Broker-dealers: Prepare for the new revenue recognition standard

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1 Broker-dealers: Prepare for the new revenue recognition standard Last May, the FASB and IASB issued a converged standard on revenue recognition (Accounting Standards Codification [ASC] Topics 606 and 610; International Financial Reporting Standard [IFRS] 15). The new rules replace most existing guidance under U.S. GAAP and IFRS. Under U.S. GAAP, the new standards are effective as of 2017 for public entities with a calendar year-end, and in 2018 for private businesses. In April 2015, the FASB and IASB both officially proposed a oneyear delay in the effective date for companies to adopt the new revenue recognition standard. What s new The standard introduces a single, five-step model (see page 3) that significantly alters how revenue is reported by various industries. The impact will vary, however, by business sector and company. Broker-dealers have diverse structures and sizes and are engaged in a wide array of activities that range from underwriting securities to asset custody. The new accounting standard is unlikely to be transformative for most firms, but there will be substantial changes in some areas. Given the complex accounting that is required for many industry services, broker-dealers should begin to analyze their operations carefully now to determine necessary changes in spite of the proposed deferrals by the FASB and IASB in the effective date.

2 6 reasons why firms should start planning for the new standard now 1. An impact on operations, not just reporting The new guidance will affect more than just financial statements: The impact will extend to employee compensation, tax strategy and other areas that are central to a firm s success. Broker-dealers need to assess the overall effect of the new standard on their operations and business processes. Consideration should also be given to documentation and systems needed to support accounting and reporting under the new standards. A cross-functional team from accounting, IT, legal and other functions may help to speed implementation. Broker-dealers also need to decide how to communicate the impact of the new guidance to stakeholders. 2. Immediate reporting decisions Although the effective date for the new standard is a few years away and, under U.S. GAAP, early adoption is prohibited for public entities, companies should start considering the transition process. One allowable transition approach is to make a cumulative entry as of the beginning of the first year of implementation. While seemingly an attractive option, it does not provide comparative income statements for the year of adoption and prior periods, which will require extensive disclosure and that broker-dealers essentially provide information as if the standard was applied retrospectively. The other approach is to retrospectively restate the prior periods so that comparative information is provided for the year of adoption. It s important to remember that if broker-dealers elect the full retrospective method, all periods presented in the financial statements will have to be shown using the new standard which means broker-dealers may need to have systems in place to start collecting relevant data as early as 2015 under the original effective date of the new standard (when comparative financial statements are required or desired). 3. Impact on customers, underwriting and investment research The new standard will not only affect broker-dealers own financial reporting; it will also affect their clients, and how broker-dealers monitor and analyze financial information. Broker-dealers will have to assess the impact of the new guidance on the reported revenue streams of their clients. The rules may also be a factor in deciding which clients, counterparties and entities broker-dealers research and which business opportunities broker-dealers pursue. 4. New disclosures required The standard calls for numerous additional disclosures, some of which may require new systems and processes to gather the information. Brokerdealers must allocate funds and implement processes as needed to ensure that these data sets are collected. The planning for complying with the guidance should begin now, even if the standard is not effective for a couple of years. 5. New internal controls required The adoption of new revenue processes for commission income, underwriting fees, asset management fees and other revenue streams may necessitate a reassessment of related controls. Specifically, identifying and making the systems and process changes to capture the information necessary to apply the new standard and to generate the appropriate financial reporting. The increased use of estimates in recognizing revenue under the new standard may necessitate new processes and controls, particularly in the area of estimating variable amounts that will be included in transaction prices. 6. Continuing new guidance Right now there is limited guidance for brokerdealers on how to apply the new standard, but help is on the way. The AICPA has 16 industry groups working on sector-specific guidance, including the Brokers and Dealers in Securities Revenue Recognition Task Force. The work of the Joint Transition Resource Group for Revenue Recognition of the FASB/IASB should also be monitored for possible guidance. In June 2014, Grant Thornton LLP released a summary discussion of the new standard and its impact, with more guidance forthcoming. 1 1 Visit our Revenue Recognition Resource Center at grantthornton.com. 2

3 An overview of the new standard Scope The general principle is that all revenue-generating customer contracts fall within the scope of ASC Topic 606, except for certain contracts such as (a) lease contracts, (b) insurance contracts, (c) various contractual rights or obligations related to financial instruments, (d) guarantees other than warranties, and (e) certain nonmonetary exchanges for which other applicable guidance exists in the ASC related to the accounting for these type of contracts. Generally, for broker-dealers, revenue-generating activities would result in customer contracts that fall within the scope of ASC 606 and IFRS 15: Executing trades of securities for customers The five-step model Based on this core principle, the new guidance adopts a single, standard approach to recognizing revenue. The following provides additional detail into each of the five steps. The 5-step model for the new revenue recognition standard (Accounting Standards Update , IFRS 15) Step 1 Step 2 Step 3 Identify a contract with a customer Identify performance obligations Determine the transaction price Distributions of mutual fund shares Investment banking advisory services Step 4 Allocate the transaction price to the performance obligations Underwriting of investment securities Wealth management services Custody and administrative services The accounting for financial instruments is outside the scope of the standard. Thus accounting for a broker-dealer s proprietary trading operations, as well as interest and dividend income on financial instruments owned or related to repurchase agreements and securities lending activities, are not affected by the new standard. Core principle The standard states that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities. Step 5 Recognize revenue when/as performance obligations are satisfied Step 1: Identify a contract with a customer A contract is an agreement between two or more parties that creates enforceable rights and obligations. It is what a vendor delivers and what the customer expects to receive, whether that s goods or services. Contracts can be written, oral or implied by business practices. Contracts exist in a legal context that vary among jurisdictions. Moreover, broker-dealers regardless of size offer a host of services and products to a variety of customers. Broker-dealers will need to apply significant judgment in applying the standard. A contract is in the scope of the standard if all of the following are true: The contract has commercial substance. The parties to the contract have approved the contract and are committed to perform their respective obligations. The entity can identify each party s rights regarding the goods or services to be transferred. The entity can identify the payment terms for the goods or services to be transferred. 3

4 In cases where one or more of the criteria is not met, a liability will be recognized for any consideration received, and the liability is reversed and recognized as revenue when either of two conditions is met: Performance is complete (all of the performance obligations in the arrangement have been satisfied), and all of the consideration has been collected and is nonrefundable. When the contract is terminated and the consideration received is nonrefundable. Step 2: Identify performance obligations These are promises within a contract to transfer either a good or service, or a bundle of goods or services. The promised item must be distinct (i.e., the customer can benefit from the good or service on its own or with readily available resources, and it is separable from the other goods or services in the contract). In identifying performance obligations, an entity must determine whether they are satisfied over time or at a point in time. Step 3: Determine the transaction price This is the consideration an entity expects to receive in exchange for transferring promised goods or services to a customer. Noncash consideration and any consideration due to the customer should be included in this calculation. Key factors to consider are: The presence of variable consideration, including such factors as performance bonuses and penalties. Variable consideration is recognized only if it is probable that there will not be a significant reversal a determination that requires careful consideration. In situations where all or part of the compensation is variable, a vendor would estimate the transaction price by either (a) expected value, which is the sum of the probability-weighted amounts or (b) the most likely amount. The time value of money (TVM) is considered if the contract contains a significant financing component. TVM may be ignored if the customer payment is expected within one year of the transfer of goods or services. Step 4: Allocate the transaction price Each obligation should be evaluated based on its relative standalone selling price, which is best determined by an observable price. If there is no observable price, the standalone selling price can be estimated by the following approaches: Adjusted market assessment Expected cost plus margin Residual (limited use) Step 5: Recognize revenue when/as performance obligations are satisfied Revenue is recognized upon the satisfaction of a performance obligation (i.e., when the promised goods or services are transferred). The transfer occurs when the customer obtains control, defined as the ability of the customer to direct the use of, and obtain substantially all the remaining benefits from, an asset. Transfers can be accomplished over time or at a point in time. They should first be evaluated over time, based on meeting any of the following criteria: The customer simultaneously receives and consumes benefits as the entity performs (e.g., there might be a daily or weekly service). The customer controls the asset as it is created (e.g., a construction contract). The vendor does not create an asset with an alternative use, and there is an enforceable right to payment for performance completed to date. Revenue may be recognized over time by using either: Output methods (direct measurements of customer value: milestones reached, units produced/delivered, time elapsed) Input methods (vendor efforts: costs incurred, labor hours expended, time elapsed) 4

5 Contract costs ASC Other Assets and Deferred Costs: Contracts with Customers which was added to the codification in the new revenue recognition guidance, will be used to account for contract costs, including fulfillment and other costs of obtaining a contract. The changes from existing GAAP could be significant. Most entities currently expense contract acquisition and fulfillment costs as incurred. Under the new standard, entities will be required to capitalize the incremental costs incurred (i.e., costs that would not have been incurred absent obtaining the contract). Costs incurred to fulfill a contract should be recognized as an asset only if the costs: Relate directly to a contract that the entity can specifically identify Generate or enhance resources of the firm used in satisfying performance obligations in the future Are expected to be recovered Parties to the contract An important issue in the five-step process is determining the roles of the different parties to the contract. Determining which entity is the customer is important throughout the revenue recognition process. For example, broker-dealers commonly provide services to funds comprising investors. Who is the customer, the fund or investor? No one factor decides but, if investors deal directly with the broker-dealer and there are only a few investors in the fund, that presents a strong case for the investor being the customer. Revenue streams There are several issues, or types of revenue, to be examined: Commission income Fee income Investment banking revenue Other revenues Principal transactions Trading commissions Interest and dividend income Entities should monitor the work of the task force, as well as that of the transition resource group of the FASB/ IASB, for developments and support. The following discussion offers a few examples of the various revenue recognition issues that broker-dealers face. Principal transactions Because financial instruments are outside of the scope of the new standard, its impact on the accounting for a broker-dealer s proprietary trading operations and any lending activities should be limited. Commissions and fees Commissions and fees represent compensation to the broker-dealer for purchases and sales of securities performed on behalf of customers. This stream reveals that the timing of revenue recognition for transactions that appear simple and straightforward is more complex upon closer examination. The commission earned for the purchase or sale of securities is usually a clear-cut transaction with rare failures. From one standpoint, the asset being transferred is the trade execution service, thus revenue should be recognized, as it is currently, on the trade date. But it can also be argued that the brokerdealer hasn t fulfilled its performance obligation until the securities are delivered. With that perspective, revenue should be recognized on the settlement date. If such a change were implemented, it would require a significant modification of current broker systems. 5

6 Investment banking revenue This category includes underwriting, distribution, advisory services, capital structuring, M&A, structuring fees, and commitment fees. Generally, advisory/m&a fees would be recognized when the performance obligation is satisfied, when the transaction occurs or upon completion of a milestone. Underwriting of securities typically begins when the lead manager(s) enters into a contract with the issuer of securities; the contract typically states the public offering price, underwriting spread, net proceeds to the issuer and settlement date. Separately, the lead manager creates a syndicate with other investment banks to distribute them to investors. The transaction price (i.e., the underwriting spread) includes: A fee to the lead manager(s) for structuring the offering, preparing documentation, etc. A selling concession to compensate each underwriter for selling shares Underwriting fees to compensate each underwriter for committing capital to the offering Each member of the syndicate is rewarded in accordance with its role. Typically, an underwriting arrangement includes a single performance obligation, so an allocation of the transaction price is not necessary. Generally, the spread is known on the day the contract is signed, so there is no variable consideration. The performance obligations are satisfied on the trade date, so fees are recognized as revenue on that day. Underwriting expense An entity may provide the service itself (as the principal) or it may arrange for another party to do so (as an agent). The principal will recognize the gross amount of the expected revenue; the agent recognizes the net amount it is entitled for its services. The key factor in making the determination is whether the entity controls the good or service before it is transferred. Underwriting expenses provide a useful example. Under current broker-dealer industry guidance in FASB ASC , underwriting expenses are generally presented net of related underwriting revenues. That will continue to be true if the brokerdealer is acting as agent; when acting as a principal, however, it will require gross presentation of underwriting revenue. 6

7 Interest and dividend income This revenue stream includes: Contractual interest received and paid on the trading and investment portfolio Dividends received on trading assets and trading liabilities, excluding derivatives Payment in kind for dividends, interest, changes in fair value, etc. Interest and dividend income on financial instruments owned, as well as that derived from repurchase agreements and securities lending, are outside the scope of the standard. Thus substantial changes in this area are not anticipated. Fee income mutual fund distribution fees Currently, mutual fund distributors capitalize incremental direct costs from selling fund shares, including commissions paid to subdistributors. The above accounting treatment remains unchanged under the new guidance. Disclosures Among the new disclosures required are: Disaggregated detail regarding the nature, timing, uncertainty, and amount of revenue and cash flows Opening and closing balances of contract assets and liabilities Description of significant changes in contract assets and liabilities These disclosures are more extensive than current requirements, and systems and processes may need to be upgraded to capture and summarize the required additional information. The revenue recognition standard may have more of an effect on your business than you think. Our best advice: Spend time now to identify the potential impact and cost of the new standard; discuss it with stakeholders and make sure the right infrastructure is in place for adoption. Contacts Mark Ramler Audit Partner Financial Services T E mark.ramler@us.gt.com Prashant Nisar Audit Senior Manager Financial Services T E prashant.nisar@us.gt.com Jack Katz National Managing Partner Financial Services Global Leader T E jack.katz@us.gt.com 7

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