Jan. 9, 2018
By Christopher G. Johnson, CPA, and Mark C. Shannon, CPA
On Jan. 2, 2018, 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, “Selling and Distribution Fee Revenue” (the implementation issue). The implementation issue addresses how a broker-dealer (Distributor) who sells shares or interests in managed accounts or pooled investment vehicles (Fund) should recognize revenue under the new standard. Comments on the implementation issue are due March 1, 2018.
The implementation issue stems from the efforts of the Brokers and Dealers in Securities Revenue Recognition Task Force, one of 16 industry task forces the AICPA established to study industry 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 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 the guide is consistent with how the board intends the standard to be interpreted.
Fees and Costs Associated With Managed Accounts or Pooled Investment Vehicles
A broker-dealer may act in the capacity of a Distributor of interests in a Fund for which the broker-dealer may receive compensation in different ways:
- An upfront fee paid at the time of the sale of interests to the investor
- Ongoing fees (for example, a 12b-1 fee) based on a contractual rate applied to the market value of the investor’s continued investment in the Fund at periodic points in time
- A fee paid when an investor exits the Fund (a contingent deferred sales charge (CDSC))
- A combination of the preceding ways
A Distributor also might incur costs such as commission charges for third-party distributors or to the Distributor’s own employees.
The Five-Step Revenue Recognition Process
Topic 606 specifies a five-step process to recognize revenue, and the implementation issue provides FinREC’s views on applying the process to a typical agreement between a Fund and a Distributor.
Step One: Identify the Contract With a Customer
Selling and distribution fees typically are stated in a written agreement between a Fund and a Distributor, and the Distributor must consider whether the agreement meets the definition of a contract with a customer under Topic 606. FinREC believes the Fund generally will be the Distributor’s customer after considering the criteria specified in Topic 606 and the indicators in the AICPA’s “Revenue Recognition – Audit and Accounting Guide.”1
It is important for the Distributor to understand how the contract with the customer (that is, the Fund) is terminated. Typically, either the Distributor or Fund can terminate the contract without significant penalty. Because the Distributor is compensated based on the investor’s continued investment in the Fund, the Distributor may continue to receive revenue for a period of time after termination. Because the investor’s actions dictate whether the Distributor earns fees, the Distributor should apply the revenue recognition provisions of Topic 606 to the contractual period over which the parties to the contract have present enforceable rights and obligations. The contractual period might be one day or less.
Step Two: Identify Separate Performance Obligations
Sales and distribution contracts might include various services that meet the definition of a “performance obligation.” For example, marketing and promotional activities, preparing Fund prospectuses or reports, selling shares, and ongoing shareholder services such as processing transactions or maintaining shareholder records might be identified in a contract.
Each service in a contract must be assessed to determine whether it represents a separate performance obligation and requires separate accounting. As part of the assessment, a Distributor might have to consider the guidance in Topic 606 related to combining contracts if contracts for different services are entered into at or near the same time with the Fund.
The Distributor’s overall promise in the contract is to provide marketing services that result in the sale of shares. Marketing and sales are highly interdependent as the sole purpose of marketing is to sell interests in the Fund. Therefore, marketing and sales would not generally be separate performance obligations. Judgment is required to determine if ongoing shareholder services represent a separate performance obligation.
Step Three: Determine the Transaction Price
The amount of a fee paid to a Distributor is determined at various points in time, depending on the nature of the fee.
Upfront fees. Upfront fees typically are defined as a fixed percentage of the value of the shares sold, and the transaction price for upfront fees is fixed on the date shares are sold to the investor.
Ongoing fees. Ongoing fees generally are variable because the amount paid at a particular point in time specified in the contract (for example, at the end of a month) generally is based on the value of the shares at the specified point in time as well as on the length of time the investor has been in the Fund. Ongoing fees are determined at various points in time based on changes in the value of the Fund and whether an investor remains in a Fund. Hence, at any given point in time, the timing and amount of any future ongoing fees that might be earned are uncertain.
Exit fees (CDSCs). CDSCs generally are variable because the amount paid typically varies based on factors similar to ongoing fees (that is, the value of the shares and the length of time the investor has been in the Fund at the date of exit).
Ongoing and exit fees typically are highly susceptible to factors outside the Distributor’s control, such as fluctuations in market value and the length of time an investor is in the Fund. With respect to future market value and investor’s behavior, historical experience is not predictive of the future. These variables can result in a broad range of possible amounts that might not be resolved for a long period of time. Therefore, FinREC believes the recognition of revenue is constrained until the uncertainties are removed.
Step Four: Allocate the Transaction Price to Performance Obligations
The objective of allocating the transaction price is to depict the amount of consideration the entity expects to be entitled to for satisfying a particular performance obligation. The Distributor typically promises to sell shares for the Fund. When a distribution contract includes multiple performance obligations, the Distributor should estimate the stand-alone selling price of each and allocate the transaction price in proportion to those stand-alone selling prices.
If a Distributor receives only an upfront fee and the Distributor concludes it has performance obligations for sales and marketing as well as ongoing shareholder services, a portion of the upfront fee is allocated to the shareholder services and is recognized.
Step Five: Recognize Revenue When or as the Entity Satisfies a Performance Obligation
For each performance obligation identified, the Distributor must determine whether it is satisfied at one point in time or over time, and recognize revenue accordingly. This analysis will vary depending on the services promised in a contract. For example, if the Distributor’s sole performance obligation is the sale of shares to investors, the performance obligation might be satisfied at a point in time (that is, the trade execution date or the point in time when the market value of an investor’s continued investment in the Fund is known and measured pursuant to the contract). In contrast, a performance obligation for shareholder services might be considered satisfied over time as the customer is simultaneously receiving and consuming the benefits provided by the Distributor.
When a contract includes obligations for both sales and shareholder services, the amount of the transaction price allocated to each performance obligation is recognized as each performance obligation is satisfied.
Distributors often incur sales commissions to be paid to other external distributors or their own employees when the Distributor sells shares of a Fund. According to FinREC, sales commissions in a distribution contract are costs to fulfill the contract. A Distributor must determine whether the costs to fulfill its distribution contract are within the scope of Accounting Standards Codification (ASC) Topic 340, “Other Assets and Deferred Costs,” or within the scope of another section of the FASB Accounting Standards Codification. Commissions paid to third-party brokers might be within the scope of ASC Topic 946, “Financial Services – Investment Companies,” which specifies such commissions are deferred and amortized.
FinREC believes sales commissions not within the scope of Topic 946 do not meet the criteria for capitalization specified in Topic 340 and should be expensed when incurred. Distributors who have agreements that include deferred distribution commission expenses should refer to the AICPA’s “Revenue Recognition – Audit and Accounting Guide”2 for further discussion.
The implementation issue’s accounting impact on the industry is expected to be low. However, a broker-dealer should analyze the specific facts and circumstances of each distribution contract and consider whether any changes to financial statement disclosures or internal controls will be required in order to implement Topic 606 for selling and distribution fee revenue.
1 “Revenue Recognition – Audit and Accounting Guide,” AICPA, 2017, Chapter 5.