FASB staff will research whether special purpose acquisition companies (SPACs) are generating issues that would fall within the range of guidance accounting rulemakers could ultimately draw up on reporting profits interest compensation.
Decisions will be made by the Private Company Council in September on whether to add a project on profits interest, according to the panel’s April 20, 2021, discussions.
Profits interest are equity-type compensation that are especially popular among limited liability companies (LLCs) and partnerships. This type of compensation might fit perfectly within the framework of SPACs, known as blank check companies, formed to raise capital through an initial public offering (IPO) with the goal of acquiring. The SEC has been cracking down how SPACs are reported.
The PCC has been researching profits interest since last year, forming a working group to study the topic with the goal of figuring out scope and potential accounting rules on the subject.
“There’s a lot of emphasis on the scope regarding private equity, I was also curious whether or not staff has looked at whether the sponsors of SPACs may also be in that pool – that was one thing that came to my mind,” Holly Nelson, chief executive officer at Key Advisory Services, said. “It does appear that there is really going to be a service component associated with these profits interest and be able to provide clarity potentially may be helpful,” she said.
Staff research on SPACs will reveal whether there has been subsequently more frequent use of profits interest awards, or if new issues have arisen related to them, according to the discussions.
“My primary concern about the process at this point, there are at least a couple of industries that I can think of that we haven’t really reached out to, those would be real estate and investment management and potentially others,” Timothy Curt, former managing director of Warburg Pincus LLC, said. “There are service businesses that were we to come up with a definition of profits interest and create something authoritative on profits interest we would need to distinguish it from other things that also equally meet that definition but we wouldn’t be necessarily be willing to scope in,” he said.
Not Complex for Specialists
Typically, the average private company accountant struggles with how to account for profits interest compensation because the accounting guidance is not clear and they are tough to evaluate.
The term profits interest is not defined in GAAP but is defined for federal income tax purposes under Revenue Procedure 93-27 as “an interest in a partnership that would receive no proceeds if the partnership were immediately liquidated.”
Research to date has indicated that profits interest as defined in tax rules in the private equity context are frequently valued using an option pricing framework, a FASB staff member said. This is because like a stock option, profits interest have no intrinsic value when granted instead they are valuable because of their upside potential – i.e. they have time value.
The AICPA Accounting and Valuation Guide: Valuation of Privately-Held-Company Equity Securities Issued as Compensation (AICPA Cheap Stock Guide), refers to common stock options, warrants, and profits interests, as instruments with option-like payoffs.
Staff said its outreach to date indicated that the valuation of profits interest is not necessarily viewed by valuation specialists as being inherently more complex than for stock options. One specialist noted that the bigger issue relate to the education of management, he said. In addition, multiple specialists noted that financial statement preparers sometimes take a perspective that profits interest should be measured at a value of zero either because management does not think they are subject to equity volatility or because they would receive no proceeds if the entity were not immediately liquidated at the grant date, which is how profits interests are measured for tax purposes.
They especially noted that view reflects a lack of understanding “of what volatility represents and that profits interest have time value in the same area as an option,” the staff member said.
Among issues staff is also studying is an agenda request from accounting firm BDO surrounding profits interest. The board would likely need to clarify whether profits interest should be accounted for within the scope of Topic 718, Compensation–Stock Compensation, or Topic 710, Compensation–General, to address the issue.
As part of next steps, FASB staff said they will decide on the need for a project by evaluating whether “there is an identifiable and sufficiently pervasive need to improve GAAP,” the issue has “technically feasible solutions and the perceived benefits of those solutions are likely to justify the expected costs of change,” and “the issue has an identifiable scope.”
This article originally appeared in the April 23, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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