On May 11, 2023, FASB issued an exposure draft seeking feedback on amendments to clarify the accounting guidance on profits interest. Due to the current lack of authoritative guidance, diversity in practice has arisen; entities most commonly analogize to treatment as a share-based payment (Accounting Standards Codification (ASC) 718) or a form of deferred compensation (ASC 710). The amendments would add an illustrative example (with four fact patterns) on how an entity would apply ASC 718 scope guidance. Comments are requested by July 10, 2023.
FASB expects that the illustrative example may result in more companies accounting for profits interest awards under ASC 718.
A profits interest provides an interest in a partnership’s future profits and/or appreciation. It can be economically similar to stock options or stock appreciation rights. This award is designed to defer taxation and is often granted as an incentive to executives of private equity portfolio companies and other pass-through entities. The use of profits interests to reward performance is not available to corporations or associations that elect to be taxable as corporations or any other form of business entity not taxed as a partnership. Currently, profits interests are not defined in accounting guidance, but they are defined for tax purposes in Revenue Procedure 93-27.
There are generally two types of partnership interests: capital interests and profits interests. A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. A profits interest is a partnership interest other than a capital interest.
|Classification||Liability||Equity or Liability|
|Measurement||Present value of the benefits expected to be provided to the employee||Equity: Grant-date fair value|
Liability: Remeasured at fair value or intrinsic value each period
|Recognition||The portion applicable to the current services is accrued each period (some guides suggest not accruing costs until “probable and reasonably estimable”)||Recognized over requisite service period straight-line or using graded attribution model (accelerated recognition of compensation cost)|
Diversity in Practice
Diversity in practice applies to both awards that meet the legal definition of a profits interest as well as other awards that are economically similar, e.g., share appreciation rights or phantom units that do not convey legal equity. Because the term “profits interest” is not currently defined in GAAP, entities have taken a facts and circumstances approach to analyze if an arrangement should be covered by ASC 718, ASC 710, or other guidance. 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, i.e., an initial public offering (IPO) or other change of control, or final liquidation of the entity.
- 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 frequently have an explicit performance condition linked to a change in control, recapitalization, IPO, or other 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 do not grant voting rights, contain various transfer restrictions, and require no initial monetary investment by the grantee.
- Profits interest awards may qualify the recipient for beneficial tax treatment.
The illustrative examples in the exposure draft are intended to help entities determine if ASC 718 applies to their unique fact patterns. If ASC 718 does not apply, entities would then defer to other guidance.
Although this issue is most prevalent for private companies, most notably private equity portfolio companies, it also can impact certain public business entities (PBEs). For example, a PBE may have profits interest awards that remain outstanding when the entity has not yet completed an IPO but has filed or furnished financial statements to the SEC or when profits interest awards remain outstanding following an IPO.
If approved, these changes would apply to all reporting entities that account for profits interest awards as compensation to employees in return for goods or services.
Transition & Effective Date
If approved, an entity would apply the guidance either:
- Retrospectively to all prior periods presented in the financial statements, or
- Prospectively to profits interest awards granted or modified on or after the effective date with qualitative disclosure about the nature of and reason for the change in accounting principle.
FASB will determine the effective date and early adoption after reviewing comment letter feedback.
FORVIS encourages you to submit a comment letter if these changes will impact your company.
For more information, visit forvis.com.