ASC 606 Updates – What Asset Management Entities Should Know

Advisor going over accounting work

Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, has become effective for all entities whose annual reporting periods begin after December 15, 2018. This new standard replaces the existing industry-specific revenue recognition rules and requires all entities to evaluate and recognize their revenue according to new, more uniform principles. It requires entities to report additional information to financial statement users about the nature, timing and uncertainty of revenue from contracts with customers. ASC 606 introduces a core principle, a five-step revenue model, that requires companies to evaluate their transactions:

  • Step 1: Identify the contract with a customer
  • Step 2: Identify the performance obligations in the contract
  • Step 3: Determine the transaction price
  • Step 4: Allocate the transaction price to the performance obligations in the contract
  • Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

For asset management entities, this new standard may affect how revenue should be recognized, which brings in more judgment and analysis.

Identifying a Customer with a Contract

Under the new standard, an asset manager will first need to identify its customer. FASB’s ASC glossary defines a customer as “a party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities in exchange for consideration.” Determining the customer in an asset management arrangement is an important first step that may affect how the guidance is applied. An asset manager may have two types of customers—a fund being managed by the asset manager or an investor who is in the fund. This requires a closer look to determine who has “obtained goods or services in exchange for consideration.”

In many arrangements, it’s not hard to see the fund is the asset manager’s customer because the fund is a separate legal entity with an independent governing board or a management team. Management and advisory fee negotiations with the asset manager are done by the board or management, or they’re based on the fund’s offering documents as defined for each investor class. A good example is a mutual fund that has a large number of diverse investors who may subscribe through a third-party broker-dealer.

In other situations, the investor may be the customer who typically directly negotiates with the asset manager. Such investors may have the characteristics of being fewer in number or having a “side letter” arrangement with the asset manager.

Where’s the Contract?

Asset managers may provide a number of services to customers, such as asset management, administration and distribution services. Asset management services generally include investment advice, research, execution of purchase, sale of investments, etc. Administrative services typically include fund accounting, financial statement preparation and periodic net asset value determination. Distribution services include underwriting and distribution of a fund’s shares and marketing activities.

An asset manager may enter into one or multiple service contracts with the same customer. With multiple contracts, the asset manager may receive different amounts of compensation under each contract, but the objective is the same—managing the customer’s assets. Under the new standard, the asset manager is required to determine if in substance these arrangements should be accounted for as a single contract or multiple contracts. If these agreements are negotiated together with a single commercial objective in mind, services in the contracts are generally viewed as one and should be treated as a single performance obligation. For example, an asset manager may enter into an investment management agreement with a private equity fund to provide asset management services for which it receives management fees. It also may enter into an expense limitation agreement, which reduces or limits the management fee earned. Under the old standard, the management fee revenue and expense reimbursement could have been accounted for separately. However, under the new standard, the management fee and expense limitation agreement are treated as one.

Multiple Performance Obligations

The new standard requires an asset manager to assess whether the services promised are distinct and therefore constitute separate performance obligations or if they should be combined to form a single obligation, unless they’re immaterial in the context of the contract with the customer. An asset manager may receive a management fee and a performance-based fee under separate agreements, even though the services provided are essentially the same, i.e., managing the fund’s assets. Under ASC 606, the two services would be considered the same performance obligation.

Over Time or at a Point in Time

ASC 606 requires reporting entities to determine at contract inception whether the performance obligation under the contract is satisfied over time or at a point in time. According to the standard, a performance obligation is satisfied over time if any one of the following three criteria is met:

  1. The customer simultaneously receives and consumes the benefits provided by the entity on an ongoing basis
  2. The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced
  3. The entity’s performance doesn’t create an asset with an alternative use to the customer, and the entity has an enforceable right to payment for performance completed to date

If none of the above criteria is met, then revenue from the performance obligation is considered satisfied at a point in time. Services provided by asset managers are generally considered satisfied over time because as the asset manager provides the management services, the customer simultaneously receives and consumes the benefits.

Determining Transaction Price

The fees earned by asset managers are generally subject to certain variables. Under ASC 606, to determine the fees earned, an entity is required to estimate variability and constraint on the transaction price. This accounting is different from the old standard it superseded.

Management Fee

Often, the management fee is calculated based on a percentage of net asset value or total fair value of invested assets of the fund. Usually the fund’s net asset value is determinable at the end of a period or quarter. However, if the asset manager’s and the fund’s quarter-ends are different, e.g., September 30 versus October 31, the asset manager is then required to estimate its quarterly management fee and consider if the fee has been crystalized for the service period ended September 30. If the fund’s net asset value at September 30 can’t be definitively determined or if it’s reversible, then such fees would be considered constrained and wouldn’t be recognized as revenue in that period.

Performance Fee or Incentive Fee

Under the old guidance, performance fee revenue was recognized at the end of either the fund life or reporting date and was calculated based on the assumption the fund life ends at each reporting date. Under ASC 606, the performance fee calculated can be shown as revenue only if it’s not probable that a significant reversal will occur at a later date. Thus, under the new standard, revenue recognition may be different for each period, but once crystallized, the fees earned and recognition would catch up.

It’s easy to see why a performance fee revenue can’t be recognized solely based on unrealized fair value in any reporting period because of the significant uncertainty of reversal (delay in timing). However, in some instances a portion of the fee can be recognized because the uncertainty has been eliminated—for example, under American waterfall where the incentive fee is measured based on each investment and one particular investment is sold (accelerates in timing)—provided the probability of clawback is minimal. If an asset manager enters into a fulcrum fee arrangement whereby the management fees have a fixed base fee, and in addition a variable component based on performance (for example, net asset value at the end of the period), under ASC 606, the asset manager should be able to recognize the base fee as revenue for each period but must carefully evaluate the variable portion for each period because it’s constrained and may reverse later.

Contract Costs Incurred as a Principal or an Agent

Once an asset manager enters into a management service agreement, administrative service agreement or distribution service agreement with a customer, it can elect to delegate the execution of certain or all activities to one or multiple third-party service providers. In general, the asset manager is still responsible for negotiating terms with these service providers and supervising operations of the fund. The asset manager will pay the subcontractor fee and reimburse for out-of-pocket expenses.

ASC 606 requires the asset manager to determine whether it’s acting as a principal or an agent when a third party is involved in providing services and is contracted by the asset manager with a customer. This analysis affects how the asset manager will present revenue and reimbursement of expenses for the performance obligation on the income statement. The asset manager is likely to be a principal if the selection of the service provider is at the asset manager’s discretion; the customer can’t terminate the service provider; and the customer holds the asset manager responsible for services provided by the third-party service provider. As a principal, the asset manager will report the revenue and costs paid to the third-party service provider separately as gross values. However, if the customer is the one who influences the selection of the service provider and actively deals with the provider, it’s likely the asset manager is merely acting as an agent. As an agent, the asset manager will report the revenue net of reimbursed costs.

Accounting for Transaction Costs

An asset manager may incur costs of obtaining a contract or costs to fulfill a contract. The accounting treatment of these costs may be subject to the cost guidance in FASB ASC 340-40 if the costs pertain to a contract with a customer within ASC 606’s scope.

If the costs of obtaining a contract are incremental—meaning the asset manager wouldn’t have incurred these costs if the contract with the customer had not been obtained—and such costs are recoverable in their entirety, then such costs can be capitalized.

Under ASC 606, costs incurred in fulfilling a contract can be capitalized if the following criteria are met:

  • The costs relate directly to a contract that can be specifically identified
  • The costs will generate or enhance resources of the entity that will be used in satisfying performance obligation(s)
  • The costs are expected to be recovered

In general, administrative and organization costs should be expensed as incurred.

Disclosure

ASC 606 has enhanced both qualitative and quantitative disclosures relating to revenue recognition. This includes separate disclosure of the following:

  • Disaggregation of revenue streams – For example, the management fee and 12b-1 distribution fee.
  • The aggregate amount of the transaction price that’s allocated to performance obligations that are unsatisfied as of the end of the reporting period – For example, performance and incentive fees that are subject to constraints.
    • ASC 606 has an exemption option related to this requirement. Under this exemption, entities can elect not to disclose any variable consideration allocated to performance obligations if they allocate in entirety to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise. For example, an asset manager enters into a management agreement on November 1 and calculates quarterly management fees earned based on committed capital. On December 31, it will recognize its management fee revenue for the months of November and December if the total commitments are known for those periods. It won’t recognize management fee revenue for January, nor will it need to disclose it because January fees relate to a completely unsatisfied performance obligation. Instead, the asset manager will disclose that the optional exemption has been applied, the nature of its performance obligation, the remaining contract term and when and how the variability will be resolved.
  • Revenue recognized in the reporting period from performance obligations satisfied in previous periods – For example, an incentive fee revenue couldn’t be recognized in the previous period because the final amount from the sale of an investment couldn’t be determined. However, in the current period, because all the hurdles and constraints are cleared and are not likely to reverse, the performance fee can now be recognized. Separate disclosures must be made because the performance obligation was satisfied in the previous period and the recognition was done in the current period.
  • The assets that are recognized to obtain or fulfill a contract.

An asset manager should review the new disclosure requirements to evaluate whether they’re currently being disclosed. Management also should evaluate if it has internal controls necessary to help ensure the completeness and accuracy of the new disclosures under ASC 606. For more information, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.

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