The new revenue recognition standard’s impact on brokers, fund managers

SUITS THE C-SUITE By Aidell R. Gregorio

Business World (08/22/2016 – p.S1/4)

International Financial Reporting Standards (IFRS) 15, Revenue from Contracts with Customers, is one of the latest global accounting developments that will have an impact on broker-dealers in securities and asset management entities. IFRS 15 may potentially change certain revenue recognition practices of brokers and fund managers, particularly in accounting for trade commissions, management and performance-based fees, and upfront fees. These potential changes may also affect their earnings per share ratio and other performance measures.

As an overview, under IFRS 15, an entity recognizes revenue to reflect the transfer of goods or services to its customers in the amount that reflects the consideration to which the entity expects to be entitled to in exchange for the goods or services. The impact of IFRS 15 may vary from one broker-dealer and fund manager to another, depending on their business activities, which are mainly anchored on fee-based revenues. Since this standard is more principles-based than the current revenue guidance, International Accounting Standards 18, Revenue,these entities will also need to exercise more critical judgment when considering the terms of the contracts with their customers.

TRADE COMMISSIONS

Broker-dealers buy and sell equity securities on behalf of their customers, and in return, charge commission fees for every trade executed. In the Philippines, the current practice for broker-dealers is that such commissions are recognized on the date of trade execution rather than the settlement date, which comes three days after the trade date. However, this practice may change when applying the concept of transfer of control under IFRS 15.

IFRS 15 refers to control of an asset as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Revenue is recognized when transfer of control is determined to have occurred. Thus, it is crucial for the entities to determine when control is transferred to their customers, as this will have an impact on the timing of revenue recognition of these entities.

Under IFRS 15, there are two views on the timing for the recognition of commission fees from trade executions.

One view is the settlement date recognition. Under this view, control is not yet transferred to the customer until the broker-dealer has satisfied its performance obligations (i.e., the promise to deliver the security purchased and the proceeds from the sale of the security) on the settlement date.

The other view is the trade date recognition. Under this view, the service being transferred is the trade execution service (not the delivery of the security or the sale proceeds). Control is transferred on the trade date, i.e. the date when the broker-dealer has fulfilled its performance obligations, which are filling out the customer’s order and entering into a trade contract on behalf of that customer.

While this issue is yet to be resolved, broker-dealers may need to prepare for significant changes in their current accounting systems if it is determined that transfer of control occurs on the settlement date, rather than the trade date.

BASE MANAGEMENT AND PERFORMANCE-BASED FEES

Fund managers generally earn base management fees based on the net asset value (NAV) of the fund calculated at the end of each reporting period (e.g.,quarterly). In some contracts, fund managers may include terms to charge the funds that they are managing if the NAV of the funds has met or exceeded a benchmark or a performance threshold. These fees are referred to as “performance-based fees,” which are almost like a bonus given to the fund manager for outperforming the expected level of NAV. Both the base management fees and the performance-based fees are variable in nature since these are derived from either the NAV or as a percentage of the net operating results of the funds. Some contracts where the fund managers earn performance-based fees may also include “clawback” provisions, where distributions received from the fund may need to be returned if a performance measure is not met.

IFRS 15 limits the amount of variable considerations to be included in the transaction price unless it is highly probable that a significant revenue reversal will not subsequently occur. Since both base management and performance-based fees are highly dependent on market forces and are outside the fund managers’ influence, both fees cannot be included outright in the transaction price at contract inception, unless the fund managers can conclude that it is highly probable that the said fees will not reverse in the future.

What is critical in this procedure is how the fund managers will apply judgment, as they need to assess each contract for the likelihood and magnitude of any revenue reversal. In assessing whether a significant revenue reversal will or will not occur, fund managers should consider certain factors, such as whether the fund is near final liquidation, the fair value of the fund assets is significantly higher than the threshold for the performance fee, or if there is an insignificant risk of change in values of the fund assets. If the fund manager cannot conclude or is uncertain that there will be no significant revenue reversal in the future (as in the case of contracts with clawbacks), then IFRS 15 limits the recognition of the performance fees, even if cash has already been received.

UPFRONT FEES

Some fund managers earn upfront fees, in the form of sales commissions, when they sell the shares of their managed funds to investors.

Under IFRS 15, fund managers should consider the following in recognizing upfront fees: (1) identifying the customer; and (2) determining whether the promised services under the contract with that customer represent separate performance obligations. IFRS 15 suggests that goods and services are separate when they are distinct by themselves and can be separately identifiable from other promises in the contract.

For each contract, fund managers will need to identify first who the customer is, which may either be the funds that they are managing or the investors of those funds. In most cases, the funds are the customer of the fund managers since it is the funds (and not the investors) that enter into the contracts for outside services.

Also, some fund managers may market and sell shares separately from the asset management services, while some might bundle these services into one as a promotional tool. If the marketing and sale functions are assessed to be distinct from the management services, the upfront fees shall be recognized outright. However, complications will arise if such functions are done to support the management services and the consideration received for the upfront fees is non-refundable. In this case, the consideration received at contract inception is treated as an advance payment for management services and will only be recognized as revenue as the management services are rendered.

MOVING FORWARD

As with any other accounting standard changes, implementation efforts of entities during the early stages will be tedious and costly. The impact may go beyond the finance functions and may affect certain existing customer relationships. Entities are given two years to assess the impact of IFRS 15 on their financial reporting as the standard becomes effective beginning Jan. 1, 2018.

It is therefore advisable that as early as now, brokers and fund managers may need to evaluate the terms of their existing customer contracts, especially those that are expected to still be outstanding when IFRS 15 becomes effective. Most important, brokers and fund managers are encouraged to consider the provisions under the standard when they enter into new contracts, balancing the pressures of compliance against the need to maintain strong and positive business relationships with their customers.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Aidell R. Gregorio is a Senior Director of SGV & Co.