CFTC Letter No. 94-3
December 9, 1993
Division of Trading & Markets
SUMMARY: Special allocations of investment partnership equity or other interests to a general partner ("GP") must be:
1) recognized in the financial statements in the same period as the net income, interest income or other basis of computation;
2) classified in the financial statements as either:
a) an expense in the partnership's statement of income; or,
b) a special allocation of net income, which is deducted in a financial statement referred to as a "statement of income and special allocation", in arriving at "net income available for pro-rata allocation";
3) separately reported in the statement of partnership equity, in addition to the pro-rata allocations of net income, as to each class of partnership interest; and,
4) deducted in the computation of net performance and related rate-of-return information, i.e., the past performance of the partnership and its GP must be based upon net income available for pro-rata distribution.
This responds to your inquiry as to how to report a special allocation of partnership equity to the general partner of an investment partnership ("partnership") in the financial statements of the partnership. In partnership agreements, these payments are variously referred to as "allocations of interest", "minimum allocations", "performance allocations", "incentive allocations" or "disproportionate profit shares". Most commonly, the partnership agreement provides that a special allocation is to be made for the advisory services provided by the GP, and that the amount of the allocation is based upon a percentage of the partnership's net income. The actual allocation of equity is generally made after the end of the applicable year. In other cases, special allocations may be based upon interest earned on partnership assets.
In this letter, these types of allocations are referred to, collectively, as "special allocations", defined as any share of profits or transfer of equity which exceeds the partner's share of profits based upon the partner's "pro-rata" capital contribution. Therefore, a "pro-rata" share of profits is the net income of the partnership not subject to special allocations and is the amount of net income shared amongst the partners based upon the percentage of partnership capital contributed by each partner./1
Existing Accounting and Reporting Guidance
There is no specific accounting standard that has been issued by the Financial Accounting Standards Board ("FASB") on this matter. Other available guidance is very general, apparently, permitting both the method presently used by the partnership and another method, described below, which the Division indicates should be used by the partnership. In particular, the Accounting Standards Division of the American Institute of Certified Public Accountants recognized the existence of the two methods in practice in a recent (September 15, 1993) exposure draft of a proposed statement of position ("SOP") entitled, "Financial Reporting for Investment Partnerships." Paragraph 8 of the document states:
Investment companies organized as limited partnerships typically provide that the general partner render performance and advisory services to the partnership. For such services, some partnerships pay fees chargeable to the partnership, while others allocate capital from the limited partners' capital accounts to the general partner's capital account, and still others employ a combination of the two methods. Because accounting for similar fees in partnerships is ill-defined in accounting standards, this SOP does not specify which accounting treatment is appropriate.
Generally accepted accounting principles ("GAAP") require that transactions be accounted for and reported according to their substance. Moreover, this is a principle that FASB pronouncements and other accounting literature frequently contain. Therefore, the essence of this issue is whether the special allocations to the GP should be classified for financial reporting purposes as an expense -- or something else. In FASB Concepts Statement No. 6, expenses are defined as: "outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations." Since the special allocation to the GP is for advisory and other services rendered to the partnership and it is also a "using up of assets" from the standpoint that the limited partners are giving up a portion of what would otherwise be their equity, there is a strong argument that the special allocation should be reflected as an expense in the financial statements.
It appears that charging partners' equity directly for the special allocation could be analogous to a direct charge to the retained earnings of a corporation. However, under GAAP, charges flowing directly through an entity's capital accounts are rarely permitted. Specifically, in corporate accounting, charges or credits to retained earnings are limited to specific items constituting corrections of a material error in prior period financial statements or accumulated prior period effects due to changes in accounting principles. In corporate accounting, even the effect of extraordinary items and discontinued operations must be included in the income statement. However, in corporate accounting, there is one item which may be analogous to the instant case. Dividends on preferred stock are subtracted from income in the income statement to derive net income applicable to common stockholders, and these dividends are deducted on the face of the income statement, after net income, to arrive at "net income available for common stock".
Therefore, it appears that all explicit accounting standards and other guidance, particularly those issued in recent years, point in a consistent direction -- that charges to an entity's equity for operating items are either not permitted or, when they are, they must appear on the income statement as an allocation of net income.
Commission regulations require the partnership's income statement, account statement and performance table to contain the amount of fees paid by the partnership:
• Regulation 4.22(a)(1)(v), 17 C.F.R. §4.22(a)(1)(v) (1993), states that: "the total amount of all advisory fees during the reporting period" must be included in the periodic account statement distributed to investors. Since this is intended to inform investors about their net returns for the period, accruals for allocations must be deducted.
• Regulation 4.22(e), 17 C.F.R. §4.22(e) (1993), states that the Statement of Income (Loss) included in a partnership's Annual Report "must itemize . . . management fees, advisory fees, incentive fees, interest income and expense . . . during the partnership's fiscal year." Therefore, it seems clear that the Commission intends for all fees and expenses of the partnership to appear in the income statement. (Also, the Division requires that reference to special allocations must be made in the same section of a pool disclosure document where expenses of the partnership are disclosed.)
• Regulation 4.21(a)(4)(ii)(D), 17 C.F.R. §4.21 (1993) defines the partnership's net performance as being: ". . . the change in the net asset value net of additions, withdrawals and redemptions." Particularly, this latter cite requires that all changes in net asset value due to operations be reported in the income statement. Also, in this context, this office interprets "change in net asset value" to mean "change in the net asset value of the limited partners". Therefore, any allocation of equity from the limited partners to the general partners would be a change in net asset value, as intended under the rule and required to be included in the computation of net performance.
Method of presentation
Based upon the aforementioned analysis, the Division has concluded that special allocations of investment partnership equity or other interests to a general partner must be: 1) recognized in the financial statements in the same period as the net income, interest income or other basis of computation; 2) classified in the financial statements as either: a) an expense in the partnership's statement of income; or, b) a special allocation of net income, which is deducted in a financial statement referred to as a "statement of income and special allocation", in arriving at "net income available for pro-rata allocation"; 3) separately reported in the statement of partnership equity, in addition to the pro-rata allocations of net income, as to each class of partnership interest; and, 4) deducted in the computation of net performance and related rate-of-return information, i.e., the past performance of the partnership and its GP must be based upon net income available for pro-rata distribution.
Format to be used if accounted for as a special allocation of net income
Following is an abbreviated format which should be used where a special allocation is to be classified as an allocation of net income. Of course, the normal Commission Rules would still apply for comparative format reporting unless your pool is filing under Rule 4.12.
Statement of Income and Special Allocation
Revenues: (itemize detail per 4.22).......................................
Expenses: (itemize detail per 4.22........................................ _______
Less: Special allocation to GP (Note __)..............................._______
Net income available for pro-rata distribution to all partners..._______
Statement of Partners' Equity
General Limited Total Partners Partners Equity
Balance, beginning of year...... XXX XXX XXXX
New units issued........................XX XX XXX
Redemptions of units................. XX XX XXX
Allocations of net income:
Special allocation.................... XXX - XXX
Pro-rata allocation........................ X XX XXX
Balance, end of year................ XXX XXXX XXXX
Paul H. Bjarnason, Jr.
/1 For purposes of determining whether an allocation is "pro-rata", the amount of capital contributed by a partner to the partnership is computed net of amounts owed by each partner to the partnership.