Nov. 21, 2016
By Christopher G. Johnson, CPA, and Mark C. Shannon, CPA
On Nov. 1, 2016, the Financial Reporting Executive Committee (FinREC) of the American Institute of Certified Public Accountants (AICPA) released, for informal and confidential comment, two draft revenue recognition implementation issues. Working drafts “Issue 3-1: Commission Income” and “Issue 3-1A: Commission Income – Trade Date Versus Settlement Date” (collectively, the working drafts) address revenue recognition implementation issues for brokers and dealers in securities (broker-dealers). The working drafts discuss potential performance obligations in common retail brokerage agreements, including whether those performance obligations are satisfied over time or at a point in time and whether the performance obligation for trade execution is satisfied on the trade or settlement date. Comments are due Jan. 2, 2017.
The working drafts stem from the work of the Brokers and Dealers in Securities Revenue Recognition Task Force, one of 16 industry task forces the AICPA established to study industries’ 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 will be included in a new revenue recognition guide that the AICPA is developing. 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 will be consistent with how the board intends the standard to be interpreted.
The working drafts address the five-step revenue recognition process in Topic 606 for a customary retail brokerage contract for a clearing broker-dealer. Common services a clearing broker-dealer provides in a retail brokerage contract include:
- Trade execution: A broker-dealer acts as an agent for an investor by determining how best to execute an order placed by a customer.
- Clearing (including settlement): A broker-dealer facilitates the delivery of securities and funds between buyers and sellers on the settlement date.
- Custody: A broker-dealer keeps various records for customers, including securities holdings and dividends and interest payments.
Other services not already listed (investment research services, for example) will be addressed in separate implementation papers.
The working drafts note that other types of broker-dealers might need to perform a separate analysis of the services they provide. For example, introducing broker-dealers may accept customer orders to purchase and sell a financial instrument, but they might have a clearing broker execute and settle the transaction because they do not provide clearing services.
Following is a summary of the conclusions reached in the working drafts for each of the five steps in the revenue recognition process for a typical retail brokerage contract between a clearing broker-dealer and a customer.
Step One: Identify the Contract
A typical retail brokerage contract specifies a commission or fee for trade execution but does not identify any other fees for custodial services or contractual minimums on the number of transactions to be executed. FinREC believes that a contract that does not contain separate fees for custodial services or contractual minimums on the number of trades to be executed is not considered a contract for the purposes of Topic 606 until a customer first submits a trade order. Even if the customer previously had deposited cash or securities into his or her account, Topic 606 does not consider such a transaction as the inception of a contract because the customer is not obligated to pay the broker-dealer any consideration for its services prior to submitting a trade order.
In contrast, for retail brokerage contracts that contain separate fees for custodial services or a guaranteed minimum number of trades, the working drafts conclude a contract exists for the purposes of Topic 606 when the customer deposits money or transfers securities into an account, when the customer executes a trade, or when the contractual term of the custody services begins.
The working drafts indicate the term of a typical retail brokerage contract might be one day or less if the contract is terminable at will by either party. Additional analysis is required if the retail brokerage contract is for a specified term, such as a period of time or for a specified number of trades.
Step Two: Identify the Performance Obligations in the Contract
The working drafts state that trade execution and clearing services (collectively called trading services) generally will be identified together as a single distinct service because, from the perspective of the customer, trading services are indistinguishable in the context of the agreement with the broker-dealer (in other words, the customer submits a trade order and expects the broker-dealer to both execute and clear the trade). While trading services generally would be viewed as a single distinct service, they typically are not identified as a performance obligation at the execution of the contract. Instead, the working drafts indicate trading services should be treated as optional purchases when a customer requests a broker-dealer to execute a trade. The working drafts further state that an option gives rise to a separate performance obligation in the contract only if the option provides a material right. Additionally, the working drafts state that an option does not provide a material right to the customer if the price of the additional goods and services to be provided reflects the stand-alone selling price for those goods or services. FinREC therefore believes broker-dealers should evaluate the pricing of their trade execution services, among other qualitative factors, to determine whether the option gives rise to a material right.
A typical retail brokerage contract includes custodial services from which a customer can separately benefit, even without executing a trade. The working drafts assert custodial services, therefore, generally will be identified as a performance obligation separate from trading services. In many cases, a broker-dealer will provide custodial services beyond the term of the contract (for example, for one day, due to the at-will termination provisions), and the working drafts note broker-dealers will need to assess whether providing such services represents a material right conveyed to the customer. The working drafts indicate there might be certain circumstances (such as if custodial services are provided at no charge solely due to prior executed trades) where custodial services could represent a material right, which would require additional analysis.
Step Three: Determine the Transaction Price
A customary retail brokerage contract contains a single commission price that relates to both the custodial services and trading services provided by the broker-dealer; however, the commission price commonly is quoted as a rate for trading services. If a contract contains separate pricing for custodial services, the consideration for the custodial services would be included in the transaction price at contract inception if the amount is not constrained, as defined in Topic 606. Similarly, any guaranteed minimum on trade commissions also is included in the transaction price at contract inception.
Step Four: Allocate the Transaction Price to the Performance Obligations in the Contract
The working drafts note that broker-dealers would allocate separately priced custodial services to the custodial performance obligation. For a typical retail brokerage contract that includes a single commission price that relates to both trading services and custodial services, the working drafts indicate that a broker-dealer should determine whether the optional purchase of trading services represents a change in transaction price or a modification of the original contract, as defined in Topic 606. The broker-dealer also must determine whether the commission price represents the stand-alone selling price for the trading services. If a broker-dealer concludes the optional purchase of trading services represents a change in the transaction price and the commission price represents the stand-alone selling price for those services, no part of the transaction price would be allocated to custodial services. In most other scenarios, the broker-dealer would allocate the transaction price between trading services and custodial services based on their stand-alone selling prices. Regardless, however, because both performance obligations would be satisfied by the end of the day for a contract terminable at will by either party, no allocation technically is required unless the broker-dealer separately presents revenue from trading services and custodial services in its financial statements. Contracts with a guaranteed minimum number of executed trades or with volume discounts would require additional analysis.
Step Five: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation
Trading services generally will be satisfied at a point in time. The working drafts also consider whether the point in time associated with trading services occurs on the trade date or the settlement date, and the working drafts indicate the trade date is the point in time at which the broker-dealer satisfies its trading services performance obligation. FinREC believes custodial services normally will be satisfied over a period of time, which, as previously noted, might be over as little as one day.
In the case of failed trades, a broker-dealer generally is expected to remedy the failure to perform by either party if the customer or the other counterparty does not remit payment or the financial instrument on the scheduled settlement date. The working drafts indicate the broker-dealer should view the remedy as similar to a warranty and should recognize a liability or expense rather than treat the remedy as a separate performance obligation. A very small number of trades are expected to fail at settlement, in which case the consideration would be variable consideration and the broker-dealer must estimate the amount of consideration that will be refunded and include that portion in the estimate of the transaction price (as a reduction of revenue instead of as a cost accrual).
The FinREC guidance provides additional detail not discussed in this article, including consideration of less common contractual structures. Overall, the conclusions expressed in the working drafts are not expected to significantly affect a broker-dealer’s recognition of commission revenue for a typical retail brokerage contract. However, broker-dealers should evaluate the specific facts and circumstances of their retail brokerage contracts to determine how they might be affected.
Interested parties should submit any comments (including the implementation issue number) by Jan. 2, 2017.