You may have heard about the Financial Accounting Standards Board’s (FASB’s) Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, but you may not know very much about this new accounting standard. This standard is codified in the accounting standards as Topic 606 (ASC 606) and is applicable to all entities. For non-public entities, it will be effective for fiscal years beginning after December 15, 2018. Public business entities must adopt the standard for fiscal years beginning after December 15, 2017. The standard does not impact the financial institution industry nearly as much as it does other industries, but there are some important concepts institutions should be aware of.
ASC 606 provides a principles-based revenue recognition approach for all entities. Since it applies to all entities, FASB believes there will be more comparability of revenue recognition practices between entities that operate in different industries. 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
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 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 reason many financial institutions have not heard much about this new revenue recognition standard is that it does not impact most of the revenue generating activities of a typical financial institution. The following revenue-related items are not included in the scope of ASC 606:
• Interest income
• Premium and discount amortization
• Mortgage servicing income
• Loan prepayment fees
• Loan late fees
• Loan origination fees
• Loan commitment fees
As you can see, a significant portion of financial institutions’ revenue is not affected by ASC 606. However, 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 the accounting for gain on the sale of other real estate (ORE). Under current accounting standards, gain on the sale of ORE that is financed by an institution may be recognized immediately or deferred using one of various methods (installment method, cost-recovery method, reduced-profit method, or deposit method). Which method is 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.
When ASC 606 is adopted, an institution that finances the sale of ORE will first need to determine whether the sale contract meets five “criteria to have a contract” in the standard (ASC 606-10-25-1). If the institution determines a contract meets these criteria, any gain will usually be recognized immediately. If a contract does not meet the necessary criteria, the transaction is not treated as a sale, and no gain is recognized unless and until the institution determines the contract meets the criteria in the future.
Of the five criteria to have a contract, the most important criterion is whether the institution believes it is probable it will collect substantially all of the consideration to which it will be entitled in exchange for the ORE. To evaluate whether an institution believes it will collect substantially all of the consideration to which it will be entitled, it will likely consider down payment, the borrower’s continuing involvement, etc., similar to the current accounting standards, but without the “bright line” rules.
Other Noninterest Income
ASC 606 will also apply to other noninterest income, including, but not limited to, the following:
• Credit card loyalty program income
• 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
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 revenue recognition treatment that is like today’s accounting. For example, let’s apply the five-step process to a monthly service charge on a deposit account:
Step 1: A contract exists between the institution and the depositor.
Step 2: The institution promises to provide one performance obligation—deposit related services (check writing and clearing, depositing funds, etc.)—for the depositor on a day-to-day basis.
Step 3: The depositor will pay a monthly service charge if they do not maintain a certain average daily balance.
Step 4: The monthly service charge received is allocated to services performed during the month.
Step 5: Revenue is recognized for the month the fee was received.
Institutions will likely recognize deposit fees when the related service is performed, which is the same accounting practice institutions follow today. This may not be true for other 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.
Impact on Borrowers
Regardless of whether this standard impacts your financial institution in any significant way, your borrowers may see substantial changes to their financial statements if they are prepared in accordance with accounting principles generally accepted in the United States (GAAP). Changes in revenue recognition practices could affect when borrowers recognize revenue for various contracts, which could directly affect financial covenants for loans even though their business operations have not changed. We encourage financial institutions to begin talking to their borrowers that have important loan covenants tied to revenue, operating income, or net income to see whether it would be appropriate to modify any of those covenants to reflect the impact of ASC 606.
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 contact your Wipfli relationship executive—we are ready to help!