Private Companies Ask That “Profits Interests” Accounting Rules Be Simplified

Private companies ask that “profits interests” accounting rules be simplified

Profits interest use — a relatively new form of equity compensation issued by limited liability companies (LLCs) — has spiked. Now, private companies and their advisors are asking the Financial Accounting Standards Board (FASB) to simplify the complex rules created to account for these transactions.

Accounting Standards

As the name suggests, “profits interest” arrangements mean recipients receive a share of the company’s future profits. Under existing U.S. generally accepted accounting principles, these transactions may be classified as the following:

• Share-based payments
• Profit-sharing
• Bonus arrangements
• Deferred compensation

The classification is according to profits interest’s specific terms and features. In most cases, the fair value basis of the award must be recorded as an income statement expense. Profits interest can also result in a liability recognition on the balance sheet and require footnote disclosures. Private companies have flagged disclosure requirements as an area in need of simplification.

Need for improvement

Profits interest awards are also utilized more often as a tool to attract and retain skilled workers because more companies are being structured as LLCs, rather than C corporations or S corporations —LLCs use profits interests exclusively and corporations tend to award traditional share options, instead.

During a June meeting with FASB, Candace Wright, Chair of the Private Company Council (PCC), said that “profits interest continues to come up as an area private companies are struggling with.” She called profits interest “a topic we all need to have on our radar as to whether or not there are some simplifications that we can do in that space.”

The topic surfaced as PCC members were discussing plans to provide a “practical expedient to measure grant-date fair value of equity-classified share-based awards.” For now, the PCC’s work is aimed at allowing private companies to use their equity-classified share options’ exercise price as the current price to determine the grant-date fair value of an award in certain circumstances.

The panel has been trying to understand the process a private company uses to establish an award’s strike price and the associated audit procedures. The work is still ongoing.

For additional information

By awarding profits interest and other equity-based compensation, many companies could incentivize exceptional performance. But accounting complexity has caused some private companies to shy away from these arrangements.

Financial reporting guidance simplification would be welcome news for many companies. For help reporting these transactions or for an update on the latest FASB developments, contact a Weaver professional.

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