ASC 606 and Revenue Recognition: Effect on Multinational Operations
The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, which supersedes the existing revenue recognition accounting rules. The new guidance is applicable for public business entities for periods beginning after December 15, 2017. All other reporting entities using U.S. generally accepted accounting principles (GAAP) must adopt ASC 606 for fiscal years beginning after December 15, 2018. Early adoption was/is permitted.
As multinational companies re-express their GAAP revenue amounts, intercompany transactions that are directly or indirectly dependent on revenue will be re-expressed as well. This will create potential challenges for firm’s accounting and tax departments, as they analyze and document the modified results on these transactions and defend against scrutiny of changes in taxable profit levels and related book/tax differences. In this alert, we analyze potential direct and indirect transfer pricing effects from restatements of revenue.
Details
ASC 606 and Transfer Pricing: Background
Upon adoption of ASC 606, companies will change their revenue recognition process, and a substantial number will have materially different GAAP revenue results. Recent analysis by Morgan Stanley indicates that some 25 percent of U.S. firms will have material changes to their financial statements as a result of the change, many of those with multinational operations. The scope of ASC 606 includes all customer contracts, with limited exceptions.[1] Therefore, most firms’ active business intra-firm dealings will be subject to the standard as well. As multinational firms adopt ASC 606, they will re-evaluate and potentially adjust current and prior years’ revenue amounts for the different reporting units within the group. See our newsletter for a detailed review of the changes in revenue recognition approach.
For multinational firms with related-party transactions, revenue restatements may impact transfer pricing for:
- Sales of tangible goods
- Provision of services (either those directly charged or indirectly charged via allocation according to revenue)
- Payments for use of tangible and intangible assets that are linked to revenue
From the perspective arm’s length compliance, the change in timing of revenue does not materially change the underlying economics of the contract, the business and related cash flows. However, as detailed below, to the extent that there are significant fluctuations in reported operating results upon adoption, these variations in reported taxable profits could drive greater scrutiny of the adopting companies’ transfer pricing positions. Thus, multinational firms should take care to document these changes from the transfer pricing perspective and reconcile them with the transfer pricing analyses performed.
Analysis
In this section we discuss the transfer pricing implications of a change in the timing of revenue stream(s). We distinguish between two broad categories:
- Direct, i.e., a multinational firm with controlled transactions that are recognized by one related party (or more) as revenue.
- Indirect, i.e., a multinational firm has controlled transactions in which an entity books third party revenue, but this revenue amount is an input or an intercompany transaction.
Cumulative vs. Retrospective Adoption
Adopting firms will apply the new revenue recognition standard on either a retrospective or cumulative basis. Under the “full retrospective” approach, adopting firms would restate prior years’ results in accordance with the standard, with certain accommodations, and book an adjustment to equity in the first financial year presented that reflects the new standard (e.g., 2016). In contrast, firms using a “modified retrospective” or “cumulative” approach will adjust their revenue and opening retained earnings amount in the year of adoption (e.g., 2018), with prior years unchanged. The following examples assume adoption of a full retrospective approach, as multiple years’ revenue results are changed. Moreover, the following examples do not address other tax accounting issues related to the change of accounting method (i.e., Form 3115) or accounting for book/tax differences (ASC 740).
Direct Effect Example
As an example of a direct effect of ASC 606, consider a foreign related party distributor of a U.S.-based software firm that shifts revenue between periods upon adoption. This could increase or decrease its U.S. GAAP operating margin or Berry ratio (ratio of gross profit to operating expenses) in those fiscal years. The following table shows a U.S. distributor’s summary income statement results, before the adoption of ASC 606:
Pre-ASC 606 Results
| USD | 2017 | 2018 | Average |
| Revenue | 150 | 180 | 165 |
| Costs of Goods Sold | 70 | 80 | 75 |
| Gross Profit | 80 | 100 | 90 |
| Operating Expense | 60 | 60 | 60 |
| Berry Ratio | 1.33 | 1.67 | 1.50 |
| Net Operating Margin | 13.3% | 22.2% | 18.2% |
The company’s results above show an improvement in operating margin from 2017 to 2018.
After adopting ASC 606, there is a shift of $40 revenue for the year 2018, with accompanying change in each year’s margin results:
Post-ASC 606 Results
| USD | 2017 | 2018 | Average |
| Revenue | 190 | 140 | 165 |
| Costs of Goods Sold | 70 | 80 | 75 |
| Gross Profit | 120 | 60 | 90 |
| Operating Expense | 60 | 60 | 60 |
| Berry Ratio | 2.00 | 1.00 | 1.50 |
| Net Operating Margin | 31.6% | 0.0% | 18.2% |
The company’s average result of the 2017-2018 period is unchanged, but post-ASC 606 adoption, 2018 is a break-even year while 2017 profit results are much higher. Thus, the foreign distributor’s 2018 result may be scrutinized upon audit by the local tax authorities, while the subsidiary’s high profits for 2017 may raise questions in the parent company’s jurisdiction. Consequently, the transfer pricing documentation for the foreign distributor’s 2018 results should include additional analysis to explain the changes in revenue recognition and show that these results, after reliable adjustments for timing differences are made, continue to be consistent with the arm’s-length standard. For instance, multi-year averaging of results, use of projections or averaging results over the term of the contract would help establish the effects of the accounting change as unrelated to the underlying economics of the transaction.
Indirect Effect Example
ASC 606 adoption could also drive an indirect change in firms’ transfer pricing results, when certain related party payments are a function of revenue. For instance, a related party manufacturer may license intangible property from its parent company, and the license may stipulate that royalties are accrued as a function of revenue. To the extent ASC 606 alters that entity’s revenue level in a given year, its corresponding royalty payments would change accordingly. If the controlled intangible property license has a royalty rate that varies according to revenue level (i.e., the rate increases as absolute revenue increases), this would introduce another source of variability in its operating results. Companies would need to take care to document the effects of adoption and parse the royalty effects attributable exclusively to ASC 606, which are not related to the value of the licensed intangible property.
Similarly, if related parties previously entered into a transaction involving financial projections (e.g., a cost sharing arrangement or asset valuation), then the parties may register changes to the ex-post results due to ASC 606. Present value calculations of discounted profits can be sensitive to timing differences of revenue, especially if the discount rate selected was relatively high. Consider the following illustration, using two years within a discounted profit model:
Discounted Profit Streams: Pre ASC 606 Valuation
| USD | 2018 | 2019 |
| Revenue | 110 | 130 |
| Net Profit | 5 | 5 |
| Discount factor | .909 | .826 |
| PV (Profit) | 4.5 | 4.1 |
| Terminal Value: | 20.0 | |
| PV (Total profits): | 28.7 |
Discounted Profit Streams: Post ASC 606 Valuation
| USD | 2018 | 2019 |
| Revenue | 150 | 90 |
| Net Profit | 45 | -35 |
| Discount factor | .909 | .826 |
| PV (Profit) | 40.9 | (28.9) |
| Terminal Value: | 20.0 | |
| PV (Total profits): | 32.0 |
Post-ASC 606 adoption, the revenue shift of $40.0 from 2019 to 2018 changes the aggregated discounted profits of those two years by $3.4, which is approximately 12 percent of the original value of $28.7.
As shown in the examples above, companies with significant changes in royalty payments or ex-post revenues or profits accruing from acquired assets would be advised to document that despite a shift in revenue between periods, the underlying economics and comparability of the market data used to establish consistency with the arm’s-length standard have not changed. Taxpayers might need to make adjustments to correct for inconsistencies in accounting of the controlled transaction, the tested party or the selected comparables. Relevant guidance in this regard from the Treasury Regulations under Section 482 is discussed below.
Comparability Adjustments for Changes in Accounting Method
Taxpayers may ask if they should apply ASC 606 in their transfer pricing analysis. The U.S. Treasury’s Section 482 Regulations support this broadly, and provide a definition of “sales revenue.” Taxpayers are instructed to follow the prevailing accounting standards and practices of their industry:
Accounting principles and conventions that are generally accepted in the trade or industry of the controlled taxpayer under review must be used.[2]
Thus there is support for adoption and application of GAAP accounting for a U.S. transfer pricing analyses. With regards to adjustments to achieve consistency of accounting methods between the controlled transaction and the selected comparables, taxpayers are instructed as follows:
The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables that materially affect operating profit affects the reliability of the result. Thus, for example, if differences in inventory and other cost accounting practices would materially affect operating profit, the ability to make reliable adjustments for such differences would affect the reliability of the results.[3]
Although the Regulations refer to inventory and cost accounting, one can reasonably infer that adoption of ASC 606, if it created a material disconnect between the tested party’s and the uncontrolled comparables’ revenue accounting, would warrant potential adjustments as well to the extent the selected comparables’ revenue accounting were dissimilar.
For transactions that involve review and analysis of a related entity’s operating profit result, the following citation from the 482 regulations is also relevant:
Operating profit means gross profit less operating expenses. Operating profit includes all income derived from the business activity being evaluated by the comparable profits method, but does not include interest and dividends, income derived from activities not being tested by this method, or extraordinary gains and losses that do not relate to the continuing operations of the tested party.[4]
We see explicit guidance under this regulation for arriving at an operating profit result that does not reflect changes unrelated to the continuing operations of the tested entity. As shown above, ASC 606 could drive abrupt changes in results due to revenue restatement, which could arguably represent the “extraordinary gains and losses” mentioned in this regulation. The upshot of this regulation is that taxpayers could adjust operating profit amounts for 482 purposes to arrive at results more indicative of the underlying operations of the firm.
As noted above, firms will apply ASC 606 on a retrospective or cumulative basis, which will drive diversity of adjustments to revenue and retained earnings within the same industry. More specifically, firms that document their transfer pricing using third-party comparable data under a comparable profits method (CPM) analysis may encounter certain comparables with material changes in their prior years’ revenue and profit amounts in prior years; this could also require review and potential application of comparability adjustments.
In short, the 482 Regulations instruct taxpayers to apply prevailing accounting standards and make reliable adjustments when there are differences that materially affect operating profit. This provides support for taxpayers to make reliable adjustments that minimize gaps that may arise between the historical market comparable data and the tested transactional data that reflects ASC 606 adoption.
[1] For instance, lease contracts, insurance, receivables, debt and equity investments and financing-related transactions are exempted.
[2] §1.482-5(d)(1).
[3] §1.482-5(c)(3)(ii); Please note that §1.482-3(c)(3)(iii) and §1.482-3(d)(3)(iii) provide for analogous guidance from the gross profit perspective, in the context of application of the Resale minus and Cost plus methods, respectively.
[4] §1.482-5(d)(4).
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