New FASB Rule on Profits Interest Awards Could Mean Change for Some Firms

The FASB on March 21, 2024, published a narrow rule on profits interest awards that could mean change for some firms — causing them to have to switch to stock compensation accounting rules at a cost.

The board issued Accounting Standards Update (ASU) No. 2024-01, Compensation—Stock Compensation (Topic 718), Scope Application of Profits Interest and Similar Awards, which provides an illustrative example that shows how to determine whether a profits interest award should be accounted for as a share-based payment arrangement under Topic 718, Compensation—Stock Compensation, or under another rule such as Topic 710, Compensation—General.

The example is intended to reduce “complexity in determining whether a profits interest or similar award is subject to the guidance in Topic 718” and eliminate “diversity in practice,” according to the “Basis for Conclusions” section of the standard. “Investors and other allocators of capital will benefit from entities accounting for economically similar awards consistently.”

But a knock-on implication for some firms is that they may have to have to change from using Topic 710 to account for “certain profits interest and similar awards” to using Topic 718. “Those preparers may incur incremental costs to apply the guidance in Topic 718,” the “Basis” text explains.

Ultimately, the board concluded that the general benefits would outweigh any costs that are incurred, and that those that already use Topic 718 for profits interest awards will see a reduction in costs.

Weighing in, some accountants said that because the standard addresses diversity in practice in accounting for awards that meet the legal definition of a profits interest, it would help to clarify issues.

“While it won’t cover all scenarios, the examples provide a much needed framework to minimize the judgment previously exercised and help promote consistency in its application,” Bob Michaels, Technical Accounting Lead at CrossCountry Consulting, said. “It is expected that the additional clarity could result in more profit interest awards being accounted for under ASC 718.”

Provisions Come After 4 Years of Effort

For some the topic is popular because profits interests provide an interest in a partnership’s future profits and are often compensation for services. They can be economically similar to stock options or stock appreciation rights but vary in each partnership. Some companies have trouble identifying when a transaction with a counterparty is a partnership and therefore represents an allocation of capital, or whether the distribution is a form of compensation, board discussions have revealed. If a company concludes it is a compensation transaction, for example, it has to figure out whether it is an equity award or a liability award.

The narrow provisions come after about four years of effort by the FASB, including research by the Private Company Council, the panel that works with the board to amend GAAP for private companies.

The board agreed to address the issue narrowly after hearing that accounting confusion had surfaced because there is no explicit definition in GAAP for profits interest awards, and agreements with those items vary. Further, the board heard that use of profits interest in the private company space has soared partly because of the tax relief provided.

Effective Next Year for Public Companies

The new standard is effective for annual periods beginning after December 15, 2024, and interim periods within those annual periods for publicly held companies, according to the main text.

For privately held companies and other entities, it is effective for annual periods beginning after December 15, 2025, and interim periods within those annual periods. Early adoption is permitted.

Companies can apply the guidance 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 company first applies the amendments.”

If applied retrospectively, the company is required to provide the disclosures in paragraphs 250-10-50-1 through 50-3 in the period of adoption. If applied prospectively, the company is required to disclose the nature of and reason for the change in accounting principle.