The legislation known as the Tax Cuts and Jobs Act (TCJA) (1) modified Sec. 451 to allow taxpayers to defer recognizing income until it is recognized in an applicable financial statement. (2) This rule helps eliminate some items that were timing differences between financial accounting income and taxable income. This article reviews the treatment of unearned revenue--also referred to as deferred revenue--from a financial accounting and tax point of view and focuses on how it can affect the seller, as well as the buyer, in a taxable acquisition.
Accounting for income
The Internal Revenue Code provides that, generally, gross income means all income from whatever source derived. (3 ) Sec. 162 provides a deduction for all ordinary and necessary expenses paid or incurred in carrying on a business. Using the cash method to analyze transactions should help show who pays tax on income. (4)
Example 1. Cash-method corporation: XYZ Corp. provides software services. In year 1, Customer B pays XYZ $100,000 for the right to use its software for the next five years. It costs XYZ $8,000 per year to maintain its software per customer. Under the cash method of accounting, XYZ would recognize $100,000 of revenue, matching the cash collected, and would recognize $8,000 of expense in year 1. The net income under the cash method would be $92,000 and, in years 2 through 5, XYZ would incur losses totaling $32,000. (5) The total net activity over the five years would be $60,000 of net income.
Example 1 illustrates why some taxpayers may benefit from being on the accrual method. Under GAAP, (6) the accrual method of accounting is required, and, therefore, expenses and revenues should be properly reflected in each accounting period to avoid distorting income for any one accounting period. In many merger and acquisition (M&A) transactions, investors will also require GAAP financial statements to get a more accurate picture of a company's financial condition.
Example 2. Accrual-method corporation: Using the facts from Example 1, except, instead of the cash method, applying the accrual method, XYZ Corp. would record a debit to cash and a credit to unearned revenue upon the receipt of $100,000 cash. This would establish an asset on the balance sheet and a corresponding liability. The liability here demonstrates that the obligation to the customer has not been fulfilled. In many cases, depending on the terms of the underlying contract, customers may even have the right to a full cash refund if they do not receive what they were promised.
Under the accrual method, as the work is performed by XYZ, revenue is earned and recognized. In year 1, an entry would be made to recognize the revenue earned for the period by making a debit to deferred revenue of $20,000 and a credit to revenue. In year 1, $8,000 of expenses are incurred. The accounting entry would be a credit to cash and a debit to expense (e.g., salaries). At the end of the year, using the accrual method, revenue on the income statement would be recognized for $20,000, and an expense of $8,000 would be recognized. On the balance sheet, the cash balance would go from $100,000 to $92,000, and the deferred revenue balance would go from $100,000 to $80,000. In summary, the net income would be $12,000 in year 1. These same entries would be recorded for years 2, 3, 4, and 5. The result is a normalized stream of net income over the next five years. Notice that regardless of whether XYZ Corp. uses the cash or accrual method, the total net income over the five years is $60,000. However, the income recognized each year varies significantly between the two methods.
In summary, when a taxpayer receives an advance payment for services, income should eventually be recognized. Said differently, unearned revenue is the liability account used to measure how much income the taxpayer has not yet recognized. (7)
Analysis of seller tax treatment in James M. Pierce Corp.
James M. Pierce Corp. operated a newspaper publishing business through its various subsidiaries. Pierce Corp. had a practice of selling "perpetual" subscriptions that were redeemable by the subscriber or heirs over a 10-year period ratably. Pierce Corp. recognized one-tenth of the income each year and recorded the unrecognized portion as a "reserve" (i.e., unearned revenue). (8 ) As the subscription was redeemed, the corresponding reserve was reduced and income was recognized.
In 1957, the Prairie Farmer Publishing Co. paid Pierce Corp. $1,406,789 in cash to acquire its assets. Prairie also assumed the obligation of Pierce Corp. to publish its Wallaces' Farmer and Iowa Homestead newspaper and agreed to carry out the terms of all subscription contracts in force as of the date of closing for the unexpired subscriptions. The balance of the reserves (unearned revenue) was $436,359, which included $40,340 in reserves for partial redemptions of the perpetual subscriptions. The remaining $396,019 was for unearned subscription revenue. The $436,359 was taken into account as an adjustment to the cash paid by Prairie. In other words, Prairie would have paid that amount more in cash to Pierce Corp. if Pierce Corp. had paid off the reserves before closing. (9)
Pierce Corp. did not record any of the reserves as gain on the sale on its 1957...