ASU 2024-01: Scope Application of Profits Interest Awards

In March 2024, the Financial Accounting Standards Board (FASB) released accounting standards update (ASU) 2024-01 regarding Topic 718 – Stock Compensation. This update addresses the scope application of profits interest awards and other awards by providing examples that companies can use to help accurately classify these awards.

Background

Before this update was released, the FASB lacked specific guidelines addressing profits interest awards within the codification. Instead, companies utilizing these types of awards had to carefully evaluate the award specifics and exercise judgment to determine the appropriate accounting treatment. The key decision lies in whether to account for these awards as share-based payment arrangements (i.e. equity) under 718 – Stock Compensation or as cash bonuses or profit-sharing arrangements under 710 – Compensation – General. Unfortunately, this lack of standardized guidance has led to wide diversity in accounting practice across companies, causing frustration for stakeholders who struggle to compare entities or understand companies’ rational.

In response to stakeholder requests for clarity, the FASB invested in a project to address these concerns. The resulting ASU adds an illustrative example to Topic 718-10 that will “reduce (1) complexity in determining whether a profits interest award is subject to the guidance in Topic 718 and (2) existing diversity in practice.”

Profits interest awards, although not explicitly defined by GAAP, serve a specific purpose.  Entities grant these awards to employees or other service providers to “align compensation with an entity’s operating performance and provide those holders with the opportunity to participate in future profits and/or equity appreciation of the entity.” These awards are commonly issued by limited liability companies (LLCs) and other businesses taxed as partnerships. Importantly, recipients do not acquire rights to the entity’s existing net assets; instead, they receive a share of the business’s profits. In practice, these profits interest units are often subordinate to other equity classes. As a result, holders of these units rarely receive a share of business profits during regular operations. However, during exit events, defined as an “initial public offering, a change in control, or a liquidation of [an entity’s] assets,” profits interest holders are more likely to participate in profits. The specific extent and type of distribution will vary depending on the distribution threshold and level of subordination.

ASU Content

ASU 2024-01 adds an illustrative example to Topic 718 that includes four fact patterns to illustrate how an entity should apply existing scope guidance in 718-10-15-3. This guidance applies to equity instruments that are given to customers or employees. The compensation must meet at least one of two requirements to be considered stock compensation:

    a. The entity issues (or offers to issue) its shares, share options, or other equity instruments to an employee or a nonemployee.

    b. The entity incurs liabilities to an employee or a nonemployee that meet either of the following conditions:

1. The amount is based, at least in part, on the entity’s stock price or other equity instruments. The award may be indexed to both the price and something else that is neither the price of the shares nor a market, performance, or service condition.
2. The awards require or may require settlement by issuing the entity's shares or other equity instruments.

The newly added Example 10 first gives common assumptions that apply to all four cases. Entity X is a partnership with a single class of outstanding equity interests, Class A units. On June 1, 20X2, Entity X grants incentive units (Class B units) to employees of a subsidiary in exchange for services. The ASU then describes the four unique fact patterns and subsequent analyses.

Case A:  Award Is a Share-Based Payment Arrangement

Case A specifies that Class B units are subordinated to Class A units. Once vested, Class B units will share profits proportionally with Class A units, but only after Class A holders have received distributions up to a threshold set on the Class B grant date. Class B units cliff vest after three years of service. When an exit event occurs, Class B units vest immediately if the grantee is still working. The grantee can then either keep the units or settle them, with Entity X distributing proceeds in the same proportional manner. If a Class B unit grantee stops working for Entity X’s subsidiary for any reason (voluntarily, due to death, disability, retirement, or at Entity X's discretion for reasons other than cause), unvested units are forfeited without compensation. However, if the grantee leaves after vesting, they retain ownership of those units. Entity X has a call right to repurchase the Class B units if a grantee leaves employment. If exercised, Entity X pays the grantee fair value for the units on the call date.

The analysis for the scope of this case focuses on condition (a) in paragraph 718-10-15-3. This condition is met because both of the following facts indicate that Entity X is offering to issue shares. First, after three years of service or an exit event, Entity X will have received the agreed-upon service, and the award will vest. Second, the Class B units give the grantee the right to participate in an interest of Entity X through periodic distributions, an exit evet, or proportional settlement. Because these facts satisfy condition (a), the update concludes that Entity X should account for this award by applying Topic 718.

Case B: Award Is a Share-Based Payment Arrangement

The facts of this case are similar to Case A. However, unlike the previous case, Class B units only vest upon an exit event. Upon such an event, the grantee can either retain the vested Class B units or have them settled in the same manner as Case A. Because they only vest upon an exit event, Class B units are forfeited if the grantee terminates employment for any reason before the exit event. However, the grantee of Class B units is eligible to begin participating in nonforfeitable operating distributions of Entity X at the grant date.

Again, the analysis focuses on paragraph 718-10-15-3 to determine proper accounting treatment. Condition (a) is met because of the same reasons that Case A qualified for Topic 718 treatment. The structure of vesting and participating in the residual interest of Entity X suggests that this is a share-based payment arrangement.

Case C: Award Is a Share-Based Payment Arrangement

In this case, the grantee of Class B units does not participate in distributions in the ordinary course of Entity X’s business, nor are they entitled to receive equity instruments of Entity X. Instead, upon an exit event, the units vest immediately and must be settled in cash based on the fair value of the Class B units, calculated by reference to the price of Class A units on the date of the exit event. To receive these proceeds, the grantee must still be employed at the time of the exit event. Additionally, Class B units are forfeited if the grantee terminates employment before the exit event.

After analyzing this case, it is determined that the condition in 718-10-15-3(a) is not met, because the Class B units do not entitle the grantee to receive shares of Equity X; therefore, Entity X is not issuing, or offering to issue, any equity instruments. However, the condition in 718-10-15-3(b)(1) is met since the cash proceeds received by the grantee in an exit event are based on the price of Entity X’s shares. This case illustrates that not all requirements must be met for the award to be deemed a share-based payment arrangement. With only 3(b)(1) being satisfied, it can be concluded that this award should be accounted for under Topic 718.

Case D: Award Is Not a Share-Based Payment Arrangement

This final case involves a completely different set of facts. The grantee of the Class B units can participate in operating distributions made by Entity X, equal to one percent of the previous year’s net income. Eligibility begins after three years of service. However, Class B units are forfeitable if the grantee is terminated for any reason, even after completing three years of service. The grantee does not receive any proceeds distributed upon an exit event, and these units do not grant equity ownership in Entity X.

Based on these facts, the condition in 718-10-15-3(a) is not met because the Class B units do not entitle the grantee to receive shares of Entity X. Additionally, paragraph 3(b)(1) is not satisfied because the proceeds received by the grantee are based on an operating metric instead of on the price of Entity X’s shares. The condition in paragraph 3(b)(2) is also not met because Entity X is not required to issue equity shares at any point. Therefore, this case fails all conditions, and the awards should not be treated as a share-based payment award under Topic 718.

Implementation

Public business entitles (PBEs) that issue profits interest awards must implement the new scope guidance for fiscal years beginning after December 15, 2024, and interim periods within those annual periods. Other entities will implement the guidance for fiscal years beginning after December 15, 2025. Early adoption is permitted.

Some companies may determine, under the new guidance, that they need to change how they account for profits interests awards already recorded in their financial statements. Entities can choose to apply the guidance either retrospectively to all prior periods presented in the financial statements, or prospectively to awards granted or modified on or after the effective date. If a company chooses to apply the amendments prospectively, it will need to disclose the nature and reason of the change in accounting principle. This flexibility allows companies to adopt this update quickly.

Conclusion

ASU 2024-01 regarding the scope application of Topic 718 – Stock Compensation helps companies classify profits interest awards as either share-based payment arrangements (Topic 718) or other cash bonuses or profit-sharing arrangements (Topic 710). Using the new case examples in the ASU, companies will be able to account for their awards more accurately, creating greater standardization and comparability across firms.