ASC 606 is about to become a reality for private companies, and now is the time to make a move to adopt the new standard. In a recent blog, we looked at the impact that the new standard has on aerospace and defense contractors and airlines, and today, we would like to turn our attention to companies that work in the financial instrument space.
Wide-Ranging Changes for Each Industry
As we discussed in a blog last year, ASC 606 is set to have vastly different impacts on different industries. Throughout that year (leading up to the effective date for public companies), the AICPA assembled task forces to discuss challenges that these companies may have.
As displayed in the table below, some industries will see major changes to every step while others will only see changes to one step. This is the nature of the change—updating 200 unique standards and bringing everything together under one large, straightforward GAAP for revenue recognition.
|Industry||Step 1||Step 2||Step 3||Step 4||Step 5|
|Aerospace and Defense||✔||✔||✔||✔|
|Construction, Building, Engineering||✔||✔|
|Licensors (Media, Life Sciences, Franchisors)||✔||✔||✔||✔|
In part 1 of our blog series, we looked at the impact on Aerospace and Defense Contractors and Airlines. Today, we would like to turn our attention to Asset Management, Brokers and Dealers, Depository and Lending, and Insurance.
Asset Management under ASC 606
Like many of the other industries listed today, asset managers often have different practices than a firm providing products or services. For these individuals or institutions, everything from the definition of a customer to accounting for different types of fees to the re-investment of customer profits may need to change. Over the past couple years, the Revenue Recognition Task Force met to discuss the potential implementation challenges that asset managers will face, highlighting a few notable areas of concern:
Who is the Customer?
The number one question that asset managers will need to ask is this: Is my customer the investor or the fund? As asset managers have contracts with the funds that they manage, funds could be considered to be the customers. However, since the sole purpose of the fund is to provide a way for the investors to use an asset manager’s services, there are cases in which the investor could also be considered a customer.
Revenue Hub explored this dilemma, noting the following criteria for inclusion:
|When the Fund is the Customer||When the Investor is the Customer|
|· The fund is a separate legal entity.
· The fund is governed by an independent board of directors.
· Fee arrangements are negotiated by the fund applied consistently.
· There is a large number of potentially diverse investors.
· The fund lacks visibility as to who is the ultimate investor.
· The fund is highly regulated.
· The asset managers and other service providers may have multiple different contractual obligations with the fund.
|· The asset manager enters into “side letter” arrangements with investors.
· Investors and asset managers actively re-negotiate fees.
· The fund is not governed by an independent board of directors.
· There is a single or limited number of investors.
For more information on defining a customer in general, see this Revenue Hub Article.
Recognition of Management Fee Revenues
While certain management fees are straightforward base fees paid over the course of an arrangement, most asset managers also offer performance-based fees as part of an arrangement. In clarifying the standard, these performance-based fees are to be treated as a single performance obligation, as the services are transferred to the customer on the same schedule as the base fees. With these performance fees based on the success of an asset manager, said fees are to be allocated to specific performance obligations and treated as variable consideration.
Often, if an asset manager exceeds expenses, the entity will offer a fee waiver to reimburse the investor for said expenses. In accounting for such waivers, asset managers need to look at the way they manage current fee waiver practices. If the agreement to reimburse fees occurs in conjunction with the service agreement, the contracts will likely be combined. However, if entered separately, asset managers will need to consider contract modification guidance, as this practice will impact the transaction price.
Cost of Managing Investment Companies
For incremental costs incurred to fulfill a contract, the capitalization and amortization process guides how all companies will recognize these costs. Under the new standard, entities should capitalize and amortize these costs if the following are true:
- The cost relates directly to a contract
- The costs generate or enhance resources used to satisfy future performance obligations
- The entity expects to recover the costs
In turn, these costs are to be amortized when a good or service is transferred to a customer (fulfils a performance obligation) or expensed if the costs will be fully amortized in a year or less.
Incentives and Incentive-Based Capital Allocations
Especially for fund performance relative to an index (where the performance is out of the control of the manager), the uncertainty creates a challenge. Since much of this is outside the control of the manager, accounting for this is a challenge under the new standard, which only allows variable consideration to be included in the transaction price if “it is probable that there will not be a significant reversal.”
Deferred Distribution Commission Expenses
Back-end load funds that charge a contingent deferred sales charge upon redemption face multiple challenges regarding the accounting practices for paying upfront commissions to third-party distributors and paying distribution fees to asset managers. FASB recommends the accounting practices should follow ASC 946-720 (with pursuant guidance from ASC 340-40-35 for impairment of capitalized interest).
Identifying the Contract
Asset managers, among others, have faced challenges in identifying contracts when transitioning to ASC 606. First, entities should determine whether a contract exists, what rights exist, and whether separate contracts need to be combined to form a single contract.
Asset Management Arrangement Revenue Gross versus Net
For asset managers working with third parties, the determination as to whether the manager is a principal or agent comes into play. This concept is rooted in ASC 605-45 and the process for recognizing revenue should remain the same (principals recognize on gross, agents on net).
Brokers and Dealers
Another financially-focused entity with variable commission structure and complex determinations regarding contracts, brokers face unique challenges and changes regarding contract determinations, variances, and more. Among the biggest issues highlighted by the task force:
When looking at the interactions that brokers have with clients, commission timing and structure is one of the most common practices that may face changes due to the new standard. Notably, however, brokers face unique challenges due to the frequency of trades, and when working with its customers, brokers need to look at the way they charge for services—most notably custody services and trade execution. On top of this, timing of commissions and fees presents a different challenge, as transfer of control could be based on either the trade date or the settlement date.
Underwriting Costs, Advisory Costs
Two specific issues exist in relation to contract costs that need to be accounted for under the new standard:
- The recognition of incremental costs of obtaining a contract
- The recognition of costs to fulfill a contract.
Brokers can expense costs expected to provide benefit within a year that will not be renewed, amortizing extended deals and charging customers.
Underwriting Income, Advisory Income
Fees related to income from underwriting or advisory services are often relatively straightforward, but present issues in timing, assessment of whether a reversal is probable, and more. One such, greenshoe options in underwriting, presents a unique distinction and qualifies as a modification of the contract which is accounted for as a separate contract. Additionally, regarding advisory service fees and related income, much of the revenue is to be treated as variable consideration and reassessed frequently to determine whether significant reversals are likely.
Soft Dollar Revenues
Soft-Dollar arrangements are arrangements in which a broker-dealer provides research to a customer in return for a certain volume of trades from that customer. Depending on how these agreements are negotiated, this could include many moving parts ranging from the use of third-party services and pursuant principal-agent considerations, the timing of and payment for meeting performance obligations, and more. The working draft from the AICPA explores some of the issues throughout all five steps of the transaction.
Out of Scope Financial Instruments
Per Revenue Hub, ASC 606-10-15-2 clarifies that financial instrument contracts held by broker-dealers are not within the scope of ASC 606, but are subject to the guidance found in ASC 310-940, ASC 320-940, and ASC 845. This means that revenues received from the following sources are not subject to ASC 606, and practitioners should continue to follow the existing guidance as it pertains to each revenue stream listed below:
Depository and Lending Institutions
For depository and lending institutions, which offer financial instruments to customers ranging from individuals to institutional investors, the number and scope of contracts these firms deal with is immense. Depository and Lending Institutions will need to expand disclosures, make a few changes to gross vs. net reporting, and potentially change their time of recognition if they hope to remain in compliance with the new standard, according to the AICPA.
Revenue Outside of ASC 606
Some types of contracts fall within both the scope of ASC 606 and other topics in the codification, and the proper accounting treatment for such contracts is addressed within the new revenue standard. An entity should first apply the separation and measurement guidance found within the non-606 ASC topic(s), and then apply the separation and measurement guidance found in ASC 606 to those portions of the contract that are not accounted for using the other ASC topic(s).
Sale of Non-Operating Assets
Banks are finding challenges with ASC 606 as it relates to the sale of non-operating assets are contained in four main categories: scope, collectability, determining the amount of consideration, and the satisfaction of performance obligations. Revenue Hub Explores these topics in greater detail here.
Are You Ready for ASC 606?
With the standard set to change the way companies in all industries do business, now is the last chance to implement the new standard for private companies. Over the next month, we will continue to explore industry trends and challenges as it pertains to the new standard, but we invite you to download our guide to revenue recognition here and contact us when you’re ready to learn more.