Common ASC 606 Issues: Broker-dealer Entities

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 the broker-dealer industry is no exception. The complex arrangements between brokers and their clients pose some of the most difficult issues for the new standard.

In this article, we provide a brief explanation of the key issues broker-dealers face when applying ASC 606, drawing on the following helpful guides published by the AICPA and the major accounting firms. 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.

For more information on any of these issues, see:

The following are the issues that companies in the broker dealer industry commonly face:

1. Commission Income – Asset Purchase and Sales

The AICPA Industry Guide for the new revenue recognition standard covers the common issues that broker-dealers face in each of the 5 steps of the new framework, as the framework relates to commission income. The issues are described as follows:

Step 1: The challenge in identifying the contract with a customer arises from the variable nature of the agreement between brokers and customers. Normally, a contract between a broker and their customer will contain terms regarding trade execution, clearing, and custody, though other services may also be added. Typically, when a customer performs a buy or sell transaction the broker charges a fee for their services in fulfilling the order. In some cases, the contract may include a separate fee for custody services or a guaranteed minimum number of trades. FinREC believes that in these scenarios the arrangement will often meet the criteria to be accounted for as a contract when the customer does one of the following: 1) deposits money, 2) transfers securities into an account, 3) executes a trade, or 4) the contractual term of the custody services begins. If the contract can be altered or terminated at any time by either party, as is true with most brokerage contracts, and one of these activities has yet to occur, then there is no contract as there has been no performance of contractually agreed upon activities.

When a separate fee for custody services or a guaranteed minimum number of trades is not included in the contract, there is no contract until a trade order has been placed by the customer, for the same reasons listed in the preceding paragraph.

Though not always the case, it is common that either party in a brokerage contract may terminate at will. This lack of a fixed duration of a contract between broker and customer requires that the guidance in ASC 606 be applied to the duration of the contract wherein enforceable rights and obligations exist, meaning that the duration could be as short as a single day for contracts terminable at will.

Related RevenueHub Articles: Step 1: Identify the Contract

Step 2: As is the case with all contracts, brokers should carefully consider whether all of the services they are contracted to perform are capable of being distinct and distinct within the context of the contract, according to ASC 606-10-25-19 through 21. Clearing services, trade execution, and custody services should all be evaluated to determine whether they give rise to a separate performance obligation within the context of the contract. FinREC believes that both trade execution and clearing services should be bundled as a single service, as they are “both inputs to the combined output of security trading”1 and are therefore not separately identifiable. FinREC also believes that these bundled services (which they collectively refer to as trade execution) are distinct and separate from custody services, as they are not highly interdependent.

Related RevenueHub Articles: Distinct Goods or Services: Case Studies

Step 3: Due to the optionality of the trade execution, as well as the separate fee that may be charged for custody services, determining the transaction price can be challenging for broker-dealers. The AICPA guide provides the following insights related to this issue:

  • An estimate of the options to execute trades that might be exercised should not be included in the transaction price, because the actual trade execution service is not accounted for until the option is exercised.
  • A guaranteed minimum on trade commissions should be included in the initial transaction price.
  • A separate fee for custody services should be included in the initial transaction price if the fee is not constrained.

Related RevenueHub Articles: Magnitude of the Constraint on RevenueVariable Consideration and the Constraint

Step 4: Under the assumptions that there is a separate fee charged for custody services, that the option for trade execution services is not a material right, and that there is no guaranteed minimum number of trades, the custody service is the only performance obligation at the point of contract inception. The separate fee will be allocated to this service. As discussed earlier, if there is no separate fee, there is no contract until a trade has been executed. The way in which the exercise of an option for trade execution services is accounted for affects the allocation of the transaction price.

The exercising of trade execution services can be accounted for as a change in transaction price or a modification of the original contract, according to ASC 606-10-32-42 through 45 and ASC 606-10-25-10 through 13.

Accounting for the option as a modification of the original contract can result in one of two outcomes, depending upon the determination of the selling price of the trade execution services. If the broker-dealer determines that the services are priced at their standalone selling prices, the option would be accounted for as a separate contract and none of the trade commissions would be allocated to the custody services. If the prices are determined not to be at their standalone values, the option would be accounted for as a new contract, with the original contract being terminated.

Accounting for the option as a change in transaction price would result in the commission for the trade execution services being added to the transaction price. As per ASC 606-10-32-29, the transaction price would then be allocated to the custody services and execution services according to their standalone selling prices.

Breaking the assumptions made earlier, if the broker-dealer identifies the option as a material right and volume discounts are offered, the material right would be its own performance obligation with its own standalone selling price. Thus, it will be allocated a portion of the contract transaction price, effectively reducing the allocated transaction price for each of the other trades.

Related RevenueHub Articles: Standalone Selling Prices, Case Study: Transaction Price Allocation                               

Step 5: There are no particularly challenging issues that have been identified in step 5 of the framework related to commission income, but broker-dealers should apply the guidance found in ASC 606-10-25 as they work to determine whether performance obligations are satisfied over time or at a point in time. FinREC believes that custody services are satisfied over time, whereas trade executions are satisfied at a point in time.

Related RevenueHub Articles: Measuring Progress with Multiple Goods or Services in a Single Performance Obligation

2. Commission Income – Trade Date

The issue with trade dates—as they relate to commission income—surrounds the question of transfer of control. The point of confusion relates to the first indicator of the transfer of control found in ASC 606-10-25-30: “The entity has a present right to payment for the asset (that is, for the service).”

FinREC believes that the transfer of control in a trade execution performance obligation occurs on the trade date, and as such the revenue allocated to the performance obligation should be recognized on the trade date.

For instances in which a payment failure occurs during a trade execution, FinREC believes that a liability or expense may need to be recognized by the broker-dealer for their obligation to remedy the failure of either the customer or the counter-party to remit payment. This means that trade failures, which can result from payment failures, do not affect the transfer of control, as the customer’s risk and rewards of ownership are not altered by failures to perform.

When a failed trade is not expected to be settled, the related consideration that will need to be refunded would be variable consideration. This refund should be estimated by the broker-dealer and then treated as a reduction of revenue. The estimated variable consideration should only include consideration for contractual trade executions, minus the estimated refund. The estimate of refundable consideration should be calculated using historical data on trades that were never settled.

Related RevenueHub Articles: Determining the Transfer of Control

3. Selling and Distribution Fee Revenue

This implementation issue has been submitted to FinREC as of the publication of this article, but has not been finalized to be included in the AICPA Revenue Recognition Guide. Furthermore, as of the publication of this article, none of the major accounting firms have published guidance on the handling of this implementation issue.

4. Underwriting and Related Fee Income

 The recognition of revenue earned in an underwriting arrangement is normally fairly straightforward, with the sale of securities being the performance obligation, which is then fulfilled on the trade date. However, an option referred to as the “greenshoe” option can make the accounting for underwriting arrangements more complicated. This option allows an underwriter to sell more shares than had been originally agreed upon if demand in the market exceeds expectations and additional sales are needed. Exercising this option would qualify as a modification of the contract and would be accounted for as a separate contract.

Related RevenueHub Articles: Contract Modifications Part I – Separate Contracts , Contract Modifications Part II – Contract Modification TreatmentContract Modifications Part III – The Hindsight Expedient

 5. Advisory Fee Income

 Services offered in an advisory arrangement can vary contract by contract. As such, professional judgement is required in identifying the separate performance obligations in each individual contract, and practitioners should expect to reach different conclusions on a contract by contract basis.

As many advisory fees are contingent upon the successful completion of a transaction, or some other factor outside the influence of the entity, many advisory service contracts will contain variable consideration and will be constrained by the inability of the entity to predict the probability of a significant reversal of revenue. Therefore, each reporting period, broker-dealers will likely need to reassess whether the occurrence of a significant revenue reversal is probable.

The nature of advisory services offered in a contract will determine whether or not revenue should be recognized over time or at a point in time. Revenue for services that are identified as separate performance obligations and for which the benefits are consumed at the same time the entity performs the service will likely qualify to be recognized over time.

Broker-dealers should evaluate the timing of revenue recognition in their advisory service contracts, as it is likely that the timing of retainer fee recognition will change with the new standard.

Related RevenueHub Articles: Determining the Transfer of ControlSeries of Distinct Goods or Services, Variable Consideration and the ConstraintAllocating Variable ConsiderationMeasuring Progress with Multiple Goods or Services in a Single Performance Obligation

6. Soft Dollar Revenues

 An arrangement wherein a broker-dealer provides their customer with research in exchange for a specified number of trades is referred to as a soft dollar arrangement. These arrangements create trade commission revenues for brokers upon the execution of the agreed upon trades.

The complexity of accounting for soft dollar revenues generated from these arrangements arises from the way in which the agreement is negotiated, the distinct nature of the broker’s obligation to provide research, and the possibility of a principal-agent relationship between the broker, the customer, and a third-party research provider. Furthermore, depending on what kind of promises are made to the customer in the contract, the performance obligation could be satisfied at a point in time or over time.

In certain cases, the performance obligation may be fulfilled before enough trades have been completed to provide sufficient consideration for the research. This will result in the need for a contract asset to be created, recognized, and then reduced by the trade commission allocated to the performance obligation. The opposite can happen when payment is received before the performance of the obligation has been fulfilled, necessitating the creation of a contract liability, which would then be reduced in a similar manner.

Related RevenueHub Articles: Presentation of Contract Assets and Contract Liabilities

As this issue involves each of the five steps of the new framework, the following list contains articles relating to each step that are of particular relevance when accounting for these soft dollar arrangements:

7. Revenues from Financial Instruments out of Scope

 ASC 606-10-15-2 clarifies that financial instrument contracts held by broker-dealers are not within the scope of ASC 606, but are subject to the guidance found in ASC 310-940, ASC 320-940, and ASC 845. This means that revenues received from the following sources are not subject to ASC 606, and practitioners should continue to follow the existing guidance as it pertains to each revenue stream listed below:

Note – The following list was obtained from the AICPA Industry Guide for ASC 606.

  • Recognition of interest and dividend income and expense from financial instruments owned or sold short (including amortization of premiums and discounts)
  • Interest (rebate) from reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions, and similar arrangements
  • Interest from debit balances in customer margin accounts and margin deposits
  • Dividends from equity instruments owned or sold short
  • Payment-in-kind (PIK) dividends and interest from investments in debt and equity securities
  • Realized and unrealized gains and losses on the transfer and derecognition of financial instruments
  • Interest on investments in debt instruments

 8. Gross Vs Net

 There are two areas in which broker-dealers should likely be concerned about the gross vs net issue: securities underwriting engagements and expense reimbursements.

Securities Underwriting – There are two questions to consider: 1) is the lead underwriter acting as a principal or an agent, and 2) is the underwriting service provided by each of the underwriters in the syndicate performed by a principal or an agent?

To answer the first question, entities should consider whether they are primarily responsible to fulfill the promises made in the contract, whether they have inventory risk both before and after the transfer of the service they are providing, and whether they have control over the price for the service they are providing. Considering general circumstances, EY believes that a lead underwriter in a syndicate arrangement is acting as an agent. This would require the lead underwriter to report their revenue separately from the revenue allocated to the rest of the syndicate.

To answer the second question, consider the same points from the first question in addition to the guidance found in ASC 606-10-55-37A, wherein a principal is described as a party that “obtain[s] control of a good or service from another party that it then combines with other goods or services in providing the specified good or service to the customer.” Again, considering general circumstances, EY believes that a lead underwriter in a syndicate arrangement is acting as a principal for the services they provide. This would require the underwriter to report their portion of the underwriting revenues and expenses on a gross basis.

EY notes that the compensation arrangements for many underwriters were designed to compensate employees based on revenues and expenses that are reported on a net basis. As the new standard will likely result in many underwriters reporting expenses and revenues on a gross basis, broker-dealers may want to reconsider the terms of the employee compensation arrangements.

Expense Reimbursements – Broker-dealers are often reimbursed by the entity they are serving for expenses incurred while providing their contracted service. The broker-dealers must determine if this reimbursement will be presented in revenue on a gross basis or net of the expenses. Because the expenses that are incurred and later reimbursed are generally inputs to the service being provided by the broker-dealer, the service is under the control of the broker-dealer, implying that the broker-dealer is the principal rather than the agent in this arrangement. As the principal in the arrangement, the broker-dealer would report revenue for the costs reimbursed on a gross basis, rather than net of the expenses.

Each specific expense reimbursement should be looked at individually and analyzed using the three criteria discussed above: 1) is the broker-dealer primarily responsible to fulfill the promises made in the contract, 2) does the broker-dealer have inventory risk both before and after the transfer of the service they are providing, and 3) does the broker-dealer have control over the price for the service they are providing?

Related RevenueHub Articles:Principal/Agent Considerations (Gross Vs Net)

 9. Contract Costs – Underwriting and Advisory Services

Two specific issues exist in relation to contract costs: 1) the recognition of incremental costs of obtaining a contract and 2) the recognition of costs to fulfill a contract.

Incremental Costs of Obtaining a Contract – In order to obtain a contract, broker-dealers often incur costs from activities such as marketing, submitting a bid and proposal, and legal fees, to name a few. An entity must determine whether these fees should be deferred and recognized as an asset, using the recoverability criteria found in ASC 340-40-25. FinREC believes that costs which are recoverable only upon the occurrence of an event or circumstance that is outside the control of the broker-dealer would not meet the criteria to be recognized as deferred assets. These could include costs such as marketing and advertising, salaries of sales support, and so on. Costs that are non-refundable and are expected to be recovered by the broker-dealer would meet the recoverability criteria for capitalization. These may include commissions, bonuses or portions of bonuses that relate to new sales or new bookings, and similar costs.

The codification provides a voluntary election option that allows broker-dealers to recognize the incremental costs of obtaining a contract as an expense when they are incurred, so long as the expected benefit period which the costs would have been recognized over is less than a year. Generally, a cost has an expected benefit of less than a year if the underlying good or service has a contract duration term of less than a year and there are no expected renewals for the underlying good or service.

These capitalized costs will be amortized, and the expense will be recognized as the broker-dealer transfers the service to the customer.

Related RevenueHub Articles: Incremental Costs of Obtaining a ContractCosts to Fulfill a Contract

Footnotes

  1. AICPA Audit and Accounting Guide: Revenue Recognition
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Author Caleb Christensen

Caleb grew up in Utah, where he found his passion for the outdoors as well as business. He considers himself a Blockchain enthusiast, and loves spending time enjoying all the beauty Utah has to offer.

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