By Matt ShoemakerIt has taken quite some time, and many revisions, to get here, but the Financial Accounting Standards Board’s new revenue recognition rule is now in effect for public companies and quickly approaching for privately held, calendar-year companies with a deadline of Dec. 31, 2019.
This rule was crafted to help standardize how revenue is recognized to increase comparability across businesses and industries. In the past, companies considered a wide range of transaction and industry guidance to recognize revenue from contracts with customers. FASB’s update helps investors, business owners and stakeholders better evaluate the long-term performance and health of one organization compared to another, even across different industries.
While this GAAP update standardizes how companies recognize revenue, adoption can have a significant effect on banks’ financial reports and accounting. For example, JPMorgan Chase’s adoption of the new standard required gross presentation of certain costs previously offset against revenue. This substantially increased revenue and certain noninterest expenses for reporting purposes, although had no effect on net income. The adoption resulted in an approximate $900 million increase in both revenue and expenses for the retrospective adoption of the new standard.
So, what is the new revenue recognition rule? At a very high level, the new standard is based on the principle that companies must recognize revenue when goods and services are transferred to the customer in an amount that is commensurable to what has been delivered.
The new rule indicates that revenue is recognized through a five-step process, including:
- Identifying the contract with a customer
- Identifying the performance obligations to fulfill
- Determining the transaction price
- Allocating the transaction price over the identified obligations
- Recognizing the revenue when (or as) the organization satisfies the obligations
All of this is accounting-speak for understanding what the bank and customer are exchanging, making the exchange to a proportional degree (fulfillment) and finally recognizing the revenue. Moreover, it is worth pointing out that revenue is no longer recognized when money or profit enters an account. Rather, it is recognized when the obligations of the contract are fulfilled by both parties.
This is likely a straightforward change for traditional banking institutions, as the update excludes interest income, loan origination, commitment and late fees, as well as premium and discount amortization. Where banks will likely see the effects is within their credit card loyalty programs, deposit-related and safety deposit box fees, interchange fees, asset management income and loan insurance income.
By far the largest effect from revenue recognition is on the gain of the sale of other real estate owned. The current rules require banks that finance sales of OREO to compare initial investments by the purchaser to determine if a sale can be recognized and what portion, if any, of a gain on sale can be initially recognized. Under the new rule, an institution that finances the sale of OREO will have to review their contract and apply the five-step process to determine when they can recognize the revenue.
Meanwhile, banks that are partnering with or purchasing fintech companies will need to carefully review how that fintech structures its contracts with clients to determine when to appropriately recognize income. This is likely a non-issue for most community banks, but for those exploring innovative ways of driving non-interest income, the five-step process will need to be applied to all profits stemming from any fintech partnership.
Although the revenue recognition rule may not significantly affect banks’ traditional revenue reporting, institutions will not know for sure until they have implemented the full, five-step process. Those banks that start working on these issues now will have less of a headache and see fewer inconsistencies leading up to the final deadline.
Matt Shoemaker is audit manager at PKM, an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.