2016.11.03 "Accounting for Profits Interests in LLCs" (Plante Moran Alert), stating generally that "Under U.S. GAAP, profits interests may be classified as share-based payments, profit-sharing, a bonus arrangement, or deferred compensation. The classification is determined by the specific terms and features of the profits interest. In nearly all circumstances, the fair value basis of the award must be recorded as an income statement expense. Profits interests can also result in the recognition of a liability on the balance sheet and require footnote disclosures."
This 2010 E&Y Accounting Guide* for share-based compensation has a more extensive discussion of the expense rules for profits interests, and includes this sentence (on page 201) consistent with the above:
Some companies have suggested that a profits interest has no value because (a) if the entity were liquidated immediately, the profits interest holder would normally not be entitled to a distribution and (b) a basis of zero is frequently assigned to the profits interest for tax purposes. While the valuation of profits interests is beyond the scope of this publication, we believe assertions of zero value for such awards are not consistent with the concepts of fair value and would suggest no retention benefit in granting the profits interests to the employees. We believe it is inappropriate to assume immediate liquidation when estimating the fair value of a profits interest, in part because that assumption would be inconsistent with the financial statement presumption that the entity is a going concern. In fact, the SEC staff has rejected the use of valuation methodologies that focus predominately on the amount that would be realized by the holder in a current liquidation. Rather, we believe that the valuation of a profits interest should consider future reasonably possible cash flow scenarios, many of which presumably would result in distributions to the profits interests’ holders. The valuation is similar to the valuation of common stock when the liquidation preference of preferred stock would absorb all distributions by the entity if it were liquidated currently.
Here is a sample S-1 disclosure from 2011 for the expense from profits interests:
Profits Interest Compensation
Halkos has granted, pursuant to the Halkos Holdings, LLC Executive Equity Incentive Plan (“Halkos Equity Plan”), non-voting membership interests to select members of the Company’s management in the form of Class B, C and D Shares. The Class B, C and D shares are profits interests in Halkos. See note 18, “Profits Interest Awards,” in the notes to these consolidated financial statements.
Class B Shares are accounted for as a profit sharing arrangement under ASC 710, Compensation—General. Expense on the Class B Shares is recorded in the period in which distributions to Class B award holders are determined to be probable. These distributions are accounted for by the Company as non-cash compensation expense with a corresponding increase in additional paid-in capital.
Class C and D shares are considered to be dual-indexed awards which will be accounted for as liability awards under ASC 718, Compensation- Stock Compensation, once it becomes probable that KPS will own less than 20% of Halkos. At that time, expense will be recognized over the implied service period and the awards will be remeasured at each reporting date at fair market value with any changes therein recorded as compensation expense. The valuation of fair market value uses a discounted cash flow and comparable company analyses to estimate an enterprise value for GBC and then uses a Black-Scholes model to allocate enterprise value to the C and D Shares. The determination of fair value is affected by assumptions regarding a number of highly complex and subjective variables. Changes in the subjective assumptions can materially affect the estimate of their fair value.