In 2024, the Financial Accounting Standards Board (the “FASB”) released updated guidance for the treatment of profits interest awards as part of Accounting Standards Update (“ASU”) 2024-01. That update is now effective for public business entities for annual and interim reporting periods beginning after December 15, 2024. The new guidance will be effective for all other entities for periods beginning after December 15, 2025, and interim periods within those annual periods. Early adoption is permitted.
How Does ASU 2024-01 Impact Existing Guidance?
The newly effective amendments from ASU 2024-01 update and clarify existing guidance under Accounting Standards Codification (“ASC”) Topic 718, which broadly covers stock-based compensation arrangements. ASU 2024-01 adds a specific statement to the scoping guidance under ASC 718-10-15 to make it clear that the scope of Topic 718 does apply to “profits interest” or similar awards. The amendments also add further illustrative examples to assist companies in applying the scoping guidance to these types of awards.
What Is a Profits Interest Award?
A “profits interest” award is a term used to distinguish arrangements where the holder, or grantee, has an opportunity to participate in the future profits and equity appreciation of an entity or grantor. This type of award aligns compensation to an employee or nonemployee with the grantor’s operating performance. A profits interest award is different from a “capital interest” award where the grantee has rights to the existing net assets of an entity, which could be impacted by changes in equity due to accumulated earnings or losses. The fact that a profits interest award only participates in future profits creates complexity for entities trying to determine if the guidance for share-based payments under Topic 718 should be followed or if the guidance under Topic 710 for cash bonuses or profit-sharing arrangements is more appropriate.
Where Are the Illustrative Examples for Applying Scoping Guidance Under Topic 718?
The standards update adds a new “Example 10” to the implementation guidance section at ASC 718-10-55-138 through 55-148. The example provides four separate cases with different assumptions to determine which awards meet the scoping criteria. Generally, a profits interest award is considered a share-based payment arrangement in the illustrative examples when:
- The grantor receives some agreed-upon consideration (e.g., service conditions are met)
- The grantee holds the right to participate in residual interest through periodic distributions, upon an exit event, or upon settlement proportionate to ownership, and
- The grantee receives cash proceeds upon settlement based on the price of the grantor’s shares.
To make sure the update is appropriately considered, each case in the provided example should be read thoroughly and compared to the fact patterns for any awards that could meet the criteria.
How Should the New Guidance Be Adopted?
ASU 2024-01 can be applied retrospectively to all prior periods presented in an entity’s financial statements, or it can be applied prospectively to profits interest awards granted or modified on or after the date an entity first applies the new guidance.
Retrospective adoption will require the normal disclosures regarding changes in accounting principle, such as the nature and reason for the change in principles, how the change was applied to the financial statements being presented, and the effect of the change on the financial statements. These disclosures are covered in ASC Topic 250-10-50-1 through 50-3. Prospective adoption will also necessitate an explanation in the notes to the financial statements regarding the nature and reason for the change in accounting principle.
Author: Ben Davenport, CPA | [email protected]
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