Getting ready for revenue recognition changes

Two new accounting standards, Revenue from Contracts with Customers (ASC 606) and Gains and Losses from the Derecognition of Nonfinancial Assets (ASC 610-20), are effective for non-public entities for fiscal years beginning after December 15, 2018. (Public business entities were required to adopt the standards for fiscal years beginning after December 15, 2017.)

ASC 606 applies to contracts with customers while ASC 610-20 applies to sales of nonfinancial assets (e.g., other real estate), but both standards share similar accounting principles and requirements. A previous article (New Revenue Recognition Guidance for Financial Institutions, January 2019) discussed the basic principle of the new standards. This article will focus on how financial institutions should prepare for the changes.

What’s not affected

To review, accounting requirements will not change for the following revenue:

• Interest income
• Premium and discount amortization
• Mortgage servicing income
• Loan prepayment fees
• Loan late fees
• Loan origination fees
• Loan commitment fees
• Gain on sale of financial instruments (e.g., loans, securities)
• Bank-owned life insurance (BOLI)

Other noninterest income will fall under the scope of the new standards and may or may not require some changes to revenue recognition practices.

Sales of other real estate (ORE)

ASC 610-20 will change how a financial institution accounts for the sale of ORE (and other nonfinancial assets), especially when those sales are also financed by the institution. The existing accounting methods for such sales (full accrual method, installment method, cost-recovery method, reduced-profit method, and deposit method) are superseded in the new standard. Instead, the institution will apply the five-step revenue recognition principles in the new standard to account for sales going forward.

The first step in the five-step process is to determine whether a contract exists. 

For a contract to exist, the institution must conclude, among other things, that all parties to the contract have approved it and are committed to perform and that it is probable the institution will collect substantially all the considerationit is entitled to. Consequently, although there are no prescribed down payment or continuing investment requirements in the new standard, the institution will still need to look at the amount of down payment, scheduled payments, recourse provisions, the borrower’s financial condition, and other relevant underwriting factors to determine whether the borrower is committed to fulfill its obligations under the related note and whether the institution expects to collect substantially all of the transaction price.

If the institution concludes a contract does exist, it will usually recognize gain (or loss) on a financed sale of ORE when the institution transfers control of the property to the borrower. 

Other noninterest income

ASC 606 will apply to other noninterest income not excluded from its scope (see discussion above).  Following is an overview of the likely requirements for two common revenue streams for community financial institutions. However, a financial institution must carefully consider how the five-step process and related requirements will apply to its specific contracts with customers and revenue streams:

• Deposit-related fees (overdraft, wire transfer, ATM, monthly service). Since deposit contracts are considered day-to-day contracts because the institution or the customer can cancel the contract at any time without penalty, fees generated from these contracts will likely be recognized when the services are performed. If it is possible that significant amounts of revenue could be reversed in the future because the revenue will be uncollectible or waived, the portion of revenue deemed uncollectible or expected to be waived will not be recognized until it is collected.
• Interchange fees. A community financial institution with interchange fees will probably be deemed an agent, arranging for a third party to provide services (debit and/or credit card transaction processing) for its customers. Interchange fees will likely be recognized daily when the debit (or credit) card transaction is generated by the customer and the institution has satisfied its performance obligation, unless significant amounts could be refunded (for example, because of credits due to refunds). Assuming the institution is an agent, interchange fees will be recognized net of any interchange expenses.

An institution will need to evaluate the accounting for these and other revenue streams within the scope of ASC 606, including but not limited to:

• Safe deposit box fees
• Loan-related insurance premiums (e.g., gap insurance)
• Asset management income
• Trust income
• Credit card loyalty program income

It is possible such revenue will be recognized just as it is today, but an institution won’t know until it applies the five-step approach (detailed in previous articles and discussed below) to each of its noninterest income contracts and revenue streams.

Getting ready for revenue recognition changes

To get ready for ASC 606, management of a financial institution should do the following:

Concluding thoughts

Financial institutions need to understand ASC 606 and ASC 610-20 so they can apply them to revenue that is within the scope of these new standards. Although it may not significantly change how revenue is recognized in the end, institutions won’t know for sure until they go through the five-step process. For help evaluating and documenting contracts that fall under the new standards, please contact your Wipfli relationship executive.