RESEARCH ASSIGNMENT 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.21 These payments could continue for, say, five 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 five years in the above example. In 2007, Blackstone planned an initial public offering of its stock. In its 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 Black-Scholes, 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 infonna- 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. CHAPTER 4 APPENDIX Sample Accounting Issues Memo The following Presto Hospitality memo is only partially complete and is provided for example purposes. Additional issues will need to be evaluated in order to fully conclude on the account- ing for this arrangement. Draft-For Discussion Purposes Only Use this DRAFT stamp in the Memorandum header until final To: Presto Hospitality Accounting Files contracts have From: Michael Jones, Accounting Policy team been reviewed. Date: 12/1/20X1 Re: Accounting for concessions agreement with Stadium Co. Describe the type Facts of transaction succinctly in the Presto Hospitality (Presto) is a public company that is in the process of signing a 10-year concessions "Re" line. agreement with a major league baseball stadium owner (Stadium Co.). The agreement would give Presto the right and obligation to operate all of the stadium's fixed concession stands and portable food and beverage carts, to provide food and beverage service to premium seating areas (including suites), and to have hawkers selling concessions in the aisles of the stadium (Sodas! Peanuts!), collectively, the "Food and Beverage Facilities." The locations of fixed concession stands within the stadium are designated in architectural drawings included within the draft concessions agreement. The draft contract states that Stadium Co., at its option and at its cost (such as the cost to rebuild leasehold improvements), can require Presto to move its locations within the stadium. The concessions agreement will require Presto to remit 50% of its gross food sales and 52% of its gross alcohol sales to Stadium Co. in exchange for the right to operate at the stadium. Presto will also be required to make an upfront payment of $5 million to Stadium Co., which will be used toward capital improvements, build-outs, and branding of the concession facilities. Throughout the operating period of this agreement, Stadium Co. will have the right to approve all of Presto's proposed menu items, pricing, and choices of suppliers, and Stadium Co. has indicated during negotiations that it plans to actively exercise this approval authority. To be chosen as the concession provider for this stadium, Presto submitted a successful bid and was selected from a group of competing potential concessionaires. Presto must determine whether this ent contains a lease within the scope of ASC 842 (Leases). If the transaction is complex or involves multiple parties, include a picture here. Issues Phrase issues 1. Does the Concessions Agreement involve an identified asset? in the form of a 2. List additional questions here. question. Analysis-Issue 1: Does the Concessions Agreement involve an identified asset? FASB Accounting Standards Codification (ASC) 842-10 (Leases) provides the following scope guidance for determining whether an arrangement is or contains a lease: 15-3 A contract is or contains a lease if the contract conveys the right to control the use of identi- fied property, plant, or equipment (an identified asset) for a period of time in exchange for consideration...Continued from previous page ASC 842-10 states the following with respect to determining whether a contract involves an identified asset: 15-9 An asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made avail- able for use by the customer. The baseball stadium (an asset) is explicitly specified in the contract. However, Presto only has the right to use specified portions of the stadium. Accordingly, two challenges that arise in applying the Consider concept of identified asset to this agreement include evaluating 1) when a portion of an asset is an using italicized identified asset and 2) whether the supplier has a substantive right to substitute the asset. We will subheaders to evaluate each of these conditions next. help organize discussion points Portion of an Asset within your Par. 15-16 provides the following guidance regarding whether a portion of an asset is an identified memo. asset: > > > Portions of Assets 15-16 A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fiber optic cable) is not an identified asset, unless it represents sub- stantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. [Emphasis added] As the Food and Beverage Facilities represent a portion of a broader asset (the Stadium), these facilities are only considered an identified asset if they are physically distinct. PwC's Leases guide book (2018) offers the following additional, interpretive guidance for assessing whether a portion of an asset is physically distinct: Present non- authoritative An identified asset must be physically distinct. A physically distinct asset may be an entire asset sources in or a portion of an asset. For example, a building is generally considered physically distinct, but guidance one floor within the building may also be considered physically distinct if it can be used sandwiches following independent of the other floors (e.g., point of ingress or egress, access to lavatories, etc.). consideration Sec. 2.3.1.3) of authoritative In this arrangement, certain of the Food and Beverage Facilities (specifically, fixed concession stands) guidance are specified on architectural drawings and are thus physically distinct. Additionally, the right to serve food and beverages in premium seating areas, including suites, involves physically distinct spaces. These concession stands and premium areas can be used independently from one another. Therefore, these spaces are all considered physically distinct. By contrast, other rights in the contract, such as the right to operate portables and the right to have food and beverage hawkers operating throughout the stadium, do not involve physically distinct portions of an asset. The location of the portable carts is not specified, and therefore any location within the stadium could be used to locate the carts. Per par. 15-16, if a portion of an asset is not physically distinct, it "is not an identified asset, unless it represents substantially all of the capacity of the asset...". This condition is not present, as use of the portables and rights of the hawkers within the broader Stadium do not represent "substantially all" of the Stadium's capacity. Therefore, these rights do not involve identified assets. Substantive Right to Substitute An additional requirement for a contract to include an identified asset is that the supplier cannot have the "substantive right to substitute" the asset during the period of use. This requirement is described in par. 15-10 as follows:Continued from previous page 15-10 Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A sup- plier's right to substitute an asset is substantive only if both of the following conditions exist: a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time). b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset). [ Emphasis added] According to the concessions agreement, Stadium Co. can require Presto to relocate its facilities within the stadium. Therefore, it is necessary to evaluate whether this substitution right is "substantive" by evaluating the conditions in par. 15-10(a) and (b). Practical Ability to Substitute (par. 15-10a): Stadium Co. has the practical ability to substitute alternative assets throughout the period of use, as it has the stated right per the contract to make changes to the specified facilities. Furthermore, alternate locations within the Stadium are available to Stadium Co. that could be used to substitute Presto's designated spaces in the Stadium. Therefore, par. 15-10(a) is met for all concession spaces in the contract. Economically would benefit from substitution (par. 15-10b): It is unclear whether the economic benefits to Stadium Co. associated with substituting the designated food and beverage spaces would be expected to exceed the costs associated with substituting these spaces. Stadium Co. would presumably incur significant relocation costs if it were to require Presto to change the location of a fixed concession stand in the Stadium, given the kitchen and other equipment involved in such a relocation effort. On the other hand, food and beverage kiosks (portables) could easily be moved without significant cost. To assist in our evaluation of this "economic benefit" condition, we considered the following implementation guidance from ASC 842-10 involving a portable concession stand. While we already concluded that the spaces on which portables will be located are not physically distinct portions of assets, we will evaluate this example for the avoidance of doubt. > > > Example 2-Concession Space 55-52 A coffee company (Customer) enters into a contract with an airport operator (Supplier) to use a space in the airport to sell its goods for a three-year period. The contract states the amount Indent excerpts of space and that the space may be located at any one of several boarding areas within the to improve the airport. Supplier has the right to change the location of the space allocated to Customer at any readability of your time during the period of use. There are minimal costs to Supplier associated with changing memo. the space for the Customer: Customer uses a kiosk (that it owns) that can be moved easily to sell its goods. There are many areas in the airport that are available and that would meet the specifications for the space in the contract. 55-53 The contract does not contain a lease. 55-54 Although the amount of space Customer uses is specified in the contract, there is no identified asset. Customer controls its owned kiosk. However, the contract is for space in the airport, and this space can change at the discretion of Supplier. Supplier has the substantive right to substitute the space Customer uses because: a. Supplier has the practical ability to change the space used by Customer throughout the period of use. There are many areas in the airport that meet the specifications for the space in the contract, and Supplier has the right to change the location of the space to other space that meets the specifications at any time without Customer's approval b. Supplier would benefit economically from substituting the space. There would be mini- mal cost associated with changing the space used by Customer because the kiosk can be moved easily. Supplier benefits from substituting the space in the airport because substitution allows Supplier to make the most effective use of the space at boardingContinued from previous page This par. 55-52 example involves an airport kiosk whose location can be easily changed. This is analogous to the portables involved in Presto's agreement, which can be easily moved. Consistent with this example, Stadium Co.'s substitution right is substantive with respect to portable concession spaces. However, with respect to more "fixed" locations, such as concession stands with kitchen equipment, the guidance offers an example illustrating that moving such spaces could impose economic cost to the supplier (Stadium Co.): 55-63 Customer enters into a contract with property owner (Supplier) to use Retail Unit A for a five- year period. Retail Unit A is part of a larger retail space with many retail units. 55-64 Customer is granted the right to use Retail Unit A. Supplier can require Customer to relocate to another retail unit. In that case, Supplier is required to provide Customer with a retail unit of similar quality and specifications to Retail Unit A and to pay for Customer's relocation costs. Supplier would benefit economically from relocating Customer only if a major new tenant were to decide to occupy a large amount of retail space at a rate sufficiently favorable to cover the costs of relocating Customer and other tenants in the retail space that the new tenant will occupy. However, although it is possible that those circumstances will arise, at inception of the contract, it is not likely that those circumstances will arise. For example, whether a major new tenant will decide to lease a large amount of retail space at a rate that would be sufficiently favorable to cover the costs of relocating Customer is highly susceptible to factors outside Supplier's influence. . . . 55-69 Retail Unit A is an identified asset. It is explicitly specified in the contract. Supplier has the practical ability to substitute the retail unit, but could benefit economically from substitution only in specific circumstances. Supplier's substitution right is not substantive because, at inception of the contract, those circumstances are not considered likely to arise. In this example, it is considered unlikely at inception of an arrangement that the supplier would move a customer using "Retail Unit A." Despite the availability of other retail units that could be substituted for Retail Unit A, the supplier's costs in moving the customer would not be expected to exceed the benefits. Therefore, the supplier's substitution right is not considered substantive. Consistent with this example, in Presto's arrangement, fixed concession stands and premium areas would be costly to move and therefore would not likely be subject to substitution. Per discussions with Presto management, based on its prior experiences with similar contracts, the food and beverage locations within the stadium are generally unlikely to be changed by the stadium owner. Conclusion-Issue 1: Identified Asset The Food and Beverage Facilities are a portion of an asset, and thus these spaces are considered "identified assets" if they are physically distinct and not subject to substantive substitution rights. We have concluded the following: Fixed concession stands, suites, and premium areas are physically distinct and are not subject to a substantive substitution right (given that relocation would be costly and thus unlikely). These locations are considered identified assets. With respect to the right for hawkers to operate in the stadium, the hawkers are not limited to a defined space (i.e., the space is not physically distinct), and thus this right does not involve an identified asset. With respect to portables, the locations are not physically distinct, and Stadium Co. has a substantive right of substitution. Thus, portables are not considered identified assets. Therefore, the identified assets in this arrangement are 1) fixed concession stands and 2) premium seating areas and suites. Given that this is not a complete memo, the "Financial Statement and Disclosure Impacts" section of the memo has been omitted