The FASB’s Private Company Council (PCC) said there is sufficient use of profits interest as compensation to senior executives to warrant developing measurement rules on the topic, but the complexity of the agreements will make it tough.
One of the hardest challenges is measurement of the profits interest, trying to figure out how to value them, because they “are not, in some instances, written up in a way where you could just use a simple option pricing model or something like that,” Jeremy Dillard, partner with SingerLewak LLP, said during June 22, 2021, PCC discussions.
“So it becomes more challenging and in certain instances they are using outside specialists to assist with determining the fair value of these, which then adds cost to the system as you’re trying to measure these things,” he said.
Profits interest is a type of compensation agreement used by Limited Liability Companies (LLC) and pass-through entities to give senior executives equity into a company. These awards are sometimes pinned to a waterfall calculation to ensure the executive stays with the firm. Under profits interest an executive receives a percentage of profits from the entity without having to contribute capital.
PCC members said companies typically analogize either to guidance in Topic 718, Compensation—Stock Compensation, or Topic 710, Compensation—General, in relation to profits interest, but determining which rule to use can be challenging and there is lack of consistency.
“Some agreements are very complex and create a lot of valuation issues and some may be a little easier,” Adam Roark, director, assurance innovation and methodology at Dixon Hughes Goodman (DHG), said.
“There is a lot of accounting by analogy – you look at it and you’re trying to analogize ‘is this a 710 award, is it 718’ and I think that’s where there’s opportunities to provide more actual guidance and less analogy because it is a little wishy-washy and it creates questions in your mind on consistency,” he said.
The PCC over the past year has been studying profits interest via a working group after the topic was flagged during one of its town hall meetings as prevalent among certain types of private entities.
So far there is an appetite for carving out a practical expedient, i.e. an accounting workaround, to address measuring profits interest, according to the discussions. One PCC member cautioned that some items being viewed as profits interest might not actually be those awards and therefore the scope of the rules would be critical.
“This is a worthwhile project,” Timothy Curt, former managing director of Warburg Pincus LLC in New York, said.
“But I am concerned that we both provide a practical expedient as it relates to measurement and also make sure that the scope of it is such that the clarity that we’re providing relates to real world problems and we don’t unintentionally scope in a bunch of things that technically aren’t profits interest but people are walking around thinking that they are,” he said.
The PCC is the panel that works with the FASB to develop and amend U.S. GAAP for private companies, the largest business demographic in the U.S.
This article originally appeared in the July 6, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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