In May 2014, Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes substantially all existing revenue recognition standards, including disclosures to the financial statements. The amendments within the ASU don’t affect revenue streams that are addressed by other standards such as “core” interest income, periodic/annual cardholder fees and fees associated with mortgage servicing rights. Although much of the standard doesn’t apply to financial institutions, the standard has a significant impact on the financial records of borrowers, particularly in the construction, real estate, manufacturing and distribution and health care industries. Credit officers and other financial institution employees who analyze borrower financial statements should understand the standard to better evaluate the financial health of the current and potential borrower.
Effect on Financial Institutions
The FASB Transition Resource Group (TRG) released Transition Resource Group Agenda 52 (TRGA 52) in April 2016 to provide guidance on which revenue streams are in or out of the scope of Topic 606.
The following topics have been discussed and clarified since the initial release of the ASU:
- Deposit service charges and fees
- Trust and asset management fees
- Interest and dividend income
- Servicing income
- Sales of foreclosed property
Deposit Service Charges & Fees
Deposit fees are within the scope of ASC 606. The effect of the change to the current method of recording deposit fees depends on the structure of the related deposit agreement. Most customer agreements are cancellable at any time by the customer without payment, resulting in a day-to-day contract with revenue recognition consistent with current treatment. When a financial institution charges a monthly maintenance fee on its account, the financial institution should determine the percentage of time maintenance fees are refunded (if any) and record the revenue accordingly. For example, if 5 percent of monthly maintenance fees are discounted as a result of customer complaints or for other reasons, the financial institution should reduce the related revenue recognized by 5 percent.
Trust & Asset Management Fees
Trust and asset management fees fall within the scope of ASC 606. Fee arrangements in association with trust and asset management should be evaluated and scrutinized under ASC 606. The first step in considering the effect of the new standard is to identify contracts with existing customers. All customer relationships that create obligations that are legally enforceable are contracts and, therefore, should be evaluated under ASC 606. While many trust and asset managers receive both performance-based fees and management fees, the resulting revenue is recognized at the same time, as managers are typically just providing one service. After contracts are identified, the most common decision point for financial institutions during the revenue recognition process surrounding trust and asset management fees is determining whether the related services are provided over time or at specific points in time. If you conclude services are performed at a specific point in time, the effect of ASC 606 may result in revenue being recognized at a slower rate than under the previous guidance. Incentive fees shouldn’t be recognized until the end of the reporting period, as these fees correspond to variable compensation.
Under ASC 606, when services are provided at specific points in time, such as variable compensation tied to market fluctuations or other outcomes that can’t be reasonably determined, the resulting revenue should be assessed at the reporting date. However, most financial institutions provide trust or asset management services to their customers on a continuous scale. In these instances, ASC 606 allows for the variable consideration allocation exception. This exception allows entities to recognize revenue based on outputs. Therefore, if customers are invoiced monthly, the entity is permitted to record revenue based the work performed, i.e., the output, through the date of the invoice. As long as it can be determined that services are provided to customers on a continuous basis, revenue recognition of trust and asset management fees for financial institutions isn’t expected to change for entities that previously recognized revenue based on invoices with individual customers.
Interest Income, Dividend Income & Credit Card Fees
Interest and dividend income and credit card fees all fall outside of the scope of ASC 606. Further clarification for credit card fees was provided by the TRG in TRGA 36, released in July 2015, which addresses questions that surfaced after the first drafts related to ASC 606. For further information about the expanded clarification, see this BKD Thoughtware® article from June 2016.
Sales of Foreclosed Property
Sales of foreclosed property—more specifically, sales where financing is involved—have the most significant effect on most financial institutions. On November 1, 2016, the American Institute of CPAs released a white paper on implementation issue 5-4, which provided additional clarity to accounting for sales of foreclosed property under ASC 606. Revenue recognition on the sale of foreclosed assets involving financing follows the below four-step process under the new standard:
- Does the seller have a controlling financial interest in the legal entity purchasing the foreclosed asset?
- If yes, don’t recognize the sale of the foreclosed asset
- If the answer to the prior question is no, does the transaction meet the definition of a contract for ASC 606? The following criteria must be met:
- Each party has approved the contract
- The entity can identify each party’s rights regarding the foreclosed asset
- The entity can identify the payment terms for the foreclosed asset to be transferred
- The contract has commercial substance
- It’s probable the entity will collect the consideration to which it will be entitled in exchange for the property
- If any of the above criteria aren’t met, do not recognize the sale of the related foreclosed asset
- If the answer to the prior question is yes, has the selling entity satisfied its performance obligation by transferring control?
- If no, don’t recognize the sale of the related foreclosed asset
- If the answer to the prior question is yes, are the terms of the transaction at market terms?
- If yes, record effect as the difference between the transaction price and the carrying value
- If no, adjust the transaction price to market terms, and then record as indicated above
The above steps outline the process surrounding seller financing sales of foreclosed assets. For a more detailed consideration of this scenario, see this BKD Thoughtware article published in November 2017.
Financial institutions often service assets for other banks. In TRGA 52, the TRG members generally agreed that income within the scope of ASC 860 related to the servicing of financial assets is excluded from ASC 606. Servicing income will continue to be recognized under the provisions of ASC 860 after the adoption of ASC 606.
Evaluating the Financial Statements of Borrowers
Significant changes to both the execution of and the disclosures within the financial statements of borrowers of financial institutions will occur after the implementation of ASC 606. Health care, manufacturing, distribution, construction and real estate borrowers could see material changes to how revenue is recognized within their financial statements. It’s important to understand the effect of Topic 606 on the financial statements of the potential and current borrower to ensure credit risk and cash flow analyses can be appropriately assessed for more accurate credit decisions. After the implementation of ASC 606, borrowers should use the following five-step model when recognizing revenue:
- Identify the contract with a customer
- Identify performance obligations
- Determine the transaction price
- Allocate the transaction price to the separate performance obligations
- Recognize revenue when (or as) performance obligations are satisfied
The effect of ASC 606 differs by industry and, even more precisely, from entity to entity. To fully understand the impact of ASC 606, it’s important to understand your customer’s core business. Revenue is recognized when a performance obligation is satisfied, which occurs when control of a good or service transfers to a customer. An asset is considered transferred when the customer obtains control. As an example, this is a significant change for the real estate industry, which currently recognizes revenue based on the applicable risks and rewards associated with each transaction. Depending on the circumstances, revenue should be recognized over time or at a specific point in time.
Expect significant changes to disclosures due to the new disclosure requirements providing more clarity concerning the timing and amount of revenues.
The disclosures should contain the following:
- Revenue disaggregated according to the nature, amount, timing and uncertainty of revenue; the disaggregated amount should reconcile to revenues in the financial statements
- Information surrounding performance obligations, specifically when the related entity generally satisfies performance obligations
- Significant payment terms
- Nature of goods and services
- Obligations for returns and refunds
- Types of warranties and any other related obligations
The above detail provides a high-level overview of the changes you should understand and anticipate related to current and potential borrowers. It’s important to understand the new standard not only to evaluate the borrower’s audited financial statements accurately but also to appropriately evaluate credit risk for borrowers without audited financial statements that have not yet adopted the standard. For a more detailed outline of ASC 606, including overviews by industry and information regarding specific transactions, visit BKD’s Revenue Recognition page.