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Question 3: Are incentive-based capital allocations, such as carried interest, within the scope of Topic 606?
Publication date: 30 Jan 2020
us FASB Staff Q&A Revenue 3
Reference(s): Section 606-10-15
Some entities, particularly asset managers, receive incentive-based performance fees via an allocation of capital from an investment fund under management (that is, through a “carried interest”). The fees are provided to compensate the asset manager for its services and performance in managing the fund. Many stakeholders think there are two aspects to those incentive-based fee arrangements: (a) compensation for asset management services and (b) financial exposure to the fund’s performance. Stakeholders have raised questions about whether those arrangements are within the scope of Topic 606 or, instead, are within the scope of other GAAP, such as Topic 323, Investments—Equity Method and Joint Ventures, which is listed as a scope exception in paragraph 606-10-15-2(c)(3).
The staff’s view is that incentive-based capital allocations are within the scope of Topic 606. The staff’s view primarily is based on the following considerations:
(a) Example 25 in Topic 606 illustrates the Board’s intention about how the new revenue model would be applied to an asset manager services contract that includes a performance-based incentive fee. While the example does not state that the form of the incentive fee is a capital allocation or cash (or some other asset), the staff does not think that the arrangement is within or outside of the scope of Topic 606 depending on whether the fee is payable by cash or via carried interest.
(b) Carried interest is designed to compensate an asset manager for the services it performs in managing and investing in the fund. The view that incentive-based capital allocations are within the scope of Topic 606 is consistent with previous Board decisions about these arrangements and results in a consistent treatment within the asset management industry and relative to service contracts in other industries.
(c) In Accounting Standards Update No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, the Board excluded performance-based fees from the analysis in determining the primary beneficiary of a VIE if (i) the compensation was commensurate with the services provided and (ii) the service agreement included only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm’s length. The basis for that decision was that service arrangements that meet these two previously mentioned criteria are inherently different from other types of variable interests because that type of compensation does not subject the reporting entity to risk of loss. The risks associated with performance-based fees are only the opportunity costs of the nonreceipt of fees and not the actual exposure to losses. The staff’s understanding is that during the deliberations of Update No. 2015-02, the Board’s intent was that carried interest arrangements represent decision-maker fees for services and not an ownership interest.
In the staff’s view, the services provided for incentive-based capital allocations, such as carried interest, are similar to services provided for separately managed accounts or non-U.S. corporations in which incentive-based performance fees are received in cash. The staff’s understanding is that the legal form of asset management contracts can vary significantly. Some stakeholders have informed the staff that there is a risk that if incentive-based capital allocations are outside of the scope of Topic 606 (because they are ownership interests and should be accounted for under other GAAP), it could result in an entity structuring its investment management arrangements (that is, by having compensation be paid via an equity interest) to circumvent the revenue model in Topic 606. Consequently, some stakeholders assert that some management contracts that are economically similar would be accounted for differently.
Many TRG members agreed that the arrangements are within the scope of Topic 606. A few TRG members stated that they can understand a view that carried interest could be considered an equity arrangement, because it is, in form, an interest in the entity. Some TRG members stated that if the arrangements are considered equity interests outside the scope of Topic 606, then questions could arise in practice about the effect of such a conclusion on the analysis of whether the asset managers should consolidate the funds. In addition, each of the seven FASB Board members stated during the meeting that they believe that carried interests are within the scope of Topic 606.
The SEC staff observer at the TRG meeting indicated that he anticipates the SEC staff would accept an application of Topic 606 for those arrangements. However, the observer noted that there may be a basis for following an ownership model. If an entity were to apply an ownership model, then the SEC staff would expect the full application of the ownership model, including an analysis of the consolidation model under Topic 810, the equity method of accounting under Topic 323, or other relevant guidance.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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