In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every industry, and asset managers are no exception. The complex arrangements between asset managers and their clients pose some difficult issues for the new standard.
The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues within ASC 606, and we will draw from the guides they have published as we provide a brief explanation of the key issues asset managers face when applying ASC 606. For more information on any of these issues, see:
- AICPA: Revenue Recognition: Audit and Accounting Guide
- Deloitte: Investment Management Spotlight: Navigating the New Revenue Standard
- EY: Technical Line: How the new revenue standard affects asset managers
- PwC: In Depth: Asset management industry supplement
We will also provide references to other RevenueHub articles for more detailed explanations of related ASC 606 topics. For general information on the basics of revenue recognition, see our RevenueHub article, The Five-Step Method.
The following are the issues that companies in the depository and lending industry commonly face:
1. Identifying the Contract
Asset managers offer a variety of services to their customers and often engage in several services at the same time for one customer. These services may be contained in a single contract or may exist separately in individual contracts. In some cases, the governing documents of a fund may dictate which services are to be provided by a manager, and these documents may be considered a contract.
FASB ASC 606-10-25-1 contains criteria for determining what is considered a valid contract. If the criteria are met, the arrangement is a valid contract and will be subject to the new revenue recognition standard found in ASC 606. In circumstances where the agreement does not meet the criteria found in 606-10-25-1 and consideration is received from a customer by the manager, ASC 606-10-25-7 through 8 should be applied to account for the rights and obligations in the contract. This arrangement should be monitored and evaluated according to the criteria in ASC 606-10-25-1 to determine if the new standard should be applied at a later date.
In cases where multiple separate contracts are entered into by the asset manager or its related parties, ASC 606-10-25-9 should be used to evaluate whether the separate contracts should be combined.
For more information on combining contracts, refer to the Combining Contracts article found on RevenueHub. For more information on identifying a contract, refer to the Identifying the Contract article also found on Revenue Hub.
2. Who is the Customer?
The asset management industry faces an added challenge when identifying the customer in an agreement, due to the relationship the asset manager has with the fund they manage and its investors. This issue arises because asset managers have contracts with the funds they manage, but the funds exist for the sole purpose of providing a way for investors to use an asset manager’s services.
Though the FASB has not offered an official view on the issue, several indicators have been identified to aid you in coming to a conclusion regarding your specific circumstances. The AICPA has noted that the list is not all-inclusive, and each indicator should be evaluated carefully, analyzing the meaningfulness of each indicator in your unique circumstances. According to the AICPA, the characteristics that may indicate that the fund is an asset manager’s customer are as follows:
- The fund is a separate legal entity that may be set up as a partnership, corporation, or business trust.
- The fund is governed by a board of directors or other form of governance, which is independent of management of the fund.
- Fee arrangements for management and advisory fees are negotiated by the fund and applied consistently by the investor class.
- There is a large number of potentially diverse investors.
- The fund lacks visibility as to who the ultimate investor is because investors have subscribed through a third-party broker-dealer’s omnibus account.
- The fund is highly regulated, as is the case with registered investment companies in the U.S.
- The asset manager and other service providers may have multiple different contractual arrangements with the fund to provide different services.
There are circumstances in which the investors should be considered the customers. According to the AICPA, the characteristics that may support this conclusion are as follows:
- The asset manager enters into individual “side letter” arrangements regarding management fees with individual investors (as may be common in certain partnership structures).
- There is active negotiation of fees or interaction between the asset manager and individual investors or a small group of investors that control the fund‘s activity directly or indirectly through their role on the board or governing body (that is, the investors as a group act together as the fund’s governance structure).
- The fund is not governed by a board of directors or other form of governance, which is independent of management of the fund.
- There is a single or a limited number of investors.
For more information on how to define and determine the customer within a contract, please refer to the definition of a customer article found on RevenueHub.
3. Management Fee Revenues
Management fee revenues are often part of the compensation that asset managers receive for their investment management arrangements. These management fees are normally a base fee that is paid for continued service over the course of the arrangement. Generally, however, an asset manager does not just offer their base services, but also provides performance-based services in conjunction with their base management services. These services are performed in conjunction with one another and are transferred to the customer on the same schedule, thus the two services would not qualify as separate performance obligations, but as a single performance obligation.
Base management fees are not variable, and therefore would be included in the transaction price, whereas performance-based fees would likely not be included due to their variable nature. Issue number five below addresses these performance-based fees in greater detail.
After determining the transaction price, it must be allocated to the performance obligations in the contract. ASC 606 allows for variable consideration to be allocated to multiple goods or services that make up a single performance obligation, if specific criteria are met. Asset manager agreements often meet these qualifying criteria, allowing for variable consideration to be allocated to distinct services provided in a certain period. The unconstrained portion of the variable consideration will then be allocated to these distinct periods, with the remaining portion of being spread over the duration of the single performance obligation.
For more information on allocating variable consideration, please refer to the Allocating Variable Consideration article found on RevenueHub.
4. Fee Waivers/Fund Expense Reimbursements
Asset managers sometimes waive their management fee or reimburse a fund for expenses incurred beyond an agreed upon threshold. The agreement to waive or reimburse these fees can be entered into in conjunction with the service agreement, but may also be agreed upon separately. If the first scenario is true, the contracts will likely be combined due to the timing of the agreements and their related nature. The second scenario requires more analysis, as the agreement to waive or reimburse will affect the transaction price of the service agreement. Contract modification guidance should be consulted to determine the proper handling of this scenario.
Regardless of which scenario is true for you, the waivers and/or reimbursements should be included in the estimate of the related fee as a reduction of the total fee amount such that the waiver/reimbursement expense will be recognized as a reduction of management fee revenue when the fee revenue is recognized. As is always the case with estimates of transaction price, the inclusion of the management fee net of the reduction should only occur to the degree that a significant revenue reversal is not probable.
For more information on variable consideration, please refer to the Variable Consideration and the Constraint article found on RevenueHub.
5. Costs of Managing Investment Companies
Under the new standard, companies will be required to capitalize and amortize incremental costs the entity incurred to obtain (e.g., sales commissions) and fulfill a contract. The entity should only capitalize and amortize the costs to fulfill a contract if (1) the costs relate directly to a specific contract, (2) the costs generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) the entity expects to recover the costs. The costs capitalized by the entity should be amortized as the entity transfers the goods or services designated in the contract to the customer. There is a practical expedient that allows entities to immediately expense the costs if they would have been fully amortized in one year or less.
For more information on how to treat the costs to obtain and fulfill a contract, read the Incremental Costs of Obtaining a Contract article and the Costs to Fulfill a Contract article found on RevenueHub.
6. Incentive or performance fee revenues (including carried interest)
Asset managers often have fee arrangements that include fees to be paid based upon the performance of the asset(s) that are being managed. On some occasions, the performance of the asset(s) is measured against a factor outside of the control of the manager, such as a market index. The uncertainty that these arrangements create regarding the amount of fees to be received can become an issue for revenue recognition.
Prior to ASC 606, ASC 605-20-S99-1 allowed for two different methods for recognizing these fees. The first method allowed for the recognition of the fee revenue to be deferred until the end of the contract, thereby eliminating all uncertainty. The second method allowed the revenue to be recognized before the end of the contract, based on termination provisions found in the arrangement that made the revenue realizable.
ASC 606 allows for variable consideration to be included in the transaction price only when it is probable that there will not be a significant reversal. When incentive or performance fee revenues are influenced by factors outside the control of the manager, a significant future reversal of revenue is probable, making users of the second method found in ASC 605-20-S99-1 subject to potential, significant delays of revenue recognition. It should be noted that the delay of recognizing these fees as revenue does not change the need to recognize the payments to employees as an expense in the period in which they are incurred.
For more information on variable consideration, please refer to the Variable Consideration and the Constraint article found on RevenueHub.
7. Incentive-based Capital Allocations
Asset managers are at times allocated a performance fee when returns are beyond the agreed upon threshold. These contractually determined fees are often based on a percentage of the proceeds of an investment or a percentage of the proceeds that exceed a predetermined benchmark. These fees are often subject to clawback provisions however, which would affect the timing of their recognition.
When determining how to handle these capital allocations, the following issues should be considered:
- The factors that are inputs to the calculation of the fee, especially factors outside of the manager’s control.
- Clawback and other provisions that would affect the probability of a reversal of revenue.
- The estimated remaining lifespan of the investment company.
- The likelihood that the value of the excess return will change due to factors outside the entity’s control.
- The degree to which the contractual hurdle rate is exceeded by the collective realized return and unrealized gain on investment.
To the extent that a significant reversal of the total revenue recognized will not occur when the uncertainty of the variable consideration is resolved, the variable consideration should be included in the transaction price. Conversely, if the variable consideration (the incentive-based capital allocation) has the potential to exceed all other fees in the arrangement and it is probable that a significant reversal will occur, the variable consideration should not be included in the transaction price. When making this determination, the Transition Resource Group (TRG) members have agreed that the assessment of whether a significant reversal will occur should be considered at a contract level rather than at the level of a specific performance obligation, meaning the entire transaction price of the contract should be considered against the variable consideration.
Upon inclusion of the capital allocation in the transaction price, managers must determine the amount that should be allocated to distinct services provided by the entity. Managers should also consider whether any of the allocation included in the transaction price should be allocated to the remainder of the performance period—if any remains—net of the distinct service period already allocated.
For more information on variable consideration, please refer to the Variable Consideration and the Constraint article found on RevenueHub. For more information on allocating variable consideration, please refer to the Allocating Variable Consideration article also found on Revenue Hub.
8. Recognition of contingent deferred sales charges
Some mutual funds offer shares to be sold without a sales charge up front. Instead these funds charge investors a contingent deferred sales charge (CDSC) at the time the shares are redeemed, if redemption occurs within a specified window of time. This CDSC fee is consideration paid by the investor to the distributor for sales-related costs. The charge is calculated as the lesser of the original cost of the investment, or the percentage of proceeds received by the investor. Put simply, this fee is a commission paid to the distributor for their services.
The Financial Reporting Executive Committee (FinREC) believes that this fee is revenue earned by the distributor from work performed under contract with a customer, and as such falls within the scope of the new revenue recognition framework. To determine how to handle your specific situation, you’ll need to walk through each step of the process for CDSC fees.
The following illustrates FinREC’s evaluation of the proper handling of CDSC fees, generally speaking:
Step 1: Generally, the fund is assumed to be the customer, and the selling and distribution of securities in exchange for revenue from the fund is the distributor’s ordinary business activity.
Step 2: Sales-related services provided by the distributor to the fund are normally considered to be a single performance obligation.
Step 3: CDSC fee revenue is variable due to the contingent nature of the consideration, with the receipt of the consideration being determined by the timing of redemption by the investor and the value of the redeemed investment proceeds.
FinREC gives no specific guidance for which method of estimation to use for determining the amount of consideration that will be received, but states that historical experience should be used for determining the expected range of outcomes.
Based on the fact that the probability of a significant reversal of recognized revenue cannot be determined until the fund redeems the invested shares, FinREC believes that the CDSC fee revenue should be excluded from the transaction price until the actual time of redemption.
Step 4: Under the assumption that there is a single performance obligation in the contract in question, the entirety of the CDSC fee should be allocated to the performance obligation. If there are other obligations identified, ASC 606-10-32-39 through 41 should be consulted to determine the proper allocation of the fee to each distinct obligation.
Step 5: No specific evaluation was made by FinREC regarding the timing of revenue recognition, but the AICPA does refer readers to ASC 606-10-25 paragraphs 27 and 30, where criteria can be found to determine if CDSC revenue should be recognized at a point in time or over time.
For more information on the five steps of the new framework, refer to the Five-Step Method overview article found on RevenueHub, as well as each of the individual articles addressing the five steps in greater depth.
9. Deferred distribution commission expenses (back end load funds)
Investment funds that operate as back-end load funds, wherein the investor is charged a contingent deferred sales charge (CDSC) at the time they redeem their investment, often have to pay third-party distributors an upfront commission for their service of referring investors to the fund. Additionally, the investment fund will also pay a distribution fee to the asset manager, who in turn will normally pay a portion of that fee to the third-party distributor.
Due to the unforeseen challenge of varying circumstances resulting in different applications of the guidance on incremental costs of obtaining a contract found in ASC 606, FASB retained the cost guidance for investment companies in ASC 946-605-25-8, which has been relocated to ASC 946-720. ASC 946-720-25-4 instructs that back-end load funds should defer and amortize the incremental direct costs and then expense the indirect costs as they are actually incurred. The challenge arises from the lack of guidance found in ASC 946-720 on when the capitalized costs should be amortized.
Accordingly, FinREC looks to ASC 340-40-35-1 for guidance, wherein we are instructed to amortize capitalized costs in a way that is consistent with how the services provided are transferred to the customer. This leaves the actual period in which the costs should be amortized to be determined by the use of judgement.
Though ASC 946-720 does not provide any guidance on the impairment of the capitalized asset, FinREC believes that impairment may be necessary, and turns to ASC 340-40-35, paragraphs 3 through 6 to determine the appropriate impairment procedures.
For more information on the treatment of incremental costs, refer to the Incremental Costs of Obtaining a Contract article found on RevenueHub.
10. Gross versus Net
Asset managers commonly work with third parties in fulfilling agreements to customers. The involvement of a third party requires the asset manager to determine whether they—the managers—are acting as a principle or an agent in the arrangement.
ASC 606 calls for an evaluation of control in determining principle versus agent considerations. Though this principle is new to ASC 606, the general concept of principle versus agent considerations remains relatively unchanged from ASC 605-45. As such, determining whether revenue should be recognized on a gross basis (when the manager is acting as a principle) or a net basis (when the manager is acting as an agent) should remain relatively the same.
For more information on principle vs agent considerations, refer to the Principal/Agent Considerations (Gross Vs Net) article found on RevenueHub.
It is likely that many other issues and questions will arise for asset managers as entities adopt ASC 606. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on the RevenueHub site for major industries identified by the AICPA. Click on the following link for a list of these articles: Industry-Specific Issues.