Accountants debate how to book carry

Is carried interest a profit share, or payment for a service rendered? 

That is the question accountants are currently trying to answer for their private equity clients. Traditionally carried interest has been treated as a tax-friendly investment return by accountants, a slice of fund profits ‘carried’ over to managing partners, as opposed to an incentive fee charged to LPs.

However, PwC, one of the “Big Four” accountancy firms, has been more openly suggesting carry should instead be treated an expense under international accounting standards. 

At the heart of the debate is how the International Financial Reporting Standards (IFRS) defines a “financial liability”. If, as PwC suggests, carried interest is an “obligation to deliver cash arising under a contractual arrangement”, then it is an expense to be recorded in a fund’s income statement. 

“Thus, unlike US GAAP where a carried interest may be presented as [a profit] allocation, a carried interest under IFRS will always be reflected as an expense,” said PwC in a 2011 report which touched on the matter. 

Sources tell PE Manager that the other large accountancy firms are taking a more blended approach, electing to treat carry on a case by case basis.  

The debate mirrors one amongst tax professionals, some of which argue carry should be interpreted ordinary income for services rendered. In the US, Congress is expected to soon debate a bill that would change the 15 percent capital gains tax treatment of carried interest to ordinary income, subject to a top income tax rate of 35 percent.

How accountants treat carry is important, “as relevant tax authorities may be tempted to follow your accounting treatment and presentation”, said Mariya Stefanova of consultancy house PE Accounting Insights.

The above issue was recently addressed in our guide to Private Equity Accounting, which can be purchased by clicking here.