Nov. 6, 2017
By Christopher G. Johnson, CPA, and Mark C. Shannon, CPA
On Nov 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, “Underwriting Revenues” (the implementation issue). The implementation issue covers how a broker-dealer should recognize revenue for underwriting services under the new standard. Comments on the implementation issue are due Jan. 2, 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.
The Underwriting Process
Entities engage broker-dealers to underwrite an issuance of securities. Underwriting, which generally is within the scope of Topic 606, involves distributing a new issue of securities or a large block of issued securities to investors. Securities offerings might be underwritten on a firm commitment, best efforts, or standby basis and often will involve a managing underwriter and a syndicate of participating underwriters. The broker-dealer section of the AICPA’s “Revenue Recognition – Audit and Accounting Guide”1 explains the difference between a managing underwriter and a participating underwriter.
When an underwriter sells securities to the public in a primary or secondary offering, it generally is compensated with an underwriting spread, which is the difference between the price paid by the underwriter to the issuer of the securities and the price paid by the public. As defined in the underwriting contract, the spread is split between the managing underwriter, participating underwriters, and, if applicable, the selling group. Depending on its role, a broker-dealer might act as a principal or an agent when performing underwriting services.
The issuer of securities sometimes will provide the underwriters with an over-allotment option to sell more securities than planned. The broker-dealer must consider whether the over-allotment option qualifies as a derivative and therefore is within the scope of Topic 815. If the over-allotment option is not a derivative, it generally will be in the scope of Topic 606 as a contract modification.
Even though typically not contractually required, an underwriter also might participate in market stabilization activities, which involves attempting to stabilize the price of a security by purchasing or selling shares directly in the market to increase or decrease the supply of the security. FinREC believes market stabilization activities do not represent an implied promise to a customer in the scope of Topic 606 because the activities are not designed with the purpose of a direct benefit to the customer. Rather, price stabilization activities benefit both the broker-dealer and broader markets as a whole and should be recognized under Topic 860 and Topic 940. The AICPA’s “Revenue Recognition – Audit and Accounting Guide”2 discusses accounting scope considerations for market stabilization activities in more detail.
The Five-Step Revenue Recognition Process
Step One: Identify the Contract With a Customer
FinREC believes the issuer of securities will be the customer of each underwriter in a syndicate group, and each underwriter must evaluate whether the underwriting agreement meets the criteria in Topic 606 to be identified as a contract with a customer. FinREC asserts that an underwriting agreement typically must be executed and legally enforceable to meet the criteria of a contract with a customer.
A broker-dealer also might contract with an issuer to provide other services such as bridge financing, term loans, or credit facilities. Broker-dealers should consider whether any separate service contracts should be combined with an underwriting agreement and evaluated as a single contract. In addition, a broker-dealer should consider whether any parts of the contract meet any of the scope exceptions in Topic 606. If so, a broker-dealer should consider Topic 606’s separation and measurement guidance.
Step Two: Identify Separate Performance Obligations
A broker-dealer might perform management underwriting services, underwriting services, and selling concession services as part of the underwriting contract. Though a broker-dealer might perform multiple services in a particular underwriting agreement, FinREC believes the services typically will be accounted for as a single performance obligation because the services are not distinct (that is, the customer’s ability to benefit from the underwriting services is dependent on completion of all the services).
A broker-dealer also must consider whether any over-allotment option represents a separate performance obligation. If the over-allotment option is in the scope of Topic 606, FinREC believes the over-allotment option is not a separate performance obligation until it is exercised (assuming the broker-dealer is not contractually obligated to exercise the option). Upon exercise, the option is treated as a contract modification, and FinREC believes a broker-dealer typically will account for the modification as a separate contract upon exercise.
Step Three: Determine the Transaction Price
A broker-dealer generally is able to determine the portion of the gross underwriting spread to which it will be entitled in exchange for the underwriting services performed. The gross underwriting spread is split based on the service provided (that is, managing underwriting, participating underwriting, or selling concession) and is contractually agreed upon. As part of the evaluation of transaction price, broker-dealers should consider the principal versus agent guidance in the broker-dealer section of the AICPA’s “Revenue Recognition – Audit and Accounting Guide.”3
If a contract for underwriting services contains variable consideration (for example, performance bonuses, incentives, or discounts), a broker-dealer must estimate the amount of variable consideration to include in the transaction price to the extent it is probable that a significant reversal of revenue will not occur in the future. Topic 606 provides factors a broker-dealer should consider when evaluating whether to include variable consideration in the transaction price.
Step Four: Allocate the Transaction Price to Performance Obligations
An underwriting agreement typically contains a single performance obligation because, as noted previously, any over-allotment option is treated as a separate contract. Therefore, a broker-dealer typically should allocate the entire transaction price determined in step three to the single performance obligation.
Step Five: Recognize Revenue When or as the Entity Satisfies a Performance Obligation
The implementation issue covers the various criteria in Topic 606 used to determine if a performance obligation is satisfied over time or at a point in time. FinREC believes an underwriting performance obligation typically is not met over time. Therefore, a broker-dealer generally will recognize underwriting revenue at a point in time.
FinREC believes the broker-dealer should recognize underwriting revenue on the trade date. This conclusion is consistent with the concept of the transfer of control related to broker-dealer commission revenue in the AICPA’s “Revenue Recognition – Audit and Accounting Guide.”4
The implementation issue includes an example transaction that broker-dealers can use to enhance their understanding of the matters addressed in the implementation issue. While the impact of the new standard on the timing of revenue recognition for underwriting services is expected to be minimal, broker-dealers currently should be considering whether any changes to financial statement disclosures or internal controls will be required to account for underwriting revenues under Topic 606.
1 “Revenue Recognition – Audit and Accounting Guide,” American Institute of CPAs, 2016, Chapter 5.