TAM addresses SAB 101 Revenue Recognition issues.

In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, Revenue Recognition in Financial Statements, to provide guidance on revenue recognition for publicly traded companies. The bulletin offered a range of fact patterns with conclusions on the proper timing of revenue recognition for financial statement purposes. As a result of SAB 101, some companies deferred recognizing revenue for financial statement purposes and, concomitantly, for income tax purposes. Letter Ruling (TAM) 200310003 addresses two issues that have faced many such taxpayers: whether the deferral of revenue recognition was an accounting-method change requiring IRS consent, and whether such deferral would clearly reflect income for tax purposes.

Facts

The taxpayer, a publicly traded company, provided telecommunication. systems and related products and services to its customers. One segment of its business included the sale of small systems that required limited customization and typically took several months to complete.

The sales agreement stated that system delivery would be made free on board taxpayer's place of business, and title and risk of loss would pass to the customer on delivery to the carrier. Final payment was due when the taxpayer's employees tested and certified the system's functionality or when the customer used the system. Finally, the customer had 10 days to notify the taxpayer, in writing, if the system was nonconforming, giving the taxpayer an opportunity to recertify the system within 90 days of the notice.

Prior to SAB 101, the taxpayer recognized income, for both financial reporting and tax purposes, when it tested and certified the system. After SAB 101, the taxpayer deferred income recognition, for both financial reporting and tax purposes, until the customer accepted the product and agreed that the taxpayer had fulfilled all post-delivery obligations.

Accounting-Method Change?

The first issue addressed was whether the deferral of revenue recognition for tax purposes was an accounting-method change requiring IRS consent (as the Service contended) or a change in underlying facts (as the taxpayer claimed). The taxpayer stated that during the period it implemented SAB 101, there was a significant increase in sales as a result of an acquisition, a greater emphasis on customer testing of systems and a higher degree of tuning the systems to meet customer satisfaction.

The IRS concluded, however, that the change in the taxpayer's business focus (emphasizing the importance of customer satisfaction) and the increase in sales volume was not a change in the underlying facts. It stated, "a change in method of accounting involves changing a reporting result by the application of a different rule to the same facts, rather than the application of the same rule to different facts." The Service indicated that the taxpayer's sales agreement had not changed before or after implementation of SAB 101; thus, the same facts were applied to different accounting methods. Hence, the deferral was an accounting-method change for tax purposes, requiring IRS consent.

The taxpayer also argued that because the new method conforms to GAAP, it should be proper for Federal tax purposes. The Service responded that conforming to GAAP does not necessarily clearly reflect income for tax purposes, referring to Thor Power Tool Co., 439 US 522 (1979). Further, changing income reporting for financial reporting purposes does not preclude the need to obtain IRS consent to change for tax purposes.

Clear Reflection of Income

The second issue addressed was whether the new method clearly reflected income for tax purposes. Generally, the criteria for recognizing income for financial reporting purposes under SAB 101 results in a greater deferral of income recognition than had been previously required. In this case, after applying SAB 101, the taxpayer was required to defer recognizing income until it received "formal acceptance" from its customers.

For tax purposes, a taxpayer is required to recognize income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. The Service determined that the taxpayer's right to the income was fixed on the "installation date," when the system was tested and certified by the taxpayer or used by the customer. Thus, the taxpayer had to recognize the income from the sale on the installation date, and could not defer income, as required for financial reporting purposes, until the customer formally accepted the system.

Thus, "formal acceptance" by customers was the distinguishing criteria for recognizing income for financial reporting and tax purposes. Under SAB 101, customer acceptance was deemed a condition precedent to income accrual. However, the Service rejected that argument for tax purposes, stating that "formal acceptance" was merely a ministerial act.

Observations

Taxpayers should be aware that book and tax emphasize different criteria for income recognition. Following Thor Power, the TAM indicates that for book purposes, as a result of a conservative approach, companies generally must defer income recognition until they are assured of its realization. Conversely, for tax purposes, as a result of concerns to "protect the public fisc," taxpayers must recognize income as soon as it is fixed and reasonably determinable. The TAM further indicates that to defer income recognition for tax purposes, a condition precedent must exist that is more than a ministerial act.

Note: in the TAM, the Service based its conclusions on both issues on the taxpayer's sales agreement. The agreement did not require the customer's final acceptance prior to final billing. However, it was industry practice to bill only after final acceptance. If the sales agreement had been changed to reflect the taxpayer's practice, such that final payment was due on customer acceptance, the IRS might have been more willing to accept the taxpayer's arguments that "all events" did not occur until that time, and there was a change in underlying facts.

FROM REZA SARMASTI, MST, AND DWIGHT MERSEREAU, J.D., LL.M., WASHINGTON, DC

Annette B. Smith, CPA

Partner

Washington National Tax Service

PricewaterhouseCoopers LLP

Washington, DC