REVENUE RECOGNITION FOR BROKER-DEALERS AND INVESTMENT ADVISERS

Objectives By the end of this webcast, you will be able to: Describe the overall approach in the new revenue recognition guidance to the financial services industry Determine how your revenue recognition accounting policies, processes and controls may be affected by the new guidance RSM US LLP. All Rights Reserved.

Revenue recognition: ASC 606 why? ASU 2014-09 was issued in May 2014 with intent of providing a principles-based framework for addressing revenue recognition Eliminates industry specific revenue recognition guidance Improves comparability between industries Core principle 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 RSM US LLP. All Rights Reserved.

Effective date Effective date of ASC 606 Calendar year end entities June 30 year end entities Public entities*, quarter and year January 1, 2018 July 1, 2018 beginning Other entities, year ending December 31, 2019 June 30, 2020 Early adoption of ASC 606 Allowed for both public entities and other entities As early as January 1, 2017 As early as July 1, 2017 * Public entities include PBEs, not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market and (c) employee benefit plans that file or furnish financial statements to the SEC. SEC announced at the July 2017 EITF meeting that they would not object to the use of non-pbe adoption dates for a PBE that meets the definition of a PBE only because of inclusion of their financial statements or financial information in another company s filing with the SEC. RSM US LLP. All Rights Reserved.

Transition options Transition Approach Full retrospective with the option to elect one or more of four practical expedients Modified retrospective with the option to elect one practical expedient Implications Restate all contracts; cumulative effect presented as of beginning of earliest period presented Do not restate contracts; cumulative effect presented as of date of initial application; disclosure of effects on current reporting period, which essentially requires doublebookkeeping in the year of adoption RSM US LLP. All Rights Reserved.

Required disclosures Detailed quantitative and qualitative information about the following must be disclosed: Disaggregated revenue by location, product type Contract assets, contract liabilities and receivable Performance obligations (POs) in general and the transaction price allocated to the remaining POs at the end of the reporting period Significant judgments related to when POs are satisfied and used to estimate and allocate the transaction price Capitalized customer contract costs RSM US LLP. All Rights Reserved.

Adoption readiness Internal controls related to adoption Implementation controls Related disclosures Steady-state accounting Pre-adoption disclosures Quantitative and qualitative disclosures of effects

Adoption readiness Identification and review of contracts Communication between accounting and operations Understand contracts and modifications Updates to accounting systems Assess quantitative impact prior to January 1, 2018 (BDs) Project timeline First reporting period January 18 FOCUS report (BDs) Interactions with auditors RSM Discovery Phase Questionnaire RSM Application Checklist http://rsmus.com/our-insights/revenue-recognition-resource-center.html RSM US LLP. All Rights Reserved.

AICPA Revenue Recognition Task Forces Task forces Broker-Dealer Asset Management Members Industry members Accounting firms AICPA representatives Goal Publish industry specific application guidance to be included in the AICPA Audit and Accounting Guide on Revenue Recognition RSM US LLP. All Rights Reserved.

AICPA revenue recognition issue review process 1. Identified and prepared by industry RRTF 2. Submitted to AICPA RRWG 3. Specific questions submitted to FASB TRG (if applicable) 4. Submitted to FinREC 5. Exposed on AICPA website 6. Resubmitted to RRWG 7. Resubmitted to FinREC 8. Finalized for AICPA Accounting Guide on Revenue Recognition (nonauthoritative) RSM US LLP. All Rights Reserved.

AICPA revenue recognition issue review process Link to AICPA site to track implementation issues on the various streams http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/r evenuerecognition/pages/default.aspx Check this link periodically to get an update on current status of issues and implementation guidance Broker-dealer issues are addressed in Chapter 5 of the AICPA guide Asset management issues are addressed in Chapter 4 of the AICPA guide

Broker-dealer revenue implementation issues Issue Description Status 1 Commission income Final 1a Commission income trade date vs settlement date Final 2 Selling and distribution fee revenue FINREC - November 3 Costs associated with underwriting Final 3a Costs associated with investment banking advisory Final services 4 Underwriting and related fee income Out for comment until January 2 5 Advisory fee income FINREC - November 6 Soft dollar revenues Comment period ended November 1 7 Revenue from financial instruments Final RSM US LLP. All Rights Reserved.

Asset management revenue implementation issues Issue Description Status 1 Who is the customer? Final 2 Management fee revenues Final 3 Fee waivers / Fund expense reimbursements Final 4 Costs of managing investment companies Comment period ended November 1 5 Incentive or performance fee revenues Final 5A Incentive-based capital allocations Final 6 Recognition of contingent deferred sales charges Final 7 Deferred distribution commission expenses ("backend Final load funds") 8 Identifying the contract Final 9 Asset management arrangement revenue -Gross versus Net Comment period ended December 1 RSM US LLP. All Rights Reserved.

Out of Scope Revenue Streams Financial Instruments ASC 310 ASC 320 Interest and dividend income and expense from securities owned/sold short Interest and dividend income and expense from financial instruments owned or sold short (including amortization of premiums and discounts) Interest (rebate) from reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions and similar arrangements Interest from debit balances in customer margin accounts and margin deposits Cash dividends on debt and equity securities RSM US LLP. All Rights Reserved.

Out of Scope Revenue Streams Transfer and Servicing ASC 860 Interest ASC 835 Realized/unrealized gains/losses on the transfer and derecognition of financial instruments (i.e., proprietary trading) Interest income on investments in debt instruments Nonmonetary Transactions ASC 845 Investments Other ASC 325 Payment-in-kind (PIK) dividends and interest from investments in debt and equity securities Dividends from equity instruments owned or sold short Cash dividend income on cost method investments RSM US LLP. All Rights Reserved.

1. Commission income Step 1: Identify the contract with a customer Generally a written contract between broker-dealer and customer Contract generally exists when first order is submitted if there s no separate fee for custody services or a guaranteed minimum number of trades Step 2: Identify POs in the contract Services provided could include: 1) trade execution 2) clearing service 3) custody service 4) research service Trade execution and clearing services are generally not separately identifiable Custody service: distinct Research service: distinct (soft-dollar) After first trade, any additional trades are considered optional purchases

1. Commission income Step 3: Determine the transaction price Trade execution and clearing services covered by commission Custody may be covered by separate fee Additional trades are optional purchases, not included in transaction price until the option exercised Step 4: Allocate transaction price to the PO If commission earned for both execution/clearing and custody need to allocate amongst POs Step 5: Recognize revenue when (or as) the entity satisfies a PO Trade execution satisfied at a point in time (trade date when control is transferred) Custody service satisfied over time

2. Selling and distribution revenues Step 1: Identify the contract with a customer Written agreement between broker-dealer and fund Fund considered customer as contract is between fund and brokerdealer (vs. investors in the fund) Step 2: Identify POs in the contracts POs: 1) sales 2) marketing 3) shareholder services Sales and marketing bundled Judgement required when determining whether shareholder services meets definition of separate PO

2. Selling and distribution revenues Step 3: Determine the transaction price Upfront fee: fixed percentage of shares sold Ongoing fee: based on value of shares (NAV) Upon investor exiting: length of time investor invested in fund Variable consideration: should not recognize revenue until probable that revenue will not be reversed Step 4: Allocate transaction price to the PO If two POs (Sales/marketing and shareholder services) and only receive upfront fee, defer a portion of revenue to ongoing services Step 5: Recognize revenue when (or as) the entity satisfies a PO Sales/marketing: point in time (trade execution) Shareholder services: ongoing services

2. Selling and distribution revenues Cost considerations: Distribution costs (i.e., sales commission to third-party broker), deferred and amortized if no upfront revenues Other costs incurred to fulfill a contract, expensed when incurred

4. Underwriting revenues (3. Costs associated with underwriting) Step 1: Identify the contract with a customer Generally met once underwriting agreement is executed and legally enforceable Contract commonly is between all underwriters in the syndicate and issuer Step 2: Identify POs in the contracts POs often include: 1) Management underwriting service 2) Underwriting services 3) Selling concession services All highly interrelated, generally a single PO If overallotment option that is not a derivative, separate contract under contract modification guidance

4. Underwriting revenues (3. Costs associated with underwriting) Step 3: Determine the transaction price Gross spread allocated amongst the syndicate group Lead underwriter generally records revenue net of the allocation to the syndicate group Step 4: Allocate transaction price to the PO One PO Step 5: Recognize revenue when (or as) the entity satisfies a PO Generally recognized at a point in time trade date Cost treatment Each participant in the syndicate group records their proportionate share of costs associated with underwriting on a gross basis

5. Advisory fee income (3a. Costs associated with advisory fee income) Step 1: Identify the contract with a customer Signed contract to provide advisory services Step 2: Identify POs in the contracts POs: Due diligence Research and analysis on potential targets Strategy and negotiation assistance Assistance with internal/external communications regarding the transaction Fairness opinions Nonrefundable consideration, consider significance

5. Advisory fee income (3a. Costs associated with advisory fee income) Step 3: Determine the transaction price Fixed: retainer Variable: success or announcement fee (constrained until transaction is successful) Step 4: Allocate transaction price to the PO Allocate based on standalone selling price Step 5: Recognize revenue when (or as) the entity satisfies a PO If promise is to achieve a specific outcome (i.e., broker a transaction), point in time If promise is to provide consulting services, over time Retainer

6. Soft dollar revenues Step 1: Identify the contract with a customer May be part of clearing/execution agreement or entered into at or near the same time Generally accounted for as single contract with clearing/execution agreement Step 2: Identify POs in the contracts When combined with clearing/execution agreement research services are generally a separate PO If broker-dealer pays third party for research, broker-dealer s PO is to arrange for goods or services provided by a third party

6. Soft dollar revenues Step 3: Determine the transaction price Commission fee received as part of clearing/execution agreement If broker-dealer pays third-party for the research, determine if principal or agent (Does broker-dealer have control over research services provided?) If principal, record revenue and expense as gross If agent, record revenue on a net basis Step 4: Allocate transaction price to the PO Allocate based on standalone selling price when research services are considered a separate PO Step 5: Recognize revenue when (or as) the entity satisfies a PO If providing ongoing access to a research analyst: satisfied over time If fixed number of analysts report: point in time as each report is provided

REVENUE STREAMS Asset Managers

1. Who is the customer? Not always clear who the customer is (fund vs. investor) Determination of the customer impacts the accounting for certain costs as well as the timing of revenue recognition and principal vs. agent considerations Fund is generally assumed to be the customer in the revenue streams described in the AICPA papers Considerations that could result in the investor being considered the customer: Side letter arrangements with individual investors Asset manager actively negotiates directly with investor vs. fund governing body No governing body of the fund independent of the asset manager Single or few investors

2. Management fee revenues Promise to provide asset management services is considered a single PO Provision of a series of distinct services that are substantially the same and have the same pattern of transfer Fees based on AUM Considered to be variable consideration Variable consideration constraint applied to fees when determining transaction price, since dependent on market volatility beyond entity s control PO is satisfied over time with progress toward complete satisfaction of the PO measured using a time-based measure of progress (i.e., daily, monthly, quarterly) subject to the variable consideration constraint Fees based on investor commitments or set dollar amount No variable consideration Allocate transaction price to each distinct services on a relative standalone selling price basis (determined at contract inception), i.e., daily, monthly, quarterly

3. Fee waivers / Fund expense reimbursements Represents a transaction price adjustment, i.e., not a promise to transfer services to the customer or payments for distinct services from the customer Evaluation of transaction price follows management/performance fee guidance Subject to specific facts and circumstances and the type of waiver: Guidance on contract modifications; or Guidance on combination of contracts

4. Costs of managing investment companies Identification of the customer is important in determining cost treatment Pre-launch costs are typically outside the scope of the new cost guidance Costs capitalized under ASC 340-40 (typically costs to obtain a contract) will be amortized and tested for impairment Cost Customer is Fund Customer is Investor Sales commissions Placement fees Asset allocator fees Not an incremental cost to obtain a contract Non-discretionary commissions capitalized if those costs are expected to be recovered Capitalize if those costs are expected to be recovered Not an incremental cost to obtain the contract; expense as incurred

4. Costs of managing investment companies Most post-launch costs fail the conditions to capitalize as costs to fulfill a contract because: Within the scope of ASC 946 guidance related to sales commissions and related costs Unlikely to meet criterion that they generate or enhance resources of asset manager that will be used to fulfill future POs Costs subject to other guidance, such as deferred sales commissions, are not subject to the disclosure requirements of ASC 340-40

5. Incentive or performance fee revenues Promise to provide asset management services considered a single performance obligation Provision of a series of distinct services that are substantially the same and have the same pattern of transfer Considered to be variable consideration Subject to fluctuation in amount and/or contingent on occurrence or nonoccurrence of a future event Excluded from transaction price until probable that there will be no significant revenue reversal Factors to consider for likelihood and magnitude of revenue reversal Impact of market volatility on underlying portfolio Extent to which ROI exceeds hurdle rate Remaining length of performance period

5A. Incentive-based capital allocations, including carried interest Method 1 and Method 2 election options from legacy GAAP is expected to be eliminated Are incentive-based capital allocations in the form of a carried interest in scope of ASC 606? FASB members believe in scope of 606 based on TRG meeting discussion SEC has indicated that in certain situations they would not object to the application of ASC 323 on equity investments to incentive-based allocations in the form of a carried interest

5A. Incentive-based capital allocations, including carried interest Follow incentive/performance fees guidance if conclude in scope of ASC 606 Regardless of whether or not a cash distribution was made by the customer Factors to consider regarding likelihood and magnitude of revenue reversal Allocation s dependence on performance waterfalls, hurdle rates, investment-byinvestment calculations Existence of clawback provisions Remaining life of investment company Whether excess unrealized returns remain susceptible to factors outside entity s control, e.g., volatility of portfolio Extent to which current realized and unrealized returns exceed hurdle rate

6. Recognition of Contingent Deferred Sales Charges (CDSC) CDSC fees are earned by selling shares of a fund, but payment is received only if the customer redeems the share within a certain period The PO is typically satisfied at a point in time At contract inception and each subsequent measurement period, the asset manager should estimate the variable consideration to determine the transaction price Generally it will be difficult to substantiate that there will not be a significant reversal until the investor redeems the shares during the contractual period As a result, variable consideration will generally be excluded from the transaction price until the investor redeems the shares

8. Identifying the contract Generally asset managers enter into separate legal agreements including: Investment management agreements Administrative agreements Sales and/or distribution agreements Side letter agreements These agreements are considered contracts with a customer once the contract existence criteria are met In the absence of separate legal agreements, the prospectus, articles of incorporation or limited partnership agreement may be considered a contract with a customer once the contract existence criteria are met

Revenue Recognition Resource Center

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