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ASC 606 means big changes for asset managers

Customers, contracts, compensation all affect accounting

RFP
working togetherAccounting Standards Codification 606, Revenue from Contracts with Customers, (Topic 606) will require significant accounting changes for many asset managers. Many of the fee arrangements under which asset managers provide services to investment companies will need to be re-evaluated under Topic 606, specifically:

  • Base management fees and related fee waivers and expense caps
  • Incentive or performance fees, including carried interest
  • Distribution and related fees

Topic 606 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.” Topic 606 provides a five-step model for determining appropriate revenue recognition:

Step 1: Identify a contract with a customer
Step 2: Identify performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when/as performance obligations are satisfied

The steps seem basic, but the process to comply with them can be cumbersome. Following we discuss the key issues associated with each step and our suggestions to help asset managers comply with Topic 606.

Identifying contracts and determining when they should be combined Under Topic 606, a contract is an agreement between two or more parties that creates enforceable rights and obligations. It identifies what a vendor provides and what the customer expects to receive. Contracts can be written, oral or implied by business practices and exist in a legal context that may vary among jurisdictions. Under Topic 606, asset managers should combine contracts if:

  • Two or more contracts with the same customer are negotiated as a package with a single commercial objective
  • The amount of consideration paid in one contract depends on the price or performance of another contract, or
  • The goods or services promised in the contracts are a single performance obligation

Who is the customer—the fund or the investor? Asset managers will need to consider a variety of facts and circumstances to determine whether fund or the investor is the customer to the contract, which could affect the timing of revenue recognition or the accounting for certain costs.

For example, if a highly regulated fund governed by a board of directors and with a large number of diverse investors has multiple contractual fee arrangements with its asset manager and other service providers, the asset manager could conclude that the fund is the customer. On the other hand, if the asset manager has individual fee arrangements that are actively negotiated with each investor, this could indicate that the investor is the customer.

The table below lists characteristics that FinREC has identified that asset managers should consider in the customer evaluation, but asset managers still must exercise consistent judgment when identifying their customers.

Who is the customer—the fund or the investor
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Group discussionIn order to properly account for fees and costs under Topic 606, asset managers need to review existing agreements with customers to determine

• Whether these agreements are contracts within the scope of the Topic 606;
• Whether to combine two or more contracts; and
• Who their customer is.

The facts and circumstance surrounding each fund, each customer and each contract will provide the answers to these questions, but that will require reviewing contracts, agreements and other fund documents, which can be a labor intensive process. Through document scanning, key word searches, AI tools and other technologies, asset managers can not only speed up the process, but also ensure a consistent, appropriate approach.
Performance obligation Asset managers generally provide services, such as investment advice, research, agreement negotiation with service providers, and overseeing the preparation of books and records, over a period of time. Under Topic 606, such services sometimes will be accounted for as a single performance obligation. FinREC believes it is reasonable to conclude that each day of service is substantially the same because the nature of the asset manager’s promise to the customer is one overall service.

Management fees Asset managers are typically paid for their services through a combination of a base management fee and an incentive or performance fee. These fees are considered variable under Topic 606 since both types of fees are dependent on a variable base (i.e., assets under management or performance during a defined period).

Topic 606 requires asset managers to estimate and limit the recognition of variable consideration so that revenue is recognized only when it is probable that it will not change substantially when the uncertainty associated with the variable consideration is resolved.

Management fees, therefore, typically would be:

  • Included in the transaction price at the end of each reporting period, when the uncertainty related to the amount of the AUM has been resolved
  • Allocated to each reporting period as the fees relate specifically to the asset manager’s efforts to provide services over the term of the contract.

Each increment of asset management service (that is, each daily provision of service) is satisfied over time as the customer simultaneously receives and consumes its benefits. Therefore, a time-based measure of progress is applied when measuring progress toward complete satisfaction of asset management services.

Unitary management fee arrangements Unitary management fee arrangements cover both asset management services and identified operational expenses or administrative functions. In this situation, asset managers need to make an assessment similar to that used regarding management fees and determine whether the unitary management fee revenue would be presented as gross or net. This requires an analysis of whether the asset manager is the principal or an agent using the guidance in Topic 606.

Fee waivers If asset managers waive some or all of their fees for a certain period, they then must determine the appropriate accounting treatment for the fee waiver. Asset managers should account for fee waivers by following the guidance for either contract modifications or combining contracts by considering the timing of execution relative to fund/account establishment or renewal of contract, timing of execution relative to services rendered, or whether the fee waiver is a flat fee waiver or an expense cap.

Performance fees Variable consideration in the form of performance fees should be excluded from the transaction price until it becomes probable that there will not be a significant reversal of cumulative revenue recognized. Topic 606 assists asset managers in assessing whether it is probable that a significant revenue reversal will occur and in determining whether all or a portion of the performance fees is not constrained from being included in the transaction price (at the inception of the contract or upon subsequent re-evaluation).

Similar to asset management fees, a time-based measure of progress is appropriate for recognizing revenue because the services are substantially the same each day and have the same pattern of transfer.

In instances where performance fees are structured with a floor and a performance-based component (fulcrum fees) or as a weighted average of performance over a period of several years, the uncertainty may only apply to a portion of the fee, which could result in partial recognition.

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Two people discussingAsset managers should consider specific facts and circumstances for each contract to take a fresh look at what services are being provided and what the entity receives from its customer in exchange for such identified services. It could be challenging to determine how the impact of variability on the consideration received under any given contract will affect the amount and timing of revenue to be recognized as well as the presentation of such revenue in the financial statements.

Asset managers should undertake a thorough assessment of current contract terms and any modifications to apply prescriptive guidance under ASC 606. Asset managers could potentially benefit from standardizing contracts across similar services and implementing a system that will track changes in contracts terms to identify those that will result in a change to the accounting and reporting of revenue.
Incentive-based capital allocations There are arrangements where a performance fee is paid by re-allocating net earnings from the capital accounts of the nonmanaging interest holders to the asset manager’s capital account when returns exceed contractual thresholds. The calculation of the amount to be allocated is typically stated in the contract as, for example, percentage of net income in excess of a specific return on investment for nonmanaging interest holders. It may also include clawback or other similar provisions that allow the investment company to look back and confirm performance, which could affect the timing of distributions or require repayment of previously distributed amounts.

It should be noted that at the April 2016 meeting of the Transition Resource Group for Revenue Recognition, all seven FASB members stated that incentive-based capital allocations, including carried interest, are within the scope of Topic 606. However, several FASB members and an SEC staff observer noted that there may be a basis for following an ownership model. If an entity were to apply an ownership model, then the SEC staff would expect its full application, including an analysis of the consolidation model under Topic 810, the equity method of accounting under Topic 323, or other relevant guidance.

Assuming that performance fees are accounted for under Topic 606, asset managers must determine if all or a portion of the performance fee is constrained from being included in the transaction price. Specifically they should consider the nature of the incentive-based capital allocation, such as inputs to the calculation and dependence on other factors, including hurdle rates, clawbacks or other similar provisions.

Asset managers should almost always assess whether all or a portion of incentive-based capital allocations is constrained because these allocations would be significant in relation to the cumulative transaction price of a contract.

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Hand shakeBecause the disclosures prescribed by Topic 606 are more extensive than current requirements, changes to systems, processes, and controls may be necessary. Some of the quantitative disclosures are optional for private companies. Companies should consider the needs of their financial statement users when considering disclosures under the new revenue standard.

The revenue recognition standard may have more of an effect on your business than you think. Our best advice for private asset managers: Spend time now to identify the potential impact and cost of implementing the new revenue standard and discuss these implications with stakeholders to make sure the right infrastructure is in place for proper implementation.
Disclosures The new revenue standard requires significantly more disclosures, both quantitative and qualitative, than current guidance. New disclosures include:

  • Disaggregated revenue
  • Opening and closing balances of contract assets and liabilities
  • Description of significant changes in contract assets and liabilities

Next Steps The AICPA Asset Management Revenue Task Force and the Joint Transition Resource Group for Revenue Recognition continue to publish industry-specific guidance to help transition to the new standard. Asset managers should look out for the finalization of implementation issues related to costs of managing an investment company and asset management arrangement revenue gross versus net, which were out for exposure until November 1, 2017 and December 1, 2017, respectively.

How Grant Thornton can help Our team has significant experience in assisting both public and private companies in the implementation of Topic 606. We help clients define and execute their business strategy to create value. We deliver practical, innovative and holistic capabilities and approach to address strategic, operational, financial reporting, and regulatory compliance.


Contacts

Michael PatanellaMichael Patanella
Partner
U.S. Asset Management Sector Leader
T +1 212 624 5258

No image availableCullen Walsh
Partner
Accounting Advisory Services
T +1 212 624 5313

Cecille PublicoCecille Publico
Senior Manager
Audit
T +1 212 624 5394