III

Read Theory in Practice 7.5 in the Scott text. You are an accountant at Blackstone Group during the time of this TIP. Management has reached out to you to conduct research related to the accounting discussed in this TIP. You need to prepare a research memo addressed to the CFO following the style presented in Chapter 4 of the Collins text. Your memo should discuss the following issues to help management decide how to account for these investments.

1. How is revenue recognized using the equity method? Provide FASB ASC references as support.

2. How would revenue be recognized if the fair value option was applied? Provide FASB ASC references as support.

3. What types of disclosures will be needed if the fair value option is selected? Provide FASB ASC references as support.

4. Which method would investors find more decision useful? A complete response will consider aspects of relevance, reliability, and full disclosure as discussed in the Scott text.

5. How would the method selected likely affect the stock price that would be received in the initial public offering? A complete answer will consider investor decision theory.

6. Your conclusion should address which accounting method you believe would provide investors with the best information for evaluating the company.

Theory in Practice 7.5 The Blackstone Group is a large U.S.-based invest ment company whose operations include investing in public companies and taking them private. A major component of its earnings from these investments derives from "carried interest. " This is a management fee based on a preferential interest in the profits earned by unconsolidated companies in which it has invested. For example, a typical arrangement would be for Blackstone to receive an annual payment of 20 percent of a company's profits in excess of a hurdle rate of return on equity?' These payments could continue for, say; ve years, after which Blackstone would plan to sell its interest in the company. Under historical cost accounting and the equity method of accounting for unconsolidated subsid- iaries, carried interest fees would be recorded as revenue each period, if and as they are earned, with the offsetting debit to the investment account. Note, however, that Blackstone's prefer ential right to receive future fees conditional on a hurdle rate of return on the equity of a firm in which it has invested has option-like characteris- tics, expiring in ve years in the above example. In 2007, Blackstone planned an initial public offering of its stock. In in; preliminary prospectus, dated March 22, it revealed that for many of its unconsolidated investments it would use the fair value option to value future carried interest fees on a fair value basis, with the offsetting credit to current earnings. Presumably, they would use an option-pricing model, such as BlackScholes, to determine fair value. If this accounting had been applied in 2006, Blackstone indicated that its 2006 earnings would have increased by $595,205, rela- tive to earnings reported using the equity method of accounting for its unconsolidated investments. Note that fair value must be reevaluated each period. Blackstone pointed out that fair valuation could introduce considerable volatility into its reported earnings. It seemed that Blackstone was willing to bear this volatility in order to secure ear- lier revenue recognition- Concerns about the reliability of Blackstone's proposed accounting soon appeared in the finan- cial media, despite the greater relevance of this approach. A major source of concern was that since the unconsolidated investments are typically private companies, the amount of public informa- tion about them is minimal. This makes it particu- larly difficult for the market to assess Blackstone's valuation, and puts considerable onus on Blackstone to fully disclose its assumptions in determining fair value. Concern was also expressed that Blackstone could bias its nancial results by means of these assumptions. In its final prospectus, dated June 25, Blackstone changed its mind, announcing that it would not use the fair value option. Instead, it would recognize carried interest quarterly based on its share of non-consolidated companies' quar- terly earnings. This episode illustrates the potential of the fair value option to implement the valuation approach, and the consequent reliability risks