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Breaking it down
What is a profits interest?
A profits interest, while not defined in GAAP, typically represents a legal equity interest that provides the holder with the right to share in distributions of the future profits and appreciation of a pass-through entity’s net assets, but not its existing capital, after the interest has been granted. Depending on the terms of the arrangement, a profits interest might be similar to the grant of a restricted equity interest, an option, a stock appreciation right, or a profit-sharing or deferred compensation arrangement.
Why issue the proposal?
When accounting for a profits interest award, one of the first steps is to consider the substance of the specific terms, conditions, and characteristics of the award and apply judgment to determine whether the award falls within the scope of Topic 718 or other guidance, such as Topic 710, “Compensation – General.”
The scoping guidance within ASC 718-10-15-3 provides that either of two conditions must be met for an award to be within the scope of Topic 718:
- The amounts must be based, at least in part, on the price of the entity’s shares or other equity instruments.
- The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
The Private Company Council and other stakeholders have highlighted diversity in practice when entities try to apply the scoping guidance within Topic 718 to profits interests, even when evaluating awards with similar fact patterns. Complexity and diversity in applying the scoping guidance often arises because of a wide array of terms and conditions that profits interest awards might contain, including options or requirements for the awards to be repurchased and/or cash settled, among others. The amendments in the proposal are meant to improve GAAP by providing examples that demonstrate how the scoping guidance in Topic 718 is to be applied to commonly seen profits interest arrangements.
Illustrative examples
The examples provided in the proposal highlight two considerations commonly found in profits interest awards:
- Whether the proceeds to be received by a grantee of a profits interest are based, at least in part, on the price of the entity’s equity
- How to assess a feature that provides for the grantee’s forfeiture of a vested award upon termination of employment
Two of the four examples demonstrate awards that are within the scope of Topic 718, while the other two examples demonstrate awards that are subject to other GAAP. The examples also provide the rationale behind why the scoping guidance in Topic 718 is or is not met.
Crowe observation: The proposed amendments focus squarely on the accounting scope of a profits interest award and do not address how to apply other aspects of Topic 718 to a profits interest award, such as whether an award is classified as a liability or as equity.
Transition and disclosure
Entities would be allowed to apply the amendments in the proposal either retrospectively to all prior periods presented in the financial statements or prospectively to profits interest awards granted or modified after the effective date. If applied prospectively, an entity would be required to disclose the nature and reason for the change in accounting principle.
Next steps
The FASB is seeking comments on the proposal. Those are due by July 10, 2023.
