Aerospace accounting method changes
There are common accounting methods that aerospace and defense companies should revisit to enhance planning opportunities and tax attributes.
Accrual to cash
Accrual to cash is an accounting method change that can be an effective way to defer taxable income — especially in the aerospace industry where standard receivable terms are 90 days or more, including government contracts.
This method change recognizes revenue when actually or constructively received and deducting items of expense when paid. Many aerospace and defense companies with average gross receipts for the three-prior year of less than $26 million can qualify to use the cash method of accounting.
Treating inventory as nonincidental materials and supplies
Companies with average gross receipts of less than $26 million for the prior three years can treat the cost of inventory as nonincidental materials and supplies. The cost can be recovered by expensing it through cost of goods sold in the year either when the inventory is provided to the customer or the year when the company pays for the cost of the item, whichever is later.
Conversion costs such as direct labor and overhead costs aren’t considered nonincidental materials and supplies.
Tangible property regulations provide that materials and supplies may be deducted if they have one or all of the following components:
- Acquired to maintain, repair, or improve
- Consist of fuel, lubricants, and similar items that will be consumed in 12 months or less
- Contain a unit of property with a useful life of less than 12 months
- Include a unit of property that costs $200 or less
- Can be identified in guidance as materials and supplies
Incidental materials and supplies — other than rotatable and temporary spare parts — can be deducted when paid. The change of method to begin deducting materials and supplies is automatic.
Rotable and temporary spare parts
The tangible property regulations issued in 2014 provide three choices to account for rotable and temporary spare parts (R&TSP) — a common scenario in the aerospace sector.
Default method
Generally, R&TSPs are deductible in the tax year if the part is disposed of by the taxpayer during that year. Disposals can sometimes take several years and require capitalizing and tracking of these assets.
Depreciable asset
A taxpayer may elect to treat R&TSPs as a depreciable asset beginning in the year the part is placed into service. This election is irrevocable and can be made annually for each R&TSP and isn’t considered a method of accounting.
Tracking and recordkeeping
The third and most complicated option for tracking R&TSPs is the method under Treasury Regulation 1.162-3(e). This method has several requirements that include maintaining detailed records, valuations, and accounting for R&TSP, which can make it undesirable to many taxpayers.
However, taxpayers who are able to track the use of R&TSP may realize the most accelerated deductions because it allows them to deduct the parts when first installed.
Deduction of subnormal goods
A company could be afforded a tax deduction for the write-down of subnormal goods if careful steps are followed. While many companies record an inventory obsolescence reserve on their financial statements, these reserves aren’t typically deductible for tax until realized.
If certain steps are taken, a deduction for subnormal goods is permitted for income tax purposes. The lower inventory valuation must be substantiated by providing evidence of the following:
- Actual offerings
- Actual sales
- Actual contract cancellations
Changes to tax inventory capitalization rules
The IRS issued final regulations in late 2018 for companies that maintain inventory. The tax inventory capitalization rules changed how companies use either the simplified production method (SPM) or simplified resale method (SRM). They also added a new method, the modified simplified production method (MSPM), that should be considered for larger producers.
Most importantly, the regulations don’t change the types of costs subject to capitalization or the amounts of these costs. Rather, they affect whether these types and amounts are included in the numerator, additional Internal Revenue Code (IRC) Section 263A costs, or denominator, IRC Section 471 costs, of the absorption ratio.
Companies will want to consider conforming to the new rules, and whether there’s an opportunity to reduce capitalization costs.
Timing of revenue recognition — IRC 451 and ASC 606
In December 2020, the IRS released final regulations for the timing of revenue recognition in the form of IRC Section 451 and Accounting Standards Codification (ASC) Topic 606. The final regulations provide an optional cost offset and an exception to recognition when there’s no enforceable right to payment.
The regulations refer to the applicable financial statement (AFS) income inclusion rule. It’s not a true book conformity requirement, but serves to accelerate, and not defer, taxable income. This could present a significant cash flow challenge for aerospace companies when the taxable income will trigger an accelerated recognition of income from ASC Topic 606. However, shifting revenue recognition to a book percentage-of-completion method (PCM) approach means the taxpayer won’t be allowed to offset with a corresponding acceleration of related expenses.
The final regulations allow companies opportunities to better match the related expenses to the accelerated revenue by permitting a reduction of revenue for the cost of goods incurred.
Considerations for the final regulations include:
- Realization. The final regulations don’t impact the determination of whether income is realized under IRC Section 61.
- Enforceable right. The final regulations provide that the AFS income inclusion amount doesn’t include amounts for which there’s no enforceable right to payment if the contract was terminated by the customer.
- Cost offset. The final regulations allow for the AFS cost offset method so a company can reduce the amount of income otherwise required under the AFS income inclusion rule.
If your company plans to adopt or has previously adopted ASC Topic 606, you’ll need to consider how the IRC Section 451 changes, as well as the related final regulations, impact your tax reporting.
Taxpayers who aren’t currently adopting ASC Topic 606 will still need to address the IRC Section 451 changes. You may be required to file one or more accounting method changes and have new book-tax differences to track.
For a detailed look at the effects of ASC Topic 606, please read our Revenue Recognition Guide and learn more adoption tips.
