Refer to Theory in Practice 7.5, describing how The Blackstone Group proposed to account for the carried interest to be received from future earnings of unconsolidated firms it has invested in.

Required

a. As a rational investor in the shares of Blackstone's initial public offering, would you find fair value accounting more or less decision-useful than historical cost accounting for the value of Blackstone's carried interest? In your answer, consider issues of relevance, reliability, and full disclosure.

b. As an investor, would the increased volatility of Blackstone's earnings resulting from fair value accounting affect the amount you would be willing to pay for its shares? Explain your answer.

c. Why do you think that Black stone changed its mind?

Theory in Practice 7.5

The Blackstone Group is a large U.S.-based investment 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 subsidiaries, 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 preferential 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 characteristics, 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, relative to earnings reported using the equity method of accounting for its unconsolidated investments.

Note that fair value must be re-evaluated 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 earlier revenue recognition.

Concerns about the reliability of Blackstone's proposed accounting soon appeared in the financial 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 information about them is minimal. This makes it particularly 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 financial 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' quarterly earnings. This episode illustrates the potential of the fair value option to implement the valuation approach, and the consequent reliability risks.