By Trey Walker, CPA | Business Assurance & Advisory Services Supervisor
ASC 606 Impact on Financial Services
Accounting professionals have been learning and sharing the Financial Accounting Standard Board’s (FASB) new revenue recognition model since May 2014, when Accounting Standard Update 2016-14, Revenue from Contracts with Customers (Topic 606) was issued (ASC 606). The new guidance provides a framework for addressing revenue recognition issues and replaces almost all pre-existing revenue recognition guidance in generally accepted accounting principles (GAAP) with the intention of improved comparability of revenue recognition practices across entities, industries, and jurisdictions. As a result, all companies and organizations have to evaluate the impact of the new revenue recognition model on their operations and activities to determine if changes are required to comply with its requirements.
Revenue Recognition Five-Step Model
The new revenue recognition model is principles-based and follows a five-step process. Those steps are as follows:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) each performance obligations is satisfied
While these steps may appear simple when listed as above, there are complexities within each step that need to be evaluated. The FASB has included within ASC 606 extensive guidance by step, and approximately 70 examples that are based on transactions in a variety of industries.
New Revenue Recognition Standard Impact on the Financial Services Industry
For those within the financial services sector, the impact of this standard is limited as revenue specifically sourced from financial instruments has been scoped out of the new standard by the FASB. Transactions that are common amongst asset managers and other financial institutions and do fall under the new rules include incentive-based capital allocations, as well as asset management and other performance-based fees.
Management fees, whether they be a fixed amount charged to the customer or based on various performance metrics, should be evaluated using the five-step model. In conjunction with step one, asset managers who manage various investment pools will also need to determine who the customer is for each contract identified. If the management arrangement is negotiated directly between the asset manager and individual investor, the individual investor should be considered the customer. The fund would be treated as the customer for the following circumstances: if the investment fund is a separate legal entity from the asset manager, the fee arrangement is determined through negotiations by the fund and are applied consistently across identified share classes, or the fund is set up in such a way that the individual investors cannot be identified.
These types of fee arrangements are considered to be variable, as the fee is typically based on performance during a specified period or the passage of time. Topic 606 requires asset managers to estimate and limit the recognition of variable consideration so that revenue is recognized only when it is probable that it will not change substantially when the uncertainty associated with the variable consideration is resolved. Due to this, management fees based on the passage of time or determined based using various performance metrics would be recognized at the end of the period when the uncertainty of the fee is resolved. For example, a company operating on a calendar year that manages an investment fund that calls for a fee of 3% of the total asset value of the underlying fund’s assets would be recognized in full on the last day of the year.
Incentive-based capital allocations
Incentive-based capital allocations are additional performance-based fees that are typically included in fund arrangements. These arrangements will call for the re-allocation of a percentage of non-managing investor returns that exceed a contracted threshold, sometimes called a “hurdle rate”. Due to the significant variability of these types of arrangements, the revenue allocation will not be recognizable until it is probable that a significant reversal of the cumulative amount of revenue recognized will not occur. This will largely be the case for any investment fund with a majority of its cumulative return stemming from the increase in value of investments held. In addition, unlike the previous standard, if the incentive fee arrangement allows for a clawback adjustment, the revenue will not be recognizable until the liquidation of the Fund. This includes incentive fees paid to the asset manager, as this type of provision would still leave the possibility of these funds being refundable if the fund suffered losses in subsequent years. Certain indicators that a significant reversal is not likely, and thus recognition of the incentive allocations would be allowable, include:
- The fair value of the remaining investments is significantly higher than the threshold for an incentive fee
- The cost basis of remaining investments is immaterial and any negative impact from future changes in fair value will not result in significant clawback
- The probability of significant fluctuations in the remaining assets’ fair value is low
- The fund is at the end of its life (near-final liquidation)
It is important to note that the new revenue recognition standard does not impact how the investment fund accounts for the incentive allocation.
Companies will need to document their evaluation of each revenue stream, including determination of streams that fall outside of the scope of the new standard. For those streams determined to be within the scope, documentation should cover each of the five steps of the revenue recognition process.
New qualitative and quantitative disclosure requirements will include the company’s contracts with its customers, significant judgments made in applying the revenue recognition guidance to those contracts, and information about any assets recognized for contract costs.
ASC 606 Effective Dates
While the effective dates for the new guidance were staggered and delayed, they are now upon us. Many public entities have already implemented ASC 606, and nonpublic entities are required to implement ASC 606 in their first annual reporting period beginning after December 15, 2018. Companies in the private sector should be well on their way to assessing how the new guidance will affect their revenue recognition policies and disclosures, developing an implementation plan and completing that implementation plan. This is particularly true for companies that plan on electing the full retrospective transition method and companies that have multi-year contract terms with their customers.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.