Accounting Standards Update Addresses Profits Interest and Similar Awards

Many entities award profits interests to employees or nonemployees to link compensation to the future profits or equity growth of the entity. While U.S. GAAP does not define what a profits interest is, IRS Rev. Proc. 93-27 defines it as a “partnership interest other than a capital interest.”

Following this principle, many awards that do not provide legal ownership nor qualify as profit interests, but are economically comparable to profit interests (such as share appreciation rights and phantom share units), should be assessed under U.S. GAAP similarly to profit interests.

These complexities can make it difficult to determine which Topic of U.S. GAAP a profits interest award is in the scope of and have resulted in diversity in practice. To address these challenges, the Financial Accounting Standards Board (FASB) issued ASU 2024-01.

The Impact of ASU 2024-01

ASU 2024-01 includes amendments which improve the clarity and operability of ASC 718-10-15-3, but do not change the guidance. The amended guidance of ASC 718-10-15-3 reads as follows:

• 718-10-15-3 The guidance in the Compensation — Stock Compensation Topic applies to all share-based payment transactions in which a grantor acquires goods or services to be used or consumed in the grantor’s own operations or provides consideration payable to a customer by either of the following:

1. Issuing (or offering to issue) its shares, share options, or other equity instruments to an employee or a nonemployee

2. Incurring liabilities to an employee or a nonemployee that meet either of the following conditions:

1. 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.)

2. The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.

The ASU also adds an illustrative example to Topic 718 which includes four cases that demonstrate how to apply the guidance of ASC 718-10-15-3 to determine under which U.S. GAAP topic of U.S. GAAP to account for a profits interest award.

The cases in the illustrative example share a few common assumptions, while adding some unique assumptions to the fact pattern for each case. The outcome of each case has been summarized below, along with the basis for the conclusion reached:

• Case A – Profits interest award accounted for in accordance with Topic 718
• Basis for conclusion: This particular award vests after required years of service or an exit event, and the vested units would provide the grantee the right to participate in residual interest of the entity. Therefore, the condition in ASC 718-10-15-3(a) was met.
• Case B – Profits interest award accounted for in accordance with Topic 718
• Basis for conclusion: This particular award vests upon an exit event, which would provide the grantee the right to participate in the residual interest of the entity. Therefore, the condition in ASC 718-10-15-3(a) was met.
• Case C – Phantom share award accounted for in accordance with Topic 718
• Basis for conclusion: Cash proceeds received in an exit event for this particular phantom share unit award would be based, at least in part, on the price of the entity’s common shares. Therefore, the condition in ASC 718-10-15-3(b)(1) was met.
• Case D – Phantom share award accounted for in accordance with guidance outside of Topic 718
• Basis for conclusion: Operating distributions to the grantee for this particular phantom share unit are based on operating metrics, and no distributions would be based on the price of the entity’s shares. In addition, the award does not entitle the grantee to receive equity instruments of the entity. Therefore, none of the conditions found in ASC 718-10-15-3(a) or (b) were met.

Effective Date and Transition Considerations

The amendments in ASU 2024-01 are effective as follows:

• Public business entities (PBEs) – annual periods beginning after December 15, 2024, and interim periods within those annual periods.
• Entities other than PBEs – annual periods beginning after December 15, 2025, and interim periods within those annual periods.

Early adoption of ASU 2024-01 is permitted for interim and annual financial statements that have not yet been issued or made available for issuance and may be applied either:

• Retrospectively to all prior periods presented in the financial statements, or
• Prospectively to profits interest and similar awards granted or modified on or after the date at which the amendments are first applied

Next Steps for ASU 2024-01

Any entity entering into profits interest and similar awards could be impacted by the amendments in ASU 2024-01. It’s important to have a trusted advisor on your side to help you navigate the complexity of assurance and accounting changes.