Broker-Dealers: Principals or Agents?

By Christopher G. Johnson, CPA, and Mark C. Shannon, CPA
On March 1, 2017, the Financial Reporting Executive Committee (FinREC) of the American Institute of CPAs (AICPA) released, for informal and confidential comment, a draft revenue recognition implementation paper titled “Issue #3-3: Principal Vs. Agent: Costs Associated With Underwriting” (the implementation issue). The working draft addresses whether an underwriter performing services under a typical underwriting contract is acting as a principal (who should recognize revenue and costs on a gross basis) or as an agent (who should recognize revenue and costs net of revenues and costs allocated to other members of the underwriting group in the income statement). Comments are due May 1, 2017.

The implementation issue stems from the efforts of the Brokers and Dealers in Securities Revenue Recognition Task Force, one of 16 industry task forces established by the AICPA to study implementation issues related to Accounting Standards Update (ASU) No. 2014-09, “Revenue From Contracts With Customers (Topic 606),” issued in May 2014 by the Financial Accounting Standards Board (FASB). According to the AICPA, the task forces are “charged with developing revenue recognition implementation issues that will provide helpful hints and illustrative examples for how to apply the new revenue recognition standard” in their respective industries.

Final revenue recognition implementation issues are included in a new revenue recognition guide that the AICPA has developed and continues to update as new implementation issues are finalized. Prior to publishing implementation issues, the AICPA submits the issues to the FASB/International Accounting Standards Board Joint Transition Resource Group for Revenue Recognition to verify that conclusions with respect to the implementation issues included in the guide are consistent with how the board intended the standard to be interpreted.


FinREC’s Conclusions

In a typical underwriting agreement, a broker-dealer is engaged to perform underwriting services on behalf of an issuer of securities, the customer. The agreement to underwrite an issuance of securities often is between the issuer and a group of underwriters, a syndicate. The syndicate generally consists of a lead underwriter and other participating underwriters, who may or may not be co-leads. The lead underwriter’s role involves organizing the other members of the syndicate, negotiating the transaction with the customer, and maintaining underwriting subscription records and records of underwriting expenses. In addition to the syndicate management role, the lead underwriter also performs underwriting services similar to the other participating underwriters.

The responsibilities and legal obligations of the participating underwriters, including the lead underwriter when performing underwriting duties as part of the syndicate, usually are governed by a syndicate agreement. Each syndicate member typically commits to selling a proportionate share of the issuer’s securities and is responsible for a proportionate amount of expenses incurred by the syndicate. Generally, each member of the syndicate is severally responsible to perform and severally liable in the event of alleged wrongdoing in performing the underwriting services.

The implementation issue provides separate analyses of principal versus agent considerations for the lead underwriter role as well as for the participating underwriter role, which includes the lead underwriter acting as a participating underwriter.

Guidance in Topic 606 for Principal Versus Agent Analyses

The lead underwriter and each syndicate member must analyze the factors identified in Topic 606 to determine if they are acting as a principal or an agent. The lead underwriter must determine if it is acting as a principal, in which case it should record all revenues collected and all expenses incurred on a gross basis, or as an agent, in which case it should record underwriting revenues net of revenues allocated to other syndicate members and expenses incurred net of the expenses that are allocated to other syndicate members.

Similarly, each syndicate member, including the lead underwriter when acting as a syndicate member, must determine if it is acting as a principal and should present its proportional share of gross revenues and expenses in the income statement, or if it is acting as an agent and should present its proportional share of revenues net of its proportional share of expenses.

Topic 606 indicates that an entity that is a principal obtains control of any one of the following: 1) a good or asset from another party, which is then transferred to the customer; 2) a right to a service from another party, which allows the entity to direct the provision of that service to the customer; or 3) a good or service from another party, which the entity combines with other goods and services to provide to the customer.

Topic 606 also provides that an entity obtains control of the specified good or service, and thus acts as a principal when: 1) the entity is primarily responsible for fulfilling the contract; 2) the entity has inventory risk before or after the goods have been ordered, during shipping, or upon return; and 3) the entity has discretion in establishing a price for the specified good or service.

The Lead Underwriter

With respect to the syndicate, the lead underwriter typically is an agent when performing the syndicate management role, as the lead underwriter typically does not have control over any good or asset provided by the participating underwriters and does not have the ability to direct the services provided by the participating underwriters. The lead underwriter also does not combine the services of the participating underwriters when providing services to the customer. Each underwriter in the syndicate has an individual contractual relationship with the customer.

The lead underwriter does not obtain control over a specified good or service provided by the participating underwriters to the customer because the lead underwriter is not primarily responsible for fulfilling the contract. Though the lead underwriter negotiates with the issuer on behalf of all members of the syndicate, the lead underwriter is arranging only for the syndicate to perform the underwriting services. Furthermore, each syndicate member named in the underwriting agreement is severally responsible for its committed share of the total offering, and each syndicate member is severally liable for any alleged wrongdoing.

In addition, the lead underwriter does not have inventory risk because it does not commit to purchase services from the other members of the syndicate or to provide services to the customer prior to execution of the underwriting agreement, at which point all participating underwriters are known and named in the contract. Since the lead underwriter role is not primarily responsible for providing the customer the underwriting services and does not have inventory risk, each of these indicators point to the lead underwriter acting as an agent when performing its role as the lead underwriter.

The economics of the contract are transparent to all syndicate participants and the lead does not have significantly more influence over pricing than the other participants. Therefore, pricing latitude is not a determinative criteria.

Though the specific facts and circumstances of each underwriting arrangement should be analyzed to reach a definitive conclusion, FinREC indicates that the factors in Topic 606 point to the lead underwriter acting as an agent when performing its role in arranging underwriting services and managing the other syndicate members. Therefore, the lead underwriter should recognize underwriting revenues and related expenses net of revenues and expenses allocated to other participating syndicate members.

Other Syndicate Members, Including the Lead Underwriter and Participating Underwriters

The syndicate members contract with various vendors in order to fulfill their performance obligation to provide underwriting services. For example, the syndicate members often must incur costs for setting up the syndicate group and for marketing and advertising, legal services, travel, printing, accounting, and other services to perform under the underwriting contract. The vendors of these services contract directly with the syndicate member, and the syndicate member combines the benefits of these services with its own to deliver its performance obligation to the customer.

Each participating underwriter primarily is responsible for performing their pro rata portion of the underwriting contract, and the vendors with which a participating underwriter contracts have no obligation to the customer (that is, the issuer of the securities). In addition, each participating underwriter is obligated to pay the service providers even if the participating underwriter does not provide its services to the customer. Both of these facts indicate that each individual participating underwriter is acting as a principal under the underwriting contract with the customer.

Similar to the conclusions discussed earlier for the lead underwriter, discretion in pricing is not determinative in this analysis.

FinREC believes that generally, the factors in Topic 606 indicate that members of the underwriting syndicate, including the lead and participating underwriters, each act as principals in performing their proportionate share of the underwriting services. Therefore, the members of the underwriting syndicate should reflect their proportionate share of underwriting gross revenues and expenses in the income statement. Each arrangement’s specific facts and circumstances should be analyzed before reaching a definitive conclusion.

Deferral of Underwriting Expenses

The guidance for deferral of incremental underwriting expenses incurred before the actual issuance of securities will not change under Topic 606. Deferred underwriting expenses are recognized at the time the related revenues are recorded or written off if the securities will not be issued.

Looking Ahead

The views expressed in the implementation issue are not expected to significantly affect a broker-dealer’s income statement presentation of underwriting revenues and expenses. Interested parties should submit any comments, including the implementation issue number, to [email protected] by May 1, 2017.

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Chris Johnson
Chris Johnson
Mark Shannon
Mark Shannon