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Breaking it down
What is a profits interest?
A profits interest, while not defined in GAAP, typically represents a legal equity interest that provides the holder with the right to share in distributions of the future profits and appreciation of a pass-through entity’s net assets, but not its existing capital, after the interest has been granted. Depending on the terms of the arrangement, a profits interest might be similar to the grant of a restricted equity interest, an option, a stock appreciation right, or a profit-sharing or deferred compensation arrangement.
Why issue the amendments?
When accounting for a profits interest award, one of the first steps is to consider the substance of the specific terms, conditions, and characteristics of the award and apply judgment to determine whether the award falls within the scope of Topic 718 or other guidance, such as Topic 710, “Compensation – General.”
Stakeholders have highlighted complexity and diversity in practice when entities try to apply the scoping guidance within Topic 718 to profits interests because of a wide array of terms and conditions that profits interest awards might contain, including options or requirements for the awards to be repurchased and/or cash settled, among others.
The ASU amends language in Topic 718 to clarify its scoping guidance and the application of that guidance to profits interest awards. To promote greater consistency of application, it provides an example with four cases that demonstrate how the scoping guidance is to be applied to commonly seen profits interest arrangements.
Illustrative example
The illustrative example provided in the final ASU focuses on the clarified scoping guidance, which specifies that a profits interest award falls within the scope of Topic 718 if either of the following is true:
- The award constitutes an offer to issue the entity’s equity.
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The proceeds to be received by a grantee of a profits interest are based, at least in part, on the price of the entity’s equity, or the award requires or may require settlement in the entity’s equity.
Each case provides the rationale behind why the scoping guidance in Topic 718 is or is not met.
Two of the four cases demonstrate awards that are within the scope of Topic 718 because they constitute an offer to issue shares. They illustrate how an entity might assess certain features of the award in making this determination, considering how factors such as vesting and forfeiture terms, distribution rights, and repurchase provisions could inform the rights to residual interest provided by the award.
The remaining two cases involve awards that do not entitle the grantee to shares, describing instead how an entity might assess the scope of the liability incurred by the grantor in connection with the award. These cases depict one award within the scope of Topic 718 because its settlement amount is based, at least in part, on the entity’s equity price. The other award depicted is subject to other GAAP because it meets none of the scoping criteria previously denoted.
Crowe observation: The amendments focus squarely on the accounting scope of a profits interest award and do not address how to apply other aspects of Topic 718 to a profits interest award, such as whether an award is classified as a liability or as equity.
Transition and disclosure
PBEs are required to adopt the ASU in annual reporting periods beginning after Dec. 15, 2024, and interim periods therein. All other entities must adopt the ASU in annual reporting periods beginning after Dec. 15, 2025, and interim periods therein. Early adoption is permitted. Entities are allowed to apply the amendments either retrospectively to all prior periods presented in the financial statements or prospectively to profits interest and similar awards granted or modified after the entity first adopts the amended guidance. If an entity applies the amendments prospectively, it is required to disclose the nature and reason for the change in accounting principle.
