The Financial Accounting Standards Board’s (FASB’s) new accounting standard, Revenue from Contracts with Customers (ASC 606), is applicable to all entities and is effective for nonpublic entities for fiscal years beginning after December 15, 2018. (Public business entities must adopt the standard for fiscal years beginning after December 15, 2017.) Although its impact on financial institutions will be limited relative to other industries, there are still some important changes institutions will have to address.
Background
As discussed in a previous article (Revenue Recognition for Financial Institutions, January 2018), ASC 606 provides a principles-based revenue recognition approach for all entities. The core principle of the standard is a five-step process entities will use to determine when and how to recognize revenue:
Step 1: Identify the contract(s) with a customer/member
Step 2: Identify the performance obligations (that is, the promises to deliver goods or services) in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations in the contract
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation
Each institution will have to apply this five-step approach to determine when income and gains that are included in the scope of the standard should be recognized in the financial statements.
What’s Not Affected
The impact on financial institutions will be relatively limited because many revenue-generating activities of typical financial institutions are not included in the scope of the new standard. The following revenue-related items are not covered by ASC 606 and therefore will see no change:
• Interest income
• Premium and discount amortization
• Mortgage servicing income
• Loan prepayment fees
• Loan late fees
• Loan origination fees
• Loan commitment fees
• Bank-owned life insurance (BOLI)
Other noninterest income will fall under the scope of the new standard and may or may not require some changes to revenue recognition practices.
Sales of Other Real Estate
The biggest impact ASC 606 will have on the financial institution industry is related to sales of other real estate (ORE) financed by an institution. Under current accounting standards, gain on a financed sale of ORE might be recognized immediately or deferred using one of various methods (installment method, cost-recovery method, reduced-profit method or deposit method). The method used depends on the amount of down payment, the borrower’s continuing investment, and other rules included in the accounting standards. These revenue recognition methods are superseded by the five-step approach discussed above.
There are no prescribed down payments or continuing investments when a financial institution finances the sale of ORE under the new standard; however, to recognize a sale (and any gain on that sale), the institution must determine whether a contract exists. Even though there are no minimum requirements, an institution will still need to look at the amount of down payment, ongoing payments, recourse, and other relevant underwriting factors to determine whether the borrower is committed to fulfill their obligations under the related note and whether the institution expects to collect substantially all of the transaction price—two important requirements for a contract to exist in ASC 606. 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 also apply to other noninterest income, including, but not limited to, the following:
• Deposit-related fees (overdraft, wire transfer, ATM, monthly service)
• Safe deposit box fees
• Interchange fees
• Loan-related insurance premiums (e.g., gap insurance)
• Asset management income
• Trust income
• Credit card loyalty program income
Institutions will need to evaluate the impact of ASC 606 on each of these and related revenue activities. Although the new standard applies to each of these activities, the result could be that revenue will be recognized just as it is today. Unfortunately, this may not be true for all types of noninterest income, so institutions should carefully apply the five-step approach to all of their noninterest income and determine the appropriate revenue recognition approach for each different contract or revenue stream.
What Should My Institution Do?
To get ready for ASC 606, management of financial institutions should:
• Review the institution’s trial balance and identify revenue-generating activities that are within the scope of ASC 606.
• Of these activities, identify activities that are material to the financial statements.
• Follow the five-step process and document: 1) the contract, 2) the performance obligation(s), 3) the transaction price, 4) whether the transaction price needs to be allocated, and 5) when revenue should be recognized.
For help evaluating and documenting contracts that fall under ASC 606, please contact your Wipfli relationship executive.
Concluding Thoughts
Financial institutions need to understand ASC 606 so that they can apply it to revenue that is within the scope of the new accounting standard. 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. Institutions that prepare financial statements in accordance with GAAP will also have to become familiar with the disclosure requirements of ASC 606, which will probably require some additional disclosure of noninterest income. If you have any questions regarding ASC 606 and its impact on your specific revenue recognition practices, please let us know!
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