An entity must first determine whether an award is within the scope of ASC 718 or is, in substance, a bonus or profit-sharing arrangement. ASC 718 applies to awards that require or may require settlement in the equity of the entity or whose settlement is based, at least in part, on the price of the entity's equity. An entity's conclusion related to whether an award is within the scope of ASC 718 can significantly affect the amount of compensation cost recognized and when such cost is recognized in the financial statements.
Nonpublic limited partnerships, limited liability companies, and other pass-through entities often establish special classes of equity, referred to as profits interests. These special equity classes often have distribution thresholds or hurdles related to amounts that must be paid to other classes of equity before the grantee of the profits interest can receive distributions. On the grant date, an award may have zero liquidation value for tax purposes but a fair value for financial reporting purposes.
While the features of a profits interest award can vary, such an award should be accounted for on the basis of its substance. If the award has the characteristics of an equity interest, it represents a "substantive class of equity" and should be accounted for under ASC 718. However, an award that is, in substance, a performance bonus or a profit-sharing arrangement would be accounted for as such in accordance with other US GAAP (e.g., typically ASC 710 for employee arrangements).
There are several characteristics to consider when determining whether an instrument is within the scope of ASC 718. To be a substantive class of equity, the profits interest must be legal form equity. An entity would also consider whether the instrument's holder can retain a vested interest in an award if the holder stops providing goods or services to the company. In determining whether a repurchase feature allows the grantee to retain a vested interest, an entity would assess whether the repurchase price of that repurchase feature is consistent with the fair value of the award. Other characteristics of the award (e.g., claim to residual assets of the entity upon liquidation, substantive net assets underlying the interest, and distribution rights after vesting) could also be relevant to the entity's conclusion.
On March 21, 2024, the FASB issued a ASU 2024-01, which clarifies US GAAP by adding an illustrative example to help entities determine whether a profits interest or similar award should be accounted for under ASC 718. The illustrative example includes four different cases, A through D, and the ASU's guidance applies to all entities that issue profits interest awards as compensation to employees or nonemployees in exchange for goods or services. For public business entities, the ASU’s amendments are effective for fiscal years beginning after December 15, 2024, including interim periods within those years. For all entities other than public business entities, the ASU’s amendments are effective for fiscal years beginning after December 15, 2025, including interim periods within those years.