SEC Views on Carried Interest Revenue Cause Uncertainty

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May 19 — All members of the Financial Accounting Standards Board agree on how carried interest payments amount to fees subject to major new revenue recognition rules.

However, auditors are uncertain about possible next steps by the board after Securities and Exchange Commission staff said some contradictory comments on the accounting topic.

Carried interest represents compensation for private equity investment-managing partners. It is a form of a disproportionate incentive-based capital allocation. The payment is made if the fund meets specified investment targets.

SEC Staff Views Don't Agree

The views of the SEC staff—presented earlier this month—appear to support an accounting path that doesn't concur with the direction FASB staked out in the final rules on revenue two years ago.

The views on the SEC staff guidance came from interviews of people familiar with the activities of an advisory group formed to help smooth the shift to the far-reaching revenue reporting standard (Accounting Standards Update 2014-09; ASC 606).

An SEC senior staff accountant has suggested that under certain circumstances, the preferred allocation of capital income reflected in performance fees—of which carried interest is a form—could be viewed as equity and accounted for under investment accounting rules (ASC 323).

FASB and the SEC staff find themselves at odds on the issue related to use of the rules that become effective in January 2018 (76 DTR G-9, 4/20/16; 12 APPR 08, 4/22/16; 19 MALR 647, 4/25/16).

Use of the FASB standard, as written and explained by the board, would lead to some large asset managers no longer being able to report large amounts of revenue as quickly as they do today.

Some board members suggested FASB could issue some form of clarification of the carried interest issue. But whether and, if so, how that might be done, remains up in the air.

Opening the Door to Different Treatment?

The recent comments from securities regulators are seen as opening the door to a more business-friendly equity treatment of carried interest — one that doesn't appear to be common practice today, in the realm of asset management.

That equity-reporting avenue, floated by SEC Deputy Chief Accountant Wesley Bricker last month, runs counter to FASB's collective view that carried interest represents variable consideration that wouldn't be booked until relatively late in the life of an investment fund, and potentially much later than asset managers would like.

The issue on accounting for carried interest, addressed in an SEC staff letter to FASB obtained by Bloomberg BNA, earlier came to a head at the April 18 meeting of the FASB advisory group, the Transition Resource Group for Revenue Recognition.

Big Issue for Big Asset Managers

For some big private equity funds and their investment company stewards, the financial accounting issue affects one of the most important lines of the financial statements, revenue, and shows up in quarterly earning statements.

Total realized revenue from carried interest can be in the low billions of dollars annually for some large asset management firms.

A number of FASB members, along with a director of a Chicago financial accounting advisory firm who is a former top SEC staff accountant, suggested at the April 18 meeting of FASB's resource group that a newly highlighted stance on equity-versus-fees/revenue stems from a desire by some in the industry for an accounting prescription that is preferable to the one in the new revenue standard.

“I find it unfortunate that we're having this conversation because people don't like the answer,” said board member Thomas Linsmeier. He added, without elaboration, “that people who had involvement” in the asset management “industry have been pushing to be able to get an answer that they feel comfortable with.”

Delayed Revenue Booking for Asset Managers

The new revenue standard contains a constraint on variable consideration in such investment/compensation scenarios.

Unlike the current treatment, available as a choice in guidance that is to be eliminated on the advent of the revenue recognition rules, the constraint in the rules issued by FASB and the International Accounting Standards Board dictates that revenue shouldn't be booked until it's probable that a significant reversal in investment fortunes won't occur.

The Carlyle Group L.P., for example, states in it most recent quarterly filing with the SEC that its partners are “still assessing the potential impact” of the FASB revenue standard. However, according to Carlyle's first-quarter 2016 report, the new rules “may have a material impact on the partnership's consolidated financial statements by significantly delaying the recognition of performance fee revenue.”

The Blackstone Group L.P. stakes out similar prospects for use of the new accounting rules in its first-quarter 2016 SEC filing, made in early May as was Carlyle's. However, it provides more detail.

“The new revenue guidance may have a material impact on Blackstone's consolidated financial statements if it is determined that both performance fees and carried interest are forms of variable consideration that may not be included in the transaction price,” according to the investment enterprise's notes condensed consolidated financial statements in its 10-Q filing for the quarter that ended March 31. “This may significantly delay the recognition of carried interest income and performance fees.”

Blackstone reported carried interest, both realized and unrealized, at almost $278.5 million in the first quarter of 2016, or about 30 percent of the firm's total revenue of $932.4 million for the period, according to unaudited condensed consolidated statements of operations.

In its 2015 annual report, Blackstone recorded a total of more than $2.4 billion in net realized carried interest for the year, up from more than $1.6 billion in 2014 and about $687 million in 2013.

Deloitte & Touche LLP is the independent auditor for BlackRock and The Blackstone Group. The two asset managers account for revenue from carried interest differently. Ernst & Young LLP audits the financial statements of The Carlyle Group.

Mark Crowley, a Deloitte partner on the Transition Resource Group, signaled that his firm would be open to exploring the accounting path described by Bricker. “But we always did think these were compensating for services,” he said of the carried interest payments made to asset managers.

Alison Spivey, an EY partner on the Transition Resource Group, spoke skeptically of a big shift in accounting policy embodied in the SEC staff's new suggestion on carried interest.

Treating carried interest as equity instruments would represent “just such a holistic shift” and “a major shift to take something that we had called revenue and no longer call it revenue,” Spivey said.

Billions in Carried Interest

Carlyle and Blackstone use what is known as “Method 2” in current accounting for revenue stemming from carried interest (ASC 605-20-S99-1, formerly EITF Topic D-96). Under that method, asset managers recognize revenue “throughout the contract, “ or “as you go,” as the FASB chairman described the practice April 18.

However, that elective accounting prescription is expected to be eliminated when the old FASB Emerging Issues Task Force guidance, crafted by Scott Taub, a managing director at Financial Reporting Advisors and the SEC staff at the time, is superseded by the 2014 revenue reporting standard.

The other choice is the 2001 EITF guidance, “Method 1,” which calls for booking carried interest at the end of an investment contract. It is used by asset management giant BlackRock, for example.

Companies will follow a prescription similar to the current “Method 1” when they begin applying the new revenue rules.

SEC Staff Accountant's Letter

In his May 2 letter, the SEC staff's Bricker wrote to the chairman of the Transition Resource Group, FASB Vice Chairman James Kroeker, to voice the commission staff's concern “that the description of the SEC's staff's long-standing views by certain TRG members” at the April 18 meeting “was inconsistent with the SEC staff's guidance.”

Without naming the previous speaker or speakers, Bricker was referring to Taub, who worked as an SEC deputy chief accountant from 2002 through 2006, including a brief stint as acting chief accountant. Taub described a long-held view of the SEC staff—and not disputed by the asset management sector some 15 years, he said—that carried interest represents revenue from fees and should be reported as such.

In his letter, Bricker cited the revenue rules' stated exceptions from coverage for financial instrument and other contractual rights or obligations within the scope of ASC 323, on the equity method. He also laid out the FASB Accounting Standard Codification's formal definition of a financial instrument as including “cash” and “evidence of an ownership interest in a company or other entity.”

“The SEC staff has long-standing guidance with respect to ownership interests in limited partnerships,” Bricker noted in the letter. He noted the SEC staff's 1995 issuance of EITF Topic D-46, Accounting for Limited Partnership Investments.

“Consistent with Topic D-46, the SEC staff has interpreted that the application of the equity method is appropriate to interests in limited partnerships, including the general partner's interest, provided that such interest provides more than minor influence over the partnership's operating and financial policies,” the SEC deputy chief accountant wrote.

Bricker also quoted a footnote in the 2001 SEC staff guidance, EITF Topic D-96, and an accounting question that arose in the realm of investments in real estate ventures. The footnote lays out the SEC staff's acceptance of continued use of the equity method of accounting by a manager who is a general partner in a partnership and if the manager “receives fees in the form of partnership allocations.”

Warning on `Unraveling' of Revenue Model

At the earlier meeting, Bricker laid out SEC staff accountants' thinking that there exists a basis for accounting for carried interest in “an ownership model.”

Employing an equity ownership model to report on carried interest would trigger use of consolidation accounting principles, according to views expressed by several participants at the April 18 Transition Resource Group meeting.

However, reporting under the consolidations rules and in the realm of accounting for “variable interest entities” would cause the revenue recognition to unravel, as at least one FASB member warned.

IASB Action Not Likely

At IASB, board Vice Chairman Ian Mackintosh, said during the April 18 meeting that, like the FASB, the London-based board views carried interest as fees that will be subject to the new revenue rules.

He suggested that in keeping with IASB's working notion to not “fiddle” with the standard unless necessary, the board would have to think carefully about calling for a disclosure reflecting continued use of a “Method 2,” throughout-the-contract booking of carried interest revenue. That disclosure proposal was floated by transition group meeting participants.

To contact the reporter on this story: Steve Burkholder in Norwalk, Conn., at sburkholder@bna.com

To contact the editor responsible for this story: Ali Sartipzadeh at asartipzadeh@bna.com

For More Information

An archived recording of the April 18 meeting of the Transition Resource Group for Revenue Recognition is available at