Common ASC 606 Issues: Asset Management

In 2018, Accounting Standards Codification (ASC) Topic 606 became effective for all public companies. This major overhaul of revenue recognition has affected almost every industry, and asset managers are no exception. The complex arrangements between asset managers and their clients pose some difficult issues for ASC 606.

The AICPA and major accounting firms have assembled task forces to research the industry-specific accounting issues within ASC 606. We will draw from the guides they have published as we provide a brief explanation of the key issues asset managers face when applying ASC 606. We will also refer to recent 10-K filings to illustrate key issues. For more information on any of these issues, see the following resources:

• AICPA, Audit & Accounting Guide: Revenue Recognition
• PwC, In Depth: Revenue from contracts with customers: The standard is final – A comprehensive look at the new revenue standard
• EY, Technical Line: How the new revenue standard affects asset managers
• Deloitte, Investment Management Spotlight: Navigating the New Revenue Standard

The following are the key issues that asset managers commonly face:

1. Identifying the Contract

Asset managers offer a variety of services to their customers and often engage in several services at the same time for one customer. These services may be contained in a single contract or may exist separately in individual contracts. In some cases, the governing documents of a fund may dictate which services are to be provided by a manager, and these documents may be considered a contract.

FASB ASC 606-10-25-1 contains criteria for determining what is considered a valid contract. If the criteria are met, the arrangement is a valid contract and is subject to the revenue recognition guidance in ASC 606. In circumstances where the agreement does not meet the contract criteria found in 606-10-25-1 and consideration is received from a customer by the manager, ASC 606-10-25-7 through 25-8 should be applied to account for the rights and obligations in the contract. This arrangement should be monitored and evaluated according to the criteria in ASC 606-10-25-1 to determine when or if the revenue recognition guidance should be applied at a later date.

In cases where multiple separate contracts are entered into by an asset manager or its related parties, ASC 606-10-25-9 should be used to evaluate whether the separate contracts should be combined.

For more information on combining contracts and identifying a contract, see:

• Combining Contracts
• Identifying the Contract

2. Who is the Customer?

The asset management industry faces an added challenge when identifying the customer in an agreement. This is due to the relationships the asset manager has with the fund they manage and its investors. This issue arises because asset managers have contracts with the funds they manage, but the funds only exist to allow investors to use an asset manager’s services.

Though the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have not offered an official view on the issue, several indicators have been identified to aid entities in coming to more specific conclusions. The AICPA has noted that the list is not all-inclusive, and each indicator should be evaluated carefully, analyzing the meaningfulness of each indicator within the unique circumstances. According to the AICPA, the characteristics that may indicate that the fund is an asset manager’s customer are as follows:

• The fund is a separate legal entity that may be set up as a partnership, corporation, or business trust.
• The fund is governed by a board of directors or other form of governance, which is independent of management of the fund.
• Fee arrangements for management and advisory fees are negotiated by the fund and applied consistently by the investor class.
• There is a large number of potentially diverse investors.
• The fund lacks visibility as to who the ultimate investor is because investors have subscribed through a third-party broker-dealer’s omnibus account.
• The fund is highly regulated, as is the case with registered investment companies in the U.S.
• The asset manager and other service providers may have multiple different contractual arrangements with the fund to provide different services.

There are circumstances in which the investors should be considered the customers. According to the AICPA, the characteristics that may support this conclusion are as follows:

• The asset manager enters into individual “side letter” arrangements regarding management fees with individual investors (as may be common in certain partnership structures).
• There is active negotiation of fees or interaction between the asset manager and individual investors or a small group of investors that control the fund‘s activity directly or indirectly through their role on the board or governing body (that is, the investors as a group act together as the fund’s governance structure).
• The fund is not governed by a board of directors or other form of governance, which is independent of management of the fund.
• There is a single or a limited number of investors.

For more information on how to define and determine the customer within a contract, please refer to the Definition of a Customer article. 

3. Management Fee Revenues

Management fee revenues are often part of the compensation that asset managers receive for their investment management arrangements. These fees are normally a small percentage of the total value of assets that is paid for continued service over the course of the arrangement. Generally, an asset manager does not just offer their base services, but also provides performance-based services in conjunction with their base management services. These services are performed in conjunction with one another and are transferred to the customer on the same schedule, thus the two services would not qualify as separate performance obligations, but as a single performance obligation.

Management fees that are based on the net value of assets under management (AUM) are variable because the asset value fluctuates over time. These fees would likely qualify for the variable consideration allocation exception because the variable consideration likely pertains to a single performance obligation. The revenue recognition is essentially the same as the treatment for performance-based fees, which is addressed in greater detail in issue number five below.

When management fees are a set amount, they would not be considered variable and therefore would be included in the transaction price.

The following table illustrates the difference:

After determining the transaction price, it must be allocated to the performance obligations in the contract. ASC 606 allows for variable consideration to be allocated to a series of goods or services that make up a single performance obligation, if specific criteria are met. Asset manager agreements often meet these qualifying criteria, allowing for variable consideration to be allocated to distinct services provided in a certain period.  The unconstrained portion of the variable consideration will then be allocated to these distinct periods, with the remaining portion being spread over the duration of the single performance obligation.

For more information on allocating variable consideration, please refer to the Allocating Variable Consideration article.

4. Fee Waivers/Fund Expense Reimbursements

Asset managers sometimes waive their management fee or reimburse a fund for expenses incurred beyond an agreed upon threshold. The agreement to waive or reimburse these fees can be entered into either (1) in conjunction with the service agreement or (2) in a separate agreement. If the first scenario is true, the contracts will likely be combined due to the timing of the agreements and their related nature. The second scenario requires more analysis, as the agreement to waive or reimburse will affect the transaction price of the service agreement. Contract modification guidance should be consulted to determine the proper handling of this scenario.

Regardless of which scenario is true for an entity, the waivers and/or reimbursements should be included in the estimate of the related fee as a reduction of the total fee amount such that the waiver/reimbursement expense will be recognized as a reduction of management fee revenue when the fee revenue is recognized. As is always the case with estimates of transaction price, the inclusion of the management fee net of the reduction should only occur to the degree that a significant revenue reversal is not probable.

For more information on variable consideration, please refer to the Variable Consideration and the Constraint article.

5. Costs of Managing Investment Companies

Under the new standard, companies are required to capitalize and amortize incremental costs the entity incurred (e.g., sales commissions) to obtain and fulfill a contract. The entity should only capitalize and amortize the costs to fulfill a contract if (1) the costs relate directly to a specific contract, (2) the costs generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) the entity expects to recover the costs.

The costs capitalized by the entity should be amortized as the entity transfers the goods or services designated in the contract to the customer. There is a practical expedient that allows entities to immediately expense the costs if they would have been fully amortized in one year or less. For contracts extending beyond a year, the amortization should take place in tandem with the transfer of related services. The estimated life of a customer or fund can act as a basis for determining the period for which the incremental costs relate.

For more information on how to treat the costs to obtain and fulfill a contract, see:

• Incremental Costs of Obtaining a Contract
• Costs to Fulfill a Contract

6. Incentive or Performance Fee Revenues

Asset managers often have fee arrangements that include fees to be paid based upon the performance of the assets that are being managed. On some occasions, the performance of the asset is measured against a factor outside of the control of the manager, such as a market index. As is the case with variable management fees, the uncertainty that these arrangements create regarding the amount of fees to be received can become an issue for revenue recognition.

Prior to ASC 606, ASC 605 allowed two different methods for recognizing these fees. The first method allowed the recognition of the fee revenue to be deferred until the end of the contract, thereby eliminating all uncertainty. The second method allowed the revenue to be recognized before the end of the contract, based on termination provisions found in the arrangement that made the revenue realizable.

ASC 606 requires variable consideration to be included in the transaction price only when it is probable that there will not be a significant reversal. When incentive or performance fee revenues are influenced by factors outside the control of the manager, a significant future reversal of revenue is probable. Therefore, recognition of these fees is delayed until the uncertainty is resolved, usually at the conclusion of the period. The delay of recognizing these fees as revenue does not change the need to recognize payments to employees as an expense in the period in which they are incurred.

For more information on variable consideration, please refer to the Variable Consideration and the Constraint article.

7. Incentive-Based Capital Allocations

Asset managers are at times allocated a performance fee when returns are beyond the agreed upon threshold. These contractually determined fees are often based on a percentage of the proceeds of an investment, or a percentage of the proceeds that exceed a predetermined benchmark. These fees are often subject to clawback provisions, however, which would affect the timing of their recognition.

When determining how to handle these capital allocations, several factors should be considered, including the following:

• The factors that are inputs to the calculation of the fee, especially factors outside of the manager’s control.
• Clawback and other provisions that would affect the probability of a reversal of revenue.
• The estimated remaining lifespan of the investment company.
• The likelihood that the value of the excess return will change due to factors outside the entity’s control.
• The degree to which the contractual hurdle rate is exceeded by the collective realized return and unrealized gain on investment.

To the extent that a significant reversal of the total revenue recognized will not occur when the uncertainty is resolved, the variable consideration should be included in the transaction price. Conversely, if the incentive-based capital allocation has the potential to exceed all other fees in the arrangement and it is probable that a significant reversal will occur, the variable consideration should not be included in the transaction price. A Q&A issued by the FASB in January 2020 explains that  the assessment of whether a significant reversal will occur should be considered at a contract level rather than at the level of a specific performance obligation, meaning the entire transaction price of the contract should be considered against the variable consideration.

Upon inclusion of the capital allocation in the transaction price, managers must determine the amount that should be allocated to distinct services provided by the entity. Managers should also consider whether any of the allocation included in the transaction price should be allocated to the remainder of the performance period—if any remains—net of the distinct service period already allocated.

For more information on variable consideration see:

• Variable Consideration and the Constraint
• Allocating Variable Consideration

8. Recognition of Contingent Deferred Sales Charges

Some mutual funds offer shares to be sold without a sales charge up front. Instead these funds charge investors a contingent deferred sales charge (CDSC) at the time the shares are redeemed, if redemption occurs within a specified window of time. This CDSC fee is consideration paid by the investor to the distributor for sales-related costs. The charge is calculated as the lesser of the original cost of the investment or the percentage of proceeds received by the investor. Put simply, this fee is a commission paid to the distributor for its services.

The Financial Reporting Executive Committee (FinREC) believes that this fee is revenue earned by the distributor from work performed under contract with a customer, and as such falls within the scope of the revenue recognition framework. To determine how to handle its specific CDSC-fee situation, an entity will need to walk through each of the five steps in the framework (AICPA Audit and Accounting Guide on Revenue Recognition (AAG REV) Chapter 4—Asset Management: 4.6.01 through 4.6.18).

The following five steps illustrate FinREC’s general evaluation of CDSC fees using the revenue recognition framework:

1. Generally, the fund is assumed to be the customer, and the selling and distribution of securities in exchange for revenue from the fund is the distributor’s ordinary business activity.
2. Sales-related services provided by the distributor to the fund are normally considered to be a single performance obligation.
3. CDSC fee revenue is variable due to the contingent nature of the consideration, with the receipt of the consideration being determined by the timing of redemption by the investor and the value of the redeemed investment proceeds.

FinREC gives no specific guidance for which method of estimation to use for determining the amount of consideration that will be received, but states that historical experience should be used for determining the expected range of outcomes.

Based on the fact that the probability of a significant reversal of recognized revenue cannot be determined until the fund redeems the invested shares, FinREC states that the CDSC fee revenue should be excluded from the transaction price until the actual time of redemption.

4. Under the assumption that the contract in question has a single performance obligation, the entirety of the CDSC fee should be allocated to the performance obligation. If other obligations are identified, ASC 606-10-32-39 through 41 should be consulted to determine the proper allocation of the fee to each distinct obligation.
5. No specific evaluation was made by FinREC regarding the timing of revenue recognition, but the AICPA does refer readers to ASC 606-10-25 paragraphs 27 and 30, where criteria can be found to determine if CDSC revenue should be recognized at a point in time or over time (AAG REV Chapter 4—Asset Management: 4.6.18).

For more information on the five steps of the revenue recognition framework, refer to the Five-Step Method overview article, as well as each of the individual articles addressing the five steps in greater depth.

9. Deferred Distribution Commission Expenses (back end load funds)

Investment funds that operate as back-end load funds, wherein the investor is charged a contingent deferred sales charge (CDSC) at the time they redeem their investment, often have to pay third-party distributors an upfront commission for their service of referring investors to the fund. Additionally, the investment fund will pay a distribution fee to the asset manager, who in turn will normally pay a portion of that fee to the third-party distributor.

Due to varying circumstances resulting in different applications of the guidance on incremental costs of obtaining a contract found in ASC 606, FASB retained the cost guidance for investment companies in ASC 946-605-25-8, which has been relocated to ASC 946-720. ASC 946-720-25-4 instructs that back-end load funds should defer and amortize the incremental direct costs and then expense the indirect costs as they are actually incurred. The challenge arises from the lack of guidance found in ASC 946-720 on when the capitalized costs should be amortized.

Accordingly, FinREC looks to ASC 340-40-35-1 for guidance, which instructs firms to amortize capitalized costs in a way that is consistent with how the services provided are transferred to the customer (AAG REV Chapter 4—Asset Management: 4.7.08). This guidance leaves the actual period in which the costs should be amortized to professional judgement.

Though ASC 946-720 does not provide any guidance on the impairment of the capitalized asset, FinREC states that impairment may be necessary, and refers to ASC 340-40-35, paragraphs 3 through 6 to determine the appropriate impairment procedures (AAG REV Chapter 4—Asset Management: 4.7.10).

For more information on the treatment of incremental costs, refer to the Incremental Costs of Obtaining a Contract article.

10. Gross versus Net

Asset managers commonly work with third parties in fulfilling agreements to customers. The involvement of a third party requires the asset manager to determine whether they—the managers—are acting as a principle or an agent in the arrangement.

ASC 606 calls for an evaluation of control in determining principle versus agent considerations. The key consideration is whether the asset manager is the party primarily responsible for fulfilling a promised service. Determining whether revenue should be recognized on a gross basis (when the manager is acting as a principle) or a net basis (when the manager is acting as an agent) will sometimes lead to significantly different revenue recognition than in the past. Asset managers must evaluate each contract (or class of contracts) to make this determination.

For more information on principal vs agent considerations, refer to the Principal/Agent Considerations (Gross Vs. Net) article.

Conclusion

Many other issues and questions will likely arise for asset managers as entities continue to apply ASC 606. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on the following link: Industry-Specific Issues.