Many asset managers still are getting up to speed with the requirements of the Financial Accounting Standards Board’s Accounting Standards Codification Topic 606, “Revenue From Contracts With Customers,” and how it will affect their financial statements, including a possible drop in revenues in the short term when revenue includes performance incentives and similar terms. Several issues in particular could pose challenges for asset managers.
The new standard in a nutshell
Issued in May 2014, Accounting Standards Update (ASU) No. 2014-09 – and its international counterpart, International Financial Reporting Standards (IFRS) 15, also titled “Revenue From Contracts With Customers” – supersedes virtually all previous revenue recognition guidance in U.S. GAAP and IFRS. It is based on the core principle that a company should recognize revenue in a way that depicts the transfer of promised goods or services to customers in the amount that reflects the consideration the company expects to be entitled to in exchange for the goods or services.
Management and performance-based fees
Asset managers can have different types of revenue contracts with their customers. Fee arrangements with hedge funds and private equity funds generally provide for a management fee and a performance-based fee, while arrangements with mutual funds include management fees and other types of fees.
Asset managers will need to evaluate their fee arrangements with hedge funds, private equity funds, and mutual funds under the new rule, which could include:
Step 1: Identifying contracts with a customer
Any arrangement with a customer (for example, limited partnership agreement, management agreement, or fund prospectus) that creates enforceable rights and obligations will generally represent a contract under the standard.
In addition to identifying contracts, asset managers will need to identify their customer under the contract. The conclusion as to who is the customer can affect the accounting for items such as fees from front-end sales loads and the costs of obtaining the contract.
Depending on the circumstances, an asset manager’s customer could be a fund or an investor. Indicators that the customer is the fund for revenue recognition purposes include:
Indicators that the customer is the fund investor include:
If an asset manager enters into two or more contracts with the same customer (or related parties) at or near the same time, ASU 2014-09 requires the contracts be combined and accounted for as a single contract in certain circumstances. An asset manager who provides services to a hedge fund or a private equity fund through a general partner entity and an investment manager may need to combine the general partner and investment management contracts because the contracts will likely have been negotiated together with a single commercial objective. Moreover, the services generally constitute a single performance obligation – management of fund assets.
In the case of mutual funds, the parties can have different contracts for, among other things, advisory services, distribution contracts, transfer agencies, and custodian services. Those contracts generally will not be combined because they have separate commercial objectives, involve separate performance obligations, and lack pricing interdependence.
Step 2: Identifying performance obligations
Asset managers commonly receive two separate forms of compensation in exchange for the single service of managing a fund’s assets, rather than for separate management services and performance-based services. Because asset management services are generally provided continuously over the course of the contract, are substantially the same, and have the same pattern of transfer, all of the services in the contract usually will represent a single performance obligation over a series of service periods (for example, quarters).
Step 3: Determining the transaction price
The standard requires asset managers to estimate the amount of variable consideration they expect to be entitled to and apply a constraint to determine the appropriate transaction price. Due to the constraint, the transaction price generally only will include the periodic management fee at the end of the period when the fee is calculated based on end-of-period net asset value (NAV) and will not include estimates of management fees for future periods, which would be constrained due to their significant variability.
Performance-based fees for hedge funds and private equity funds also come with significant variability, and often must be constrained until they crystallize at the end of the performance period or are no longer subject to a clawback adjustment. Generally, these fees cannot be recognized until it is probable that a significant reversal of the cumulative amount of revenue recognized will not occur. Indicators that a significant fee reversal is not probable may include:
Step 4: Allocating the transaction price to the performance obligations
The standard calls for the transaction price to be allocated to the identified performance obligations based on the stand-alone selling price of each obligation. However, an exception that allows a company to allocate variable consideration to one or more distinct goods and services that make up part of a performance obligation will generally apply to asset managers’ performance obligations in many cases.
Specifically, the asset manager’s variable compensation will generally relate directly to their effort to provide investment management services for a specified period within a contract (a month or a quarter) that are distinct from the services provided in other periods. As such, any variable consideration that is not constrained will generally be allocated to the distinct performance periods, rather than spread across the entire service period.
Step 5: Recognizing revenue when the entity satisfies a performance obligation
Under the new standard, a company must determine whether it satisfies its performance obligations over time or at a point in time and recognize the revenue accordingly. Investment management services are generally satisfied over time because the customer simultaneously receives and consumes the benefits from an asset manager.
The asset manager may choose either an input or output method of measuring progress on each performance obligation. An asset manager that uses the output method may be allowed under the standard to apply a practical expedient that recognizes revenue in the amount that it has a right to invoice. Regardless of the method chosen, asset managers often find that time elapsed provides the best depiction of performance in transferring control of the investment management services to the customer.
Exhibits 1 and 2 illustrate the revenue recognition under the new standard, with examples for private equity and a hedge fund.
Exhibit 1 assumes invested capital of $10 million with annual management fees of 2 percent of ending period invested capital (no fee offsets) payable annually in arrears, and a carried interest of 20 percent (no hurdle rates). Clawback provisions are in effect on the carried interest until the fund is fully wound down. Prior to adopting the new revenue standard, the manager has historically used Method 2 to recognize revenue.
The new standard in a nutshell
Issued in May 2014, Accounting Standards Update (ASU) No. 2014-09 – and its international counterpart, International Financial Reporting Standards (IFRS) 15, also titled “Revenue From Contracts With Customers” – supersedes virtually all previous revenue recognition guidance in U.S. GAAP and IFRS. It is based on the core principle that a company should recognize revenue in a way that depicts the transfer of promised goods or services to customers in the amount that reflects the consideration the company expects to be entitled to in exchange for the goods or services.
Management and performance-based fees
Asset managers can have different types of revenue contracts with their customers. Fee arrangements with hedge funds and private equity funds generally provide for a management fee and a performance-based fee, while arrangements with mutual funds include management fees and other types of fees.
Asset managers will need to evaluate their fee arrangements with hedge funds, private equity funds, and mutual funds under the new rule, which could include:
- Base management fees, fee waivers, and expense caps
- Performance-based fees, including carried interest
- Reimbursement of startup or ongoing costs
- Distribution and related fees
Step 1: Identifying contracts with a customer
Any arrangement with a customer (for example, limited partnership agreement, management agreement, or fund prospectus) that creates enforceable rights and obligations will generally represent a contract under the standard.
In addition to identifying contracts, asset managers will need to identify their customer under the contract. The conclusion as to who is the customer can affect the accounting for items such as fees from front-end sales loads and the costs of obtaining the contract.
Depending on the circumstances, an asset manager’s customer could be a fund or an investor. Indicators that the customer is the fund for revenue recognition purposes include:
- The fund is governed by a board of directors
- Consistent fees are charged for each class of investor
- The asset manager negotiates the management fees with the fund as part of the offering document or with its governing body
- The fund has a large number of unrelated investors
Indicators that the customer is the fund investor include:
- The fund is governed by investors who can terminate the manager directly
- Fees are negotiated individually with investors
- The asset manager negotiates the management contract and fees with individual investors
- The fund has a small number of unrelated investors
If an asset manager enters into two or more contracts with the same customer (or related parties) at or near the same time, ASU 2014-09 requires the contracts be combined and accounted for as a single contract in certain circumstances. An asset manager who provides services to a hedge fund or a private equity fund through a general partner entity and an investment manager may need to combine the general partner and investment management contracts because the contracts will likely have been negotiated together with a single commercial objective. Moreover, the services generally constitute a single performance obligation – management of fund assets.
In the case of mutual funds, the parties can have different contracts for, among other things, advisory services, distribution contracts, transfer agencies, and custodian services. Those contracts generally will not be combined because they have separate commercial objectives, involve separate performance obligations, and lack pricing interdependence.
Step 2: Identifying performance obligations
Asset managers commonly receive two separate forms of compensation in exchange for the single service of managing a fund’s assets, rather than for separate management services and performance-based services. Because asset management services are generally provided continuously over the course of the contract, are substantially the same, and have the same pattern of transfer, all of the services in the contract usually will represent a single performance obligation over a series of service periods (for example, quarters).
Step 3: Determining the transaction price
The standard requires asset managers to estimate the amount of variable consideration they expect to be entitled to and apply a constraint to determine the appropriate transaction price. Due to the constraint, the transaction price generally only will include the periodic management fee at the end of the period when the fee is calculated based on end-of-period net asset value (NAV) and will not include estimates of management fees for future periods, which would be constrained due to their significant variability.
Performance-based fees for hedge funds and private equity funds also come with significant variability, and often must be constrained until they crystallize at the end of the performance period or are no longer subject to a clawback adjustment. Generally, these fees cannot be recognized until it is probable that a significant reversal of the cumulative amount of revenue recognized will not occur. Indicators that a significant fee reversal is not probable may 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)
Step 4: Allocating the transaction price to the performance obligations
The standard calls for the transaction price to be allocated to the identified performance obligations based on the stand-alone selling price of each obligation. However, an exception that allows a company to allocate variable consideration to one or more distinct goods and services that make up part of a performance obligation will generally apply to asset managers’ performance obligations in many cases.
Specifically, the asset manager’s variable compensation will generally relate directly to their effort to provide investment management services for a specified period within a contract (a month or a quarter) that are distinct from the services provided in other periods. As such, any variable consideration that is not constrained will generally be allocated to the distinct performance periods, rather than spread across the entire service period.
Step 5: Recognizing revenue when the entity satisfies a performance obligation
Under the new standard, a company must determine whether it satisfies its performance obligations over time or at a point in time and recognize the revenue accordingly. Investment management services are generally satisfied over time because the customer simultaneously receives and consumes the benefits from an asset manager.
The asset manager may choose either an input or output method of measuring progress on each performance obligation. An asset manager that uses the output method may be allowed under the standard to apply a practical expedient that recognizes revenue in the amount that it has a right to invoice. Regardless of the method chosen, asset managers often find that time elapsed provides the best depiction of performance in transferring control of the investment management services to the customer.
Exhibits 1 and 2 illustrate the revenue recognition under the new standard, with examples for private equity and a hedge fund.
Exhibit 1 assumes invested capital of $10 million with annual management fees of 2 percent of ending period invested capital (no fee offsets) payable annually in arrears, and a carried interest of 20 percent (no hurdle rates). Clawback provisions are in effect on the carried interest until the fund is fully wound down. Prior to adopting the new revenue standard, the manager has historically used Method 2 to recognize revenue.
