Accounting Standards Update No. 2014-09 Revenue from Contracts with Customers (“Topic 606”): What Investment Managers Need to Know

Who:  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 recognize revenue from the transfer of goods or services to customers.

What types of revenue are excluded from the scope of Topic 606?

Examples of revenue excluded from the scope of Topic 606 include:

• Realized and unrealized 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.
• 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. 

Impact of Topic 606 on recognition of incentive fees and allocations

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 (i.e., the incentive fee has “crystalized”).
• Method 2: Recognize revenue related to incentive fees on the reporting date “as if” the related investment fund liquidated and the incentive fee was 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 “crystalize” 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 crystalize 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.

Potential timing difference between the investment manager and the fund it manages

Application of Topic 606 may give rise to a timing difference between the accounting period in which incentive fee revenue is recognized by an investment manager in its management company books and records and the accounting period in which the corresponding expense or allocation is recognized by the fund. 

For example, assume a private equity fund provides for an incentive allocation upon the disposition of an investment.  As of 12/31/2018, the fund has yet to dispose of any investments, though they have appreciated in value since purchase.  Accordingly, as of 12/31/2018, 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, specialized 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 12/31/2018, 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 recognized by the investment manager whereas the corresponding allocation has been recognized by the fund.

Under what circumstances might Topic 606 impact an investment fund?

As we 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.

How will the new standard impact portfolio companies of private equity funds?

Revenue and other revenue-based figures such as 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.

Tell me more about this new five-step revenue recognition process

Under Topic 606, an entity will recognize 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.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

How do I know if I have a contract with a customer?

Topic 606 defines contract and customer:

• A contract is an agreement between two or more parties that creates enforceable rights and obligations.
• 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.

Additional information about the timing of implementation of Topic 606

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.

How does Topic 606 affect income taxes?

At present, the amount and timing of revenue recognized by investment management firms (including entities serving as general partners of investment funds) for U.S. 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.