What Is Reallowance? Meaning, Calculation, and Example Explained

Reallowance is a term in finance, particularly in underwriting and securities distribution. It refers to additional compensation given to broker-dealers who assist in selling an offering but are not part of the primary underwriting group. This incentive expands the distribution network for new securities.

Components That Affect the Amount

Several factors determine the reallowance a broker-dealer receives. The total underwriting spread—the difference between the price investors pay for a security and the amount the issuing company receives—plays a key role. Within this spread, portions go to managing underwriters, selling concessions, and reallowances. The underwriting agreement specifies the percentage allocated to reallowance based on non-underwriting firms’ participation.

Market conditions also influence reallowance. In strong markets with high demand, underwriters may offer lower reallowances since sales require minimal effort. In weaker markets, higher reallowances encourage broader distribution. The type of security matters as well. Equity offerings, particularly IPOs, often have different reallowance structures than debt securities, where institutional investors dominate.

Regulatory considerations further shape reallowance amounts. The Financial Industry Regulatory Authority (FINRA) imposes limits on underwriting compensation to prevent excessive fees. FINRA Rule 5110 caps total underwriting compensation, indirectly affecting reallowances. The Securities and Exchange Commission (SEC) mandates transparency in fee disclosures, ensuring investors understand issuance costs.

Calculation Steps

Determining reallowance begins with identifying the total compensation structure in an underwriting agreement, which includes the management fee, underwriting fee, selling concession, and reallowance. Since reallowance is a subset of the selling concession, the first step is determining how much of the total spread is allocated to concessions.

Next, the percentage allocated to reallowances is calculated. This percentage, predetermined in the underwriting agreement, varies based on non-underwriting firms’ participation. If the selling concession is $1.00 per share and the reallowance is set at 40%, a broker-dealer assisting in distribution receives $0.40 per share.

The total reallowance payout depends on the number of shares sold. Multiplying the per-share reallowance by the total number of shares distributed determines the final compensation. If a broker-dealer sells 50,000 shares at $0.40 per share, the total reallowance earned is $20,000.

Example Scenario

A mid-sized investment bank participates in distributing a corporate bond issuance. While not part of the lead underwriting syndicate, it is granted the opportunity to sell a portion of the offering. Leveraging its client network, the firm places the bonds with institutional and retail investors who may not have direct access to the primary underwriters.

The underwriting agreement specifies reallowance based on bonds sold. The firm coordinates with its sales team to market the bonds to pension funds, insurance companies, and high-net-worth individuals. It must balance competitive pricing with maximizing compensation.

As the offering progresses, the firm successfully places a significant bond volume. The earned reallowance must be recorded accurately for financial reporting and compliance. Proper documentation ensures adherence to regulatory requirements and prevents discrepancies in compensation disclosures.

Placement in Financial Statements

Reallowance payments received by broker-dealers are recorded as commission income on the income statement. Since these payments stem from assisting in securities distribution, they are classified alongside other brokerage commissions rather than underwriting fees, which are reserved for firms directly managing the offering. This distinction is necessary for regulatory reporting and financial analysis, as different revenue streams carry unique tax implications and disclosure requirements.

Expenses related to securing reallowance income, such as sales and marketing costs, appear under operating expenses. Outreach efforts or additional sales incentives reduce net earnings, making cost tracking essential for profitability assessments, particularly for firms frequently participating in securities distribution.

On the balance sheet, reallowance receivables may be recorded under accounts receivable if payments are pending from the underwriting syndicate. Broker-dealers typically receive their portion based on underwriting agreement settlement timelines. Delays in payment can affect cash flow, making it important to monitor outstanding receivables and ensure timely collection.