Background
Certain entities provide employees or nonemployees with profits interest awards to align compensation with an entity’s operating performance and provide those holders with the opportunity to participate in future profits and/or equity appreciation of the entity. The term profits interest is not defined in GAAP but differentiates those interests from capital interests held by investors that provide those holders with rights to the existing net assets in a partnership or similar entity (for instance, a limited liability company [LLC]). Because profits interest holders only participate in future profits and/or equity appreciation and have no rights to the existing net assets of the partnership, it becomes difficult to determine whether a profits interest award should be accounted for as a share-based payment arrangement (Topic 718) or similar to a cash bonus or profit-sharing arrangement (Topic 710, Compensation—General, or other Topics).
Correct accounting depends upon the correct classification of awards. While the legal and economic forms of these awards can vary, they should be accounted for based on their substance. An award that has the characteristics of an equity interest represents a substantive class of equity and should be accounted for under ASC 718; however, an award that is, in substance, a performance bonus or a profit-sharing arrangement would be accounted for in accordance with other guidance as applicable to employee arrangement such as ASC 710. In other words, profits interest awards may be akin to equity interests or profit sharing/bonus arrangements. In the absence of any authoritative guidance, judgment is required to make that assessment, which in practice, has resulted in diverse accounting for these awards.
FASB, in its efforts to improve the operability of the guidance in ASC 718-10-15-3, has issued ASU 2024-01 adding examples to illustrate the scope application of ASC 718. The illustrative example includes four fact patterns to demonstrate how an entity would apply the scope guidance in paragraph 718-10-15-3 to determine whether profits interest awards should be accounted for in accordance with ASC 718. ASU also amends certain language in the Scope and Scope Exceptions Section of Topic 718 to improve its clarity and operability without changing the guidance.
ASU 2024-01 guidance applies to all entities that issue profits interest awards as compensation to employees or non-employees in exchange for goods or services. The ASU is likely going to be relevant for certain PBEs also who (a) have not yet completed an IPO but have filed or furnished financial statements with or to the U.S. Securities and Exchange Commission (SEC) or (b) less commonly, in situations in which profits interest awards have remained outstanding following an IPO.
A. What are profits interest awards?
IRS Revenue Procedure 93-27 defines a profits interest as an interest in a partnership that would receive no proceeds if the partnership were immediately liquidated at the time of receipt of the partnership interest. Profits interests are contrasted with capital interests, which are partnership interests whose holders would receive proceeds if the entity were immediately liquidated. A profits interest provides the holder with rights to a share of only the partnership’s future profits and/or equity appreciation and does not provide the holder with rights to the existing net assets of the partnership.
The characteristics of a profits interest award can vary such that in some instances, the award may be more akin to other types of equity awards (such as stock options), but in other instances, the award may be more akin to a performance bonus or profit-sharing arrangement. Common terms and characteristics of profits interest awards include but may not be limited to:
- Management’s intent is to award the recipient compensation upon a sale, liquidity event (for example, an initial public offering [IPO] or other change of control), or final liquidation of the entity or awards having an explicit performance condition linked to liquidity event.
- Awards have a relatively high distribution hurdle. Recipients of such awards generally will not receive distributions in the normal course of business because of the high threshold required and the level of subordination. Recipients are more likely to receive residual value upon a sale or liquidity event.
- Awards may or may not have an explicit service condition required for vesting.
- Forfeiture and repurchase provisions vary significantly. Some awards are forfeited upon separation from the entity for any reason, while other awards include a call option exercisable at fair market value, calculated value, or some other amount.
- Awards typically (1) do not grant voting rights, (2) contain various transfer restrictions, and (3) require no initial monetary investment by the grantee.
- Profits interest awards may qualify the recipient for beneficial tax treatment.
B. Classification assessment of profits interest awards
Step 1: Determining whether profits Interest Awards are profit-sharing arrangements or performance bonus.
ASC 718-10-15-3 provides guidance for the scope applicability of ASC 718 to stock compensation awards. As per the principles of ASC 718-10-15-3, if it is determined that an award (or the underlying security) has predominantly equity characteristics (even if junior to other classes of equity interests), it is subject to the scope of the ASC 718. In other words, if payment under the arrangement is required to be settled in or based, at least in part, on the price of the entity’s shares or other equity instruments, the arrangement is in the scope of ASC 718. ASU also amended the language of ASC 718-10-15-3 (as reproduced below) to improve its clarity and operability without changing the guidance.
One of the key considerations in determining whether profits interest awards are profitsharing arrangements or performance bonuses is the employee’s rights upon voluntary termination. If an employee is only entitled to share in profits while providing employee service and forfeits those rights upon termination of employment, the arrangement would generally be considered akin to a profit-sharing arrangement or performance bonus, not an equity award.
Step 2: Profits interest awards not in the nature of profit-sharing arrangement or performance bonus to be classified as Equity or Liability.
The awards classified as within the scope of ASC 718 need to be further assessed as to whether features of the award result in the “Liability” or “Equity” classification. Key factors, which should be considered for such classification assessment include:
- The legal form of the instrument (to be classified as equity, it must be considered legal equity of the partnership or LLC)
- Participation features such as voting rights, distribution rights, and liquidation rights (i.e., to be classified as equity, the instrument must participate in the residual returns of the entity’s net assets in a manner consistent with equity ownership)
- Transferability of the instrument
- Retention of vested interests upon termination of employment or when a nonemployee ceases to provide goods or services (liability classification is likely when vested interests are not retained upon termination)
- The settlement and repurchase features. (using the applicable guidance from EITF 00-23, Issue 23, which is still applied in practice)
C. Recognition and measurement principles of profits interest awards
Main Principles of Examples added by amendments to Topic 718
The amendment adds Example 10: Profits Interest and Similar Awards to ASC 718-10-55. The Example includes Cases A through D, discussed in ASC 718-10-55-138 through 55-148, to improve the understandability of how an entity should apply the guidance in ASC 718-10-153 to determine whether a profits interest award is within the scope of ASC 718. The following example illustrates the guiding principles emanating from amendments:
Background
As part of the profit-sharing arrangement between the Fund and Excel Partners (EP), EP distributes 50% of the EP’s return on investment if the fund returns exceed 10% of the investment. This additional capital distribution made by the EP is in the form of promote units. The promote units are distributed as follows if the fund returns exceed 10% of the investment.
Investors
60% to XYZ Inc.
40% to XYZ employees that invested in EP
Assumptions
On December 20X4, the EP distributes 100 % promote units to their investors.
Summary of the illustrations added in ASU as a new guidance
Effective date
Transition
Entities can apply the amendments either:
- retrospectively to all prior periods presented in the financial statements or
- prospectively to profits interest and similar awards granted or modified on or after the date at which the entity first applies the amendments.
If the prospective application is elected, an Entity must disclose “the nature of and reason for the change in accounting principle.”
For more information on the amendment in ASU, see the press release on the FASB’s Web site.
