The Financial Accounting Standards Board (FASB) recently issued a proposed Accounting Standards Update (ASU), Compensation—Stock Compensation (Topic 718): Scope Application of Profits Interest Awards.
Certain entities provide employees or other service providers with profits interest awards intended to align compensation with an entity’s operating performance and provide those holders with the opportunity to participate in future profits and equity appreciation of the entity. The term “profits interest” is not defined in generally accepted accounting principles (GAAP) but differentiates those interests from capital interests held by investors that provide those holders with rights to the existing net assets in a partnership. Because profits interest holders only participate in future profits and equity appreciation and have no rights to the existing net assets of the partnership, it can be difficult to determine whether a profits interest award should be accounted for as a share-based payment arrangement under Topic 718, Compensation—Stock Compensation, or similar to a cash bonus or profit-sharing arrangement under Topic 710, Compensation—General. Currently, many entities evaluate the terms, conditions and characteristics of a profits interest award and apply judgment to determine whether to account for the award under Topic 718 or Topic 710, which has led to diversity in practice even when evaluating similar fact patterns.
Under the proposed ASU, the FASB would add an illustrative example to demonstrate how an entity would apply the scope guidance in paragraph 718-10-15-3 to determine whether profits interest and similar awards should be accounted for in accordance with Topic 718. The fact patterns in the proposed illustrative example focus on the grantee’s ability to retain the profits interest awards upon termination of employment, as well as the right to participate in the residual net assets of the entity upon dissolution, liquidation or an exit event proportionate to ownership.
The amendments in the proposed ASU would be applied either (1) retrospectively to all prior periods presented in the financial statements or (2) prospectively to profits interest awards granted or modified on or after the effective date. If the proposed amendments are applied prospectively, an entity would be required to disclose the nature of and reason for the change in accounting principle. The FASB will determine the effective date and whether early adoption will be permitted for the proposed amendments after it considers its stakeholders' feedback.
Stakeholders are encouraged to review and provide comment on the proposed ASU by July 10, 2023.
