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In order to attract and retain skilled workers, there has been an increase in the use of “profits interest” awards. With this increase, companies are being structured as limited liability companies (LLCs), rather than corporations.
However, some private companies are shying away from this due to accounting complexity. It is expected the Financial Accounting Standards Board (FASB) may be able to provide some relief soon.
A Shift in Equity Compensation
Traditional stock options are more likely to be awarded by corporations, but LLCs exclusively use profit interests instead. The name suggests that recipients of these arrangements are provided with a share of the company’s future profits.
Transactions may be classified as under existing U.S. Generally Accepted Accounting Principles (GAAP):
- Share-based payments
- Bonus arrangements or
- Deferred compensation
Specific features and terms of the profits interest may determine the classification. It is common for the fair value of the award to be recorded as an income statement expense. Recognizing liability on the balance sheet and the requirement of footnote disclosures may also be the result of profits interest.
Simplification is Necessary
Arrangements like this can be used to accomplish a number of business objectives. Profits interests are usually distributed to employees but can also be awarded to investors, third-party service providers, and other individuals.
Awards are issued in exchange for future services, withholding direct payment or financial investment. Profits interest can be provided with a variety of terms of features. For example, awards may contain contingency features, such as participation thresholds, limited time periods, vesting requirements, forfeiture provisions, and expiration dates. As a result of this variability, there may be additional complexity when compared to alternative forms of equity compensation and could require particular techniques regarding valuation.
Candace Wright, Chair of the Private Company Council (PCC) stated, “Profits interest continues to come up as an area private companies are struggling with,” during a meeting with the FASB earlier this year. Eager private companies have been looking to the FASB for additional guidance and practical expedients on such issues as acceptable audit techniques, disclosure requirements, and valuation methods.
It’s a Work in Progress
Employers, employees, and other stakeholders would enjoy some simplification of financial reporting guidance. If you are looking for updates on the latest FASB developments or require assistance when reporting these transactions under existing U.S. GAAP, contact us. We look forward to hearing from you.