Is carried interest an expense or a reallocation of profits Under IFRS?
Outline of the problem
In the Carried Interest chapter of my book called “Private Equity Accounting” I have scratched the surface of a subject which might be of interest to you, namely the treatment of carried interest as anexpense under IFRS, and while some recognised industry experts would prefer to apply the traditional treatment favoured by the industry, namely as a reallocation of profits, others argue that carried interest under IFRS should rather be treated as an expense and even some publicly traded big private equity houses reporting under IFRS, such as 3i, on the advice of their auditors and their Technical departments, now treat and present in their (publicly available) financial statement carried interest as an expense.
Should you change your traditional treatment as a reallocation of profits which have always been the industry preference as it follows the legal treatment and aligns the accounting treatment with the LPA, all ultimately driven by the tax treatment, to a treatment as an expense, or should you stick to it? You may not even know that there are two competing opinions, so let’s see which side of the discussion would feel more compelling to you.
Traditional treatment favoured by the industry
Traditionally, carried interest, following the tax-efficient legal structuring as an ownership share, has been viewed as an investment return, and therefore, accounted for as a reallocation of profits from the LPs to the Carried Interest Partner (CIP), rather than a performance/incentive fee charged by the CIP, as it is in substance.
The competing treatment
In some sources (not new at all) issued by the Big 4, such as the PwC Illustrative IFRS Financial Statements 2008 Private Equity and subsequently Illustrative IFRS Financial Statements 2009 Private Equity, that treatment has been advocated long time ago, but may be some of us did not like (or simply did not take notice of) it and preferred to ignore that “new” (then) treatment and kept accounting for carry in our industry preferred way – as a reallocation of profit, unless the issue has been flagged up by auditors advocating that treatment, such as PwC.
What is the argument to treat carry as an expense and when should the expense be recognised?
What, for instance, PwC say in their “Similarities and Differences: a comparison of US GAAP and IFRS for investment Companies” publication is:
“It (understand carry) is the mechanism by which the fund’s manager and its principals and staff earn a share of the fund’s profits. A service is rendered by the general partner, which gives rise to a financial liability (with a corresponding expense) as soon as the service is rendered as the obligation to pay meets the definition of a financial liability in IAS 39 (obligation to deliver cash arising under a contractual arrangement) and such obligation being recorded in income statement. Thus, unlike US GAAP where a carried interest may be presented as an allocation, a carried interest under IFRS will always be reflected as an expense (when the appropriate thresholds have been met).”
What this paragraph suggests is that we should account for carry as per its substance (i.e. as a performance/incentive fee) rather than its legal form (i.e. as a return on its ownership share).
Just to avoid confusion and emphasise the recognition point of the carry expense/obligation advocated by this source, the expense should be recognised simultaneously with the financial liability, i.e. not before you can recognise that financial liability as per IAS 39 as explained in the next paragraph, which is usually pass hurdle in a whole-of-fund (also referred to as “all capital first” in the US) carry scheme, as it usually correlates with the legal obligation to pay cash.
To elaborate on the recognition of the financial liability, para 14 of IAS 39 stipulates that a financial asset or a financial liability shall be recognised in an entity’s statement of financial position when, and only when, the entity becomes a party to the contractual provisions of the instrument. With regards to the application of the recognition of financial assets and financial liabilities in the aforementioned para 14 principle, para AG 35(a) stipulates that unconditional receivables and payables are recognised as assets or liabilities when the entity becomes a party to the contract and, as a consequence, has a legal right to receive or a legal obligation to pay cash.
Beware of the tax treatment!
Although the accounting treatment should generally be separated from the tax treatment, we accountants always fear that the tax authorities may feel tempted to follow the accounting treatment and use it as an argument to impose a less beneficial tax treatment on the entities we prepare accounts for, so my general advice to you, no matter what accounting framework you are applying, would be that you carefully consider your accounting and presentation of carried interest (and the timing of the recognition) in your financial statements, so that they do not get misinterpreted by the tax authorities.
Similar competing treatment for Priority Profit Share (PPS)
In fact, a similar competing treatment, supported by the same arguments, extends to the Priority Profit Share (PPS)/General Partner’s Share (GPS)/General Partner’s Priority Share (GPPS) used instead of management fee in the majority of the funds structured as UK Limited Partnerships, due to its more beneficial tax treatment.
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Whichever opinion you favour, please share with us how you treat and present carried interest in your accounts and at what point you recognise it, as well as what your auditors’ opinion is (and who they are), and what you think of presenting it as an expense, by sending an e-mail to firstname.lastname@example.org and you will automatically enter the pool of candidates for our “The Best Reader Annual Award” provided by PEAI PE Accounting International magazine.