The use of profits interest, a relatively new form of equity compensation issued by limited liability companies (LLCs), has spiked. Now, private companies and their advisors are asking the Financial Accounting Standards Board (FASB) to simplify the complex rules that have evolved to account for these transactions.
Ways to Account for Profits Interest
As the name suggests, “profits interest” arrangements provide recipients with a share of the company’s future profits. Under existing U.S. Generally Accepted Accounting Principles (GAAP), these transactions may be classified as:
- Share-based payments,
- Bonus arrangements, or
- Deferred compensation.
The classification is determined by the specific terms and features of the profits interest. While profits interests do not always need to be recorded, in some cases, the fair value basis of the award is recorded as an income statement expense. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures. The disclosure requirements have been flagged by private companies as one area in need of simplification.
>> Read “4 Ways Partnerships Can Offer Equity-based Compensation to Service Providers”
Why Private Companies are Struggling with Profits Interests
The use of profits interest awards as a tool to attract and retain skilled workers has increased, as more companies are being structured as LLCs, rather than as C Corporations or S Corporations. Profits interests are used exclusively by LLCs. Corporations tend to award traditional share options instead.
“Profits interest continues to come up as an area private companies are struggling with,” said Candace Wright, Chair of the Private Company Council during a June meeting with the FASB. She called profits interest “a topic we all need to have on our radar as to whether or not there are some simplifications that we can do in that space.”
The topic surfaced as Private Company Council members were discussing plans to provide a “practical expedient to measure grant-date fair value of equity-classified share-based awards.” The Private Company Council’s current work is aimed at allowing private companies to use the exercise price of their equity-classified share options as the current price for purposes of determining the grant-date fair value of an award in certain circumstances.
The panel has been trying to understand the process a private company uses to establish an award’s strike price and the audit procedures associated with that process. The work is still ongoing.
The Future of Profits Interests
Many companies could incentivize exceptional performance by awarding profits interest and other types of equity-based compensation. But accounting complexity has caused some private companies to shy away from these arrangements.
Simplification of the financial reporting guidance would be welcome news for many employers and employees. For now, consult with your accounting team to properly report these transactions under existing U.S. GAAP and stay tuned on the latest updates from the FASB.
Contact Beth Reho at firstname.lastname@example.org or a member of your service team to discuss this topic further.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.