January 2, 2018 Financial Reporting Center Revenue Recognition Working Draft: Broker-Dealer Revenue Recognition Implementation Issue Issue #3-2: Selling and Distribution Fee Revenue Expected Overall Level of Impact to Industry Accounting: Minimal Wording to be Included in the Revenue Recognition Guide: Background: 1. Managed accounts or other pooled investment vehicles (collectively funds ) enter into agreements with distributors to distribute, i.e. sell, shares to investors. 1 There are different ways distributors may be compensated for the same service. Fees may be paid upfront, over time (e.g., 12b-1 fees) on the basis of a contractual rate applied to the monthly or quarterly market value of the fund (NAV), upon investor exit from the fund (i.e., a contingent deferred sales charge (CDSC)), or as a combination thereof. 2 2. Upfront, ongoing and CDSC fees are discussed below as distribution fees. 3. Distributors may incur costs such as commission charges for the performance of sales and/or distribution services by sales representatives (its employees) or third-party distributors on their behalf. Identify the contract with a customer (FASB ASC 606-10-25-1 through 25-8) 4. Selling and/or distribution commissions and fees are generally stated in written agreements such as selling and/or distribution agreements. To determine whether the written agreement meets the definition of a contract with a customer within the scope of the revenue standard, an entity should consider the criteria in FASB ASC 606-10-25-1: 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 1 Such funds can have varying strategies (e.g., investment grade bonds, emerging market, high-yield and distressed among others.) 2 For example, 12b-1 fees may be combined with CDSC fees that decline over time.
d. The contract has commercial substance e. Collection of the consideration is probable 5. FASB ASC 606 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. In this regard, a fund typically contracts with a distributor to, over a period of time, sell and/or distribute securities on its behalf (in exchange for specified commissions and fees), which is the distributor s ordinary business activity. Given this contractual relationship and consideration of the indicators in the section Determining the Customer in an Asset Management Arrangement in paragraphs 4.1.01-4.1.10 of the Asset Management chapter of the AICPA Audit and Accounting Guide: Revenue Recognition, FinREC believes that the fund will generally be the distributor s customer for purposes of applying FASB ASC 606. For purposes of this issue, the fund is considered the customer under the selling and/or distribution contract with the distributor. However, entities should consider their own contracts and related facts and circumstances when identifying the customer. 6. Distribution contracts are typically terminable upon notice by either party without incurring a significant termination penalty. When the distributor gives or is given notice of termination, the contract ceases at the end of the notice period, typically 60-90 days. In the event that the distributor is terminated by the fund, the distributor may still be entitled to ongoing fees so long as the investors it placed in the fund remain invested. These ongoing fees terminate only if/when the investor terminates the distributor as their broker of record. FASB ASC 606-10-25-3 explains that when a contract has no fixed duration and can be terminated or modified by either party at any time, an entity should apply the guidance in FASB ASC 606 to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations. Identify separate performance obligations (FASB ASC 606-10-25-14 through 606-10-25-22) 7. Services promised in a selling and/or distribution contract generally include 1) the sale of fund interests, 2) marketing services and 3) other shareholder services. Marketing services may include development, formulation and implementation of marketing and promotional activities, preparation, printing and distribution of prospectuses and reports. In some cases, distribution contracts may also include ongoing shareholder services such as processing of shareholder transactions and the maintenance of shareholder records. Depending on the promises within a selling and/or distribution contract, the distributor may identify a single performance obligation or multiple performance obligations. 8. Each distributor should consider the specific terms of a given selling and/or distribution contract and identify performance obligations as defined in FASB ASC 606-10-25-14. In order to evaluate the performance obligations included in a selling and/or distribution contract, the distributor should identify the goods or services promised to the customer and evaluate the nature of these promises to the customer. In making this assessment, consideration may need to be given to the guidance on combination of contracts in FASB ASC 606-10-25-9 when the different types of services are contracted separately but at or near the same time with the customer. 9. As discussed in FASB ASC 606-10-15-14, a performance obligation is a promise to transfer to the customer either: a. A good or service (or a bundle of services) that is distinct, or b. A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. 10. Each of the services included in a contract should be analyzed under paragraphs 19-22 of FASB ASC 606-10-25 to determine whether it is a distinct service that represents a performance obligation that should be accounted for separately. 11. The nature of the distributor s overall promise in the contract is to provide marketing services in conjunction with the sales of shares. In order to sell shares to investors, the distributor may develop and formulate marketing materials related to the fund offering. Generally, the marketing and selling of the shares are performed by the same distributor where the distributor is paid only upon a sales of shares with no separate fee for marketing. 12. As the success of selling shares is highly dependent upon the marketing efforts, sales and marketing are highly interrelated and interdependent on one another as the purpose of marketing is to solely sell shares. The distributor integrates marketing and selling services to provide the combined output of selling the shares for which the customer has contracted. In other words, the entity is using the services as inputs to deliver the combined output specified by the customer. Therefore, FinREC believes both sales and marketing generally would not be considered separately
identifiable based on FASB ASC 606-10-25-19(b) and 606-10-25-21(c). However, individual facts and circumstances of specific agreements and arrangement should be carefully evaluated. 13. As noted in paragraph 7, a distribution agreement generally includes 1) the sale of fund interests, 2) marketing services and 3) other shareholder services. As noted in paragraph 12 above, FinREC believes that generally the sale and marketing services are combined to make one performance obligation. Judgment and additional analysis is required when determining whether shareholder services meet the definition of a performance obligation that is separately identifiable under FASB ASC 606-10-25-21. See paragraphs 23 and 27 below. Determine the transaction price (FASB ASC 606-10-32-2 through 606-10-32-27) 14. A distributor s compensation for selling and/or distribution services is established by the contract between the distributor and the fund and is normally included in the prospectus written by the fund. Contracts may be structured with distribution fees that become determinative (i.e., uncertainty resolved) at different times, including upfront, over time, upon an investor s redemption, or a combination thereof. 15. Upfront distribution fees are generally a fixed percentage of the share price. In this manner the transaction price for upfront fees is fixed at the date the shares are sold to the investor. 16. A distributor s compensation from ongoing distribution fees received is generally variable. The fee is generally calculated as a fixed percentage of the then current value of the shares and received on an ongoing periodic basis so long as the investor remains invested in the fund. 3 The total amount of compensation is dependent on the value of the shares at future points in time as well as the length of time the investor remains in the fund. 17. A distributor s compensation from CDSCs is generally variable. CDSCs may be paid upon an investor s exit from the fund. The amount of compensation generally varies based on the length of time the investor remained in the fund as well the value of the shares at the time of redemption. 18. FASB ASC 606-10-32-11 requires that an entity include variable consideration in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. 19. FASB ASC 606-10-32-12 provides factors to consider when assessing whether variable consideration should be constrained based on the likelihood and the magnitude of a revenue reversal. 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, and the judgment or actions of third parties. b. The uncertainty about the amount of consideration is not expected to be resolved for a long time. c. The entity s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value. d. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. e. The contract has a large number and a broad range of possible consideration amounts. 20. Distributors should evaluate whether the estimated variable consideration should be constrained (i.e., excluded from the transaction price and hence from revenue recognition) in accordance with the factors noted above. 21. FinREC believes if contracts with customers are characterized by the following factors, then it is likely that a distributor s circumstances would result in a constraint of the variable consideration, as variable consideration is included in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved: 3 Generally, the distributor must also remain the broker of record in order to be entitled to the fee.
a. Variable consideration in selling and/or distribution contracts is highly susceptible to factors outside the distributor s control such as the market value of the fund s shares at future points in time and the length of time the investor will remain invested in the fund. b. There is uncertainty as to the amount of ongoing distribution fees and CDSCs and this uncertainty is not expected to be resolved for a long time. However, a portion of the fees will become fixed and no longer constrained when the uncertainty is resolved at subsequent dates. c. Despite a distributor s historical experience with similar contracts, that experience generally would be of little predictive value in determining the future market value of investor shares or the period of time an investor will hold investments. d. The ongoing distribution fees and CDSCs generally have a large number of and a broad range of possible amounts. Allocate the Transaction Price to Performance Obligations (FASB ASC 606-10-32-28 through 606-10-25-35) 22. Generally, the nature of the distributor s overall promise in the contract is to sell the security and provide marketing services which generally form a single performance obligation as noted in paragraph 13. As noted in paragraph 12, judgment and additional analysis is required when assessing whether shareholder services are distinct in terms of the contract and therefore meet the definition of a performance obligation. 23. If shareholder services do not meet the definition of a performance obligation that is distinct in terms of the contract, FinREC believes the distribution arrangement will generally only have one performance obligation that generally includes sales, marketing and shareholder services. If shareholder services meet the definition of a performance obligation that is distinct, FinREC believes the distribution arrangement generally includes two performance obligations: sales and marketing combined as one performance obligation and shareholder services as a separate performance obligation. 24. In accordance with FASB ASC 606-10-32-29, when there are multiple performance obligations, the distributor should determine the standalone selling price of each performance obligation and allocate the transaction price in proportion to those standalone selling prices. Paragraphs 31-35 of FASB ASC 606-10-32 provide guidance on allocating the transaction price to multiple performance obligations. 25. Variable consideration (and subsequent changes to that amount) should be allocated entirely to one or more, but not all, performance obligations or to one or more, but not all, distinct services promised in a series of distinct services that forms part of a single performance obligation, if both of the following criteria in FASB ASC 606-10-32-40 are met: a. The terms of the variable payment relate specifically to the entity s efforts to satisfy the performance obligation or transfer the distinct good or service, and b. Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective in FASB ASC 606-10-32-28 when considering all of the performance obligations and payment terms in the contract. 26. FASB ASC 606-10-32-28 explains that the objective of allocating the transaction price to performance obligations is to allocate an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. 27. If the distributor concludes that there are two performance obligations, one for sales and marketing and one for ongoing servicing, the transaction price should be allocated between the two performance obligations and the amount allocated to servicing recognized as discussed in FASB ASC 606-10-32-28. Recognize revenue when (or as) the entity satisfies a performance obligation (606-10-25-23 through 606-10-25-37 and 606-10-32-1) 28. For each performance obligation, in accordance with FASB ASC 606-10-25-24 the distributor is required to determine whether that performance obligation is satisfied over time or at a point in time. If the criteria listed in FASB ASC 606-10-25-27 for performance obligations satisfied over time are not met, then the performance obligation is considered to be satisfied at a point in time.
29. This analysis will vary depending on the services promised in a contract. For example, if the distributor s sole performance obligation is the sales of securities to investors, performance obligations may be considered to be fulfilled at a point in time (i.e., trade execution date). Once the trade is executed (e.g., shareholders purchase the securities), the distributor has a present right to payment from the fund (although certain of the fees may be variable based on future events). Additionally, once the trade is executed, the fund has the risks and rewards of the services provided (by accepting the shareholder s investment in the security). 30. If the contract promises shareholder services that meet the definition of a separate performance obligation, FinREC believes the performance obligation for providing shareholder services should be considered to be satisfied over time as the customer is simultaneously receiving and consuming the benefits provided by the distributor as the distributor performs this service in accordance with FASB ASC 606-10-25-27(a). Cost Recognition 31. Distributors often pay sales commissions to external distributors or its internal sales representatives for distribution and sales of securities on their behalf. FASB ASC 606-10-15-5 refers to FASB ASC 340-40 for guidance on costs incurred that relate to contracts with customers. In addition, FASB ASC 946-720-25-4 also provides guidance on accounting for certain distribution costs. Distributors should evaluate the nature of the contracts and associated costs to determine whether Topic 946 or Topic 340 applies. 32. FASB ASC 340-40-25 provides accounting guidance for two categories of costs related to contracts with customers: 1) incremental costs of obtaining a contract and 2) costs to fulfill a contract. If the fund is determined to be the customer in the contract, FinREC believes that sales commissions are costs to fulfill a contract, because the contract with the fund is already in place. 33. Costs incurred in fulfilling a contract with a customer that are within the scope of another Topic should be accounted for in accordance with those other Topics or Subtopics. In this regard, for sales commissions paid to third-party subdistributors, consideration should be given to the applicability of FASB ASC 946-720-25-4. FASB ASC 946-720-25-4 provides guidance on the accounting for distribution costs for mutual funds with no upfront fees. The term distribution costs as used in FASB ASC 946-720-25 is interpreted in practice to refer to costs related to third-party service providers. This understanding is also acknowledged by the FASB in paragraph BC303 of FASB ASU 2014-09, where this specific paragraph is mentioned in relation to sales commissions paid to third-party brokers. If FASB ASC 946-720-25-4 applies, then incremental direct costs, such as sales commissions, should be deferred and amortized, and indirect costs expensed. For a similar analysis of deferred distribution commission expenses, refer to the discussion in the Deferred Distribution Commission Expenses ( back-end load funds ) section in paragraphs 4.7.01-4.7.10 in the Asset Management chapter of the AICPA Audit and Accounting Guide: Revenue Recognition. 34. Other costs incurred to fulfill a contract with a customer that are not within the scope of another Topic should be assessed to determine if the costs meet the criteria of FASB ASC 340-40-25-5. FinREC believes that sales commissions do not meet the criteria of FASB ASC 340-40-25-5 as the commissions do not generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future (sub-paragraph (b) of FASB ASC 340-40-25-5); therefore, sales commissions not in the scope of FASB ASC 946-720- 25-4 should be expensed when incurred. Comments should be received by March 1, 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 27707-8110. 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. 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