Profits interests, often referred to as incentive units, carried interests, or management participation units, are commonly issued by LLCs, partnerships, and other pass-through entities to align management compensation with increases in company value. Historically, Generally Accepted Accounting Principles (GAAP) did not contain explicit examples addressing whether these awards should be accounted for as share-based payments under ASC 718, Compensation – Stock Compensation (ASC 718) or as profit-sharing/bonus arrangements that would likely fall under other accounting guidance such as ASC 710, Compensation – General (ASC 710). As a result, significant diversity in practice developed, creating complexity for management teams of privately held companies as well as their service providers.
About ASU 2024-01
In March 2024, the FASB issued Accounting Standards Update (ASU) 2024-01, Compensation – Stock Compensation (Topic 718): Scope Application of Profits Interest and Similar Awards, to clarify how entities should evaluate profits interests and similar awards and determine whether they fall within the scope of ASC 718. The standard does not create new accounting models, but it does provide illustrative guidance and clarifies the application of existing ASC 718 scope provisions.
As disclosed verbatim in 718-10-15-3 awards are within the scope of ASC 718 if either a) or b) below are met:
- Issuing (or offering to issue) its shares, share options, or other equity instruments to an employee or a nonemployee
- Incurring liabilities to an employee or nonemployee that meet either of the following conditions:
The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance or service condition.)
The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
Whereas under ASC 710, compensation arrangements might be tied to earnings, profits or an internal fair market value formula, but would not be tied to the Company’s share price.
The practical effect of ASU 2024-01 is that many profits interest arrangements that historically may have been viewed as profit-sharing arrangements (and likely falling under other accounting guidance such as ASC 710) will now require a more robust ASC 718 analysis and, in many cases, will be accounted for as share-based compensation.
Key Considerations for Private Companies
Here are some steps to consider if your company has issued profits interests:
1. Determine whether ASC 718 applies using the illustrative examples and fact patterns provided in ASU 2024-01
2. If ASC 718 applies, determine whether the award should be classified as equity or a liability. (If ASC 718 does not apply, determine the appropriate accounting model that should be used to evaluate these awards.)
3. Decide the most appropriate approach for measuring fair value on the date of grant.
4. If the instrument is liability-classified, be prepared to update the fair value at each reporting date (equity-classified instruments are not remeasured).
5. Consider ASC 718-20-30-20C, which provides a practical expedient for privately held companies to use valuations such as those commonly referred to as 409As (U.S. Department of Treasury Section 409A of the U.S. Internal Revenue Code). When deciding whether to adopt the practical expedient, privately held companies should weigh whether they have any future plans or interest in going public.
Management should gather documents to support its accounting conclusions, including the following:
- Company agreements such as LLC or partnership agreements
- Incentive unit plan documents
- Award agreements
- Board approvals and/or related meeting minutes
- Compensation committee approvals and/or related meeting minutes
Management should also consider the following items when performing valuation and accounting analysis related to the granting of profits interests and documenting their conclusions. Long-term considerations and proper planning can allow teams to get ahead of the complexity of these transactions.
- Tracking tools – management teams may decide to use manual tools such as Excel or Smartsheet versus third-party platforms or service providers such as Carta, Morgan Stanley at Work or Cake Equity to track the details of the awards
- Potential impact of vesting terms depending on service, performance and market conditions which may affect valuation and expense recognition
- Impact of hurdle calculations
- Significant assumptions or award features that could impact valuation calculations
ASU 2024-01 represents one of the most significant recent developments affecting private-company equity compensation. While the ASU does not change the underlying accounting model, it clarifies when profits interests and similar awards should be evaluated under ASC 718. As a result, many private companies may experience increased stock-compensation expense, greater valuation complexity, and heightened documentation requirements as it is deemed likely that more awards will be accounted for under ASC 718 going forward.
Need Help Evaluating the Accounting Impact of Profit Interests?
CBIZ professionals can help you assess ASC 718 applicability, navigate valuation considerations, and develop documentation to support your accounting conclusions. Connect with our team to discuss your specific situation.
ASU 2024-01 is an accounting standard issued by the FASB that clarifies how entities should evaluate whether profits interests and similar awards fall within the scope of ASC 718, Compensation – Stock Compensation. The guidance provides clarification and illustrative examples rather than creating a new accounting model.
Many profits interest arrangements that were previously treated as profit-sharing arrangements (and were likely classified under other accounting guidance such as ASC 710) may now require a more comprehensive ASC 718 analysis and, in many cases, will be accounted for as share-based compensation.
Companies should determine whether ASC 718 applies, assess whether the award should be classified as equity or a liability, select an appropriate fair value measurement approach and prepare for ongoing remeasurement if the award is liability-classified. Privately held companies may also be able to use certain valuation practical expedients available under ASC 718.
Management should gather and retain key supporting documents, including LLC or partnership agreements, incentive unit plan documents, award agreements, board approvals, and compensation committee approvals or meeting minutes.
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