During the pandemic, cash has been tight for many small businesses, which may make it hard to attract and retain skilled workers. In lieu of providing cash bonuses or annual raises, some companies may decide to give valued employees a share of their future profits. While corporations generally issue stock options, limited liability companies (LLCs) use a relatively new form of equity compensation called “profits interests” to incentivize workers. Here’s a summary of the accounting rules that are used to account for these transactions.
What are classified as awards?
Under U.S. Generally Accepted Accounting Principles (GAAP), profits interest awards may be classified as:
- Share-based payments,
- Bonus arrangements, or
- Deferred compensation.
Classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an expense on the income statement. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.
Flexibility and valuation
Under GAAP, fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date. If quoted market prices and other observable inputs aren’t available, unobservable inputs are used to estimate fair value.
One of the upsides to issuing profits interest awards is their flexibility. There’s no standard definition of a profits interest; the term “profits” can refer to whatever is agreed to by the LLC and the recipient of the award. In addition, profits interest units may be subject to various terms and conditions, such as:
- Vesting requirements,
- Time limitations,
- Specific performance thresholds, and
- Forfeiture provisions.
An LLC may offer multiple types of profits interests, allowing it to customize awards for various purposes. The varieties of terms and conditions that can be incorporated into a profits interest requires the use of customized valuation techniques.
Reporting rules need improvement
Many private companies struggle with how to report profits interests. In recent years, the Financial Accounting Standards Board (FASB) has discussed ways to simplify the rules, including scaling back the disclosure requirements and providing a practical expedient to measure grant-date fair value of these awards. No changes have been made yet, however.
For more information
Accounting complexity has caused some private companies to shy away from profits interest arrangements. But they can be an effective tool for attracting and retaining workers under the right circumstances. Contact your financial advisor for help reporting these transactions under existing GAAP or for an update on the latest developments from the FASB.