Accounting for Profits Interest Awards

Profits interests, and similar awards received clarity from the FASB in 2024 through ASU 2024-01. These provided some examples to help explain when these awards could be accounted for under ASC 718 Stock Compensation guidance.  

While these instruments can provide significant benefits, their accounting treatment can be complex and requires careful consideration.  

What are Profits Interest Awards? 

Organizations provide employees, contractors, and other key providers with profits interests or other similar awards (e.g., phantom stock plans, incentive units) to incentivize and retain talent.  

Unlike stock options, these are not contracts to acquire ownership. However, they allow for participation in the organization's future growth, providing recipients with a stake in future profits and/or appreciation of the organization.   

Key Benefits of Profits Interest Awards 

• Tailored Incentives: Customizable vesting schedules and performance criteria.  

• Cash Flow Management: No immediate cash outlay.  

• Suitable for Passthrough Entities: Ideal for partnerships and LLCs that may not have stock.  

How Do You Approach Recognizing a Profits Interest or Similar Award? 

The accounting depends on the facts and circumstances of these awards and accordingly requires judgment.   

Step 1: Understand the terms and conditions of the awards: 

Understanding the economic purpose and exercisability of the awards is key. The terms and conditions of the awards are defined in the specific award and often detailed within the organization's partnership or operating agreement and incentive plan documents. The organization should understand the purpose of issuing these awards in the larger context of its benefit packages and the potential scenarios for these awards to be exercised and vested ultimately. 

Step 2: Evaluate for the appropriate accounting model: 

The primary accounting consideration for such awards revolves around evaluating whether they are more akin to compensation (i.e., performance bonus or profit-sharing arrangement) or equity awards. These awards often hold similarities to stock options, incentivizing employees’ performance today for the ultimate reward of future appreciation in an organization’s value, with vesting and service requirements.   

Accordingly, such awards could be appropriately scoped into the similar US GAAP guidance, ASC 718 – Stock Compensation, which allows for a specific set of accounting rules for valuing and recognizing such awards and the benefit of an exception to derivative guidance.   

However, the circumstances and terms of the award may be more similar to a bonus, requiring the award to be accounted for in accordance with ASC 710 – Compensation.  Below are typical key considerations that require judgment to conclude on the proper accounting model: 

Key considerations that may indicate treatment under ASC 718 Stock Compensation 

• Awards are valued based, at least in part, on the value of the entity’s equity value. 

• Vested awards are treated like a typical stock award, receiving a pro-rata share. 

• Awardees are eligible to participate in separate cash bonus programs the Organization offers. 

• Awards survive past termination or change in control. 

Key considerations that may indicate treatment under ASC 710 Compensation 

• Awards that have a fixed value or are derived from a formula. 

• Settlement of award required upon an exit or distribution is fixed without a pro-rata basis. 

• Awards are issued in lieu of a cash bonus program. 

• Vested awards are forfeited or repurchased upon employee termination.   

Many awards may involve a mixture of these attributes. Accordingly, a careful evaluation of the circumstances and the organization’s intent for issuing the awards is required to determine the proper accounting model.  

On March 21, 2024, the FASB board published ASU 2024-01, which provides illustrative guidance to help entities determine whether profits, interest, and similar awards should be accounted for as a share-based payment arrangement within Topic 718, Compensation – Stock Compensation. The intention was to clarify the appropriate application of ASC 718 and reduce disparities in practice. 

Step 3: Determine the appropriate measurement and recognition of the award: 

The accounting model concluded in step 2 above will determine the appropriate measurement.  Compensation costs under ASC 710 would be measured as liabilities based on the present value of expected future payments and remeasured at each reporting date.  However, under 718, the awards would be measured at fair value on the grant date and recognized over the vesting period. The classification of the awards between liability or equity treatment will depend on requirements to be settled in cash or their ability to be settled in equity. Additionally, vesting features based on performance criteria may be subject to consideration of contingency guidance (ASC 450).    

Some other considerations include: 

• Profits interest awards are generally designed to be tax-free upon grant and taxed as a capital gain upon sale.  Typically, awardees must file a Section 83(b) Election with the IRS within 30 days of the grant and remain an employee or service provider to the partnership when the award vests.   

• Some awards depend on a complex waterfall of distributions, which may warrant a complex valuation model considering different scenarios, including a PWERM or Monte Carlo. 

Conclusion

Accounting for profits interest and similar awards requires careful analysis and judgment. By understanding the key factors and applying the appropriate accounting standards, organizations can maintain accurate financial reporting and comply with relevant regulations.  

For additional information on accounting for profits interests and other recent FASB guidance, please contact an EisnerAmper Assurance professional using the form below.