounting method changes

Transcription

1 ASC 740 implications of accounting method changes December 2015

2 Contents Background... 1 Overview... 2 Transition to new accounting method... 3 Changes from proper accounting methods... 4 Automatic changes... 4 Example #1A Proper to proper, positive 481(a) adjustment:... 4 Example #1B Proper to proper, negative 481(a) adjustment:... 6 Non-automatic changes... 7 Example #2A Proper to proper, negative 481(a) adjustment... 7 Example #2B Proper to proper, positive 481(a) adjustment...8 Changes from improper accounting methods Example #3A Improper to proper, positive 481(a) adjustment...11 Example #3B Improper to proper, negative 481(a) adjustment Let s talk PwC

3 Background For federal income tax purposes, a taxpayer must obtain Internal Revenue Service (IRS) consent before changing its method of accounting for any item. In general, this consent is obtained by filing Form 3115, Application for Change in Accounting Method. IRS revenue procedures exist that are intended to encourage prompt and voluntary compliance with tax accounting principles. They do this by providing favorable terms and conditions for taxpayer initiated method changes. Depending on the facts surrounding the change, terms can include a prospective year of change, a four-year spread of an unfavorable Section 481(a) adjustment, and audit protection that prevents the IRS from raising the same issue in an earlier year. As companies are faced with continuous legislative, business and operational changes within their organizations, taxpayers may look to proactively monitor and manage their tax accounting methods to ensure proper and advantageous methods are used. In addition, cash tax efficiency continues to be a priority for many companies accounting method elections can help (or hurt) in achieving it. Recent developments such as the issuance of the new revenue recognition accounting standard and tangible property regulations only further illustrate the relevance and importance of prudently selecting tax accounting methods. To assist in working through the accounting considerations, we have drafted the following guidance with related examples to highlight common scenarios we find in practice. PwC 1

4 Overview The two most important characteristics of a tax method of accounting (hereinafter "accounting method") are (1) timing and (2) consistency. If the treatment of an item does not affect the timing for including items of income or claiming deductions, it is not an accounting method and generally IRS approval is not needed to change it. In order to affect timing, the treatment must impact the year in which an income or expense item is reported. If the treatment of the item affects the total amount of income or expense recognized by the taxpayer over the item s life, then an accounting method is not involved. In general, to establish an accounting method, the method must be consistently applied. This consistency requirement varies depending upon whether an accounting method is proper or improper: The use of a proper accounting method in a single U.S. federal income tax return constitutes consistency and, therefore, results in the adoption of an accounting method. An improper accounting method is adopted after it has been used consistently in two or more consecutive returns. Once an accounting method has been established for tax purposes, any change must be requested by the taxpayer and approved by the IRS. Changes in accounting methods cannot be made by amending returns. Rather, there are two procedures for requesting a voluntary change from the IRS: (1) automatic and (2) non-automatic. In the case of an automatic change, IRS consent is deemed to have been received once all the requirements of the IRS guidance are met. With a non-automatic change, IRS consent is received only upon written consent from the IRS. In either case, the request for change is generally filed on federal Form PwC 2

5 Transition to new accounting method In general, whenever a taxpayer changes its accounting method, the tax law provides for a transition from the old accounting method to the new accounting method. The "cut-off" approach results in a prospective change beginning with the year of change. Transactions arising during or subsequent to the year of change are reported utilizing the new accounting method. Transactions arising prior to the year of change continue to be accounted for using the old accounting method. The other, more common transition approach is a "cumulative catch-up" via an Internal Revenue Code 481(a) adjustment. Under this approach, a taxpayer must compute a 481(a) adjustment as of the first day of the year of change as if the new method of accounting were always used (i.e., for both old and new transactions). In general, a negative 481(a) adjustment (i.e., reduction of taxable income) is taken into income entirely in one tax year (the year of change) while a positive 481(a) adjustment (i.e., increase to taxable income) is spread over four years, beginning with the year of change. In certain circumstances, the four year adjustment period may be shortened or accelerated, and therefore, the applicable procedures governing tax accounting method changes should be considered in order to verify the period over which the 481(a) adjustment is taken into account based upon the taxpayer s specific facts and circumstances. PwC 3

6 Changes from proper accounting methods Because there may be more than one proper method of accounting for an item, taxpayers may decide that another proper method of accounting is more preferable to them or better reflects income. As a result, change procedures exist that allow taxpayers to request a change in accounting with consent from the IRS. These changes can either be automatic or non-automatic. Automatic changes Automatic changes are granted if the change being requested is: (1) one that qualifies for automatic approval by the IRS and (2) the taxpayer complies with all of the provisions of the automatic change request procedure. We believe that automatic changes (i.e., those enumerated in the applicable IRS guidance) should be reflected in the financial statements when management has concluded that it is qualified, and has the intent and ability to file for an automatic change in accounting method. This treatment is based on the notion of perfunctory consent. An automatic change in accounting method is similar to other annual elections that are made by the taxpayer upon filing the tax return. Management should form a judgment based upon all available facts and as to how it will treat such items when filing its tax return and account for the items in a consistent manner when preparing its financial statements. Example #1A Proper to proper, automatic method change, positive 481(a) adjustment: Background/Facts: In December 2XX1, Company XYZ (a calendar year filer) has elected to change from the deferral method of accounting for advance payments to the full inclusion method as of 1/1/2XX1. This change is deemed automatic by the IRS and after analysis, management has concluded that it has the ability, intent, and qualifies for the method change. The company has an applicable tax rate of 40%. The following book and tax basis balances exist related to deferred revenue for advance payments at 1/1/2XX1: Book basis: $2,000,000 Tax basis: $2,000,000 Future temporary difference: $0 After the accounting method change, Company XYZ will have the following book and tax basis balances at 1/1/2XX1 related to deferred revenue for advanced payments: Book basis: $2,000,000 Tax basis: $0 Future deductible temporary difference: $2,000,000 PwC 4

7 Tax accounting treatment: Management will reflect the impact of the accounting method change in the 2XX1 financial statements, as they have met the requirements for perfunctory consent (qualification, intent, and ability to file). In order to properly reflect the impact of the accounting method change, the following tax accounting entries related to the 481(a) adjustment will be required as part of the 2XX1 provision process: Entry #1: Dr: Deferred tax expense $800,000 Cr: Deferred tax liability - 481(a) adjustment $800,000 To record the positive 481(a) adjustment of $800,000 ($2,000,000 x 40%) related to the change in accounting method Entry #2: Dr: Deferred tax liability - 481(a) adjustment $200,000 Dr: Current tax expense $200,000 Cr: Deferred tax expense/benefit $200,000 Cr: Income tax payable $200,000 To record the current & deferred tax impact related to the 481(a) adjustment in 2xx1 ($800,000/4) Entry #3: Dr: Deferred tax asset - deferred revenue $800,000 Cr: Deferred tax expense/benefit $800,000 To adjust the deferred tax asset balance on the deferred revenue for advanced payments at 1/1/2XX1 from $0 to $800,000 as a result of the accounting method change Note that as the accounting method only changes the timing of tax deductions, the three entries have no net impact on total tax expense. The creation of the positive 481(a) adjustment results in two deferred tax balances. One relates to the temporary difference related to the deferred revenue for advanced payments, the second relates to the deferral of the catch up adjustment (i.e., the 481(a) adjustment), which represents deferred income for tax purposes with no book basis. In addition to the entries related to the 481(a) adjustment (which provides a catch up at 1/1/2XX1), the company will account for its 2XX1 current and deferred provision under its new accounting method. In the 2XX2, 2XX3, and 2XX4 provision process, the company will unwind the deferred tax liability related to the 481(a) adjustment with the following entry in each year: Dr: Deferred tax liability - 481(a) adjustment $200,000 Dr: Current tax expense $200,000 Cr: Deferred tax expense/benefit $200,000 Cr: Income tax payable $200,000 PwC 5

8 Example #1B Proper to proper, automatic method change, negative 481(a) adjustment: Background/Facts: In December 2XX1, Company XYZ (a calendar year filer) elected to change its accounting method from capitalizing prepaid expenses to deducting eligible prepaid expenses as of 1/1/2XX1. This change is deemed automatic by the IRS and after analysis, management has concluded that it has the ability, intent, and qualifies for the method change. The company has an applicable tax rate of 40%. The following book and tax basis balances related to prepaid expenses exist at 1/1/2XX1: Book basis: $5,000,000 Tax basis: $5,000,000 Future temporary difference: $0 After the accounting method change, Company XYZ will have the following book and tax basis balances at 1/1/2XX1 related to prepaid expenses: Book basis: $5,000,000 Tax basis: $3,500,000 Future taxable temporary difference: $1,500,000 Tax accounting treatment: Management will reflect the impact of the accounting method change in the 2XX1 financial statements, as they have met the requirements for perfunctory consent (qualification, intent, and ability to file). In order to properly reflect the impact of the accounting method change, the following tax accounting entries related to the 481(a) adjustment will be required as part of the 2XX1 provision process: Entry #1: Dr: Income tax payable $600,000 Cr: Current tax expense/benefit $600,000 To record the benefit ($1,500,000 x 40%) of the negative 481(a) adjustment on the accounting method change in current tax expense Entry #2: Dr: Deferred tax expense $600,000 Cr: Deferred tax liability - prepaid expenses $600,000 To adjust the deferred tax liability balance on fixed assets at 1/1/2XX1 from $0 to $600,000 as a result of the accounting method change Unlike example 1A, in this scenario there is a negative 481(a) adjustment of $600,000 related to the method change. Accordingly, the company will recognize the full amount of the negative 481(a) adjustment as a decrease to current tax expense in 2XX1, with no deferred component. This results in only one deferred tax liability which represents the difference between the book and tax basis of the underlying items using the new accounting method. Again, note that the two entries have no net impact on total tax expense as the current year benefit of $600K is offset by the deferred expense attributable to the adjustment of the deferred tax liability. In addition to the entries related to the 481(a) adjustment, the company will account for its 2XX1 current and deferred provision under its new accounting method. PwC 6

9 Non-automatic changes Non-automatic changes require the affirmative consent of the IRS. The effects of a non-automatic change from one proper method to another should not be reflected in the financial statements until approval is granted because the IRS has the discretion to deny the application or alter its terms. Appropriate financial statement and/or MD&A disclosure of anticipated or pending requests for method changes should be considered. Example 2A Proper to proper, non-automatic method change, negative 481(a) adjustment Background/Facts: Company XYZ has elected to change its accounting method of depreciating fixed assets for tax year 2XX1. This is a change from one proper accounting method to another and is a non-automatic method change as prescribed by the IRS. In the 2 nd quarter of 2XX2, the company received approval of the method change from the IRS. The negative 481(a) adjustment of $2M (decrease to taxable income) was calculated as of 1/1/2XX1. The company has a 40% tax rate. The following book and tax basis balances exist related to the prior accounting method at 1/1/2XX1: Book basis: $8,000,000 Tax basis: $6,000,000 Future taxable temporary difference: $2,000,000 After the accounting method change, Company XYZ will have the following book and tax basis balances at 1/1/2XX1: Book basis: $8,000,000 Tax basis: $4,000,000 Future taxable temporary difference: $4,000,000 Tax accounting treatment: In the 2XX1 financial statements, the company does not reflect the impact of the accounting method change, as approval has not been received from the taxing authority. To the extent the potential impact of the method change is significant to the financial statements, disclosure in the tax footnote or MD&A may be warranted. In the 2 nd quarter 2XX2 financial statements, the company will reflect the impact of the accounting method change, as the taxing authority has formally approved the request. In order to properly reflect the impact of the accounting method change, the following tax accounting entries will be required as part of the Q2 2XX2 provision process: Entry #1: Dr: Income tax receivable $800,000 Cr: Current tax expense/benefit $800,000 To record the benefit ($2,000,000 x 40%) of the negative 481(a) adjustment on the accounting method change in current tax expense Entry #2: Dr: Deferred tax expense $800,000 Cr: Deferred tax liability $800,000 To adjust the deferred tax liability balance at 1/1/2XX1 from $800,000 to $1,600,000 as a result of the accounting method change PwC 7

10 Additionally, note that the company will need to account for the impact of the 2XX1 current and deferred activity under the new accounting method and consider whether the new method would impact the company s 2XX2 interim tax provision. Depending on a company s interim balance sheet procedures for tax accounts, consideration may need to be given to appropriately reflecting the impact of the new accounting method on the quarterly financial statements. Example 2B Proper to proper, non-automatic method change, positive 481(a) adjustment Background/Facts: Similar fact pattern as example 2A, except a $2M positive (increase to taxable income) 481(a) adjustment results from the method change. The following book and tax basis balances exist related to the prior accounting method at 1/1/2XX1: Book basis: $9,000,000 Tax basis: $4,000,000 Future taxable temporary difference: $5,000,000 After the accounting method change, Company XYZ will have the following book and tax basis balances at 1/1/2XX1: Book basis: $9,000,000 Tax basis: $6,000,000 Future taxable temporary difference: $3,000,000 Tax accounting treatment: Similar to example 2A, in the 2XX1 financial statements, the company does not reflect the impact of the accounting method change, as approval has not been received from the taxing authority. To the extent the potential impact of the method change is significant to the financial statements, disclosure in the tax footnote or MD&A may be warranted. In the 2 nd quarter 2XX2 financial statements, the company will reflect the impact of the accounting method change, as the taxing authority has formally approved the request. As positive 481(a) adjustments must generally be recognized in taxable income over 4 years, the company will reflect the 2XX1 portion of the cumulative catch up adjustment which was recognized with the 2XX1 tax filing in the interim filing, along with a deferred tax liability for the remainder of the 481(a) adjustment: Entry #1: Dr: Deferred tax expense $800,000 Cr: Deferred tax liability- 481(a) adjustment $800,000 To record the positive ($2,000,000 x 40%) 481(a) adjustment related to the change in accounting method Entry #2: Dr: Deferred tax liability - 481(a) adjustment $200,000 Dr: Current tax expense $200,000 Cr: Deferred tax expense/benefit $200,000 Cr: Income tax payable $200,000 To record the current & deferred tax impact related to the 481(a) adjustment in 2xx1 ($800,000/4) The company will also need to adjust their existing deferred tax liability with the following entry at Q2 2015: PwC 8

11 Entry #3: Dr: Deferred tax liability $800,000 Cr: Deferred tax expense/benefit $800,000 To adjust the deferred tax liability balance as of 1/1/2XX1 from $2,000,000 to $1,200,000 as a result of the accounting method change The company will also need to account for the impact of the 2XX1 current and deferred activity under the new accounting method and consider whether the new accounting method and the 2XX2 portion of the 481(a) adjustment would impact the company s 2XX2 interim tax provision calculation. In the 2XX2, 2XX3 and 2XX4 provision process, the company will unwind the remaining deferred tax liability related to the 481(a) adjustment with the following entry in each year: Future entry: Dr: Deferred tax liability - 481(a) adjustment $200,000 Dr: Current tax expense $200,000 Cr: Deferred tax expense/benefit $200,000 Cr: Income tax payable $200,000 PwC 9

12 Changes from improper accounting methods A taxpayer may determine that it is using an improper accounting method. As a result, the company will need to consider whether the historical financial statements included an error and any effects of uncertain tax positions, including potential interest and penalties. A company may look to change its accounting method voluntarily to one which is proper by filing a Form 3115 with the IRS. We believe that a company making a voluntary change from an improper method to a proper method resulting in a positive adjustment (whether automatic or non-automatic) should generally record the tax effects in the financial statements when the Form 3115 has been filed with the IRS. This treatment is based on the notion that when a taxpayer files for a change from an improper to a proper accounting method, the taxpayer has affirmatively requested permission from the IRS to change its accounting method. When a company makes a voluntary change from an improper method to a proper method that results in a negative adjustment, we believe the company should generally record the tax effects in the financial statements when management has concluded that it is qualified, and has the intent and ability, to file for a change in accounting method. This treatment is based on the notion of perfunctory consent. It is important to note that, upon financial statement recognition of a change from an improper accounting method, the taxpayer will also need to consider the impact the change will have on any previously unrecognized tax benefits (including accrued interest and penalties) related to the improper method. In general, when a taxpayer files for a change from an improper to a proper accounting method, the taxpayer receives audit protection for prior years. In certain circumstances, however, the filing of a Form 3115 with the IRS will not provide audit protection. Therefore, the procedures governing accounting method changes should be carefully considered in order to verify whether the filing of a Form 3115 will preclude the IRS from changing the taxpayer s method of accounting for the same item for a taxable year prior to the requested year of change. Upon changing to a proper accounting method with a positive 481(a) adjustment, any liability for unrecognized tax benefits previously recorded should be reclassified to a deferred tax liability, which now represents the deferred tax consequences of the 481(a) adjustment. PwC 10

13 Example 3A Improper to proper, positive 481(a) adjustment Background/Facts: Company XYZ identified an improper accounting method in the tax process during 2XX0. The company booked a $360,000 (tax effected) uncertain tax position related to the improper method as well as $50,000 of related interest upon identifying the issue in 2XX0. The company accrued an additional $40,000 of tax and $5,000 of interest in 2XX1 related to the uncertain tax position. In 2XX2, the company filed Form 3115 with the IRS to obtain approval to change to a proper method. At the time of filing Form 3115, the company had a tax rate of 40% with the following book and tax basis at 1/1/2XX2 under the improper method: Book basis: $8,000,000 Tax basis: $6,000,000 Future taxable temporary difference: $2,000,000 After the accounting method change, Company XYZ will have the following book and tax basis balances at 1/1/2XX2 related to the proper method: Book basis: $8,000,000 Tax basis: $7,000,000 Future taxable temporary difference: $1,000,000 Tax accounting treatment: During 2XX0, the company identified the improper accounting method, but did not file Form 3115 with the IRS requesting use of a proper method until 2XX2. In addition to considering the impact of the error on previously filed financial statements, the company should record an uncertain tax position for the exposure (or benefit) related to the improper method upon identification in 2XX0 with the following entries: Entry #1: Dr: Current tax expense $360,000 Cr: Uncertain tax position $360,000 To record the uncertain tax position upon identification of improper method in 2XX0 Entry #2: Dr: Current tax expense $50,000 Cr: Uncertain tax position interest $50,000 To record interest related to the uncertain tax position upon identification of improper method in 2XX0 Entry #3: Dr: Deferred tax liability $360,000 Cr: Deferred tax expense/benefit $360,000 To adjust the deferred tax liability to reflect the taxable temporary difference under the proper method In 2XX1, the company accrues additional tax and interest related to the improper method using the following entries: Entry #4: Dr: Current tax expense $40,000 Cr: Uncertain tax position $40,000 To record additional uncertain tax position for 2XX1 activity related to the improper method PwC 11

14 Entry #5: Dr: Current tax expense $5,000 Cr: Uncertain tax position interest $5,000 To record additional interest related to the uncertain tax position for 2XX1 related to the improper method Entry #6: Dr: Deferred tax liability $40,000 Cr: Deferred tax expense/benefit $40,000 To adjust the deferred tax liability to reflect the taxable temporary difference under the proper method Because the impact of the method change results in a positive 481(a) adjustment, the company should reflect the impact of the accounting method change in the financial statements in 2XX2 upon filing of Form We generally believe immediate inclusion in the financial statements is appropriate, as the taxpayer typically receives audit protection when the taxpayer files a copy of Form Accordingly, the entries for the 2XX2 tax provision include the following: Entry #7: Dr: Deferred tax expense $400,000 Cr: Deferred tax liability - 481(a) adjustment $400,000 To record the positive ($1,000,000 x 40%) 481(a) adjustment related to the change in accounting method As positive 481(a) adjustments are generally recognized over 4 years, the company will reflect $100K of the $400K total 481(a) cumulative catch up adjustment within the 2XX2 taxable income calculation. A deferred tax liability for the $300K of remaining 481(a) adjustment is included on the 2XX2 balance sheet and will unwind in 2XX3, 2XX4, and 2XX5. Upon securing audit protection, the company should also reverse uncertain tax positions and interest previously booked. The company would reverse their previously booked uncertain tax position and interest with the following entries: Entry #8: Dr: Uncertain tax position $400,000 Cr: Current tax expense/benefit $400,000 To reverse the uncertain tax position previously booked for the improper accounting method upon securing audit protection Entry #9: Dr: Uncertain tax position interest $55,000 Cr: Current tax expense/benefit $55,000 To reverse the uncertain tax position interest previously booked for the improper accounting method upon securing audit protection Note that any liability for unrecognized tax benefits previously recorded is effectively reclassified to an income tax payable or deferred tax liability, which now represents the current and deferred tax consequences of the 481(a) adjustment. PwC 12

15 Example 3B Improper to proper, negative 481(a) adjustment Background/Facts: During 2XX0, Company XYZ identified an improper accounting method within the income tax process. The company booked a $360,000 (tax effected) uncertain tax position related to the improper method. The company recorded an additional $40,000 related to the uncertain tax position in 2XX1. In 2XX2, the company decides to file Form 3115 with the IRS to obtain approval to change to a proper method. At the time of filing Form 3115, the company had a tax rate of 40% with the following book and tax basis at 1/1/2XX2 under the improper method: Book basis: $5,000,000 Tax basis: $3,000,000 Future taxable temporary difference: $2,000,000 After filing for the accounting method change, Company XYZ will have the following book and tax basis balances related to the proper method: Book basis: $5,000,000 Tax basis: $2,000,000 Future taxable temporary difference: $3,000,000 Tax accounting treatment: During 2XX0, the company identified the improper accounting method, but did not decide to file Form 3115 with the IRS requesting use of a proper method until 2XX2. Accordingly, the company should record an uncertain tax position for the exposure (or benefit) related to the improper method upon identification in 2XX0 with the following entries: Entry #1: Dr: Uncertain tax position $360,000 Cr: Current tax expense/benefit $360,000 To record the uncertain tax position upon identification of improper method in 2XX0 Entry #2: Dr: Deferred tax expense $360,000 Cr: Deferred tax liability $360,000 To adjust the deferred tax liability to reflect the taxable temporary difference under the proper method In 2XX1, the company accrues additional tax related to the improper method using the following entries: Entry #3: Dr: Uncertain tax position $40,000 Cr: Current tax expense/benefit $40,000 To record additional uncertain tax position for 2XX1 activity related to the improper method Entry #4: Dr: Deferred tax expense $40,000 Cr: Deferred tax liability $40,000 To adjust the deferred tax liability to reflect the taxable temporary difference under the proper method PwC 13

16 As this method change is improper to proper, audit protection is typically obtained when the taxpayer files Form As the change in accounting method results in a negative 481(a) adjustment, the company should reflect the financial statement impact of the accounting method change in the period it concludes that it is qualified, and has the intent and ability, to file for a method change (2XX2). In 2XX2, the company records the following tax accounting entries: Entry #5: Dr: Income tax payable/receivable $400,000 Cr: Current tax expense/benefit $400,000 To record the benefit of the negative ($1,000,000 x 40%) 481(a) adjustment within current income tax expense Upon concluding that it will file Form 3115, the company should also reverse uncertain tax positions previously booked (or in this case, recognition of benefit). The company would reverse their previously booked uncertain tax position with the following entries: Entry #6: Dr: Current tax expense $400,000 Cr: Uncertain tax position $400,000 To reverse the uncertain tax position previously booked for the improper accounting method upon decision to file Form 3115 Note that any asset for unrecognized tax benefits previously recorded is effectively reclassified to either a reduction to the income tax payable or an income tax receivable which represents the tax consequences of the 481(a) adjustment. PwC 14

17 Let s talk For a deeper discussion of how accounting method changes can impact the tax accounting of your business, please contact: Tax accounting services David Wiseman, Partner US Tax Accounting Services Leader +1 (617) david.wiseman@pwc.com Steve Schaefer, Partner National Professional Services Group +1 (973) steven.schaefer@pwc.com Mark Wilmot, Director US Tax Accounting Services +1 (313) mark.j.wilmot@us.pwc.com PwC 15

18 This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Solicitation 2015 PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.