Working Draft: Broker-Dealer Revenue Recognition Implementation Issue. Financial Reporting Center Revenue Recognition

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1 December 15, 2017 Financial Reporting Center Revenue Recognition Working Draft: Broker-Dealer Revenue Recognition Implementation Issue Issue #3-5: Investment Banking M&A Advisory Fees Expected Overall Level of Impact to Industry Accounting: Moderate Wording to be Included in the Revenue Recognition Guide: Identify the contract(s) with a customer 1. Broker-dealers may enter into agreements to provide advisory services to customers for which they charge the customers fees. Generally, broker-dealers provide advisory services on corporate finance activities such as mergers and acquisitions, reorganizations, tender offers, leveraged buyouts, and the pricing of securities to be issued. Brokerdealers may also provide other types of advisory services not specifically related to corporate finance activities. 2. A broker-dealer will enter into an advisory contract that may not contain a duration and that may be terminable at will by either party without cause. The contract may contain non-refundable retainer fees or success fees, which may be fixed or represent a percentage of value that the customer receives if and when the corporate finance activity (e.g., the sale of a business) is completed ( success fee ). In some cases, there is also an announcement fee that is calculated on the date that a transaction is announced based on the price included in the underlying sale agreement. In most cases the retainer fees, announcement fee or other milestone fees reduce any success fee subsequently invoiced and received upon the completion of the corporate finance activity. In addition, the customer may require a bespoke valuation or fairness opinion in conjunction with the sale of a business. This service can be performed by the brokerdealer as part of, or separate from, the advisory contract with the customer, or by a separate broker-dealer. 3. A broker-dealer should evaluate whether the advisory contract meets the definition of a contract with a customer based on the criteria in FASB ASC An advisory contract is accounted for in accordance with the guidance in FASB ASC 606 only when all of the following criteria are met: a. The contract has been approved (in writing, orally, or in accordance with customary business practices) and the parties are committed to perform their respective obligations b. The broker-dealer can identify each party s rights c. The broker-dealer can identify the payment terms

2 d. The contract has commercial substance e. Collection of the consideration is probable 4. When assessing the collectability criterion, a broker-dealer will need to consider the customer s ability and intent to pay the consideration when it becomes due. Assuming the collectability criteria are met, FinREC believes that generally a signed contract between two parties in an agreement to provide advisory services will meet the definition of a contract with a customer under FASB ASC 606. If either the broker-dealer or the customer has the right to unilaterally cancel the contract without paying a substantive termination penalty, the contract term might be day-to-day (or minute-tominute). However, when an advisory contract includes a nonrefundable retainer payment, a broker-dealer will need to evaluate whether the nonrefundable fee relates to the transfer of a good or service. FinREC believes that typically, a retainer fee represents an advance payment for future goods or services that would be part of the consideration allocable to the goods or services in the advisory contract and would be recognized when or as the goods or service to which the consideration is allocated is transferred to the customer. Identify the performance obligations in the contract 5. Advisory contracts may have one or more services that meet the definition of a performance obligation. To determine the performance obligations included in an advisory services contract, a broker-dealer is required to evaluate the nature of the promise(s) to the customer. As noted in FASB ASC , activities that a broker-dealer undertakes to fulfill a contract that do not transfer goods or services to the customer are not performance obligations. 6. The assessment of what is the promised service in an advisory contract requires judgment. For example, the nature of a promise in an advisory contract may be to successfully broker the sale of a business. In other contracts, the nature of a promise may be to provide advice to a company that may or may not culminate in the purchase or sale of a business. 7. For example, a broker-dealer may perform tasks common to an advisory agreement, such as a. Developing strategies and assisting the customer in preparing financial forecasts and analysis ( due diligence ); b. Providing research and analysis on potential targets, including financial forecasting, cultural fit analysis, etc.; c. Providing strategy and negotiation assistance; and d. Assisting with internal and external communications regarding the transaction. The broker-dealer should consider whether such activities transfer a good or service (or multiple goods or services) to the customer, or whether the performance of these services helps to fulfill one overall promise made to the customer. 8. Per FASB ASC , at contract inception, a broker-dealer shall assess the goods or services promised in a contract with a customer and shall identify, as performance obligations, each promise to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct; or b. A series of distinct goods and services that are substantially the same and that have the same pattern of transfer to the customer. If a promised good or service is not distinct, a broker-dealer shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the broker-dealer accounting for all the services promised in a contract as a single performance obligation. 9. In applying FASB ASC 606, a broker-dealer should evaluate all of the goods or services promised in the advisory contract, including those implied by a broker-dealer s customary business practice, to identify the separate performance obligations. A broker-dealer should carefully consider whether each good or service is capable of being distinct and is distinct within the context of the contract in accordance with paragraphs FASB ASC through For example, the task of providing due diligence services could be considered capable of being distinct. However, in an arrangement in which the customer engages the broker-dealer to broker the sale of a business, the broker-dealer should evaluate whether those due diligence services are distinct in the context of the overall contract.

3 10. FASB ASC includes certain factors to evaluate whether the promise to transfer the good or service is distinct in the context of the contract. For example, a good or service that is highly dependent on, or highly interrelated with, other goods or services promised in the contract may not be separately identifiable. 11. When it is determined that a promise is to provide consulting and/or advisory services and the criteria for recognizing revenue over time have been met, after assessing which services are distinct in the context of the contract, a brokerdealer should give consideration to whether each of the services is considered a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer per FASB ASC This is an important determination in an advisory contract, as it affects the number of performance obligations and the pattern of measuring the progress towards satisfying the performance obligations. Under FASB ASC , if the otherwise distinct services are substantially the same and transfer to the customer over time using the same method of measuring progress, then an entity would account for them together as a single performance obligation. 12. When assessing whether providing the customer with a fairness opinion in conjunction with advising on the sale of a business is a separate performance obligation, the broker-dealer should consider whether a good or service is transferred to the customer. FinREC believes that a fairness opinion should generally be considered a distinct good or service accounted for as a separate performance obligation, based on it meeting both criteria in FASB ASC : a. The fairness opinion can be obtained from another broker-dealer outside of the advisory services contract; and b. The fairness opinion is not an input to a combined output of selling the business. That is, the fairness opinion and advisory services do not modify or customize each other, are not integrated into a combined output, and are not highly interrelated (i.e., the broker-dealer would be able to fulfill its promise to transfer the advisory services independent from its promise to subsequently provide the fairness opinion). 13. The balance of this paper assumes that (with the exception of a fairness opinion) the broker-dealer has concluded that the goods and services provided under a merger and acquisition advisory agreement constitute a single performance obligation. Determine the transaction price 14. The transaction price is the amount of consideration to which a broker-dealer expects to be entitled in exchange for transferring promised goods or services to a customer. In a typical advisory contract, there may be both a fixed and a variable component. The fixed component usually relates to the nonrefundable retainer fees and the fairness opinion (if part of the same contract). The variable component usually relates to a success fee that becomes due upon completion of the transaction or an announcement fee that becomes due upon the announcement of the transaction. 15. The amount of variable consideration that the broker-dealer can include in the transaction price is limited to the amount for which it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainties related to the variability are resolved. 16. FASB ASC provides several factors to consider when assessing whether variable consideration should be constrained and to what degree it should be constrained. Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following: a. The amount of consideration is highly susceptible to factors outside the entity s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service. b. Resolution of the uncertainty about the amount of consideration is not expected for a long period of time. c. The entity has limited experience with similar types of contracts or the experience has limited predictive value. d. The entity has a practice of offering a broad range of price concessions or changing payment terms and conditions in similar circumstances for similar contracts. e. There is a large number and broad range of possible outcomes. Based on these factors, particularly the first and last factors, it may be difficult for a broker-dealer to assume that a transaction will be completed and that it is probable that including the variable fee (e.g., a success fee) in the transaction

4 price will not result in a significant revenue reversal when the uncertainty related to the variable consideration is resolved. 17. Estimates of variable consideration can change as facts and circumstances evolve. A broker-dealer should continually revise its estimates of variable consideration at each reporting date during the contract period. 18. FASB ASC (a) states that in addition to variable consideration stated in a contract, variability relating to consideration promised by a customer may arise when the customer has a valid expectation that a broker-dealer may accept an amount of consideration less than the price stated in the contract based on the broker-dealer s customary business practices, published policies, or specific statements. That is, it is expected that the entity will offer a price concession. Broker-dealers sometimes do not invoice customers for reimbursable expenses or fees to which they are entitled in the contract for purposes of maintaining the client relationship for future engagements. The broker-dealer should therefore consider such price concessions in its estimation of variable consideration. Allocate the transaction price to the performance obligations in the contract 19. Once the performance obligations have been identified and the transaction price has been determined, the brokerdealer will allocate the transaction price to the distinct performance obligations. If the broker-dealer determines there are multiple performance obligations in the advisory contract (for example, a promise to provide a fairness opinion and to broker the sale of a business), the broker-dealer would then allocate the transaction price to each performance obligation. 20. In accordance with FASB ASC , the transaction price should be allocated to the performance obligations based on their relative standalone selling prices. If the broker-dealer determines that the standalone selling price of an item is not directly observable, it should be estimated. FASB ASC 606 does not prescribe or prohibit any particular method for estimating the standalone selling price, as long as the method results in an estimate that faithfully represents the price that an entity would charge for the goods or services if they were sold separately. 21. The transaction price is generally allocated to all performance obligations in a contract based on their relative standalone selling prices. However, variable consideration might be attributable to one or more, but not all, of the performance obligations in an arrangement. Variable consideration (and subsequent changes in the estimate of that consideration) should be allocated entirely to a single performance obligation only if both of the following criteria are met in FASB ASC : a. The terms of a variable payment relate specifically to the entity s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service). b. Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract. 22. The guidance in FASB ASC may apply to an advisory arrangement in which there is a success fee (i.e., variable consideration). For example, in an advisory arrangement that includes multiple performance obligations (e.g., to broker and/or to advise on the sale of the business and to issue a fairness opinion), the success fee may relate entirely to the promise to broker and/or to advise on the sale of the business. This may meet the allocation objective if another fixed fee that is consistent with the standalone selling price of the fairness opinion is allocated to that performance obligation. 23. To meet the allocation objective as stated in FASB ASC (b), the FASB staff noted in a July 2015 Revenue Transition Resource Group meeting (paper number 52, paragraph 43) that stakeholders should apply reasonable judgment to determine whether the allocation results in a reasonable outcome. Standalone selling prices in some cases might be used to determine the reasonableness of the allocation, but they are not required to be used. 24. As described above, the amount of variable consideration a broker-dealer can include in the transaction price is limited to the amount for which it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainties related to the variability are resolved. 25. If other advisory activities such as those discussed in paragraph 6 do not represent a separate performance obligation because no good or service is transferred to the customer or because the broker-dealer concludes the good or service is highly interrelated with or dependent on other goods or services in the contract, none of the transaction price would be allocated to those individual activities.

5 Recognize revenue when (or as) the entity satisfies a performance obligation 26. Revenue is recognized when a performance obligation is satisfied, which is when the promised goods or services are transferred to the customer. Transfer occurs when the customer takes control of the promised good or service. 27. In accordance with FASB ASC a broker-dealer should identify whether performance obligations are satisfied over time or at a point in time. To make this determination, a broker-dealer should first assess the criteria for over-time recognition in FASB ASC which states: An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met: a. The customer simultaneously receives and consumes the benefits provided by the entity s performance as the entity performs b. The entity s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced c. The entity s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. 28. FinREC believes it is unlikely that broker-dealer arrangements will meet the criterion in paragraph FASB ASC (b) since the performance does not create or enhance a customer-controlled asset nor the criterion in ASC (c) since these engagements generally do not provide for an enforceable right to payment for performance completed to date. However, the criterion in FASB ASC (a) may be met for certain arrangements. FASB ASC notes that for some types of performance obligations, the assessment of whether a customer receives the benefits of an entity s performance as the entity performs and simultaneously consumes those benefits as they are received will be straightforward. For other types of performance obligations, FASB ASC notes that an entity may not be able to readily identify whether a customer simultaneously receives and consumes the benefits from the entity s performance as the entity performs and provides the following additional guidance to evaluate whether a customer simultaneously receives and consumes the benefits from the entity s performance as the entity performs: In those circumstances, a performance obligation is satisfied over time if an entity determines that another entity would not need to substantially re-perform the work that the entity has completed to date if that other entity were to fulfill the remaining performance obligation to the customer. In determining whether another entity would not need to substantially re-perform the work the entity has completed to date, an entity should make both of the following assumptions: a. Disregard potential contractual restrictions or practical limitations that otherwise would prevent the entity from transferring the remaining performance obligation to another entity. b. Presume that another entity fulfilling the remainder of the performance obligation would not have the benefit of any asset that is presently controlled by the entity and that would remain controlled by the entity if the performance obligation were to transfer to another entity. 29. The application of the concept in FASB ASC was further discussed in FASB s Revenue Transition Resource Group (TRG) Agenda Ref. No. 46: Pre-production Activities. Paragraph 10 of TRG Agenda Ref. No. 46 states: Paragraph notes that sometimes an entity may not be able to readily identify whether this criterion is met. In those circumstances, an entity would consider whether another entity would need to re-perform the work that the entity has completed to date if that other entity were to fulfill the remaining performance obligation. For example, consider a scenario in which an entity is performing engineering and development as part of developing a new product for a customer. If the entity provides the customer with periodic progress reports (in a level of detail that would not require the customer to contract with another entity to re-perform the work) or if the entity is required to provide the customer with the design information completed to date in the case of a termination, then the entity likely would conclude that control of that service has transferred to the customer. While such guidance in TRG Agenda Ref No. 46 was provided in the context of preproduction activities in a manufacturing arrangement, the guidance may be helpful when evaluating whether another entity would be required

6 to substantially re-perform the work that the broker-dealer has completed to date if the other entity were to fulfill the remaining performance obligation to the customer. 30. FinREC believes the obligation by a broker-dealer to provide a fairness opinion that is a separate performance obligation would likely be recognized at a point in time when the fairness opinion is provided to the customer. That is, the customer is not simultaneously receiving and consuming the benefit of the entity s performance to provide the fairness opinion in accordance with FASB ASC (a), the services would not meet the criterion in FASB ASC (b), and it is unlikely the services would meet the criterion in paragraph FASB ASC (c). 31. In regards to other performance obligations in broker-dealer engagements, entities will need to determine whether any of the criteria for recognizing revenue over time in FASB ASC are met. As noted above, FinREC believes it is unlikely that broker-dealer arrangements will meet the criteria in paragraph FASB ASC (b) or (c); however, FASB ASC (a) may be met for some arrangements. The determination as to whether the criterion in FASB ASC (a) is met may require significant judgment and should consider all the facts and circumstances in the arrangement, including the specific contract terms (including payment terms), nature of the services being provided to the customer, knowledge and information provided to the customer or retained by the broker-dealer, and other relevant details of the arrangements. 32. If the broker-dealer determines that the criterion in FASB ASC (a) is met for a performance obligation, revenue allocated to the performance obligation (subject to the constraint in FASB ) would be recognized over time as performance occurs using an appropriate measure of progress as determined in accordance with FASB ASC through If the broker-dealer determines that the criterion in FASB ASC (a) is not met for a performance obligation, revenue (including milestone payments, retainer fees, announcement, success fees or other fees) allocated to the performance obligation (subject to the constraint in FASB ) would be recognized at the point in time the broker-dealer determines control of the service transfers to the customer in accordance with FASB ASC (likely at the point in time that performance under the broker-dealer engagement is completed or the contract is cancelled). Comments should be received by February 15, 2018, and sent by electronic mail to Ivory Bare at ivory.bare@aicpa-cima.com, or you can send them by mail to Ivory Bare, Product Management and Development, AICPA, 220 Leigh Farm Road, Durham, NC DISCLAIMER: This publication has not been approved, disapproved or otherwise acted upon by any senior committees of, and does not represent an official position of, the American Institute of Certified Public Accountants. It is distributed with the understanding that the contributing authors and editors, and the publisher, are not rendering legal, accounting, or other professional services in this publication. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Copyright 2015 by American Institute of Certified Public Accountants, Inc. New York, NY All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please copyright@aicpa.org with your request. Otherwise, requests should be written and mailed to the Permissions Department, AICPA, 220 Leigh Farm Road, Durham, NC