Money has been tight for many small businesses during the COVID-19 pandemic—and that can make attracting and retaining skilled workers difficult. As a result, some companies may decide to give valued employees a share of future profits, rather than offering cash bonuses or annual raises. Corporations typically do this in the form of issuing stock options, but limited liability companies (LLCs) can use “profits interests”—a relatively new form of equity compensation—to incentivize workers. Here’s a quick guide to the accounting rules governing these transactions.
Award classification
Profits interest awards may be classified in four ways under U.S. Generally Accepted Accounting Principles (GAAP). Classification is determined by the specific terms and features of the profits interest awards, and awards may be classified as:
- Share-based payments
- Bonus arrangements
- Deferred compensation
- Profit-sharing
Generally speaking, the fair value of the award needs to be recorded as an expense on the income statement. Profits interest awards may also require footnote disclosures if they result in the recognition of a liability on the balance sheet.
Valuing profits interest awards
Fair value is defined under GAAP as the price an entity would receive if they sold an asset—or paid to transfer a liability—in an orderly transaction taking place between market participants and occurring at the acquisition date. Unobservable inputs are used to estimate fair value when quoted market prices and other observable inputs are unavailable.
One advantage of profits interest awards is that they’re flexible: since there’s no standard definition of a profits interest, the term “profits” can be used to refer to whatever the LLC and the recipient of the award have agreed to.
LLCs can customize awards for various purposes by offering several types of profits interests. Profits interest units may also be subject to various terms and conditions, including:
- Specific performance thresholds
- Time limitations
- Vesting requirements
- Forfeiture provisions
Because a variety of terms and conditions can be incorporated into a profits interest, the use of customized valuation techniques is required.
Possible changes to profits interests reporting
Private companies frequently struggle with properly reporting profits interests. Although no changes have yet been made, the Financial Accounting Standards Board (FASB) has recently discussed ways to simplify the rules. Possible changes include providing a practical expedient to measure these awards’ grant-date fair value and scaling back the disclosure requirements.
Contact us today
Due to the complexity of accounting, private companies sometimes shy away from profits interest arrangements—but under the right circumstances, profits interest awards are an effective tool for attracting and retaining workers. If you need help reporting these awards or an update on the latest developments from the FASB, contact us today.