4.1.01 Step 1 of the revenue recognition process under FASB ASC 606 is to “Identify the contract with a customer.” FASB ASC 606-10-25-2 notes that, “a contract is an agreement between two or more parties that creates enforceable rights and obligations.” The FASB ASC master glossary defines customer as “a party that has contracted with an entity to obtain good or services that are an output of the entity’s ordinary activities in exchange for consideration.”

4.1.02 Determining which party is the customer is an important consideration. The asset management industry is somewhat unique in that an asset manager generally enters into contracts with funds, but the funds are vehicles that enable investors to pool their money through the funds in order to benefit from an asset manager’s services. This situation raises the question as to whether the fund or the investor would be viewed as the customer. This determination could affect the following:

•     The timing of revenue recognition (for example, if an asset manager has multiple contracts or promises in a contract, that would either be accounted for separately or together, depending on who the customer is for each individual contract or promise).

•     The accounting for certain costs (for example, costs associated with launching a new fund or obtaining new investors could be either expensed as incurred or capitalized depending on whether they are associated with obtaining customers or fulfilling performance obligations).

4.1.03 FASB and the IASB discussed this question during a public meeting. A staff paper dated January 28, 2013, noted the following:

Since there is a wide spectrum of asset management arrangements, the terms and conditions of these arrangements could result in the upfront commission costs paid by an asset manager in a back-end load fund being interpreted as either fulfillment costs or contract acquisition costs. The staff noted that this distinction revolves around whether the distribution and investment management services provided by the asset manager are accounted for as separate performance obligations or a single performance obligation. Additionally, the assessment is impacted by who is determined to be the customer in these arrangements, the fund or the individual investor.

4.1.04 The staff held a public meeting in connection with this staff paper. During the meeting FASB and the IASB once again acknowledged the need to identify the customer but refrained from offering a view. The boards noted that given the wide variety of potential structures, there could be situations where the fund is the customer and other circumstances may lead to a conclusion that the investor is the customer.

4.1.05 Entities will need to consider the specific facts and circumstances of each arrangement in evaluating whether the investor or the fund is the customer. To assist in this evaluation, the indicators below have been developed for use by the asset management industry, and may be used as a framework to assist preparers in applying judgment to their specific facts and circumstances. These lists are not intended to be all inclusive and should not be viewed as checklists. The existence or absence of any one indicator should not be considered determinative. The substantive nature of indicators should also be considered. That is, weight given to the existence of any indicator should be commensurate with its meaningfulness in the context of the given contract. For example, the existence of a manager removal right could reflect either legally-imposed restrictions or an investor’s influence over the terms of the contract. Judgment will need to be applied and weights attributed to the indicators based on relevant facts and circumstances.

4.1.06 FinREC believes the following characteristics may support a conclusion that the fund is the customer:

a.     The fund is a separate legal entity that may be set up as a partnership, corporation, or business trust.

b.     The fund is governed by a board of directors or other form of governance, which is independent of management of the fund.

c.     Fee arrangements for management and advisory fees are negotiated by the fund and applied consistently by the investor class.

d.     A large number of potentially diverse investors is an indicator that the asset manager’s relationship is more directly with the fund.

e.     The fund lacks visibility as to who the ultimate investor is because investors have subscribed through a third-party broker-dealer’s omnibus account.

f.     The fund is highly regulated, as is the case with registered investment companies in the U.S.

g.     The asset manager and other service providers may have multiple different contractual arrangements with the fund to provide different services.

4.1.07 An example of a situation in which a fund is the customer would be a registered investment company with hundreds of investors, including relationships through omnibus accounts, whereby none of the investors are deemed to have influence over the contracts between the funds and their service providers.

4.1.08 Conversely, in certain situations, the investor (or investors) may be the customer if one considers the relationship holistically. FinREC believes that the following characteristics may suggest that the investor (or investors) is the customer:

a.     The asset manager enters into individual “side letter” arrangements regarding management fees with individual investors (as may be common in certain partnership structures).

b.     There is active negotiation of fees or interaction between the asset manager and individual investors or a small group of investors that control the fund’s activity directly or indirectly through their role on the board or governing body (that is, the investors as a group act together as the fund’s governance structure).

c.     The fund is not governed by a board of directors or other form of governance, which is independent of management of the fund.

d.     There is a single or a limited number of investors.

4.1.09 An example of a situation in which an investor may be considered the customer is a single investor fund where the investor has influence over the service arrangements, including pricing, and the design of the fund provides for no corporate governance through a board of directors or other form of governance, which is independent of management of the fund.

4.1.10 Ultimately, there is no single determinative factor when identifying the customer in relation to the revenue recognition guidance. Entities should be thoughtful about the specific facts and circumstances of each arrangement and apply a consistent approach in performing the evaluation.

4.1.11 Asset managers provide a number of services to customers, including, but not limited to, asset management, administration, and distribution:

a.     Asset management services include providing investment advice, research services, and conducting a continual program of investment, sale, and reinvestment of client assets, under a contract that is commonly referred to as the investment management agreement (IMA).

b.     Administrative services typically include fund accounting, preparation of financial statements, calculation of the net asset value of the fund, and other business management activities. These activities may be agreed upon pursuant to a separate administrative agreement or included within the IMA.

c.     Distribution services include underwriting and distribution of fund shares and other marketing and distribution activities. These other activities may include the preparation, printing and distribution of prospectuses, reports, and sales literature, and/or the preparation of information, analyses and opinions related to marketing and promotional activities. These activities are agreed upon under a sale or distribution agreement or explicitly stated in the fund prospectus.

Depending on the product and jurisdiction, some or all of these services may be included in a single contract (such as the fund prospectus, a governing document, or a standalone service agreement) or in multiple separate contracts. Additionally, the asset manager may enter into side letter agreements with various parties to modify the terms of the previously mentioned contracts (for example, the amount of consideration to which the entity is entitled).

4.1.12 FASB ASC 606-10-25-2 notes that, “a contract is an agreement between two or more parties that creates enforceable rights and obligations.” Industry considerations relevant and applicable to the customer assessment are discussed in detail within “Determining the Customer in an Asset Management Arrangement” in paragraphs 4.1.01–4.1.10. Upon the identification of the customer, evaluation of step 1 of FASB ASC 606 can proceed.

4.1.13 FASB ASC 606-10-25-1 contains the following criteria that must be met in order for an arrangement to be considered a valid contract with a customer subject to the revenue recognition framework of FASB ASC 606:

a.     The parties to the contract have approved the contract and are committed to perform their respective obligations;

b.     The entity can identify each party’s rights regarding the goods or services to be transferred;

c.     The entity can identify the payment terms for the goods or services to be transferred;

d.     The contract has commercial substance; and

e.     The asset manager believes it is probable that the consideration to which it will be entitled will be collected.

4.1.14 The absence of any of these criteria raises questions about whether the contract establishes enforceable rights and obligations, which is the premise on which the boards’ definition of a contract is based.

4.1.15 If a contract with a customer does not meet the criteria in FASB ASC 606-10-25-1 and an entity receives consideration from the customer, the entity should account for its rights and obligations in that contract pursuant to the separate recognition guidance in paragraphs 7–8 of FASB ASC 606-10-25. Additionally, FASB ASC 606-10-25-6 indicates the entity must continue to assess the contract to determine whether the criteria in FASB ASC 606-10-25-1 are subsequently met and hence the revenue recognition model can be applied.

4.1.16 Under FASB ASC 606-10-25-1, the IMA, administrative agreement, sale or distribution agreement and any relevant side letter agreements should be accounted for as contracts with a customer within the framework of FASB ASC 606 when all of the following characteristics are met:

a.     The parties to the agreement(s) have approved the agreement(s) and are committed to perform their respective obligations.

b.     The asset manager can identify the services it will transfer to the customer.

c.     The asset manager can identify the amount of consideration to which it will be entitled for the services it will transfer (for example, timing and amount of payments are specified in the contract).

d.     The agreement(s) have commercial substance.

e.     The asset manager believes it is probable that the consideration to which it will be entitled will be collected.

4.1.17 In certain cases, the asset manager may not enter into separate legal agreements with a customer for the provision of any or all of the services described previously. Instead, the fund prospectus, articles of incorporation or limited partnership agreement (collectively, the fund’s “governing documents”) may explicitly state the services to be provided by the asset manager. In these instances, FinREC believes that in the absence of separate legal agreements for the different promised services, the fund’s governing documents may also be considered a valid contract in accordance with FASB ASC 606-10-25-1 if they possess the following characteristics:

a.     The terms are mutually agreed upon by both parties.

b.     The fund’s governing documents state the rights of each party related to the services to be transferred to the customer and payment terms for consideration paid to the asset manager.

c.     The arrangement has commercial substance.

d.     The asset manager believes it is probable that the consideration to which it will be entitled will be collected.

4.1.18 When the asset manager or its related parties, or both, enters into separate agreements for asset management, administrative and sales and distribution services, consideration should be given to whether the contracts should be combined. In accordance with FASB ASC 606-10-25-9, the asset manager should combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:

a.     The contracts are negotiated as a package with a single commercial objective.

b.     The amount of consideration to be paid in one contract depends on the price or performance of the other contract.

c.     The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with paragraphs 14–22 of FASB ASC 606-10-25.

4.1.19 Generally, the various services provided by an asset manager or its related parties, or both, are negotiated concurrently with the customer, thereby meeting the criteria for contract combination under FASB ASC 606-10-25-9A. However, criteria in paragraphs 9A–9C of FASB ASC 606-10-25 may or may not be met depending on an asset manager’s facts and circumstances. In evaluating the criterion in FASB ASC 606-10-25-9C, particular attention should be given to the indicators in FASB ASC 606-10-25-21 and the related examples in the guidance to determine whether the services promised in the different contracts are separately identifiable.

4.6.01 Certain mutual funds may offer share classes that are sold without a front-end sales charge to investors upon subscription. These investors may instead be charged a contingent deferred sales charge (CDSC) if the investment is redeemed within a certain period. The CDSC is an asset-based fee received by the distributor upon the redemption of the investment during a contractual redemption period, representing consideration for sales and marketing (sales-related) costs incurred by the distributor upon initial sale of shares. The CDSC is calculated as a contractual percentage of the lesser of the redemption proceeds or original cost and may be reduced based on the duration of the investment. These fees are not subject to clawback subsequent to the redemption of the investment. While the investor effectively pays either the front-end load or CDSC, both are essentially a commission earned by the distributor from the fund for its distribution services—either reducing how much is remitted to the fund for a purchase of shares, or increasing how much is collected from the fund for a redemption of shares.

4.6.02 FinREC believes the CDSC fees represent revenue earned by the distributor from a contract with customers that is within the scope of FASB ASC 606.

4.6.03 The considerations for revenue recognition in accordance with FASB ASC 606 are the same for both the standalone distributor and the consolidated asset management entity.

4.6.04 Industry considerations relevant to the determination of the customer and applicable to this step are discussed in detail within “Determining the Customer in an Asset Management Arrangement” in paragraphs 4.1.01–4.1.10.

4.6.05 Additionally, services provided to the customer are generally described in the fund prospectus. Considerations relevant in evaluating the contract with the customer are discussed in detail within the section “Identifying the Contract With a Customer in an Asset Management Arrangement” in paragraphs 4.1.11–4.1.19.

4.6.06 Although each arrangement should be evaluated based on its unique facts and circumstances, for purposes of this analysis, the fund is assumed to be the customer. The distributor’s ordinary business activity is to sell or distribute these securities in exchange for sales and distribution revenue from the fund.

4.6.07 An entity should identify the performance obligations in existence within the contract. FASB ASC 606-10-25-14 describes a performance obligation as “…a promise to transfer to the customer either (a) a good or service (or a bundle of goods or services) that is distinct [or] (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.”

4.6.08 An entity should consider the specific terms of a given contract and the unique facts and circumstances of the arrangement when determining whether the services associated with the sale of the shares constitutes a performance obligation.

4.6.09 An entity should evaluate whether the service it promises to the customer is distinct based on the following two criteria in FASB ASC 606-10-25-19:

a.     The customer can benefit from the service either on its own or together with other resources that are readily available to the customer (that is, the service is capable of being distinct).

b.     The entity’s promise to transfer the service to the customer is separately identifiable from other promises in the contract (that is, the service is distinct within the context of the contract).

4.6.10 FinREC believes that sales-related services provided to the fund would generally be considered a single performance obligation (sales-related performance obligation). Considerations relevant to the identification of performance obligations associated with the sales-related services are included within Broker Dealer Issue 3-2: Selling and Distribution Fee Revenue.

Variable Consideration

4.6.11 FASB ASC 606-10-32-2 states

…The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both...

4.6.12 FASB ASC 606-10-32-33 further states “the nature, timing, and amount of consideration promised by a customer affect the estimate of the transaction price” and cites variable consideration and constraining estimates of variable considerations among the examples that would influence determining the transaction price.

4.6.13 In accordance with FASB ASC 606-10-32-6, the consideration paid for the sales-related services in the form of CDSC is variable as the entity’s entitlement to the consideration is contingent on the timing of redemption by the investor and the value of sales proceeds.

4.6.14 As required by FASB ASC 606-10-32-8, an entity should estimate the amount of variable consideration using one of the following two methods, determined at the start of the contract and updated, as appropriate, at each subsequent reporting period:

a.     The expected value of the contract determined by the probability-weighted amounts in a range of possible consideration amounts.

b.     The most likely amount equal to the single most likely amount in a range of possible consideration amounts.

The entity should consider its historical experience with similar arrangements in similar jurisdictions to estimate the expected range of outcomes. This historical experience should include an evaluation of investor behavior and fund performance.

Constraining the Cumulative Amount of Revenue Recognized

4.6.15 As discussed in FASB ASC 606-10-32-11, “an entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with FASB ASC 606-10-32-8 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”. Consistent with the factors listed in FASB ASC 606-10-32-12, while the distributor may have historical experience with arrangements, this history may have a low predictive value of the future investor redemption activity. Further, the amount of consideration is subject to certain contingencies outside the control of the entity, such as future market volatility and the timing of investor redemption during the contractual CDSC period, which can range from one year (for certain U.S. funds) to multiple years (for certain international funds). Additionally, given the terms of the consideration earned, there may be a broad range of possible consideration amounts and the amount is likely unknown until the time of investor redemption.

4.6.16 Variable consideration in the form of CDSC fees will be excluded from the transaction price until it becomes probable that there will not be a significant reversal of revenue recognized, which, as a result of the above factors, FinREC believes generally is not anticipated to happen until the fund redeems the investor’s shares.

4.6.17 The objective of allocating the transaction price is for an entity to assign the transaction price to each performance obligation in an amount of consideration to which the entity expects to be entitled. As described in paragraph 4.6.10, the sales-related performance obligation is generally considered a single performance obligation and, therefore, the entire amount of CDSC fee would be allocated to the sales-related performance obligation. If there are other distinct performance obligations identified in the contract, then consideration would need to be given to the factors in paragraphs 39–41 of FASB ASC 606-10-32 to determine how the CDSC fee would be allocated.

4.6.18 For each performance obligation, the distributor needs to determine whether that performance obligation is satisfied over 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. If the distributor’s performance obligation is the sale of fund shares and the ancillary sales and marketing activities undertaken as part of performing this service do not transfer a good or service to the fund, the sales-related performance obligation may be considered to be satisfied at a point in time (that is, trade execution date) in accordance with FASB ASC 606-10-25-30.

4.6.19 Management fees are generally asset-based fees received from managed accounts or from pooled investment vehicles (that is, funds) in exchange for asset management services. In addition to investment advisory services, in many cases, the asset manager is also responsible for ensuring the proper functioning of fund operations, which includes engaging and monitoring applicable third-party service providers who perform services such as record keeping, administration, custody, transfer agency, and fund accounting. These services allow the customer to continue operating and reporting in compliance with applicable laws and regulations. These services are performed and provide benefit to the customer consistently over a given time period.² The management fee is typically calculated as a percentage of gross or net assets at a point in time or the average of such assets over a given period (such as daily, monthly, or quarterly), and the billing terms of the fee (both timing [for example, in arrears or in advance] and frequency) are included in the IMA that is entered into between the asset manager and the customer. For example, an asset manager may be paid a fee per annum of 1 percent of daily net assets to manage a mutual fund for a 1-year time period. The mutual fund is required to pay 1/365 of 1 percent of each day’s net assets for every day that the asset manager manages the fund, with the fee payable the first of the following month. Application of the revenue recognition model in FASB ASC 606 to management fees in a contract with a customer to provide asset management services is illustrated in Example 25, Management Fees Subject to the Constraint, paragraphs 221–225 of FASB ASC 606-10-55.

4.6.20 For purposes of the following analysis, assume that entitlement to and amount of management fees do not depend on the performance of the investments under management meeting specified investment return thresholds and that there is no associated clawback provision.³

4.6.21 Considerations relevant to evaluating performance fees are discussed in detail within the section “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such As Carried Interest)” in paragraphs 4.6.55–4.6.81 and in the section “Incentive-Based Capital Allocations” in paragraphs 4.6.81–4.6.93 of this appendix.

4.6.22 Industry considerations relevant to determining the customer and evaluating the contract are discussed in detail within the section “Determining the Customer in an Asset Management Arrangement” in paragraphs 4.1.01–4.1.10 and the section “Identifying the Contract With a Customer in an Asset Management Arrangement” in paragraphs 4.1.11–4.1.19 of this appendix. FinREC believes that irrespective of whether the fund or investor is identified as the customer for purposes of applying FASB ASC 606 to the promise to provide asset management services, the identified performance obligations and corresponding accounting treatment discussed herein will not differ. However, the revenue recognition analysis may differ depending on the existence of other performance obligations and also application of the cost guidance in FASB ASC 340-40 may differ based on the nature of the cost.

4.6.23 When evaluating management fees, an entity should identify the performance obligations. FASB ASC 606-10-25-14 describes a performance obligation as “…a promise to transfer to the customer either:

a.     A good or service (or a bundle of goods or services) that is distinct.

b.     A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 606-10-25-15).”

4.6.24 For a promised good or service to be distinct, both of the following criteria in FASB ASC 606-10-25-19 must be met:

a.     The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

b.     The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

4.6.25 Several steps are involved in applying the preceding guidance, starting with identifying all the promised goods or services in the contract. Services promised to the customer may be described in an IMA or a prospectus, or both. Although in many cases all the promised goods or services might be identified explicitly in the contract, FASB ASC 606-10-25-16 notes that they may be implicit as well: “A contract with a customer also may include promises that are implied by an entity’s customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises create a reasonable expectation of the customer that the entity will transfer a good or service to the customer.” Moreover, FASB ASC 606-10-25-18 provides examples of promised services, including the following:

(d)     Performing a contractually agreed-upon task (or tasks) for a customer.

(e)     Providing a service of standing ready to provide goods or services . . . or of making goods or services available for a customer to use as and when the customer decides.

(f)     Providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party . . .).

4.6.26 An entity should consider the specific terms of a given IMA, and the unique facts and circumstances of the arrangement, including the entity’s prior business practices, when identifying explicit and implicit promises, in addition to the performance of asset management services.

4.6.27 Once promises in the contract have been identified, an entity must then identify the performance obligations. A promised service can be a performance obligation if it meets the distinct criteria either on

a.     a standalone basis, or

b.     a combined basis, together with other promises because either

i.     each service is not distinct (hence, they are “bundled” together), or

ii.     each service is distinct, but the criteria are met that require them to be accounted for as a series.

In all instances, the guidance on determining whether a promise is distinct in paragraphs 19–22 of FASB ASC 606-10-25 should be applied.

4.6.28 Consistent with Example 25 in FASB ASC 606-10-55-222, the promise to provide asset management services is considered a single performance obligation in accordance with FASB ASC 606-10-25-14(b) as it requires the provision of a series of distinct services that are substantially the same and have the same pattern of transfer (the services transfer to the customer over time and use the same method to measure progress—that is, a time-based measure of progress). The promise to provide asset management services often encompasses the provision of supporting administrative activities, such as providing regulatory compliance services, ensuring that the investment company complies with applicable stock exchange listing requirements, negotiating contractual agreements with third-party providers of services, overseeing the determination and publication of the investment company’s net asset value, and overseeing the preparation and filing of the investment company’s tax return (as applicable). These services are considered ancillary and part of the nature of the promised asset management service to the customer.

4.6.29 In evaluating the nature of the asset manager’s promise to provide asset management services, FinREC believes that the asset manager either explicitly or implicitly creates a reasonable expectation of the customer that the asset manager will provide oversight and overall management of the fund or portfolio of assets. Governing documents for funds, such as the prospectus, often explain that the asset manager has ultimate responsibility for managing each fund’s investment and business operations, subject to the oversight of the fund’s board (if applicable). Also, governing documents typically highlight that this authority has been delegated to the asset manager under a separate management agreement entered into with the fund. The asset manager often serves as manager of a fund pursuant to an investment advisory agreement or other management agreement entered into between them and the fund. Fund management responsibilities often involve negotiating the terms of and subsequently monitoring adherence to service provider agreements with third-party service providers (for example, custodian, fund administrator, transfer agent and registrar, auditor, distributor, and fund accountant), determining or confirming the net asset value of the fund and raising any material service performance issues (as well as possible resolutions) to the fund’s board, amongst other duties.

4.6.30 FinREC believes that each increment of asset management service is distinct because the customer can benefit from each day of service on its own and each day of service is separately identifiable. Each day’s service is separately identifiable because of the following:

a.     The asset manager does not provide an integration service between the days. Although the various underlying activities are generally coordinated and are inputs to the combined asset management service, each day that those combined activities are provided is not an input to a combined output. Also, the utility to the customer of asset management services performed on any given day is not significantly affected by such services performed on another day. Although certain services performed on any given day may affect actions that are ultimately taken on another day, such as investment research activities or analysis of ongoing market developments, they are not considered inputs to services performed on those other days because until the asset manager actually undertakes an action, (i) the customer does not receive the utility of prior activities undertaken, and (ii) prior activities may be rendered obsolete by current market events and reaction required to address customer needs.

b.     Each day does not modify or customize the services provided on another day.

c.     The days of service are generally not highly interdependent or interrelated because the entity can fulfill its obligations each day independent of fulfilling its obligations for the other days.

4.6.31 With respect to the “substantially the same” criterion, FinREC believes it is reasonable to conclude that each day of service is substantially the same because the nature of the asset manager’s promise to the customer is one overall service. Even if the individual activities that comprise the performance obligation vary from day to day, the nature of the overall promise is the same from day to day. Therefore, the asset manager has promised the daily investment management service (as opposed to promising to deliver a specified amount of each underlying activity) and the conditions are met for the promise to provide asset management services to represent a single performance obligation based on the series guidance in FASB ASC 606-10-25-15.

4.6.32 In accordance with FASB ASC 606-10-32-2, the total transaction price is the amount of consideration the asset manager expects to receive for performing asset management services and includes both fixed and variable amounts. The amount of the transaction price that the asset manager will recognize as revenue comprises management fees, and incentive or performance fees, if applicable. Any amount of fees that are variable are subject to the constraint described in paragraphs 11–12 of FASB ASC 606-10-32. Refer to the discussion of the accounting for performance fees in the section, in the section, “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such as Carried Interest).” As well, consideration should be given to any fee waivers, including expense caps. Considerations relevant to evaluating fee waivers, including expense caps, are discussed in detail within the section, “Management Fee Waivers and Customer Expense Reimbursements.”

Variable Consideration

4.6.33 In accordance with FASB ASC 606-10-32-6, consideration paid for asset management services in the form of management fees that is tied to a measure of assets or capital, such as assets under management (AUM), is variable consideration because the amount of these fees is subject to fluctuation based on changes in AUM.

4.6.34 As a form of variable consideration, management fees are estimated based on terms contained in the IMA as of contract inception. This estimate must be updated each financial statement reporting period (reporting period); for internal reporting purposes, more frequent updates may occur. FinREC believes that the expected value method (sum of probability weighted amounts) will best predict the amount of management fees that the asset manager will be entitled to given the large number of possible consideration amounts as discussed in FASB ASC 606-10-32-8. However, before including an estimate of management fees in the transaction price, consideration must be given to whether the constraint should be applied.

4.6.35 The amount of variable consideration that can be included in the transaction price is limited to the amount for which it is probable that a significant revenue reversal will not occur when the uncertainties related to the variability are resolved. The management fee is typically calculated based either (a) on AUM as of a date or dates within a given reporting period, or (b) on AUM for a period of time that is not greater than a reporting period. The element of variability relative to management fees relates to the fact that the fees are based on the AUM, and the AUM can vary each day. The date of the measurement period and reporting period will often align.

4.6.36 Consequently, the management fee, in its entirety, can usually only be included in the transaction price at the end of each reporting period. FinREC believes that prior to this date, estimate of the management fee likely would be constrained from inclusion in the transaction price based on the guidance in paragraphs 11–13 of FASB ASC 606-10-32. The promised consideration is dependent on the market and, thus, is highly susceptible to factors outside the asset manager’s influence. In addition, management fees typically have a large number and broad range of possible consideration amounts. Although the asset manager may have experience with similar contracts, that historical experience is of little predictive value in determining the future performance of the market.

4.6.37 For contracts with more than one performance obligation or that contain a single performance obligation comprised of a series of distinct goods or services, the transaction price must be allocated to each performance obligation or, if certain conditions are met, to each distinct good or service in the series (for example, to each daily provision of service). In accordance with FASB ASC 606-10-32-29, the transaction price should be allocated to each performance obligation identified on a relative standalone selling price basis (determined as of contract inception), except as specified for allocating discounts in paragraphs 36–38 of FASB ASC 606-10-32 and for allocating variable consideration in paragraphs 39–41 of FASB ASC 606-10-32.

4.6.38 In order to allocate a variable amount (and subsequent changes to that amount) 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, as in the case of a performance obligation to provide asset management services, both of the following criteria in FASB ASC 606-10-32-40 must be 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.

4.6.39 FASB ASC 606-10-32-28 states 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. Allocating management fees to each reporting period would meet the allocation objective because the amount allocated corresponds to the value provided to the customer for that period.

Satisfaction of the Performance Obligations

4.6.40 For each performance obligation, an entity shall determine at contract inception whether it satisfies the performance obligation over time or at a point in time, as explained in FASB ASC 606-10-25-24. The guidance in FASB ASC 606-10-25-27, and related paragraphs, is applied to determine whether a performance obligation is satisfied over time. Applying this guidance to a series of distinct goods or services that collectively represents a single performance obligation means that each of those promised goods or services must be a performance obligation satisfied over time (FASB ASC 606-10-25-15(a)). The nature of the promise in providing the services informs the unit of accounting to which the guidance on satisfaction of a performance obligation applies. With respect to the promise to provide daily asset management services, each increment of service performed (that is, each daily investment management service) is the applicable unit of accounting to which the three criteria in FASB ASC 606-10-25-27 is applied. The three criteria are as follows:

a.     The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs 5–6 of FASB ASC 606-10-55).

b.     The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced (see FASB ASC 606-10-55-7).

c.     The entity’s performance does not create an asset with an alternative use to the entity (see FASB ASC 606-10-55-28), and the entity has an enforceable right to payment for performance completed to date (see FASB ASC 606-10-55-29).

4.6.41 FinREC believes that each increment of asset management service (that is, each daily provision of service) is satisfied over time because the customer simultaneously receives and consumes the benefits of the advisory services in accordance with FASB ASC 606-10-25-27(a), as another entity would not need to substantially re-perform any of the services performed to date and the customer can benefit from each day of service on its own.

Measuring Progress Toward Complete Satisfaction of a Performance Obligation

4.6.42 For performance obligations satisfied over time, the entity should determine how to measure progress towards complete satisfaction of the performance obligation. FASB ASC 606-10-25-31 states that the objective when measuring progress is to depict the transfer of services to the customer (that is, the satisfaction of an entity’s performance obligation).

4.6.43 FinREC believes that a time-based measure of progress should be applied when measuring progress toward complete satisfaction of the asset management services performance obligation (and, hence, for recognizing as revenue management fees). Consistent with FASB ASC 606-10-55-222 of Example 25, asset management services constitute a single performance obligation pursuant to the series provision in FASB ASC 606-10-25-14(b) because not only is the asset manager providing a series of distinct services that are substantially the same (that is, daily asset management services), but those distinct services have the same pattern of transfer. Daily asset management services have the same pattern of transfer because (a) they are transferred to the customer over time, in accordance with FASB ASC 606-10-25-27, and (b) use the same method to measure progress—a time-based measure of progress.

4.6.44 Entities should consider the guidance in paragraphs 36–37 of FASB ASC 606-10-25 and then conclude whether their selected methodology is a reasonable measure of progress toward complete satisfaction of the performance obligation. As stated in FASB ASC 606-10-25-36, an entity should only recognize revenue for its performance if it can reasonably measure progress toward complete satisfaction of the performance obligation. Accordingly, the method used to measure progress should be based on reliable information.

4.6.45 The following example for management fees is meant to be illustrative, and the actual determination of the amount and timing of fees recognized in revenue should be based on the facts and circumstances of an entity’s specific situation.

Example 4-6-1—Management Fees

Pursuant to an IMA, an asset manager is paid a fee per annum of 1 percent of daily net assets to manage a mutual fund for a one-year time period. The mutual fund is required to pay 1/365 of 1 percent of each day’s net asset value for every day that the asset manager manages the fund, with the fee payable in arrears (the first business day of each following month). The days of asset management service collectively form a single performance obligation pursuant to the series guidance. This is because the service performed each day is substantially the same and has the same pattern of transfer to the customer (over time). Each period of service lasts one day, asset management services are performed every business day, and the customer receives and consumes the benefits of the performed services as the asset manager provides them. The transfer of services is continuous, and the asset manager has a right to consideration from the fund in an amount that corresponds directly with the value to the fund of the asset manager’s performance completed to date. Accordingly, the criteria in FASB ASC 606-10-32-40 relating to the allocation of variable consideration would likely be met. If so, the asset manager should allocate the transaction price and recognize revenue relating to the performance of daily asset management services over the given month, calculated by multiplying the 1 percent management fee by the fund’s respective day’s net assets divided by the number of days in the year.

Example 4-6-1 is consistent with Example 25 of FASB ASC 606. Specifically, in FASB ASC 606-10-55-225, the guidance explains that “at the end of each quarter, the entity allocates the quarterly management fee to the distinct services provided during the quarter in accordance with paragraphs 39(b) and 40 of FASB ASC 606-10-32. This is because the fee relates specifically to the entity’s efforts to transfer the services for that quarter, which are distinct from the services provided in other quarters, and the resulting allocation will be consistent with the allocation objective in FASB ASC 606-10-32-28.”

4.6.46 Similar to a traditional management fee arrangement, a unitary management fee arrangement involves the asset manager performing asset management services as well as other services associated with operations of a fund. The main difference is that the asset manager also agrees to pay for certain specified operating services in exchange for the unitary fee. As explained subsequently, the preceding analysis for management fees applies equally to unitary management fee arrangements; notable exceptions or additional analysis points are indicated.

4.6.47 A “unitary fee” may also apply in other scenarios. For example, a single fee may only cover the provision of operating services. Alternatively, a single fee may cover investment advisory services and fund administration services but not other related services such as custody and transfer agency services. Key to the evaluation of all unitary fee arrangements is the determination of the nature of the overall promise to the customer. Irrespective of how contracts are arranged, if a single fee is paid to an asset manager that covers more than one service, the asset manager must determine if the promise in the contract is to transfer to the customer either (a) each of the underlying services, or (b) a combined service to which the promised goods or services are inputs. Note that for some situations, an additional assessment on combination of contracts may be required. For purposes of this section, the focus is on unitary management fee arrangements that include payment for investment advisory services as well as a number of operating services.

Background—Unitary Management Fee Arrangements

4.6.48 Unitary investment management fees are generally asset-based fees received from certain managed funds, managed exchange-traded funds (ETFs), and common collective trust funds (CCTFs) for the provision of investment advisory as well as management or payment of certain specified other operational expenses, or both. As with management fees, the unitary management fee is typically calculated as a percentage of gross or net assets at a point in time or the average of such assets over a given period (such as daily, monthly, or quarterly), and the billing terms of the fee (both timing [in arrears or in advance] and frequency) are included in a management agreement between the asset manager and the customer. The fund or unit trust is typically deemed to be the customer under Step 1 of the revenue recognition model.

4.6.49 Similar to management fee arrangements, in a unitary management fee arrangement, the asset manager is appointed as manager with all the powers, duties, and discretions exercisable in respect of the management of the fund or unit trust. As manager, they are typically responsible for ensuring the operation of the fund or unit trust, irrespective of who performs the services.

4.6.50 Under unitary management fee agreements, investors are aware that a single fee is being charged, the fee is paid to the asset manager in its capacity as manager, and the fee covers payment for certain operational expenses. Example operating services covered by the unitary management fee include administrative services such as ongoing record keeping, custodianship of assets, transfer agency and registry services, regulatory filing, audit and tax advisory services, accounting services, printing, information services, and distribution services. Investors may be made aware of the identity of some appointed third-party service providers for certain delegated operating services because that information may be disclosed in the prospectus (for example, the administrator or custodian). Irrespective of whether the manager performs the operating services or delegates them, the services are all performed for and provide benefit to the fund or unit trust (that is, the customer) consistently over a given time period.

4.6.51 Notably, the same operating services that are covered by the unitary management fee are performed on behalf of the fund under management fee arrangements. The main difference between these two types of arrangements is the entity that makes payment for operating expenses (that is, the asset manager versus the fund). The primary reason for having two types of “payment arrangements” is the fund’s ability to manage its cost. Under unitary fee management fee arrangements, the onus is on the asset manager to manage operating costs. They are responsible for any costs that cannot be covered by the unitary fee they receive as payment for managing the fund (that is, by the unitary management fee). Comparatively, under management fee arrangements, the fund is exposed to cost overruns, subject to limitations in the form of expense caps. Depending on facts and circumstances related to a given fund, shareholders may prefer one arrangement over the other.

4.6.52 Whether the unitary management fee revenue should be presented gross or net of the cost of outsourced operating services requires an analysis of the principal versus agent criteria in paragraphs 36–40 of FASB ASC 606-10-55. Industry considerations relevant to evaluating presentation of unitary management fees are discussed within the section “Asset Management Arrangement Revenue—Gross Versus Net” in paragraphs 4.6.94–4.6.107.

4.6.53 The following example for unitary management fees is meant to be illustrative, and the actual determination of the amount and timing of fees recognized in revenue should be based on the facts and circumstances of an entity’s specific situation. For purposes of the following analysis, assume that entitlement to and amount of the unitary management fee do not depend on the performance of the investments under management meeting specified investment return thresholds and that there is no associated clawback provision.

Example 4-6-2—Unitary Management Fees

Step 1: Identify the Contract With a Customer

Refer to the discussion of this step in preceding example 4-6-1. The same assessment applies to unitary management fee arrangements.

Step 2: Identify the Performance Obligations in the Contract

FinREC believes that a similar assessment to the example example 4-6-1 for management fees applies to unitary management fee arrangements. The main difference is that under unitary management fee arrangements, the asset manager receives a higher management fee designed to encompass the additional costs associated with discharging payment to third-party service providers (this is typically explained in the fund governing documents). To the extent the cost of services provided by a third-party service provider exceeds the asset manager’s anticipated amount budgeted as part of its unitary management fee, such excess is paid out of the asset manager’s assets. In comparison, under a management fee contract, the fund typically directly pays the operating service costs. Nonetheless, the nature of the asset manager’s promise is the same in either instance. It is the promise to stand ready or provide a single service until the arrangement is terminated by either party or until the fund is dissolved, pursuant to contractual terms (also see the preceding discussion under management fees). This additional service of discharging payment occurs concurrently with the traditional investment advisory services and has the same pattern of transfer, making the accounting evaluation similar to that for management fees and consistent with Example 25 in paragraphs 221–225 of FASB ASC 606-10-55.

Some of the operating services over which the asset manager is responsible for paying may be performed primarily during a particular time or times of the year, for example, audit and legal services and regulatory filing services. As well, payment for these services may only be made at these times. However, there are typically aspects of such services that are performed throughout the year, as other asset management-related services are performed.

When evaluating the nature of the promise to the customer, FinREC believes that if disclosure in the governing documents is made of the amount of the unitary fee attributable to each operating service covered by the unitary management fee, then this disclosure should not, in and of itself, dictate the identification of distinct goods or services.

Because the nature of the asset manager’s promise in a unitary fee arrangement is to provide day-to-day management of a fund, the promise involves the provision of a number of services that collectively represent the complete service promised to the customer. Underlying services may include investment advisory services, accounting services, preparing proxies, printing prospectuses, providing distribution services, and custodian and transfer agency services. All of these underlying activities could significantly vary within a day or from day to day; however, that is not relevant to the evaluation of the nature of the promise. In this regard, the nature of the contract is to provide integrated fund management services, inclusive of investment advisory services and certain operating services, as opposed to a specific quantity of specified services. Similar to management fee arrangements, FinREC believes that it is reasonable to conclude that each day of service is substantially the same. That is, even if the individual activities that comprise the performance obligation vary from day to day, the nature of the overall promise is the same from day to day. The daily services are those activities that are required to satisfy the asset manager’s obligation to provide an integrated fund management service. FinREC believes that a similar assessment to the preceding assessment for management fees applies in these instances.

Refer to the discussion in example 4-6-1 for determining satisfaction of the performance obligations, measuring progress toward complete satisfaction of a performance obligation, determining the transaction price, and allocating the transaction price to performance obligations. The same assessment applies to unitary management fee arrangements.

4.6.54 Incentive or performance fees (collectively, performance fee) represent variable consideration paid by the customer for asset management services when the performance of the fund or separate account exceeds a specified benchmark or contractual hurdle over a contractual performance period or the life of the fund. These fees may be calculated as a percentage of AUM, the market appreciation of the fund or separate account, or other criteria. For a discussion on incentive-based capital allocations, refer to section “Incentive-Based Capital Allocations” in paragraphs 4.6.81–4.6.93.

4.6.55 Example 25 in paragraphs 221–225 of FASB ASC 606-10-55 illustrates application of the guidance on variable consideration to performance fees. As noted in this FASB ASC 606-10-55-224, performance fees paid as consideration for asset management services may not be included in the transaction price because “the variability of the fee based on the market index indicates that the entity cannot conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur if the entity included its estimate of the incentive fee in the transaction price.”

4.6.56 Industry considerations relevant to the determination of the customer and applicable to this step are discussed in detail within the section “Determining the Customer in an Asset Management Arrangement” in paragraphs 4.1.01–4.1.10.

4.6.57 Additionally, considerations relevant in identifying the contract with the customer are discussed in detail within the section “Identifying the Contract With a Customer in an Asset Management Arrangement” in paragraphs 4.1.11–4.1.19. Notably, services provided to the customer may be described in either a governing document, such as the fund prospectus, or in a separate investment management agreement.

4.6.58 The asset manager should identify the performance obligations within the contract at inception of the contract. FASB ASC 606-10-25-14 describes a performance obligation as “...a promise to transfer to the customer either: (a) a good or service (or a bundle of goods or services) that is distinct, [or] (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.”

4.6.59 The asset manager should consider the specific terms of the contract and the unique facts and circumstances of the arrangement when determining the performance obligation to which the customer’s payment of performance fees relates, pursuant to the guidance in FASB ASC 606-10-25-14 and related paragraphs.

4.6.60 FASB ASC 606-10-25-19 requires a promised service to meet the following criteria in order to be distinct and, hence, to represent a performance obligation:

a.     The customer benefits from the service either on its own or together with other resources that are readily available to the customer (that is, the service is capable of being distinct).

b.     The asset manager’s promise to transfer its service must be separately identifiable from other promises in the contract (that is, the promise to transfer the service is distinct within the context of the contract).

4.6.61 Consistent with Example 25 in paragraphs 221–225 of FASB ASC 606-10-55, and as described in paragraphs 4.6.28–4.6.31 of the section “Management Fee, Excluding Performance Fees” the promise to provide asset management services is considered a single performance obligation because the asset manager transfers a series of distinct services (that is, daily asset management services) that are substantially the same and have the same pattern of transfer to the customer.

4.6.62 In accordance with FASB ASC 606-10-32-1, the transaction price that the asset manager expects to receive comprises variable consideration in the forms of base management and performance fees to the extent that those are not constrained in accordance with paragraphs 11–13 of FASB ASC 606-10-32.

4.6.63 Considerations relevant in evaluating management fee revenue are discussed in detail in paragraphs 4.6.32–4.6.36 of the section “Management Fee Revenue, Excluding Performance Fees.”

Variable Consideration

4.6.64 In accordance with FASB ASC 606-10-32-5, consideration paid for asset management services in the form of performance fees is considered variable because it is subject to fluctuation with respect to amount (for example, in asset value, market performance) or is contingent on a future event during the contractual period (for example, meeting a specified compound hurdle rate), or both.

4.6.65 FASB ASC 606-10-32-8 requires that the amount of variable consideration is estimated using one of the following two methods, depending on which method the asset manager expects to better predict the amount of consideration to which it will be entitled:

a.     The expected value of the contract determined by the sum of probability-weighted amounts in a range of possible consideration amounts.

b.     The most likely amount equal to the single most likely amount in a range of possible consideration amounts.

4.6.66 In accordance with FASB ASC 606-10-32-9, the asset manager should consider all the information (historical, current, and forecast) that is reasonably available to the entity, including its historical experience with similar arrangements in similar jurisdictions to determine the estimate of variable consideration. Consideration should be given to the accuracy of previously forecasted results and actual fund performance to help determine if there is a range of possible consideration amounts that could be used to derive the expected value (that is, in a probability-weighted estimate) or most likely amount to which the entity will be entitled.

Constraining Estimates of Variable Consideration

4.6.67 As discussed in FASB ASC 606-10-32-11, an asset manager shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with FASB ASC 606-10-32-8 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. Consistent with the factors listed in FASB ASC 606-10-32-12, although an asset manager may have historical experience with similarly structured fee arrangements, this history may have low predictive value of the future market performance. Further, the amount of performance fees is typically subject to certain contingencies outside of the control of the asset manager, such as market volatility, and may have a broad range of possible consideration amounts.

4.6.68 Therefore, in accordance with FASB ASC 606-10-32-11, variable consideration in the form of performance fees will be excluded from the transaction price until it becomes probable that there will not be a significant reversal of cumulative revenue recognized.

4.6.69 An asset manager may determine that all or a portion of its performance fees is not constrained from being included in the transaction price based on an assessment of the factors in FASB ASC 606-10-32-12, conducted either at inception of the contract or upon subsequent re-evaluation. Such amount should be recognized prior to the end of the performance period if the relevant facts and circumstances indicate that it is probable that significant reversal will not occur. In making this assessment, the entity may consider factors such as the following:

a.     The extent to which the underlying investment portfolio is subject to future changes, such as market volatility and investment and reinvestment, which could affect the calculation of the performance fees

b.     The extent to which there is a return on investment in excess of the contractual hurdle rate

c.     The time remaining in the performance period

4.6.70 See examples 4-6-3 and 4-6-4 for instances of this evaluation.

4.6.71 As discussed in FASB ASC 606-10-32-39, variable consideration may be attributed to the entire contract or a specific part of the contract. When there is more than one performance obligation in a contract or there are distinct goods or services promised as part of a single performance obligation, variable consideration may be attributed to one or more, but not all, of those performance obligations or distinct goods or services, respectively.

4.6.72 In order to allocate a variable amount (and subsequent changes to that amount) entirely to one or more, but not all, performance obligations or to one or more, but not all, distinct goods or services that forms part of a single performance obligation, both of the following criteria in FASB ASC 606-10-32-40 must be 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.

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.

4.6.73 FASB ASC 606-10-32-28 states 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.

4.6.74 Consistent with FASB ASC 606-10-55-225, at the end of the reporting period, the entity should allocate an amount of estimated variable consideration (after updating its assessment of whether the estimate is constrained) included in the transaction price to the distinct services provided during the reporting period in accordance with paragraphs 39(b) and 40 of FASB ASC 606-10-32.

Satisfaction of the Performance Obligations

4.6.75 For each performance obligation, an entity must determine at contract inception whether it satisfies the performance obligation over time or at a point in time, as explained in FASB ASC 606-10-25-24. A performance obligation must be satisfied over time in order to meet the criterion in FASB ASC 606-10-25-15(a) to be a series of distinct goods or services.

4.6.76 Consistent with the guidance illustrated in Example 25 in FASB ASC 606-10-55-222, the performance obligation to provide asset management services represents a series of distinct services that are substantially the same and have the same pattern of transfer to the customer. With respect to the latter point, the services transfer to the customer over time and use the same method to measure progress, that is, a time-based measure of progress. The criterion in FASB ASC 606-10-25-27(a) to recognize revenue over time is met because the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

Measuring Progress Toward Complete Satisfaction of a Performance Obligation

4.6.77 If the performance obligation is satisfied over time, the entity would next determine how to measure progress towards complete satisfaction of the performance obligation. An entity must determine if an output method or an input method, as described in paragraphs 16–21 of FASB ASC 606-10-55, is more appropriate for measuring progress. The selected method must be applied consistently to similar performance obligations and in similar circumstances.

4.6.78 FinREC believes that a time-based measure of progress, as described in FASB ASC 606-10-55-222, is the appropriate approach for recognizing revenue over time because the services are substantially the same each day and have the same pattern of transfer.

4.6.79 Entities should consider guidance in paragraphs 36–37 of FASB ASC 606-10-25 and conclude whether their selected methodology is a reasonable measure of progress based on reliable inputs. An entity may only recognize revenue if it can reasonably measure progress toward complete satisfaction of the performance obligation.

4.6.80 The following examples are meant to be illustrative, and the actual application of the guidance in paragraphs 5–14 of FASB ASC 606-10-32 for estimating variable consideration to be included in the transaction price should be based on the facts and circumstances of an entity’s specific situation.

Example 4-6-3—Performance Fees

An asset manager enters into an IMA with a hedge fund for the provision of investment advisory services. The asset manager is entitled to a monthly management fee equal to 0.50 percent of the monthly average assets under management. Additionally, the asset manager is entitled to a performance fee equal to 20 percent of the gross annual return of the fund in excess of the 12 percent contractual hurdle rate. The performance fee, assuming the hurdle rate is met, is paid at the end of the calendar year. There is no provision in the IMA that requires the asset manager to return amounts paid in previous calendar years if in subsequent years the hurdle rate is not met (that is, there is no “clawback” provision).

The following evaluations represent considerations for two years in the life cycle of the hedge fund and are for illustrative purposes only. The same evaluation would be performed in other performance periods.

As of September 30 of the fifth calendar year, the fund had gross year-to-date appreciation of 20 percent. There are no restrictions on the continued investment or reinvestment of the fund’s portfolio holdings. Since inception, similar funds in the related investment objective have experienced quarterly market volatility ranging from depreciation of 10 percent to a return of 25 percent.

The asset manager determined that it is not probable that a significant reversal of the calculated 1.6 percent performance fee (20 percent of the 8 percent gross annual appreciation in excess of the contractual hurdle rate) will not occur based on the following factors:

•     The fund has the ability to invest or reinvest its proceeds into additional portfolio holdings.

•     The fund is subject to significant market volatility in the fourth calendar quarter, which could result in a decline in the gross annual return below the contractual hurdle.

•     The current gross annual return earned to date is not significantly higher than the contractual hurdle.

Based on these factors, the asset manager did not include an estimate of the performance fee in the transaction price as of September 30 of the fifth calendar year.

As of September 30 of the ninth calendar year, the fund had gross year-to-date appreciation of 50 percent. During the year, the investment portfolio was sold and the proceeds were invested in a money market fund to preserve the year-to-date gains.

The asset manager determined that it is probable that a significant reversal of the calculated 7.6 percent performance fee (20 percent of the 38 percent gross annual appreciation in excess of the contractual hurdle rate) will not occur:

•     The fund composition changed from a portfolio of investments to a single investment in a money market fund with a stable net asset value of $1.

•     Although the fund is subject to market volatility in the fourth calendar quarter, which could result in a decline in the gross annual return, any decline would not be expected to be significant given the type of underlying funds (for example, treasuries), and the return through September 30 significantly exceeds the contractual hurdle.

•     The current gross annual return earned to date is significantly higher than the contractual hurdle.

Given the change in the composition of the underlying investment portfolio to a money market fund with a stable net asset value, the full performance fee of 7.6 percent is included in the transaction price as of September 30 of the ninth calendar year. However, the asset manager should evaluate whether the unconstrained performance fee is allocated to the distinct services provided prior to September 30 of the ninth calendar year in accordance with paragraphs 39(b) and 40 of FASB ASC 606-10-32 or if a portion should be deferred and recognized over the remaining performance period.

If the investment portfolio was not moved to an investment in a money market fund with a stable net asset value and, therefore, still subject to additional market fluctuations, the asset manager should consider whether a portion of the 7.6 percent performance fee would still be subject to the constraint guidance.

Example 4-6-4—Fulcrum Fees⁴

Certain performance fees may be structured with a floor and a performance-based component (fulcrum fees) or as a weighted average of performance over a period of several years. In such cases, the uncertainty may only apply to a portion of the performance fee, which could result in partial recognition of the performance fee. Careful attention should be paid to the specific facts and circumstances of each performance fee when determining any constraint on the estimate of performance-based consideration that may be included in the transaction price.

As an example, the prospectus for a fund may contain the following fee provisions:

The management fee will be 0.60 percent of average quarterly AUM. If fund performance outperforms its benchmark index on the annual basis by

•     1 percent but less than 2 percent, the management fee will be increased to 0.65 percent of average AUM.

•     2 percent but less than 4 percent, the management fee will be increased to 0.70 percent of average AUM.

•     4 percent or greater, the management fee will be increased to 0.75 percent of average AUM.

If the fund underperforms its benchmark index by

•     1 percent but less than 2 percent, the management fee will be decreased to 0.55 percent of average AUM.

•     2 percent but less than 4 percent, the management fee will be decreased to 0.50 percent of average AUM.

•     4 percent or greater, the management fee will be decreased to 0.45 percent of average AUM.

In such a case, the minimum (or fixed) portion of the fulcrum fees (in the preceding example, the minimum is the 0.45 percent fee) for the given quarter becomes fixed as compared to its benchmark index. Therefore, the minimum fee would be evaluated consistent with other base management fees at the end of each quarterly reporting period, including consideration of the constraint guidance, as described in the section, “Management Fee Revenue, Excluding Performance Fees.”

Depending on the facts and circumstances of the arrangement, the asset manager may exclude the fulcrum fee earned above the minimum fee of 0.45 percent from the transaction price because it is not probable that a significant reversal of the fee will not occur prior to the end of the performance period and, therefore, the amount is constrained. If this is the case, then the performance-based component of the fulcrum fee should be excluded from the transaction price until it becomes probable that there will not be a significant reversal of cumulative revenue recognized based on the factors in FASB ASC 606-10-32-12 as well as specific considerations for the asset management industry described in paragraph 4.6.69.

4.6.81 Incentive-based capital allocations, including carried interest, are arrangements in which a performance fee is allocated to an asset manager or its affiliate (collectively, the asset manager) through a re-allocation of net earnings from the capital accounts of the non-managing interest holders to the asset manager’s capital account when returns exceed contractual thresholds.

4.6.82 Unlike typical performance fees, which may be calculated by applying fixed contractual basis points to assets under management, incentive-based capital allocations are based on a contractual methodology to determine the allocated share of profits. For example, incentive-based capital allocations may be based on a percentage of the investment company’s⁵net proceeds from the sale of an investment or on a percentage of net proceeds in excess of a specific profit benchmark. For a discussion on incentive or performance fees (collectively, performance fee) that do not involve a re-allocation of profits, refer to the section “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such as Carried Interest)” in paragraphs 4.6.54–4.6.80.

4.6.83 Incentive-based capital allocations may also include clawback or other similar provisions that allow the investment company to look back and confirm performance, which could affect the timing of distributions or require repayment of previously distributed amounts. Clawback provisions require the return of all or a portion of previously distributed incentive-based capital allocations made to the asset manager if contractually-specified conditions are not met (for example, declines in the performance of the underlying portfolio).

4.6.84 At the April 2016 TRG meeting, members considered whether incentive-based capital allocations, such as carried interest, are within the scope of FASB ASC 606. The following were discussed in paragraphs 6–10 of TRG Agenda Ref No. 55, April 2016 Meeting—Summary of Issues Discussed and Next Steps:

6. Some entities, particularly asset managers, receive incentive-based performance fees via an allocation of capital from an investment fund under management (that is, through a “carried interest”). The fees are provided to compensate the asset manager for its services and performance in managing the fund. Many stakeholders think there are two aspects to those incentive-based fee arrangements: (a) compensation for asset management services and (b) financial exposure to the fund’s performance. Stakeholders have raised questions about whether those arrangements are within the scope of Topic 606 or, instead, are in the scope of other GAAP, such as Topic 323, Investments—Equity Method and Joint Ventures, which is listed as a scope exception in paragraph 606-10-15-2(c)(3).

7. All seven FASB Board members were present at the TRG meeting and each stated their views that those arrangements are within the scope of Topic 606. Board members highlighted that:

(a)     On various occasions during development of the new revenue standard, the FASB and the IASB discussed how the new revenue recognition guidance would apply to asset management contracts. The topic was discussed during public joint Board meetings on September 24, 2012, November 19, 2012, and January 30, 2013. At the January 30, 2013 joint Board meeting, the Boards confirmed their proposal in the 2011 Exposure Draft that an asset manager’s performance-based incentive fees are subject to the constraint on variable consideration.

(b)     Example 25 of Update 2014-09 illustrates the application of the variable consideration constraint guidance to an asset manager contract. Although Example 25 is not explicit about whether the guidance applies to fee arrangements in which the asset manager is compensated for performance-based fees via an interest, such as a carried interest, the Board’s view is that this example illustrates the intent that performance-based fees are in the scope of Topic 606.

(c)     A few Board members highlighted a potential inconsistency in feedback received from some stakeholders about the nature of carried interest during the outreach phase of ASU 2015-02, Consolidation (Topic 810)—Amendments to the Consolidation Analysis, and during the implementation phase of the new revenue standard. In outreach for the project leading to Update 2015-02, some stakeholders asserted that carried interest is a fee for services and, therefore, it should not be considered a variable interest under the consolidation guidance. This assertion seems inconsistent with a view that carried interest is an equity interest for the purposes of determining whether the contracts are within the scope of Topic 606. Several Board members also stated their belief that if the arrangements are considered equity interests outside the scope of Topic 606, an entity would need to evaluate the effect of that conclusion on its consolidation analysis under Topic 810, Consolidation.

8. Many TRG members agreed that the arrangements are within the scope of Topic 606. A few TRG members stated that they can understand a view that carried interest could be considered an equity arrangement, because it is, in form, an interest in the entity. Some TRG members stated that if the arrangements are considered equity interests outside the scope of Topic 606, then questions could arise in practice about the effect of such a conclusion on the analysis of whether the asset managers should consolidate the funds.

9. The SEC staff observer indicated that he anticipates the SEC staff would accept an application of Topic 606 for those arrangements. However, the observer noted that there may be a basis for following an ownership model. If an entity were to apply an ownership model, then the SEC staff would expect the full application of the ownership model, including an analysis of the consolidation model under Topic 810, the equity method of accounting under Topic 323, or other relevant guidance.

10. The FASB staff does not recommend that the Board undertake standard-setting action as a result of this discussion. This is because the staff thinks Topic 606 is clear that performance based fees, such as carried interest arrangements, are within the scope of Topic 606. Several TRG members had the same view. In addition, each of the seven FASB Board members stated during the meeting that they believe that carried interests are within in the scope of Topic 606.

4.6.85 The following assumes that the arrangement is within the scope of FASB ASC 606. If the entity determines that the arrangement is evaluated using the ownership model as described by the SEC staff observer in paragraph 4.6.84, the following evaluation does not apply.

4.6.86 For application of all the steps of the revenue recognition model in FASB ASC 606 to performance fees, including industry-specific considerations in regard to constraining estimates of variable consideration, refer to paragraphs 4.6.54–4.6.80 of the section “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such as Carried Interest).” These steps and considerations apply equally to incentive-based capital allocation arrangements, irrespective of whether a cash distribution is made by the customer.

4.6.87 When evaluating the factors listed in paragraph 4.6.69 of the section “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such as Carried Interest),” the asset manager should consider the nature of the incentive-based capital allocation specifically in regard to the following:

a.     The inputs of the calculation of the incentive-based capital allocations and the dependence of the ultimate incentive-based capital allocation on other factors, such as investment company performance waterfalls, hurdle rates (variable, index, fixed rate), or investment-by-investment calculations.

b.     The existence of clawback or other similar provisions.

4.6.88 In addition, FinREC believes that consideration should be given to the following factors in determining if variable consideration is constrained:

a.     The remaining life of the investment company

b.     Whether the excess unrealized return remains susceptible to factors outside the entity’s influence, including volatility in the fair value of the underlying portfolio of investments

c.     The extent to which the current realized return and unrealized gains on investment collectively exceed the contractual hurdle rate

4.6.89 In accordance with FASB ASC 606-10-32-11, an entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with FASB ASC 606-10-32-8 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.

4.6.90 As discussed in FASB ASC 606-10-32-12, determining the amount of variable consideration to include in the transaction price should consider both the likelihood and magnitude of a revenue reversal. An estimate of variable consideration is not constrained if the potential reversal of cumulative revenue recognized is not significant. FinREC believes that generally, the incentive-based capital allocation may be considered significant as compared to the cumulative transaction price of the contract, which may include management or administrative fees, or both, because this component of the transaction price has the potential to exceed other fees earned based on the nature and design of the fee structure.

4.6.91 Further, as explained in TRG Agenda Ref 25, January 2015 Meeting—Summary of Issues Discussed and Next Steps, paragraph 49 states the following:

TRG members generally agreed that the constraint on variable consideration should be applied at the contract level. Therefore, the assessment of whether a significant reversal of revenue will occur in the future (the constraint) should consider the estimated transaction price of the contract rather than the amount allocated to a performance obligation.

4.6.92 Once included in the transaction price, an asset manager should determine whether a portion of the incentive-based capital allocation or the entire amount may be attributed to the distinct services already provided to the customer (for example, from the inception of the investment company through the date the variable consideration is unconstrained) in accordance with paragraphs 39(b) and 40 of FASB ASC 606-10-32. Also, the asset manager should consider whether a portion of the unconstrained incentive-based capital allocation included in the transaction price should be allocated to any remaining performance period, based on facts and circumstances.

4.6.93 Consistent with guidance from TRG Agenda Ref. No. 55 and Example 25 of FASB ASC 606 cited previously, FinREC believes that the following example demonstrates the application of the guidance on constraining estimates of variable consideration in FASB ASC 606 to incentive-based capital allocations, such as a carried interest.

Example 4-6-5—Applying the guidance on variable consideration to an incentive-based capital allocation arrangement

A general partner (GP), an affiliate of an asset manager, is entitled to receive an incentive-based capital allocation equal to 20 percent of the appreciation of a closed-end three-year⁶ limited partnership in excess of $8 million per annum, evaluated on a cumulative basis over the life of the investment company. The investment company has a calendar year-end. The GP holds a 0.01 percent general partnership interest and another entity under common control with the GP, and the asset manager holds a 2 percent limited partner interest. Any distribution made prior to the end of the investment company’s life is subject to a clawback provision if the cumulative investment company performance does not exceed the cumulative three-year hurdle of $24 million.

The GP enters into an investment management agreement with the affiliated asset manager to provide asset management and related services to the fund. For discussion about base management fees earned by the asset manager for the asset management services, see the section, “Management Fee Revenue, Excluding Performance Fee Revenue.”

A three-year investment company life is assumed in this example for illustration purposes only; application of the key concepts in FASB ASC 606 would similarly apply for longer term investment companies.

The evaluation performed herein is from the consolidated asset manager perspective, including the interests held by the general partner entity, limited partner entity, and asset manager.

At the inception of the contract with the investment company, the consideration paid for asset management services in the form of incentive-based capital allocations is tied to variable factors, including the ultimate realized return on the portfolio investment. As such, at contract inception, the asset manager determined that it cannot conclude that it is probable that a significant reversal of the calculated incentive-based capital allocations will not occur, so it did not include an estimate of the incentive-based capital allocation in the transaction price.

During the first year, the underlying investments in the investment company appreciated by $10 million. Accordingly, the asset manager’s general partner account was allocated $1,000 (0.01% × $10,000,000) of the current year unrealized appreciation as well as $400,000 of the excess unrealized appreciation (20% of $2,000,000 excess unrealized appreciation ($10,000,000 – $8,000,000) while its limited partner account was allocated $200,000 (2% of $10,000,000), before the incentive-based capital allocation.

The following table illustrates the calculation of the allocation by the investment company in its standalone financial statements:

Year 1: Investment Company Reporting

The asset manager evaluated the following additional factors to determine whether the incentive-based capital allocation should be constrained from inclusion in the transaction price in accordance with paragraphs 11–12 of FASB ASC 606-10-32:

•     The investment company is approximately 80 percent invested as of the end of year 1, and the asset manager has identified the target investments to be made prior to the end of the investment period. The portfolio comprises non-marketable equity and debt investments in accordance with the investment objective stated in the limited partnership agreement. However, these investments may experience significant future volatility in value as they primarily comprise early-stage companies.

•     The asset manager is still contemplating the ultimate exit plan for each of the portfolio investments, such as IPO or direct sale.

•     The expected remaining life of the investment company is considered long enough for the investment company to experience declines in the annual appreciation below the contractual hurdle (and, ultimately, in the cumulative hurdle, as well).

•     The excess unrealized return over the contractual hurdle for the year (returns of $10 million over the contractual hurdle of $8 million) remains susceptible to factors outside the entity’s influence, particularly volatility in the fair value of the underlying portfolio investments. Additionally, the appreciation to-date of $10 million does not exceed the cumulative hurdle required at the end of year 3 of $24 million.

Based on these factors, the asset manager determined that it cannot conclude that it is probable that a significant reversal of the calculated incentive-based capital allocations will not occur, so it did not include an estimate of the incentive-based capital allocation in the transaction price as of December 31st of year 1.

During the second year, the underlying assets in the investment company appreciated by $7 million. A portion of the first year’s incentive-based capital allocation is then reallocated back to the limited partners because the inception-to-date market appreciation of $17 million ($10,000,000 + 7,000,000) only exceeds the cumulative contractual hurdle of $16 million⁷by $1 million. As a result, the cumulative incentive-based capital allocation must be reduced by $200,000.⁸The allocation by the investment company in its standalone financial statements would be as follows:

Year 2 (non-cumulative): Investment Company Reporting

Further, the asset manager evaluated the following factors to determine whether the incentive-based capital allocation should be constrained:

•     The investment company’s portfolio is fully invested, and significant changes to the population of investments are unlikely. The asset manager is required to distribute all income (dividends and interest) earned from the underlying portfolio. However, the underlying investee companies are still early-stage companies subject to significant volatility in value.

•     The investment company continues to be subject to significant market volatility over the remaining year of the investment company’s life that could result in a decline in the annual return below the contractual hurdle.

•     No portfolio investments have been acquired, sold, or otherwise transferred to a third party (for example, through an IPO), and there are no current negotiations being undertaken for the sale of the investments.

•     The inception-to-date excess unrealized return over the inception-to-date contractual hurdle remains susceptible to factors outside the entity’s influence, particularly volatility in the fair value of the underlying portfolio investments.

•     The cumulative returns to-date of $17 million do not exceed the cumulative hurdle required at the end of year 3 of $24 million.

Based on these factors, the asset manager determined that it cannot conclude that it is probable that a significant reversal of the cumulative incentive-based capital allocation of $200,000 ($400,000 allocated in year 1 less the reversal of $200,000 in year 2) will not occur, so it did not include an estimate of the incentive-based capital allocation in the transaction price as of December 31 of year 2.

During the six months ended June 30 of the third and final year of the investment company’s life (that is, prior to the calendar year-end), the investment company recognized net gains of $11 million. The investment company liquidated approximately 90 percent of its portfolio, resulting in cumulative realized gains of $28 million, comprising $11 million of current period gains and a reclassification of previously recorded unrealized gains of $17 million. This reclassification had no impact on total net increase in net assets of the investment company (the investment company equivalent of net income) through June 30 of year 3. There is no anticipated realized gain or loss on the remaining 10 percent of the portfolio as of June 30; this assertion is supported by the soon-to-be executed sale of these investments at their acquisition cost (current negotiation for their sale is well underway). The inception-to-date gains of $28 million exceeds the cumulative contractual hurdle as of June 30 of $20 million,⁹ resulting in a cumulative incentive-based capital allocation of $1.6 million.¹⁰ In the current year, the asset manager’s general partner account would be allocated $1,100 (0.01% × $11,000,000) of the current-year realized appreciation as well as the additional $1.4 million¹¹ capital allocation needed to arrive at the total incentive-to-date allocation of $1.6 million. Its limited partner account would receive an allocation of $220,000 (2% of $11,000,000), before the incentive-based capital allocation.

The allocation as of June 30 of year 3 by the investment company in its standalone financial statements is as follows:

For the purposes of revenue recognition, the asset manager evaluated the following additional factors to determine whether the incentive-based capital allocation should be constrained:

•     The investment company has liquidated 90 percent of its portfolio and is in the process of selling the remaining investments. The proceeds from the sales are held in cash and cash equivalents subject to final distribution to the limited partners.

•     The sale of the remaining portfolio is nearly finalized, and the terms of the draft contract indicate no anticipated gains or losses.

•     Given the sale of substantially all the investment company’s underlying investments and significant negotiations for the remaining investments, the investment company is no longer subject to significant market volatility.

•     The excess appreciation earned to date is significantly higher than the contractual hurdle.

Given the change in the composition of substantially all the underlying investment portfolio to cash and cash equivalents, which is not expected to experience significant market fluctuations over the remaining six months of the investment company’s life, the asset manager determined that it is probable that a significant reversal of the inception-to-date capital allocation will not occur for a portion of the incentive-based capital allocation. Assuming no further appreciation on the remaining 10 percent of the portfolio yet to be sold, the asset manager determined the amount of incentive-based capital allocation that can be included in the transaction price to be $800,000¹³as of June 30. The amount of variable consideration was determined based on the expected value method.

Upon inclusion of the $800,000 in the transaction price, a portion of the $800,000 or the entire amount may be allocated to the distinct services provided from the investment company’s inception through June 30 of year 3 in accordance with paragraphs 39(b) and 40 of FASB ASC 606-10-32.

In this particular situation, the asset manager determines that the full $800,000 is allocated to the asset management services provided to the investment company from the investment company’s inception through June 30 of year 3. The fee relates to the entity’s efforts to transfer the services for the period from inception through June 30 of year 3, which are distinct from the services to be provided for future quarters and, therefore, would be consistent with the allocation objective in FASB ASC 606-10-32-28. Further, the returns on the investments have been realized and substantially all the services associated with the sale of the remaining portfolio investments have been completed.

The following table illustrates the difference between attribution of the incentive-based allocation performed by the investment company and the asset manager’s inclusion of such variable consideration in the transaction price and, ultimately, in its recorded revenue:

4.6.94 Asset managers provide a number of services to customers (either fund or investor), which often include, but are not limited to, asset management, administration, and distribution, as follows:

a.     Asset management services include providing investment advice, performing research services, and conducting a continual program of investment, sale, and reinvestment of investor assets, under a contract that is commonly referred to as the IMA.

b.     Administrative services typically include fund accounting, preparation of financial statements, calculation of the net asset value of the fund, and the provision of other business management activities. These activities may be agreed upon pursuant to a separate administrative agreement or included within the IMA.

c.     Distribution services include underwriting and distribution of fund shares and other marketing and distribution activities. These activities may involve the preparation, printing, and distribution of prospectuses, reports, and sales literature, and the preparation of information, analyses, and opinions related to marketing and promotional activities. These activities are agreed upon under a sale or distribution agreement or explicitly stated in the fund prospectus.

4.6.95 In certain cases, the asset manager may elect to delegate the execution of some or all of the aforementioned activities to a third-party service provider (for example, subadvisor, distributor, or administrator). While the delegation of operating activities may be permissible based on the terms set forth in the IMA or other governing document, the asset manager is generally responsible for negotiating terms with the service provider, and, at a minimum, for supervising and arranging the day-to-day operations of the fund or separately managed portfolio.

4.6.96 The asset manager must determine whether it is acting as a principal or an agent when another party is involved in providing services that the asset manager has promised in a contract with a customer. This analysis affects how the asset manager will present revenue for the performance obligation on the income statement. The determination of the asset manager’s role as principal or agent should be based on the totality of information and the facts and circumstances relevant to each arrangement and applied to each specified service.

4.6.97 An entity is a principal if it controls the specified service before that service is transferred to a customer, as discussed in FASB ASC 606-10-55-37. The term ‘specified service’ means distinct services (or distinct bundles of services) to be provided to the customer (see paragraphs 19–22 of FASB ASC 606-10-25).

4.6.98 As discussed in FASB ASC 606-10-25-18, specified services in a contract with a customer may include, but are not limited to, the following promised services:

a.     Performing a contractually agreed-upon task (or tasks) for a customer

b.     Providing a service of standing ready to provide goods or services or of making goods or services available for a customer to use as and when the customer decides

c.     Providing a service of arranging for another party to transfer goods or services to a customer

4.6.99 Examples of promised services in contracts with customers in the asset management industry may include asset management, fund administration, distribution, and sales and marketing services and other operating activities. In general, many or most of these promises represent supporting activities associated with the overriding promise to the customer to provide asset management services, which represents a single performance obligation. To determine whether any of the promised services should be accounted for as a separate specified service, the conditions to be a distinct good or service (or distinct bundle of goods or services) must be met, as described in paragraphs 19–22 of FASB ASC 606-10-25. Considerations relevant to identifying separate performance obligations for the provision of asset management services are discussed in detail in paragraphs 4.6.19–4.6.53 of the section “Management Fee Revenue, Excluding Performance Fee Revenue. ”

4.6.100 The asset manager should determine the nature of its promise; specifically, whether its performance obligation is to provide the specified services or to arrange for the provision of the specified services by another party. In accordance with FASB ASC 606-10-55-36A, to determine the nature of its promise, the entity should do the following:

a.     Identify the specified services to be provided to the customer

b.     Assess whether the entity controls each specified service before that service is transferred to the customer

4.6.101 As discussed in FASB ASC 606-10-55-37, an entity is a principal if it obtains control of the specified service before that service is transferred to the customer. An asset manager that is a principal typically obtains control of one of the following:

a.     A good or another asset from the other party that it then transfers to the customer.

b.     A right to a service to be performed by a third-party service provider, which gives the asset manager the ability to direct that party to provide the service to the customer on the asset manager’s behalf.

c.     A service from a third-party service provider that the asset manager combines with other services in providing the specified service to the customer. If the asset manager provides a significant service of integrating services provided by another party into the specified service for which the customer has contracted, the asset manager controls the specified service before it is transferred to the customer. In this case, the asset manager first obtains control of the specified service from the other party and directs its use to create the combined output that is the specified services.

4.6.102 In accordance with FASB ASC 606-10-55-38, an asset manager is an agent if its performance obligation is to arrange for the provision of the specified service by another party and it does not control the specified service before that service is transferred to the customer.

4.6.103 In determining whether the entity obtains control of a specified service before it is transferred to the customer, the following should be considered:

a.     The definition of control (FASB ASC 606-10-25-25): ‘Control’ refers to the asset manager’s ability to direct the use of, and obtain substantially all of the remaining benefits from, the service. In addition, control includes the asset manager’s ability to prevent others from directing the use or obtaining the benefits from the service. FASB ASC 606-10-25-25 explains that the “benefits” of the service are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, and it provides examples of how benefits can be obtained from a service.

b.     The existence of some (or all) of the indicators in FASB ASC 606-10-55-39: The existence of some (or all) of the indicators provides additional evidence that the asset manager controls a specified service before it is transferred to the customer. No individual indicator is determinative, and no weight of relative importance is assigned to individual indicators. As a result, (1) the indicators may not apply equally in all instances, (2) some indicators may not apply to certain contracts, (3) different indicators may provide more (or less) persuasive evidence for different specified services, and (4) the listing of indicators included in the guidance is not all inclusive.

As explained in paragraph BC16 of FASB Accounting Standards Update (ASU) No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), these indicators do not override the assessment of control, should not be viewed in isolation, do not constitute a separate or additional evaluation, and should not be considered a checklist of criteria to be met in all scenarios.

4.6.104 The following indicators discussed in FASB ASC 606-10-55-39 are relevant in assessing whether the asset manager controls the specified good or service before it is transferred to the customer, and is therefore acting as a principal:

a.     Who is primarily responsible for fulfilling the promise to provide the specified service?

i.     FinREC believes that the asset manager may be primarily responsible for fulfilling the promise to provide the specified service when one or more of the following characteristics are present, based on the particular facts and circumstances of the given contract with the third-party service provider:

1.     The customer holds the asset manager, as opposed to the third-party service provider, accountable to the services outlined in the contract with the customer (for example, management agreement, distribution agreement). The customer addresses service issues, concerns, or other questions that pertain to specifications of the services promised in that contract with the customer directly with the asset manager. The customer relies on the asset manager to resolve any service discrepancies in regard to the delegated services, specified in the contract with the customer.

2.     The customer either does not interact or has limited interaction with the third-party service provider. The asset manager is responsible for oversight of the day-to-day activities of the third-party service provider.

3.     In certain instances, the customer may have the ability to seek remedies from the asset manager for poor service performance by the third-party service provider. For example, the customer may be entitled to remedy in the form of a financial payment or waiver of investment management fees. Separate from any payment or waiver granted to the customer, the asset manager may also have the right to seek remedy or indemnification from the third-party service provider pursuant to that service provider’s warranty or indemnification of its services (for example, indemnity from losses, costs, claims, expenses, or demands incurred by the asset manager or its affiliate arising from a breach by the servicer of its service provider agreement entered into with the asset manager or its affiliate).

4.     If not satisfied, the customer has the ability to terminate its relationship with the asset manager, require the asset manager to rectify the situation, or both. In these instances, the customer generally does not have the right to either directly terminate or require the asset manager to terminate the service provider agreement with the third-party service provider.

5.     The customer is not a party to the executed service provider agreement and does not hold rights to engage and direct the services of the third-party service provider. If the customer is required to approve the service provider agreement that is negotiated separately between the asset manager and the third-party service provider, the asset manager still remains primarily responsible for the provision of services. Overall, consideration should be given to the extent to which the customer has the ability to direct the services provided by the third-party service provider (for example, the ability to propose and approve of material amendments to the service provider agreement, extensive involvement in the oversight of services, direct communication with the third-party service provider, and substantive right to terminate the service provider agreement).

6.     Also, while not a determinative characteristic by itself, the asset manager may consider whether it has supplier discretion for identifying and engaging the third-party service provider, so long as the third-party service provider meets the general requirements of the customer.

ii.     FinREC believes that the asset manager may not be primarily responsible for fulfilling the promise to provide the specified service if any or all of the following factors exist, based on the particular facts and circumstances of the given contract with the third-party servicer:

1.     The customer is a party to the executed service provider agreement and holds the rights to engage and direct the services of the third-party service provider. The customer does not direct questions or concerns about the specified services to the asset manager, including those related to specifications of services promised; instead, the customer works directly with the third-party service provider, as allowed by the service provider agreement.

2.     The customer has the ability to directly negotiate amendments or terminate the service provider agreement.

b.     Does the asset manager have inventory risk before or after the specified service has been transferred to the customer?

i.     The indicator described in FASB ASC 606-10-55-39(b) regarding inventory risk generally does not support the conclusion that the asset manager is acting as a principal because the asset manager does not commit itself to obtain services from a service provider before obtaining the contract with the customer or hold physical inventory.

c.     Does the asset manager have discretion in establishing prices for the specified service?

i.     FinREC believes the following considerations are applicable in determining whether the asset manager has such discretion:

1.     If the asset manager has ultimate discretion in establishing the fee paid by the customer for the specified services, it may indicate that the asset manager controls the specified services before they are transferred to the customer. If the asset manager has limited ability to establish the price paid by the customer for the specified service (for example, the price is determined ultimately by the third-party service provider), it may indicate that the asset manager does not have discretion in establishing prices. However, an agent may have some flexibility in setting prices in order to generate additional revenue from its service of arranging for goods or services to be provided by other parties to customers.

2.     The customer’s awareness of the amount paid to the third-party service providers does not in and of itself preclude the asset manager from concluding that it controls the specified services prior to transfer.

4.6.105 In accordance with FASB ASC 606-10-55-37, an entity acting as a principal may satisfy its performance obligation to provide the specified service itself or it may engage another party to satisfy some or all of the performance obligation on its behalf. Either way, the entity recognizes revenue in the gross amount of consideration to which it expects to be entitled in exchange for that specified service when (or as) it satisfies the associated performance obligation. The related payments to third-party service providers would be presented separately.

4.6.106 In accordance with FASB ASC 606-10-55-38, if the entity’s performance obligation is to arrange for the provision of the specified service and the entity does not control the specified service provided by another party before that good or service is transferred to the customer, it is acting as an agent and would recognize revenue based on the net amount of consideration it expects to be entitled to for providing that specified service. FASB ASC 606-10-55-38 further clarifies that entity’s “fee or commission might be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.”

4.6.107 The following examples are intended to be illustrative based on assumed facts and circumstances. The application of the guidance on principal versus agent considerations under FASB ASC 606 should be based on the facts and circumstances of an entity’s specific arrangements, which may or may not necessitate further evaluation of the indicators in FASB ASC 606-10-55-39. To the extent facts and circumstances of a given contract differ in practice from the assumed facts below, the evaluation and conclusions below may not be applicable. The indicator described in FASB ASC 606-10-55-39(b) regarding inventory risk has been excluded from these examples, as the asset manager does not generally purchase or commit itself to purchase services from the third-party service provider prior to entering into a contract with a customer, as discussed in paragraph 4.6.104.

Example 4-6-6—Unitary Management Fee Arrangement

The asset manager enters into a management agreement with a fund to provide or arrange for the provision of asset management, fund administration, and other management and administrative services necessary for the operation of the fund in exchange for a single all-inclusive management fee based on the net asset value of the fund (“unitary management fee”). The asset manager is responsible for ensuring the operation of the fund—including general management, administration, and provision of investment advisory services—subject to the oversight of the board of directors of the fund.

The asset manager, having been hired by the fund to act as manager and investment advisor, is empowered to provide or arrange for its affiliates or third-party service providers to provide some or all of those services. In this situation, for services delegated to third-party service providers, the asset manager will enter into service provider agreements and will pay the contractually agreed-upon fee stipulated therein, out of the unitary management fee that it receives from the fund.

For some of the services covered by the unitary management fee, the service provider agreement may be signed by the fund (through a representative of the fund board) or by both the fund and the asset manager. Such circumstances would be based on corporate structure and local legal requirements. The inclusion of the fund as a party to the agreement may change the evaluation and conclusion of the asset manager’s role as principal or agent based on the rights and obligations attributed to the fund, if any, in regard to the services performed by the third-party service provider.

If the fees it pays to third-party service providers exceed the unitary management fee received from the fund, the shortfall is borne solely by the asset manager. Similarly, the asset manager is entitled to retain excess fees received from the fund if the fees paid to third-party service providers do not exceed the unitary management fee.

The fund is responsible for certain costs that it will pay directly, including but not limited to taxes (for example, stamp duty), commissions and brokerage expenses, licensing fees relating to any applicable index, and costs associated with borrowings undertaken by the fund.

The asset manager determines that the fund is the customer and that the promised service to be provided to the customer pursuant to the management agreement is asset management services, which is a single performance obligation. Considerations relevant to identifying performance obligations are discussed in detail in paragraphs 4.6.19–4.6.53 of the section “Management Fee Revenue, Excluding Performance Fee Revenue.”

Assessment of control under FASB ASC 606-10-55-37A:

a.     Does the asset manager control a good or another asset from the other party that it then transfers to the customer?
No, the asset manager determines that it does not obtain control of a right to services performed by a third-party service provider that it then transfers to the customer. Unlike in Examples 47 and 48 in paragraphs 325–334 of FASB ASC 606-10-55, the customer is indifferent as to whether the asset manager, its affiliate or any other third-party service provider carries out the specified services, so long as those services are in accordance with the contractual terms; the asset manager does not obtain a right to services before a customer is identified. Further, the asset manager only contracted with third-party service providers after having been engaged by the customer. The asset manager is not transferring a specified asset; the contract representing the right to services is not transferred.

b.     Does the asset manager control a right to a service to be performed by a third party that gives the asset manager the ability to direct that party to provide the service to the customer on their behalf?
Yes, the asset manager controls the right to the services performed by third parties (for example, subadvisory or fund administration services) in context of the combined output that is the specified service of asset management services (also see c. below). The asset manager is primarily responsible for fulfilling the promise to provide asset management services and, while certain components of those services may be delegated to third-party service providers, remains responsible for ensuring that the services are performed and are acceptable to the customer in regard to the overall provision of asset management services.

c.     Are the services provided by third-party service providers combined with service provided by the asset manager prior to transferring those services to the customer?
Yes. The services performed by the third-party service providers are components of the asset manager’s overall promise to the customer to provide asset management services. Specifically, the nature of the contract is to provide integrated fund management services, inclusive of investment advisory services and certain operating services, as opposed to a specific quantity of specified services. The asset manager combines the services performed by the third-party service providers together with services performed by the asset manager (for example, the portfolio management services) in providing the combined service to the customer. Even though third parties perform certain of the underlying operating services and activities, the asset manager ultimately remains responsible for those services meeting customer specifications and for the resolution of disputes identified by the customer or by itself as part its normal management of the fund’s business operations.

In addition, the asset manager assesses the following indicators in FASB ASC 606-10-55-39 to provide further evidence that it controls the specified service before it is transferred to the customer (and the asset manager is therefore the principal):

a.     Does the asset manager have primary responsibility for fulfilling the promise to provide the specified service?
Yes, the asset manager is primarily responsible for fulfilling the promise to provide asset management services. Although the asset manager delegates certain services (for example, advisory, fund administration, and so on) to third-party service providers, the asset manager is responsible for ensuring that the services are performed and are acceptable to the customer.
The asset manager continuously and actively monitors outsourced services, regularly communicates with third-party service providers, is responsible for identifying any performance issues or concerns, and follows up with the third-party service providers (and with the fund board, if the matter is material) with regard to any corrective action plan set by itself or put forward by the fund. Further, the asset manager is responsible for all acts and omissions of third-party service providers, as per its contract with the fund. The asset manager is responsible for identifying and negotiating terms of service provider agreements with third-party service providers, including fees and the type and level of services to be performed, with final selection of third-party service providers and the final contract terms subject to customer approval. Since the approval rights do not afford the customer the ability to direct the services provided by the third-party service providers, they do not in and of themselves prohibit the asset manager from being primarily responsible for fulfilling the promise to provide the specified service. Further, the fund does not possess any incremental rights in regard to oversight or direction of the third-party service providers by virtue of its contract approval right (the customer is also not a party to the executed contracts with third-party service providers).

b.     Does the asset manager have pricing discretion?
Yes, the asset manager has discretion in setting the price paid by the fund to the asset manager for the provision of the specified service independent of the amount it agrees to pay the third-party service provider.

Based on the analysis above, the asset manager concludes that it is acting as the principal in the transaction and should accordingly recognize revenue on a gross basis.

Example 4-6-7—Distribution Agreement

The asset manager’s affiliated broker-dealer, a consolidated subsidiary of the asset manager, (referred to as “distributor affiliate” for purposes of this example) enters into a distribution agreement with a fund to provide certain distribution-related services, including but not limited to marketing and promotional activities, distribution of sales literature, and sales support services. In exchange, the distributor affiliate receives a fee based on the net assets of the fund that is separate and distinct from the asset management fee paid by the fund for asset management services performed by the asset manager.

The distributor affiliate subsequently delegates performance of the distribution activities to third-party broker-dealers under separately executed distribution agreements. Pursuant to these distribution agreements, the third-party broker-dealers agree to sell the shares of the fund to investors on their distribution platforms in exchange for a fee. The amount paid to the third-party broker-dealers may be calculated based on the fee paid to the distributor affiliate by the fund, either a percentage of the net assets of the fund or a fixed fee.¹⁴

The distributor affiliate determines that the fund is the customer and that the promised service to be provided to the customer pursuant to the distribution agreement is distribution-related services.

Assessment of control under FASB ASC 606-10-55-37A:

a.     Does the distributor affiliate control a good or another asset from the other party that it then transfers to the customer?
No, the distributor affiliate does not obtain control of a right to services performed by a third-party service provider that it then transfers to the customer. Unlike in Examples 47 and 48 in paragraphs 325–334 of FASB ASC 606-10-55 the customer is indifferent as to whether the third-party service provider, the distributor affiliate, or any other third-party service provider carries out the specified services, as long as those services are in accordance with the contractual terms; the distributor affiliate does not obtain a right to services before a customer is identified. Further, the distributor affiliate only contracted with third-party dealers after having been engaged by the customer. The distributor affiliate is not transferring a specified asset; the contract representing the right to services is not transferred.

b.     Does the distributor affiliate control a right to a service to be performed by a third party that gives the asset manager the ability to direct that party to provide the service to the customer on their behalf?
Yes, the distributor affiliate controls the right to services performed by third-party dealers (for example, distribution and sales-support services) in context of the combined output that is the specified service of distribution-related services (also see c. below). The distributor affiliate is primarily responsible for fulfilling the promise to provide distribution-related services and, while certain components of those services may be delegated to third-party broker-dealers, the distributor affiliate remains responsible for ensuring that the services are performed and are acceptable to the customer in regard to the overall provision of distribution-related services. The distributor affiliate, not the fund, retains the right to evaluate services performed by the third-party broker-dealer, to address service issues as and when they arise, to propose amendments to the dealer agreement as and when it deems appropriate, and to terminate the dealer agreement as and when it deems prudent.

c.     Are the services provided by third-party service providers combined with service provided by the distributor affiliate prior to transferring those services to the customer?
Yes, the services performed by the third-party broker-dealers are components of the distributor affiliate’s overall promise to the customer to provide distribution-related services. Specifically, the nature of the contract is to provide to the customer the combined distribution-related services. The distributor affiliate combines the services performed by all of the third-party broker-dealers, together with services performed by the distributor affiliate, if applicable, in providing the promised service to the customer. Even though third parties perform certain or all of the distribution-related activities, the distributor affiliate ultimately remains responsible for those services meeting customer specifications and for the resolution of disputes identified.

In addition, the distributor affiliate assesses the following indicators in FASB ASC 606-10-55-39 to provide further evidence that it controls the specified service before it is transferred to the customer (and is therefore the principal):

a.     Does the distributor affiliate have primary responsibility for fulfilling the promise to provide the specified service?
Yes, the distributor affiliate is primarily responsible for fulfilling the promise to provide distribution-related services. Although the distributor affiliate subcontracts distribution services to third-party dealers, it remains responsible for the acceptability of those services. The distributor affiliate continuously and actively monitors outsourced services, regularly communicates with third-party dealers, is responsible for identifying any performance issues or concerns, and follows-up with the third-party dealer (and with the fund board for material matters) with regard to any corrective action plan set by itself or put forward by the fund. Further, the distributor affiliate is responsible for all acts and omissions of third-party dealers as per the distribution agreement.
In addition, the distributor affiliate has sole discretion in selecting third-party dealers, the level of service to be provided by the third-party dealers, and the contractual fees that they will pay (which are agreed upon without approval from the fund board). It is the responsibility of the distributor affiliate to perform upfront and ongoing due diligence in identifying, retaining, and, as applicable, removing appropriate third-party dealers.

b.     Does the distributor affiliate have pricing discretion?
Yes, the distributor affiliate has discretion in setting the price paid by the fund for the provision of the specified service independent of the amount that it agrees to pay the third-party service provider.¹⁵

Based on the analysis above, the distributor affiliate concludes that it is acting as the principal in the transaction and should accordingly recognize revenue on a gross basis.

Example 4-6-8—Out-of-Pocket Expense Reimbursement

The asset manager enters into an asset management agreement with a fund to provide asset management services in exchange for a management fee based on the net asset value of the fund (“management fee”). The fee is paid monthly in arrears. Additionally, the fund agrees to reimburse the asset manager for reasonable out-of-pocket expenses incurred as part of performing asset management services. Customary out-of-pocket expenses incurred in connection with fulfilling the asset manager’s performance obligation to provide asset management services may include, but are not limited to, due diligence-related travel expenses (airfare, hotel, and meals), legal fees and other professional services fees, and filing and regulatory fees.

Paragraph 11 of TRG’s July 18, 2014 Agenda Ref Memo No. 2, which summarizes some stakeholders’ views, states that “[a]n entity could use the principal-agent framework to help it to determine whether the customer is compensating the entity for a cost it incurred to provide a good or service (that is, as a principal) or, instead, whether the entity is arranging for the customer to pay its (the customer’s) obligation to another party (that is, acting as an agent).”

Further, paragraphs 10–11 of TRG’s July 18, 2014 Agenda Ref Memo No. 5 state that

“[t]he TRG discussed questions about determining whether to present specific types of billings to customers as revenue or as a reduction of the related expense amounts. Examples of those amounts billed to customers include shipping and handling fees, reimbursements of other out-of-pocket expenses, and various taxes collected from customers and remitted to governmental authorities. The discussion focused on the definition of transaction price in paragraph 606-10-32-2 (IFRS 15, paragraph 47) and the principal versus agent considerations in paragraphs 606-10-55-36 through 55-40 (IFRS 15, paragraphs B34–B38). TRG members said that the new revenue standard provides sufficient guidance about determining the appropriate presentation of amounts billed to customers.”

Per FASB ASC 606-10-32-2, “The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes).” Therefore, in accordance with FASB ASC 606-10-32-2, reimbursements of out-of-pocket expenses that are collected on behalf of third parties — for example, filing and regulatory fees owed by the fund — should be excluded from the transaction price and reflected as receivable on the asset manager’s balance sheet. These reimbursements do not represent an amount of consideration the asset manager expects to be entitled in exchange for transferring the asset management services to the fund.

FinREC believes that the amounts of out-of-pocket expenses billed to customers for costs incurred by the asset manager in satisfying its performance obligation, such as due diligence-related travel expenses, legal fees, and other professional fees, should be included as part of the transaction price and presented gross. This is because the fund is compensating the asset manager for costs incurred to provide asset management services where the asset manager is acting as a principal.

The out-of-pocket expenses incurred by the asset manager in satisfying its performance obligation should be assessed as costs to fulfill a contract in accordance with FASB ASC 340-40. Industry considerations relevant to the assessment of these costs are discussed in detail within the section “Costs of Managing Investment Companies” in paragraphs 4.7.47–4.7.76.

4.7.01 Certain investment funds, generally referred to as back-end load funds, are established where the investor is not charged any fee upon initial investment into the fund, but rather is charged a CDSC if they withdraw their investment from the fund within a specified period of time (for example, seven years). The CDSC is calculated as a percentage of the investment being withdrawn from the fund subject to the CDSC (for example, a 6 percent redemption fee on a $100,000 withdrawal would result in a $6,000 CDSC fee upon an investor redemption) and could be structured such that the percentage declines with each year the investor remains in the fund.

4.7.02 Despite the deferral of the sales commission, the mutual fund distributor, which is typically a subsidiary of an asset manager, of the investment fund pays an upfront commission to a third-party distributor, usually a broker-dealer. The third-party broker-dealer receives the commission in exchange for referring investors to the fund.

4.7.03 Separately, the fund pays a recurring distribution fee to the asset manager who generally passes along a portion of the ongoing fee to the third-party distributor.

4.7.04 Guidance on the accounting for costs related to a contract with a customer within the scope of FASB ASC 606 is provided in FASB ASC 340-40. However, FASB ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) retained, but amended, the specific cost guidance related to non-front-end load funds (that is, back-end load funds) in FASB ASC 946-720-25-4.

4.7.05 BC303 of ASU No. 2014-09 states the following:

FASB noted that depending on the specific facts and circumstances of the arrangement between an asset manager and the other parties in the relationship, the application of the guidance on incremental costs of obtaining a contract might have resulted in different accounting for sales commissions paid to third-party brokers (that is, in some cases the commission would have been recognized as an asset, while in others it would have been recognized as an expense). FASB observed that it had not intended the application of Subtopic 340-40 to result in an outcome for these specific types of sales commissions that would be different from applying existing U.S. GAAP. Consequently, FASB decided to retain the specific cost guidance for investment companies in FASB ASC 946-605-25-8 which has been moved to Subtopic 946-720, Financial Services—Investment Companies—Other Expenses.

4.7.06 FASB ASC 946-720-25-4 specifically addresses the accounting for deferred distribution commission expense as follows:

Distributors of mutual funds that do not have a front-end load shall defer and amortize the incremental direct costs and shall expense the indirect costs when incurred.

4.7.07 If incremental direct costs are capitalized and an asset is recognized, FASB ASC 946-720-25-4 requires that the asset be amortized but does not provide specific guidance over what period the asset should be amortized.

4.7.08 FinREC believes that asset managers may consider the guidance on capitalized cost amortization in FASB ASC 340-40-35-1, which provides that the asset “shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.” Judgment on estimating the appropriate amortization period must be applied.

4.7.09 FinREC believes that the capitalized asset should also be evaluated for impairment, although FASB ASC 946-720-25-4 does not provide specific guidance on impairment considerations.

4.7.10 FinREC believes that asset managers may consider the guidance on capitalized cost impairment in paragraphs 3–6 of FASB ASC 340-40-35, which specifies in FASB ASC 340-40-35-3 that an impairment loss should be recognized if the carrying amount of the capitalized cost exceeds (1) the remaining amount of consideration the asset manager expects to receive in exchange for the services provided, less (2) the costs that relate directly to providing those services and that have not been recognized as expenses.

4.7.11 Asset managers often charge asset-based fees in exchange for performing asset management services. These services are performed and provide benefit to the customer¹⁶consistently over a given time period (for example, daily, monthly, quarterly, semi-annually, or annually). The terms of the management fee, which are typically a percentage of gross or net assets or average gross or net assets over a given period (such as daily, monthly, or quarterly) or at a point in time, and the billing terms of the fee (generally monthly, quarterly, or semi-annually) are included in an IMA between the asset manager and the customer. In accordance with FASB ASC 606-10-25-14(b) and consistent with Example 25 in paragraphs 221–225 of FASB ASC 606-10-55, the promise in the IMA to provide asset management services is a single performance obligation. This is because the promise consists of a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer (that is, transferred over time and generally performed daily). Considerations relevant to identifying separate performance obligations in IMAs are discussed in detail within the section “Management Fee Revenue, Excluding Performance Fee Revenue.”

4.7.12 In certain instances, some asset managers may waive or refrain from charging a portion or all the management fees for a certain period of time. Most fee waivers arise from one of two agreements by the asset manager: (a) to reduce a specified portion of management fees (referred to as flat fee waivers) or (b) to limit the total expense ratio that accrues to and is specific to a particular share class, typically expressed as a percentage of average daily net assets and referred to as an expense cap. Expense caps are designed to limit the amount of expenses a shareholder experiences and can exist at a master fund level (in a master-feeder structure) or fund level and are specific to each share class. They may be affected by reductions in fees or cash reimbursements of fees, or both. Comparatively, “flat” reductions of management fees apply to all share classes and are granted separate from expense caps. For purposes of this section, unless stated otherwise, fee waivers and expense caps will collectively be referred to as fee waivers.

4.7.13 Fee waivers generally are legally enforceable and may not require a significant degree of judgment to interpret or involve uncertainty. Nonregistered funds may grant fee waivers and expense caps. However, such grants are not commonplace and are often granted for particular reasons, such as poor fund performance or to remain competitive (maintain clients). Investment companies registered under the Investment Company Act of 1940 (referred to as registered funds or funds for the purpose of this section, unless otherwise indicated) may have either or both contractual and voluntary fee waivers, as described subsequently.

4.7.14 Contractual fee waivers are typically documented in a fund’s prospectus. They may also be documented in an expense limitation agreement or similar type of contract that outlines the terms of all (or most) of the asset manager’s contractual fee waivers in existence at any given time. For example, this contract may detail the applicable expense limit for specified registrants, the method of computing the liability that the asset manager owes under the expense cap, year-end adjustment, applicable management or administration fee that is waived, or the conditions pursuant to which the asset manager has a right to claim reimbursement of previously waived or reduced fees and expenses reimbursed from specified share classes of specified portfolios.

4.7.15 Contractual fee waivers are generally¹⁷in place for a minimum of one year beginning on the filing date of the prospectus and are renewed or approved by the fund’s board annually in conjunction with the filing of the prospectus. They are commonly implemented at fund launch. In comparison, voluntary fee waivers do not require approval of the fund’s board, have no minimum time period, can be discontinued at any time by the asset manager, and may be less transparent to new shareholders because they may not be reflected in the prospectus fee table or footnote.

4.7.16 “Flat” fee waivers may be stated in terms of a fixed amount or may be variable (for example, calculated as a certain number of basis points applied to the daily average asset value). Expense caps tend to be stated in terms of a percentage of the value of assets under management or AUM. Any number of reasons may cause an asset manager to grant a fee waiver, including market factors (for example, competition), interest in attracting or retaining investors, addressing a client’s dissatisfaction in service (for example, customer goodwill), or service disruptions, among others. Asset managers typically do not receive any distinct goods or services from the customer for providing fee waivers. This is assumed to be the case for purposes of this section.

4.7.17 As indicated previously, some asset managers may agree to limit the amount of certain operating expenses incurred by shareholders (that is, expense caps). Expense caps reduce the fund’s expense ratio because the asset manager agrees to either (a) reduce the amount of management or administration fees due them from the specific share class or (b) provide a cash reimbursement of certain operating expenses. Expense caps involve a more complex implementation process than “flat” fee waivers. They often involve a specific ordering of reductions in fees and fee reimbursements to achieve the contractual or voluntary expense cap. The sequence in which fees are reduced or reimbursed begins by evaluating the particular expenses related to the share class to which the expense cap applies. If those expenses pertain to fees paid to the asset manager (for example, for administration, advisory, or call center services), they are waived to the extent applicable based on the expense cap. To the extent they pertain to fees paid to external vendors (for example, for transfer agency, networking, and other operating expenses), the asset manager may reimburse such amounts to the fund or may make payment directly to the third-party vendor. If still more waivers or reimbursements are required in order to support the expense cap, then fund-level expenses are reviewed for possible reduction or reimbursement. Additional waivers or reimbursements are required when class level expenses for the given period have been reduced to zero (through class-level fee waiver) and the expense cap (which is share-class-specific) has not yet been achieved. Other expenses (those incurred at the fund level on behalf of shareholders of all classes) must, therefore, be reduced or reimbursed. Expenses that are waived or reimbursed at the fund level benefit shareholders in all share classes (that is, share classes that are not subject to the particular expense cap will also benefit from the incremental reduction in fees or reimbursement).

4.7.18 To the extent that fee waivers exceed the gross management fee payable to the asset managers for a given performance period, the asset manager normally will not receive any fees and, instead, will pay the excess amount to the fund. Conversely, if the cumulative daily fee waivers or expense reimbursements exceed the fund’s final calculated fee waiver or expense cap, respectively, the asset manager may be able to claim a refund, depending on the terms of the given fee waiver. Notably, these adjustments tend to be immaterial because throughout the year (a) there is generally only a one-month lag in obtaining expense information from a fund for any days of a given month that the asset manager must estimate due to its internal reporting process, and (b) an asset manager often has “actual” data for most, if not all, days of each month (for example, for the first 25 days of each month), depending on internal reporting requirements. Therefore, based on the internal accounting cut-off date for reporting purposes, either (a) no estimation is required because monthly reporting is conducted early in the following month, or (b) only limited estimation is required for a few days each month (that is, by extrapolation from the actuals data) because the internal reporting cut-off date is a few days prior to month-end.

4.7.19 The accounting treatment of fee waivers is affected by the following factors:

a.     Timing of execution relative to fund or account establishment or IMA renewal.

b.     Timing of execution relative to services rendered (that is, before or after).

c.     Whether they pertain to a “flat” fee waiver or to an expense cap.

4.7.20 For purposes of this section of the appendix, fee waivers are classified in one of three categories, as described in the following table.

4.7.21 Industry considerations relevant to the determination of the customer and identification of the contract with the customer are discussed in detail within the section, “Determining the Customer in an Asset Management Arrangement,” in paragraphs 4.1.01–4.1.10 and the section “Identifying the Contract With a Customer in an Asset Management Arrangement” in paragraphs 4.1.11–4.1.19 in this appendix. FinREC believes that irrespective of whether the fund or investor is identified as the customer for purposes of applying FASB ASC 606 to the promise to provide asset management services, the identified performance obligations and corresponding accounting treatment discussed herein will not differ. However, the revenue recognition analysis may differ depending on the existence of other performance obligations, and also application of the cost guidance in FASB ASC 340-40 may differ based on the nature of the costs. The evaluation of contract modifications is addressed in paragraphs 4.7.22–4.7.27.

Contract Modifications

4.7.22 FinREC believes that the guidance on contract modifications applies to fee waivers that are not executed concurrently with fund or account establishment or renewal of a contract (that is, fee waivers in categories 2 and 3) because these fee waivers change existing enforceable rights and obligations of the parties to the original contract. Although there is typically not a change in the scope of services to be performed under the related contract, the fee waiver represents an agreed-upon change in the transaction price.

4.7.23 If these fee waivers are subsequently renewed concurrent with renewal of the related contract, then contract modification guidance will not apply. Instead, in those situations, consideration must be given to other provisions within FASB ASC 606; specifically, refer to the discussion that follows on category 1 fee waivers and applicability of the guidance on combination of contracts.

4.7.24 Category 2 fee waivers. The contract modification guidance in FASB ASC 606-10-25-13(a) applies because the remaining services to which the fee waiver pertains are distinct from services transferred before the date of the contract modification. As explained in paragraphs 4.7.31–4.7.32, the promise to provide asset management services is a single performance obligation that represents a series of distinct services, pursuant to the guidance in FASB ASC 606-10-25-14(b). Basis for Conclusions paragraph BC79 supports the application of FASB ASC 606-10-25-13(a) to this type of single performance obligation, that is, a single performance obligation that represents a series of distinct goods or services. In applying FASB ASC 606-10-25-13(a), FinREC believes that category 2 fee waivers are accounted for as if they were a termination of the existing contract and, the creation of a new contract. Therefore, the amount of these fee waivers is allocated to the remaining distinct services within the single performance obligation.

4.7.25 If the customer’s right to the fee waiver is linked to payment of future management fees, then the asset manager must continue to transfer asset management services to the customer to generate the management fees against which the fee waiver will be applied. As such, the fee waiver relates to the promise to provide future asset management services. This may be the case when a fee waiver states that it will only be provided if the customer continues to engage the asset manager under the IMA and, if the customer terminates the contract with the asset manager, the customer will forfeit the right to any fee waiver not yet provided.

4.7.26 Category 3 fee waivers. The contract modification guidance in FASB ASC 606-10-25-13(b) applies because the remaining services to which the fee waiver pertains are not distinct from services transferred before the date of the contract modification. In fact, there are no remaining services to be performed related to the fee waiver. Accordingly, the transaction price and the asset manager’s measure of progress toward complete satisfaction of the performance obligation are updated to reflect the amount of the fee waiver as of the contract modification date. That is, the adjustment to revenue is made on a cumulative catch-up basis on the date of contract modification. This adjustment to revenue should be recognized at the date of contract modification, even if payment of the fee waiver is linked to payment of future management fees, provided the asset manager is obligated as of that date to pay or remit the full amount (that is, the fee waiver is not subject to forfeiture). For further discussion, see item (b) in paragraph 4.7.27.

4.7.27 If the customer’s right to the fee waiver is not linked to payment of future management fees, then the asset manager is not required to continue to transfer asset management services to the customer to generate the management fees against which the fee waiver will be applied. As such, the fee waiver relates to the promise to provide past asset management services. This may be the case, for example, when (a) the fee waiver is granted in full upon its execution, or (b) when a fee waiver is provided over a specified period of time and entitles the customer to a catch-up adjustment for any amount of the fee waiver not yet paid if and when they terminate their contract with the asset manager or the fund prior to the end of the fee waiver period.

Combination of Contracts

4.7.28 FinREC believes that the guidance on combination of contracts applies to fee waivers that are executed concurrent with fund or account establishment or renewal of a contract (category 1). As explained in the section “Identifying the Contract With a Customer in an Asset Management Arrangement” in paragraphs 4.1.11–4.1.19, in certain instances, two or more separate contracts should be evaluated collectively for purposes of applying FASB ASC 606.

4.7.29 Based on the contract combination guidance in FASB ASC 606-10-25-9, FinREC believes the contract¹⁹and fee waiver would collectively be considered a single contract. The contracts are entered into at or near the same time with the same customer and the amount of consideration to be paid in one contract (the fee waiver) depends on the price or performance, or both, of services rendered under the other contract (for example, the IMA). For example, a fee waiver may provide for a reduction in management fees in the amount of 0.20 percent per annum of daily average asset value for the remaining performance period as and when management services are rendered.

4.7.30 Upon concluding that the fee waiver should be combined with the related contract, the fee waiver, management fees, and any other forms of consideration per the contract (for example, performance fees) should be evaluated as components of the transaction price to which the asset manager expects to be entitled in exchange for transferring promised services to the customer under the contract.

4.7.31 As explained in paragraphs 4.6.28–4.6.31 of the “Management Fee Revenue, Excluding Performance Fee Revenue” section, the promise to provide asset management services represents a single performance obligation based on application of the series guidance in FASB ASC 606-10-25-14(b) and related paragraphs.

4.7.32 The aforementioned guidance, as well as that included in FASB ASC 606-10-25-19 on identifying performance obligations, applies to the service contract that underlies all fee waivers (irrespective of fee waiver category). Fee waivers are not, in and of themselves, promises to transfer control over goods or services to the customer, nor are they payments for distinct goods or services from the customer. Instead, they generally represent a transaction price adjustment under FASB ASC 606-10-32-36, whether affected through a contract modification or an agreed-upon upfront reduction in management fees.

4.7.33 Considerations for evaluating the amount of management fees and performance fees to include in the transaction price are discussed in detail in paragraphs 4.6.32–4.6.36 of the “Management Fee Revenue, Excluding Performance Fee Revenue ” revenue section and in paragraphs 4.6.62–4.6.70 of the “Incentive or Performance Fee Revenue, Excluding Incentive-Based Capital Allocations (Such as Carried Interest )” section. The following discussion provides considerations specific to fee waivers in categories 1 and 2.

Variable Consideration and Consideration Payable to a Customer

4.7.34 Generally, for fee waivers in categories 1 and 2 as of their respective effective date, the guidance on both consideration payable to a customer and variable consideration must be contemplated. Both sets of guidance apply because the fee waivers (a) represent payment to the customer (generally in the form of a billing adjustment or cash reimbursement) and (b) are variable in amount (that is, subject to an underlying variable factor or subject, or both, to the continued provision of asset management services). According to FASB ASC 606-10-32-25, if consideration payable to a customer includes a variable amount, an entity must estimate the transaction price in accordance with the guidance on variable consideration. The guidance on variable consideration requires that an estimate of the amount to include in the transaction price be determined by using one of the following two methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.     The expected value of the contract determined by the sum of probability-weighted amounts in a range of possible consideration amounts.

b.     The most likely amount equal to the single most likely amount in a range of possible consideration amounts.

4.7.35 The estimated amount of variable consideration that is included in the transaction price must be updated each reporting period along with a re-evaluation of the applicability of the guidance on constraining estimates of variable consideration. FinREC believes that the expected value method (sum of probability-weighted amounts) will best predict the amount of base management fees that the asset manager will be entitled to given the large number of possible consideration amounts and limited predictive value of the asset manager’s experience with similar types of fee waivers, as discussed in FASB ASC 606-10-32-8.

4.7.36 However, variable consideration can only be included in the transaction price to the extent it is not subject to the constraint. See paragraphs 4.7.38–4.7.43 for further discussion.

4.7.37 In applying the variable consideration guidance to fee waivers in categories 2 and 3, an additional timing consideration applies. That is, the asset manager must determine whether this guidance applies prior to the granting of the fee waiver, that is, prior to the effective date of the contract modification (as opposed to as of the date of contract modification). Such would be the case when an implicit price concession exists because negotiations of a fee waiver are well underway as of the end of the reporting period (with anticipated resolution in the near term), or the customer has a valid expectation as of the end of a reporting period that a fee waiver will be granted based on the entity’s customary business practices, published policies, or specific statements.

Constraining the Cumulative Amount of Revenue Recognized

4.7.38 The transaction price for the performance obligation to which fee waivers relate (namely those in categories 1 and 2, which relate to the promise to provide asset management services on a go-forward basis), should include an amount of variable consideration estimated in accordance with FASB ASC 606-10-32-8 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. For fee waivers with a fixed amount (a “fixed fee waiver”), this typically means that the transaction price will reflect the entire amount of the fee waiver upon its effective date, or earlier if the asset manager believes that there is an implicit fee waiver as discussed in paragraph 4.7.37.

4.7.39 Comparatively, non-fixed fee waivers require evaluation of the factors listed in FASB ASC 606-10-32-12 to determine whether a portion or all of the amount estimated in accordance with FASB ASC 606-10-32-9 is restricted from inclusion in the transaction price until the underlying contingency is resolved. Non-fixed fee waivers are often calculated by applying a specified rate (basis points) to a measure of AUM (for example, daily average net AUM); therefore, their element of variability is the associated AUM, which can vary each day. Resolution of this underlying contingency (typically, the associated AUM) occurs when the measure of AUM (or other variable factor) on which the fee waivers are calculated becomes fixed. FinREC believes that the constraint guidance will often apply to non-fixed fee waivers because AUM is dependent on the market and, thus, is highly susceptible to factors outside the asset manager’s influence. In addition, non-fixed fee waivers typically have a large number and broad range of possible consideration amounts. Further, although the asset manager may have experience with similar contracts, that historical experience is typically of little predictive value in determining the future performance of the market or the asset manager’s intent on issuing additional similar fee waivers in the future.

4.7.40 Another consideration when evaluating the amount of fee waiver to reflect in the transaction price is that the amount to reflect may need to be greater than the estimated amount of the fee waiver as determined in accordance with paragraphs 5–9 of FASB ASC 606-10-32, due to broader macroeconomic events. Consider the situation described in the following paragraphs.

4.7.41 If the amount of AUM significantly declines for a given reporting period, the amount of the associated fee waiver may significantly increase and could potentially result in repayment of management fees, specifically in the case of expense caps. As explained previously, expense caps (a) are generally written in terms of a percentage of average daily net assets, on an annual basis, and (b) as with “flat” fee waivers, are subject to the guidance on constraining estimates of variable consideration. Accordingly, if AUM significantly declines, the quantified dollar amount of the expense cap (calculated based on the contractual percentage of average daily net assets) could be significantly lowered. In these instances, therefore, it would be easier for the expense cap to be met and for a greater amount of operating expenses to exceed the expense cap; hence, a larger fee waiver would need to be provided. As such, the asset manager may not be able to conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized to-date will not occur. When the amount of promised consideration from the customer, including management fees, is highly susceptible to external factors (such as the potential for fluctuations in net assets arising from market changes and unpredictable shareholder activity), the recognition of revenue may be constrained in accordance with paragraphs 11–12 of FASB ASC 606-10-32.

4.7.42 Although the variable consideration may be constrained when an expense cap exists, the constraint would most likely have a material impact on the recognition of revenue when the asset manager believes that the net assets might fluctuate significantly during the current period. Factors to consider include the following:

a.     Stability of the net assets (that is, if the fund has reached critical mass)

b.     Susceptibility to significant investor subscription and redemption activity

c.     Investment objective of the fund or portfolio relative to market conditions and macroeconomic events and history of instability or uncertainty, resulting in volatile investment valuations

4.7.43 Because fee waivers typically pertain to an asset management service performance obligation that (a) is satisfied over time, (b) represents a series of distinct services in accordance with FASB ASC 606-10-25-14(b), and (c) is provided in exchange for variable consideration in the form of management fees, considerations relevant to the allocation of variable consideration apply. These considerations are discussed in detail within the section, “Management Fee Revenue, Excluding Performance Fee Revenue.”

Satisfaction of the Performance Obligations—Contracts Entered at or Near the Same Time

4.7.44 For all fee waivers, satisfaction of the corresponding performance obligation to provide asset management services must be assessed. As described previously, fee waivers do not represent distinct performance obligations themselves but, rather, an adjustment to the transaction price allocated to a related performance obligation by representing (a) a component of transaction price as of fund or account establishment or contract renewal (category 1), (b) a component of transaction price as of contract modification date (category 2), or (c) a change in price of a contract that is affected by a contract modification (categories 2 and 3). Considerations related to evaluating satisfaction of a performance obligation to provide asset management services are discussed in detail in paragraphs 4.6.42–4.6.46 of the section “Management Fee Revenue, Excluding Performance Fee Revenue.”

Measuring Progress Toward Complete Satisfaction of a Performance Obligation

4.7.45 Because all fee waivers pertain to a performance obligation to provide asset management services and that performance obligation is satisfied over time, considerations relevant to measuring progress toward complete satisfaction of this performance obligation apply. These considerations are discussed in detail in paragraphs 4.6.44–4.6.46 of the section “Management Fee Revenue, Excluding Performance Fee Revenue.”

4.7.46 The examples in this section are meant for illustrative purposes only and are not intended to be all inclusive. They highlight application of key concepts discussed in this appendix as they relate to the three categories of fee waivers defined herein. Consideration should be given to all relevant facts and circumstances of an entity's situation. Certain aspects of the points raised for assessment in the examples may apply to a greater or lesser extent to an entity's own situation, as required by the given facts and circumstances.

Example 4-7-1—Category 2: “Flat” Fee Waiver

An asset manager launched a new mutual fund and did not concurrently agree to provide a fee waiver or expense cap. The fund’s prospectus established the management fees for the fund’s three share classes, which range from 30 basis points (bps) to 45 bps per annum. Over the following year, certain regulations were changed such that it became easier for similar funds to be launched by foreign asset managers. Upon identifying a number of new products entering the market similar to its own while performing its ongoing, regular market trend analysis, the asset manager undertook a competitor analysis and determined that it should reduce its fees on all of its share classes (at least temporarily) to remain competitive. This fee waiver was implemented mid-year and not concurrent with the annual issuance of its prospectus. The fee waiver is expected to be applied for the foreseeable future at the asset manager’s sole discretion.

In accounting for the fee waiver, the asset manager determines that the guidance on contract modifications in paragraphs 10–13 of FASB ASC 606-10-25 applies. In particular, subparagraph (a) of FASB ASC 606-10-25-13 is the appropriate guidance because the remaining services to be performed by the asset manager under its IMA with the mutual fund is distinct from services previously rendered. Before finalizing this assessment, the asset manager also considers whether the variable consideration guidance applies and, hence, an estimate of the fee waiver should be included in the transaction price prior to the effective date of the contract modification. In this regard, the asset manager determines that it has insufficient history of fee waivers granted by this mutual fund; the impetus behind fee waivers granted for other mutual funds were primarily driven by unique market events and conditions and, hence, have limited predictive value; and that its customary business practices, published policies, and statements are not sufficient to create a valid expectation of the customer that the entity will accept an amount of consideration that is less than the stated management fee in the IMA. In summary, until completion of the competitor analysis and management signoff of a voluntary fee waiver, the asset manager concludes that the fee waiver should not be reflected in the transaction price.

The asset manager will treat the fee waiver as a reduction of the transaction price (and, hence, of revenue) because the billing adjustment represents consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange. When determining when to reflect the fee waiver in the transaction price (and, hence, in revenue), the asset manager considers the factors in FASB ASC 606-10-32-12 because the fee waiver does not have a fixed amount. Instead, the amount of the fee waiver is calculated by applying a specified number of basis points to average daily AUM. Accordingly, based on the asset manager’s assessment and as outlined in paragraph 4.7.39, only the daily calculated amount of the fee waiver is reflected in the transaction price each day, post-effective date of the fee waiver.

Example 4-7-2—Category 1: “Flat” Fee Waiver

An asset manager agrees to manage a fund pursuant to an IMA with a stated management fee at the annual rate of 1 percent of the fund’s daily average net assets. Concurrently, the asset manager agrees to waive a flat (non-variable) 0.20 percent of daily average net assets for a one-year period, subject to annual renewal. Because the two agreements are entered into with the same customer, the asset manager considers the guidance on combining contracts in FASB ASC 606-10-25-9 when determining its accounting for the fee waiver. The asset manager concludes that the IMA and fee waiver agreement (documented in the fund’s prospectus) meet the two conditions in FASB ASC 606-10-25-9 to be evaluated collectively under FASB ASC 606 because they are entered into at or near the same time with the same customer and have a single commercial objective.

In applying FASB ASC 606 to the combined contract, the asset manager determines that both the management fee and fee waiver pertain to the same performance obligation, to provide asset management services for the customer. That is, they are both components of consideration promised by the customer for a single promised service. Accordingly, the asset manager concludes that the transaction price (and, hence, revenue) should be determined on a go-forward basis by applying an annualized percentage of 0.80, that is, the annual management fee of 1 percent less the fee waiver of 0.20 percent, to the fund’s daily average net asset value.

The asset manager will treat the fee waiver as a reduction of the transaction price (and, hence, of revenue) because the billing adjustment represents consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange. When determining when to reflect the fee waiver in the transaction price (and, hence, in revenue), the asset manager considers the factors in FASB ASC 606-10-32-12 because the fee waiver does not have a fixed amount. Instead, the amount of the fee waiver is calculated by applying a specified number of basis points to average daily AUM. Accordingly, based on the asset manager’s assessment and as outlined in paragraph 4.7.39, only the daily calculated amount of the fee waiver is reflected in the transaction price each day, post-effective date of the fee waiver.

Example 4-7-3—Category 1: Expense Cap

Background

The asset manager manages a fund for which it is entitled to a management fee at the annual rate of 1 percent of the fund’s average daily net assets. Upon launching the fund, the asset manager concurrently agrees to an expense cap for the fund’s single share class to help attract investors while the fund is in its growth phase to get up to scale. The expense cap contractually limits specified fund operating expenses to 1.20 percent of daily average net asset value on an annualized basis. To determine the quantified dollar amount of an expense cap for any given day, the mutual fund calculates the operating expenses incurred year-to-date as a percentage of year-to-date daily average net asset value. This percentage is then annualized and compared to the 1.20 percent agreed-upon expense cap. If the ratio is greater than 1.20 percent, the asset manager will reduce its management and administrative fees or reimburse the fund for all or a portion of the excess, or both, based on the specific order of expense waivers and reimbursements to achieve this particular expense cap.

For a given day during the current period, the expense cap ratio is determined to be 1.25 percent. Based on the specific order of expense waivers and reimbursement to achieve the share class’s expense cap, the difference is first required to be satisfied by a reduction in the asset manager’s management and administrative fees. After reducing those fees to zero, a portion of that difference remains to be supported. The asset manager satisfies this remaining amount with a cash reimbursement to the fund, which relates to fees paid to external vendors.

The asset manager will treat the expense cap, whether affected by the fee waiver or cash reimbursement, as a reduction of the transaction price (and, hence, of revenue) because the billing adjustment and payment represents consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange. When determining when to reflect the expense cap in the transaction price (and, hence, in revenue), the asset manager considers the factors in FASB ASC 606-10-32-12 because the expense cap does not have a fixed amount. Instead, the amount of the expense cap is calculated by applying a specified number of basis points to annual AUM (calculated based on average daily AUM to operationalize). Accordingly, based on the asset manager’s assessment and as outlined in paragraph 4.7.39, only the daily calculated amount of the expense cap is reflected in the transaction price each day, post-effective date of the expense cap.

Example 4-7-4—Category 1: Expense Cap and “Flat” Fee Waiver

Background—See background in example 4-7-3.

In addition to the expense cap, the asset manager agrees to a flat (non-variable) fee waiver of 0.20 percent per annum. As of a given day, the mutual fund estimates that annualized expenses to-date are 1.23 percent. As a result, the asset manager records revenue at the rate of a net annualized management fee of 0.77 percent. This rate is determined by subtracting from the annualized management fee of 1 percent (a) the 0.20 percent annualized fee waiver, and (b) the annualized expense cap of 0.03 percent.

The asset manager observes that depending on continued AUM volatility, its management fee may need to be constrained further from recognition in the current period, that is, below the net annualized rate of 0.77 percent. At each subsequent reporting date, the asset manager will need to determine whether any additional portion of the consideration should be constrained from inclusion in the transaction price (and, hence, in revenue). The asset manager must use judgment in determining the amount of transaction price (and, hence, revenue) that is limited by the revenue constraint discussed in paragraphs 11–13 of FASB ASC 606-10-32.

The asset manager will treat the expense cap and fee waiver as a reduction of the transaction price (and, hence, of revenue) because the related billing adjustments represent consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange. When determining when to reflect the expense cap and fee waiver in the transaction price (and, hence, in revenue), the asset manager considers the factors in FASB ASC 606-10-32-12 because neither the expense cap nor the fee waiver has a fixed amount. Instead, the amount of both the expense cap and the fee waiver is calculated by applying a specified number of basis points to average daily AUM. Accordingly, based on the asset manager’s assessment and as outlined in paragraph 4.7.39, only the daily calculated amount of the expense cap and fee waiver is reflected in the transaction price each day, post-effective date of the expense cap and fee waiver.

Example 4-7-5—Category 2: “Flat” Fee Waiver

An asset manager agrees to provide a fee waiver to a customer as a goodwill gesture to help cover costs they recently incurred as a result of the asset manager’s actions. Specifically, due to an internal reorganization, the fund’s management team and investment guidelines were changed, which required the customer to incur certain costs in making the necessary legal agreement transfers. The asset manager agrees to reduce its management fees by a specified amount over the next four quarters. The customer is entitled to the fee waiver for as long as it remains a client of the asset manager over that period of time. If the customer terminates its contract with the asset manager prior to the end of the four quarters, they forfeit any unpaid fee waiver.

Similar to example 4-7-1, in accounting for the fee waiver, the asset manager determines that the guidance on contract modifications in paragraphs 10–13 of FASB ASC 606-10-25 applies. Also, akin to example 4-7-1, the asset manager determines that FASB ASC 606-10-25-13(a) is the specifically applicable guidance because the remaining services to be performed by the asset manager under its IMA with the mutual fund are distinct from services previously rendered. Although the motivation for providing the fee waiver is a past incident, the fact that future reductions in billings depend on the asset manager continuing to perform asset management services under the IMA supports the fee waiver’s relevance to its promise to provide future asset management services.

The asset manager also considers whether the fee waiver is subject to the variable consideration guidance and, if so, when. In this regard, the asset manager determines that the fee waiver is a form of variable consideration (it does not have a fixed amount); the amount of the fee waiver is calculated by applying a specified number of basis points to average daily AUM. Then, consideration is given to whether this form of price concession should be included in the transaction price prior to or as of the effective date of the contract modification. The asset manager observes that it has insufficient history of fee waivers granted by this mutual fund; the impetus behind fee waivers granted for other mutual funds were primarily driven by unique market events and conditions and, hence, have limited predictive value; and that its customary business practices, published policies, and statements are not sufficient to create a valid expectation of the customer that the entity will accept an amount of consideration that is less than the stated management fee in the IMA. Given these factors, the asset manager concludes that until management approves the voluntary fee waiver and the waiver becomes effective, the fee waiver should not be considered for inclusion in the transaction price because there is no implicit price concession as described in FASB ASC 606-10-32-7. Once the fee waiver is effective, the asset manager evaluates the factors in FASB ASC 606-10-32-12. Based on the asset manager’s assessment of this guidance and in accordance with the framework in paragraph 4.7.39, only the daily calculated amount of the fee waiver is includible in the transaction price each day, post-effective date of the fee waiver.

The asset manager will treat the fee waiver as a reduction of the transaction price (and, hence, of revenue) because the billing adjustment represents consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange.

Example 4-7-6—Category 3: “Flat” Fee Waiver

The same facts as in example 4-7-5 apply, except that the customer does not forfeit any unpaid fee waiver should the customer terminate the contract with the asset manager prior to the end of the fee waiver payout period. The asset manager is obligated upon grant date to provide the fee waiver in full. Therefore, should the customer’s contract be terminated prior to the full year, any unpaid fee waiver will become due and payable to the customer at that time.

Similar to examples 4-7-1 and 4-7-5, in accounting for the fee waiver, the asset manager determines that the guidance on contract modifications in paragraphs 10–13 of FASB ASC 606-10-25 applies. However, dissimilar to the prior examples, the asset manager determines that FASB ASC 606-10-25-13(b) is the specifically applicable guidance because the remaining services to which the fee waiver pertains are not distinct from services transferred before the date of the contract modification. In fact, there are no remaining services to be performed in order for the customer to be entitled to the fee waiver. Accordingly, the transaction price and the asset manager’s measure of progress toward complete satisfaction of the performance obligation are updated to reflect the amount of the fee waiver as of the contract modification date.

The asset manager also considers whether the fee waiver is subject to the variable consideration guidance and, if so, when. In this regard, the asset manager determines that the fee waiver is a form of variable consideration (it does not have a fixed amount); the amount of the fee waiver is calculated by applying a specified number of basis points to average daily AUM. Then, consideration is given to whether this form of price concession should be included in the transaction price prior to or as of the effective date of the contract modification. The asset manager observes that it has insufficient history of fee waivers granted by this mutual fund; the impetus behind fee waivers granted for other mutual funds were primarily driven by unique market events and conditions and, hence, have limited predictive value; and that its customary business practices, published policies, and statements are not sufficient to create a valid expectation of the customer that the entity will accept an amount of consideration that is less than the stated management fee in the IMA. Given these factors, the asset manager concludes that until management approves the voluntary fee waiver and the waiver becomes effective, the fee waiver should not be considered for inclusion in the transaction price because there is no implicit price concession as described in FASB ASC 606-10-32-7. Once the fee waiver is effective, the asset manager evaluates the factors in FASB ASC 606-10-32-12. Based on the asset manager’s assessment of this guidance and in accordance with the framework in paragraph 4.7.39, only the daily calculated amount of the fee waiver is includible in the transaction price each day, post-effective date of the fee waiver.

The asset manager will treat the billing adjustment as a reduction of the transaction price (and, hence, of revenue) because the payment represents consideration payable to the customer, and the asset manager is not receiving a distinct good or service from the customer in exchange. However, unlike in the prior examples, the fee waiver, in its entirety, will be reflected as a reduction in revenue as well upon grant date because (a) there are no remaining contingencies that restrict inclusion of the full amount in the transaction price (that is, the asset manager is obligated to provide the fee waiver in full as of this date and the amount is known), and (b) the asset manager is not required to perform future services. Whether and when the customer subsequently terminates its contract with the asset manager has no implication on the asset manager’s obligation to provide the fee waiver as of grant date or the amount of the fee waiver owed to the customer.

4.7.47 Asset managers incur various costs related to sponsoring and managing investment companies. Costs may be incurred to establish the investment company, raise capital from potential investors, or pay for costs incurred in the ordinary course of performing services for the customer pursuant to an investment management agreement (IMA). Costs involved in these activities may include, but are not limited to, structuring and underwriting expenses to form a new investment company, commissions paid to third-party broker-dealers (up-front, ongoing, or back-end commissions) to market and issue shares to prospective investors, placement fees paid to third parties to raise capital, and out-of-pocket expenses, such as commissions and brokerage fees, due diligence travel expenses (airfare, hotel, and meals), legal and other professional fees incurred in the performance of services, and filing and regulatory fees. The accounting treatment for these costs may be subject to the cost guidance in FASB ASC 340-40 if they pertain to a contract with a customer within the scope of FASB ASC 606.

4.7.48 Applicability and evaluation of the guidance in FASB ASC 340-40 for a given cost may differ depending on whether the asset manager identifies the investment company or the investor as its customer in the contract. Industry considerations relevant to determining the customer and identifying the contract are discussed in detail in paragraphs 4.1.01–4.1.10 of the “Determining the Customer in an Asset Management Arrangement” section and in paragraphs 4.1.11–4.1.19 of the “Identifying the Contract With a Customer in an Asset Management Arrangement” section.

4.7.49 FASB ASC 340-40 provides the accounting treatment for incremental costs of obtaining a contract within the scope of FASB ASC 606 and accounting for costs of fulfilling a contract with a customer that are not within the scope of another Topic. Incremental costs of obtaining a contract with a customer are those that would not have been incurred if the contract had not been obtained. Costs to fulfill a contract are those that relate directly to an existing contract or a specified anticipated contract. If certain conditions are met for either type of cost, the costs incurred would need to be capitalized, amortized, and periodically tested for impairment. Each cost incurred in relation to a contract with a customer within the scope of FASB ASC 606 would need to be evaluated separately under the guidance in FASB ASC 340-40, based on who the asset manager has identified as its customer in the contract.

Incremental Costs of Obtaining a Contract

4.7.50 Paragraphs 1–3 of FASB ASC 340-40-25 explain that costs of obtaining a contract should be recognized as an asset if they are incremental and expected to be recovered. In accordance with FASB ASC 340-40-25-2, incremental costs of obtaining a contract with a customer are those costs that an entity would not have incurred if the contract with the customer had not been obtained (that is, payment is contingent upon obtaining the contract with the customer). This depends on who is the customer.

4.7.51 In determining whether the costs are considered “recoverable,” the asset manager should evaluate if it would expect that the future consideration to which it is entitled under the contract would be sufficient to recoup or reimburse those costs in their entirety.

4.7.52 Costs incurred prior to and for the purpose of forming the investment company. In establishing an investment company, an asset manager may incur costs prior to the inception of the investment company (pre-launch costs), also referred to as organization and offering costs. Such costs may include fees paid to third parties for structuring and underwriting of the investment company. In these instances, in exchange for payment, the third-parties will provide advice regarding the design and organization of the investment company, as well as services related to the sale and distribution of investment company shares. The asset manager may be required to pay for certain expenses incurred by the third-party service provider, regardless of whether the investment company launches. These expenses may include legal fees; accounting fees; costs and expenses related to the transfer and delivery of the shares to the underwriters; the cost of printing or producing agreements; filing fees; all fees and expenses in connection with the preparation and filing of registration statements; the cost of printing certificates representing the shares, the costs, and charges of any transfer agent, registrar or depository; and costs and expenses related to investor presentations on “road shows” undertaken in connection with the marketing of the offering of the shares.

4.7.53 Upon incurring the aforementioned organization and offering costs, the asset manager generally does not have a contract with a customer under FASB ASC 606, since it cannot have a contract with a customer when the investment company does not yet exist, when the investment company is the customer. If the investor is the customer, these costs are not incremental costs to obtain a contract because these costs would have been incurred even if the contract with the customer had not been obtained. Therefore, FinREC believes that, generally, organization and offering costs are not incremental costs of obtaining a contract with a customer and should be evaluated to determine whether the amounts are within the scope of other authoritative guidance or should be analyzed under the guidance for costs to fulfill an anticipated contract with a customer (regardless of whether the customer is the investment company or the investor). For a discussion of the accounting treatment of these costs, refer to paragraphs 4.7.63–4.7.68.

4.7.54 Costs incurred after establishment of the investment company. Other typical costs incurred by an asset manager that may be subject to evaluation under the guidance for incremental costs of obtaining a contract include the following:

a.     Sales commissions paid to the asset manager’s wholesalers (employees) or to third-party broker-dealers after the launch of the investment company

b.     Placement fees paid to a placement agent for each investor identified by the placement agent that invests in the investment company

c.     Asset allocator fees (also referred to as platform fees)

4.7.55 Distributors, including in-house broker-dealers of asset managers, often pay sales commissions to external distributors or their sales representatives (their employees) for distribution and sales of securities on their behalf. Sales commissions may be discretionary or nondiscretionary in nature. Discretionary sales commissions are subjective in nature and generally are not directly attributable to obtaining a specific contract. Nondiscretionary sales commissions are objective in nature (that is, they are not subject to or influenced by someone’s discretion or judgment), and are paid in accordance with explicit terms in a written or oral contract, or are implicitly understood to be payable based on customary business practices (that is, the entity is committed). The accounting for sales commissions differs depending on whether the customer is the investment company or the investor. When the investor is the customer, emphasis is placed on the importance of sales commissions being nondiscretionary in nature because discretionary sales commissions would not constitute ‘incremental’ costs.

4.7.56 Placement fees relate to the sale of securities of private investment companies. Placement agents are typically compensated upon successful placement of the investment company shares or units with investors that the placement agent introduces to the investment company.

4.7.57 Asset allocator fees are fees paid to third-party platform providers that allow for an asset manager’s investment companies to be listed on the asset allocator’s business-to-business platform to facilitate the promotion and sale in the secondary market of the shares or units issued by investment companies by and among distribution partners. Payment of platform fees entitles the asset manager access to the asset allocator’s investor base, thereby allowing the asset manager to reach a broader group of investors. Generally, platform fees are incurred regardless of how many investors invest in the asset manager’s investment companies through this platform.

4.7.58 FinREC believes that the determination of who the customer is (the investment company or the investor) drives the assessment of whether sales commissions and placement fees are incremental costs to obtain a contract.

4.7.59 Comparatively, asset allocator fees generally would not be incremental costs to obtain a contract because they are incurred regardless of whether the contract with the customer is obtained.

4.7.60 If the investment company is the customer, FinREC believes that the following costs are not related to obtaining the contract with the investment company and therefore would not be considered incremental costs of obtaining a contract:

a.     Sales commissions (discretionary or nondiscretionary) paid to the asset manager’s wholesalers (employees)

b.     Sales commissions (discretionary or nondiscretionary) paid to third-party broker-dealers

c.     Placement fees

d.     Asset allocator fees

These costs should be assessed to determine whether the guidance on costs to fulfill a contract in FASB ASC 340-40-25-5 applies.

4.7.61 If the investor is the customer, FinREC believes that in accordance with paragraphs 1–2 of FASB ASC 340-40-25, the following costs should be capitalized as incremental costs of obtaining a contract if the entity expects to recover the costs:

a.     Nondiscretionary sales commissions paid to the asset manager’s wholesalers (employees)

b.     Nondiscretionary sales commissions paid to third-party broker-dealers

c.     Placement fees

4.7.62 The following table summarizes FinREC’s views on certain common costs incurred by asset managers:

Costs to Fulfill a Contract with a Customer

4.7.63 The guidance in FASB ASC 340-40 provides the accounting treatment for costs incurred to fulfill a contract with a customer that are not within the scope of other authoritative literature.

4.7.64 FASB ASC 340-40-25-5 states that costs to fulfill a contract that are not addressed under other authoritative literature should be recognized as an asset if all of the following criteria are met:

a.     The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).

b.     The costs will generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.

c.     The costs are expected to be recovered.

4.7.65 FASB ASC 340-40-25-8 states that an entity shall recognize the following costs as expenses when incurred:

a.     General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract)

b.     Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract

c.     Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance)

d.     Costs for which the entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations)

Costs That Do Not Qualify as Costs to Obtain a Contract

4.7.66 For all costs that do not qualify as incremental costs of obtaining a contract with a customer, an entity should first determine whether they are included in the scope of other authoritative literature. Those costs that are not in the scope of other authoritative literature but are incurred for a specific contract would be recognized as an asset if they meet all of the capitalization criteria for costs to fulfill a contract with a customer as put forth in FASB ASC 340-40-25-5 (see paragraph 4.7.64).

4.7.67 Pre-launch costs described in paragraph 4.7.52 pertain to the formation of a fund and typically are costs incurred in the performance of start-up activities, as defined in FASB ASC 720-15-20, Other Expenses, Start-Up Costs. According to this guidance, start-up activities are those one-time activities related to, among other things, introducing a new product or service or commencing some new operation. Start-up activities also include activities related to organizing a new entity (commonly referred to as organization costs).

4.7.68 FinREC believes that costs to launch a new investment vehicle are within the scope of FASB ASC 720-15 and, therefore, outside the scope of FASB ASC 340-40. FASB ASC 720-15-25-1 requires start-up costs, including organization costs, to be expensed as incurred.

4.7.69 Similarly, when the investment company is the customer, for sales commissions paid to third-party distributors and employees, consideration should be given to the applicability of FASB ASC 946-720-25-4, which provides guidance on the accounting for distribution costs for investment companies with no front-end fees. If FASB ASC 946-720-25-4 applies, then incremental direct costs, such as sales commissions, would be deferred and amortized. If FASB ASC 946-720-25-4 does not apply, the guidance on costs to fulfill a contract in FASB ASC 340-40-25-5 would be applied to determine whether the sales commissions paid qualify for capitalization. For a similar analysis of deferred distribution commission expenses, refer to the discussion in the section “Deferred Distribution Commission Expenses (Back-End Load Funds)” in paragraphs 4.7.01–4.7.10.

4.7.70 Out-of-pocket expenses may or may not arise in connection with the satisfaction of the asset manager’s performance obligation to provide asset management services to the investment company. Customary out-of-pocket expenses incurred in connection with fulfilling the asset manager’s performance obligation to provide asset management services may include, but are not limited to, commissions and brokerage fees, due diligence-related travel expenses (airfare, hotel, and meals), legal fees and other professional services fees, and filing and regulatory fees. Comparatively, the asset manager may incur out-of-pocket expenses that do not pertain to the performance of promised services in the contract with the customer.

4.7.71 Out-of-pocket expenses that are incurred by the asset manager in satisfying its performance obligation to provide asset management services should be assessed as costs to fulfill a contract. Out-of-pocket expenses that are not incurred by the asset manager in satisfying its performance obligation to provide asset management services do not qualify as costs to fulfill a contract because these expenses do not meet the criteria in FASB ASC 340-40-25-5(a).

4.7.72 FinREC believes that most costs incurred by asset managers after a contract with a customer exists, and that are not within scope of other Topics, will generally fail to meet all three criteria for capitalization as a cost to fulfill a contract—regardless of whether the investment company or the investor is the customer. In particular, FinREC believes that the requirement for capitalization of costs to fulfill a contract in FASB ASC 340-40-25-5(b) will be challenging to meet for typical asset management contracts with customers. This is because, given the nature of services provided by an asset manager, an asset manager may not be able to distinguish whether such costs relate to past, current, or future performance obligations, in which case the asset manager would be required to expense these costs as incurred in accordance with FASB ASC 340-40-25-8(c) for costs that relate to past performance obligation or FASB ASC 340-40-25-8(d) for costs that relate to partially satisfied performance obligation (see paragraph 4.7.65).

Amortization and Impairment

4.7.73 FASB ASC 340-40-35-1 states that costs capitalized under FASB ASC 340-40 should be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.

4.7.74 An asset manager will need to utilize judgment when determining a systematic basis for amortization. A systematic basis will generally include determining the expected period of benefit of the asset, which may be measured using average customer life, term of the investment company (if definite-lived), or another basis that is consistent with the transfer of the investment management services provided. The basis will likely be different depending on whether the investment company or the investor is the customer, because the different customers have different average “lives.” Contracts with investment companies may have contractually stated terms, while contracts with investors may not have definite lives and, accordingly, an asset manager would assess the appropriate expected contractual lives.

4.7.75 As a practical expedient, FASB ASC 340-40-25-4 notes that an entity may expense incremental costs to obtain a contract as incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.

4.7.76 FASB ASC 340-40-35-3 explains that an entity should recognize an impairment loss in profit or loss to the extent that the carrying amount of an asset recognized as an incremental cost to obtain a contract or a cost to fulfill a contract exceeds

a.     the amount of consideration that the entity expects to receive in the future and that the entity has received but has not recognized as revenue, in exchange for the goods or services to which the asset relates, less

b.     the costs that relate directly to providing those goods or services and that have not been recognized as expenses.