Accounting Standards Update (ASU) 2024-01: Clarifying the Scope of Profits Interest Awards

With a heightened focus on compensation tactics for companies, especially in the private equity and venture capital (PE/VC) space, executive teams and stakeholders are beginning to utilize more creative ways to recognize and incentivize employees outside of typical salary and cash bonuses. Profits interest units can be a key differentiating factor for companies that provide employees the opportunity to share in the upside in a fast-growing company and help in both recruitment and retention of top-performing team members.

In March 2024, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2024-01, Compensation—Stock Compensation (ASC 718) Scope Application of Profits Interest and Similar Awards, introducing critical clarifications for the application of profits interest awards under ASC 718. This update provides guidance for companies and accounting firms to address inconsistencies in accounting practices for profits interest and similar awards.

Key Takeaways from ASU 2024-01

1. Purpose of the Update: This clarification was developed to assist entities in determining whether profits interest awards fall within the scope of ASC 718 or ASC 710, Compensation—General. This difference can impact a company’s operations as those awards falling under ASC 710 are classified as a liability, whereas awards under ASC 718 provide a more precise framework to determine whether the awards are deemed equity or a company liability. The update introduces illustrative scenarios to reduce diversity in practice and improve comparability in financial reporting.
2. What Are Profits Interest Awards? Profits interest awards are compensation arrangements commonly used by partnerships and LLCs. They grant recipients a share in future profits or equity appreciation without conferring rights to the entity’s existing net assets. These awards are often tied to exit events such as sales or IPOs. Typically, recipients are not required to pay upon exercise or upfront to receive the benefits upon an exit event.
3. Challenges Addressed: Before this update, a lack of clear guidance resulted in varying interpretations and inconsistent accounting for profits interest awards. ASU 2024-01 addresses this issue by offering practical examples to apply the proper accounting under U.S. Generally Accepted Accounting Principles.
4. Impact on Portfolio Companies:
   • Simplified and More Consistent Accounting: Companies that grant profit interest awards will benefit from clearer guidance regarding how these awards should be accounted for. This reduces ambiguity and helps companies apply a consistent approach to profit interests in their financial statements.
   • Changes in Financial Reporting: Companies may need to adjust their accounting practices to reflect the clarified guidance, particularly in classifying and measuring profit interest awards and determining the appropriate timing of recognizing compensation expense. For example, if profit interest awards were previously treated as liability awards but are now required to be classified as equity, this could impact how and when companies report compensation expenses.
   • Compliance and Implementation Costs: While the ASU clarifies the treatment of profit interest awards, companies may need to invest in updating their accounting policies and systems to reflect the new guidance. For companies with large numbers of employees receiving profit interests, this could result in increased administrative and compliance costs.
   • Tax Implications: Although the ASU focuses on accounting for profit interest awards, companies should also consider the tax implications of these changes, particularly since the tax treatment of profit interests may differ from the accounting treatment. It may be necessary to revisit tax strategies and ensure that tax reporting aligns with accounting treatment.
5. Impact on Private Equity and Venture Capital Firms: These clarifications are significant for PE/VC portfolio companies. Profits interest awards are frequently used to attract and retain top talent, and understanding whether these awards are classified as equity or liabilities is crucial. Proper classification impacts the financial statements and valuation of portfolio companies. Firms should align with their teams to align consistently across their portfolio.
6. Implementation Details:
   • Effective Dates: Public companies must apply the update for fiscal years beginning after Dec. 15, 2024, while private companies have until Dec. 15, 2025. Early adoption is permitted.
   • Transition Options: Entities can apply the guidance retrospectively or prospectively, providing flexibility in implementation. If the ASU is adopted retrospectively, entities must include the required disclosure for a change in accounting principle as detailed in ASC 250, Accounting Changes and Error Corrections.

How We Can Help

CBIZ accounting professionals specialize in evaluating compensation structures, including profits interest awards, to ensure compliance with ASC 718 and ASC 710. Whether determining appropriate classifications or advising on structuring agreements to align with intended outcomes, our expertise ensures you stay ahead in an evolving regulatory landscape. Connect with a CBIZ professional today. To learn more about how CBIZ can assist portfolio companies, please visit CBIZ’s Portfolio Company Practice.

For detailed insights into ASU 2024-01 and its applications, contact our team or visit the FASB website for the full update.