The implementation of Topic 606 is designed to create a common revenue standard to improve comparability of revenue recognition across entities, industries, jurisdictions and capital markets. Todd Hankin, Matthew Maulbeck and Ben Leung of EisnerAmper examine what it is, what it does and its consequences.
Topic 606 will apply to all entities, including investment managers and general partners of investment funds.
What: It prescribes the method of accounting for revenue from contracts with customers.
When: It goes into effect for the year ending December 31, 2018 for nonpublic entities that report on a calendar-year basis.
Where: It may impact the amount and timing of revenue reported in an entity’s income statement.
Why: It creates a common revenue standard to improve comparability of revenue recognition across entities, industries, jurisdictions and capital markets.
How: An entity will use a five-step process to determine when, and in what amount, to recognise revenue from the transfer of goods or services to customers.
What is excluded?
"Investment managers will be required to delay recognition of revenue related to incentive fees until it is probable that a significant reversal of revenue will not occur."
Examples of revenue excluded from the scope of Topic 606 include:
• Realised and unrealised gains from investment securities and financial instruments (including debt and equity securities, private placements, investments in other funds and derivative contracts including options, futures, swaps and forward contracts);
• Interest and dividend income; and
• Income from lease contracts.
In other words, revenue from investment activities is unaffected by Topic 606.
How will Topic 606 impact investment managers and general partners of funds?
Topic 606 applies to revenue typically earned from providing investment management services (and revenue earned as a function of serving as the general partner of an investment fund), including asset-based management fee income, performance-based incentive fees (including incentive or carried-interest allocations earned from an investment fund or similar entity) and income from providing financial planning and consulting services.
Entities that receive performance-based incentive fees or allocations may see the most significant impact of Topic 606, as discussed in the following examples.
Under existing standards, either of the following methods is acceptable for recognition of incentive fees and allocations:
• Method 1: Defer recognition of revenue related to incentive fees until all contingencies have been resolved (ie, the incentive fee has ‘crystallised’).
• Method 2: Recognise revenue related to incentive fees on the reporting date ‘as if’ the related investment fund liquidated and the incentive fee were due on that date.
Topic 606 will require recognition of revenue related to performance-based incentive fees or allocations in a manner similar to Method 1. Consequently, investment managers will be required to delay recognition of revenue related to incentive fees until it is probable that a significant reversal of revenue will not occur, which would generally be the point at which the fees ‘crystallise’ and are no longer subject to ‘claw back’ or return to investors in the fund.
This will likely be most significant to managers of private equity funds whose incentive fees crystallise only upon the sale or other disposition of investments instead of upon the passage of time (for example, as of each year-end) and because such fees are often subject to claw-back.
Application of Topic 606 may give rise to a timing difference between the accounting period in which incentive fee revenue is recognised by an investment manager in its management company books and records and the accounting period in which the corresponding expense or allocation is recognised by the fund.
For example, assume a private equity fund provides for an incentive allocation upon the disposition of an investment. As of December 31, 2018, the fund has yet to dispose of any investments, although they have appreciated in value since purchase. Accordingly, as of December 31, 2018, despite an increase in value of the investments held by the fund, under Topic 606, the investment manager has determined that the incentive allocation has yet to meet the criteria for revenue recognition in its books and records because the investment manager is unable to conclude that it is probable that a significant reversal of the incentive allocation will not occur.
On the other hand, specialised investment company accounting guidance requires the fund to reflect the incentive allocation in the equity balances of its investors at each reporting date as if it had sold/liquidated all assets at current fair value, allocated all gains and losses and distributed the net assets to each investor. Accordingly, at December 31, 2018, the fund in this example would record an incentive allocation because its investments had appreciated in value and if it were to liquidate on that date an incentive allocation would be payable to the investment manager.
In this example, the difference between the revenue recognition criteria in Topic 606 applicable to the investment manager and the accounting followed by the fund produce an asymmetrical result because the incentive allocation has yet to be recognised by the investment manager, whereas the corresponding allocation has been recognised by the fund.
What about investment funds?
As noted previously, recognition of revenue from investment activities is unaffected by Topic 606. Consequently, the extent to which Topic 606 will impact investment funds is likely to be very limited. For example, an investment fund would apply Topic 606 in the rare circumstance that it enters into a contract with a customer to provide goods or services in exchange for consideration.
Revenue and other revenue-based figures such as earnings before interest, taxes, depreciation and amortisation (EBITDA) are typical inputs that private equity funds consider when estimating the fair value of investments in private portfolio companies. The implementation of Topic 606 may result in substantial changes to revenues reported by portfolio companies as well as improved comparability and the disclosure of more useful information about revenue. The implications of these changes and the possible impact to fair value estimates must be carefully considered.
The five-step revenue recognition process
Under Topic 606, an entity will recognise revenue to depict the transfer of 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.
Topic 606 prescribes a five-step process to achieve proper revenue recognition:
• Step 1: Identify the contract with a customer, where a contract is an agreement between two or more parties that creates enforceable rights and obligations, and a customer is 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.
• Step 2: Identify the performance obligations in the contract.
• Step 3: Determine the transaction price.
• Step 4: Allocate the transaction price.
• Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation.
Nonpublic entities are required to apply Topic 606 for annual reporting periods beginning on or after December 15, 2017 (in other words, December 31, 2018 is the first reporting date under the new standard for nonpublic entities that report on a calendar-year basis).
Public entities are required to apply Topic 606 for reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Nonpublic entities may elect to early adopt Topic 606 for reporting periods beginning after December 15, 2016 whereas early adoption is prohibited for public entities.
At present, the amount and timing of revenue recognised by investment management firms (including entities serving as general partners of investment funds) for US federal income tax purposes is unaffected by Topic 606. However tax laws are subject to change and entities are advised to stay tuned for future developments in this area.
Similar guidance was issued under International Financial Reporting Standard 15: Revenue from Contracts with Customers. IFRS 15 shall be applied for annual reporting periods beginning on or after January 1, 2017.
Topic 606, Cayman, EisnerAmper, Regulation