The FASB’s update to ASC 718 is a gift that keeps on giving, at least in terms of blog entries. Today I discuss something many of you may not have considered: the impact the update will have on the calculation of common equivalents under the Treasury Stock Method.
EPS: A Story of a Numerator and a Denominator
Earnings per share simply allocates a company’s earnings to each share of stock. It is calculated by dividing earnings (the numerator) by the number of shares common stock outstanding (the denominator). Public companies report two EPS figures: Basic EPS and Diluted EPS. In Diluted EPS, the denominator is increased for any shares that the company could be contractually obligated to issue at some point in the future, such as shares underlying stock options and awards. These arrangements are referred to as “common equivalents.”
A Quick Refresher on the Treasury Stock Method
The Treasury Stock Method is used to determine how many shares should be included in the denominator of Diluted EPS for all of the arrangements that could obligate the company to issue shares in the future. Under the Treasury Stock Method, companies assume that all of these arrangements are settled (regardless of vesting status), the underlying shares are issued, and any proceeds associated with the settlement are used to repurchase the company’s stock. The net shares that would be issued after taking into account the hypothetical repurchases increase the denominator in the EPS calculation.
The possible sources of settlement proceeds include any amount paid for the stock, any windfall tax savings (“windfall” is the operative word here), and any unamortized expense. For a more detailed explanation, see the chapter “Earnings Per Share” in Accounting for Equity Compensation in the United States.
What the Heck are “Windfall” Tax Savings?
“Windfall” tax savings are those that increase paid-in capital rather than decreasing tax expense. Normally, tax savings result from expenses and reduce the company’s tax expense. But this isn’t always the case with the tax savings from stock compensation. Sometimes the company’s tax deduction is greater than that expense recognized for an award. Currently when that occurs, the tax savings resulting from any deduction in excess of the expense simply increases paid-in capital; this savings doesn’t reduce tax expense.
How Does the Update to ASC 718 Change This?
Any windfall tax savings have to be accounted for somewhere in the EPS calculation. Right now, because these savings don’t impact tax expense or earnings, and thus aren’t reflected in the numerator of the EPS equation, they are treated as a source of settlement proceeds and reduce the denominator.
Once the update goes into effect, this is all changed. All tax savings, windfall or otherwise, will reduce tax expense and increase earnings, which means these savings will be reflected in the numerator for EPS. Because the savings will be reflected in the numerator, they will no longer be treated as a source of settlement proceeds under the Treasury Stock Method.
You Have to Admit, It Does Simply Things
The upshot is that, once a company has adopted the update to ASC 718, the settlement proceeds when applying the Treasury Stock Method to awards will be limited to just two sources: the purchase price and any amortized expense. Windfall tax benefits will be eliminated as a source of proceeds.
Last week’s news that the CEO of Telsa Motors, Elon Musk, had exercised stock options with an estimated value of $100 million spread like wildfire. Picked up by the national news outlets – the news was well covered. It’s not every day that a CEO exercises $100M worth of stock options and pays cash for the taxes (yes, the company confirmed he paid cash for his taxes). This was a cash exercise with no sale involved. As I read several articles on this transaction, I realized there is still much taken for granted when an executive transacts in the company’s stock. I’ll cover highlight some of those areas in today’s blog.
The article that caught my rapid attention was Forbes’ “Elon Musk Exercising Stock Options Could Mean Tesla Will Disappoint Next Week.” Now, before I get too far down this path, I have to say I know nothing about Tesla’s inner-workings and nothing about their earnings. So anything I am saying IS pure speculation. The title of the article got me interested, though. I mean could the exercise of stock options really, single handedly foreshadow less than stellar earnings? If I had to dissect that assumption, my own thoughts went to something far more benign – I mean, what if the CEO had a 10b5-1 plan (after all, these options that were exercised were scheduled to expire in December 2016) that was merely acting on autopilot in an attempt to exercise these stock options before they expire? I have no idea whether Tesla’s CEO has a 10b5-1 plan or not. According to Tesla’s proxy statement, 3 officers do have 10b5-1 plans. And, according to the NASPP’s 2014 Domestic Stock Plan Administration Survey, co-sponsored by Deloitte, of the companies that do allow (but not require) 10b5-1 plans for insiders, 62% of CEOs of those companies were using the plans. Is it possible? Yes, it is. Do we know? No, we do not. That’s not even the point, though.
What does a 10b5-1 plan have to do with things taken for granted? These plans got some negative publicity a couple of years ago when the SEC looked into whether or not the plans, in principle, were being abused. There were some situations where it appeared that 10b5-1 transactions were well-timed around negative news – as in the company may have delayed or accelerated the timing of that news around the planned transactions. Nothing much ever happened from that speculation, and, for the most part, I’d venture to say these plans are not being abused. Rather, this type of plan works fairly well if used as intended, especially in aiding executives and other insiders to put distance between their decision making about their shares and the execution of those transactions. What worries me is that the possibility of a 10b5-1 plan’s existence still often seems to be overlooked when the media casts the spotlight onto these larger, high profile transactions. Not all of it is their fault, though. There is no present requirement for the existence of a 10b5-1 plan to be disclosed. Some companies voluntarily disclose the existence of plans and subsequently footnote their Form 4s noting transactions that occurred pursuant to a trading plan. Without disclosure, the media remains unaware that the executive may be operating under one of these plans. Does disclosure need to happen? The law firm of Morrison and Foerster summarized that consideration in an FAQ on 10b5-1 plans:
Should a Rule 10b5-1 plan be publicly announced?
A public announcement by any person of the adoption of a Rule 10b5-1 plan is not required. A company may choose to disclose the existence of certain Rule 10b5-1 plans in order to reduce the negative public perception of insider stock transactions. A company making such disclosu
re generally will disclose the existence of a plan but not the specific details. Typically, the disclosure will be for executive officers, directors, and 10%
shareholders required to file ownership forms under Section 16(a) of the Exchange Act (that is, Forms 3, 4,and 5). A company can choose whether to announce the existence of a Rule 10b5-1 plan by a press release followed by a Form 8-K or solely by a Form 8-K. The applicable Form 8-K item is Item 8.01, although Item 7.01 may be used under appropriate circumstances.
If a company decides to publicly announce the adoption of a Rule 10b5-1 plan, it is advisable to publicly announce changes to or termination of such plan as well. Under the Dodd-Frank Act, the SEC is required to implement a regulation prescribing disclosure by reporting issuers of their hedging policies. The proposed rule, if it becomes final in its current form, may result in more companies disclosing the existence of trading programs of executive officers.
While we await final hedging rules from the SEC, companies may consider proactively looking at their 10b5-1 disclosures and the potential positive potential such disclosures could have on mitigating public perception of their executive transactions. Disclosing the existence of a plan and attributing transactions related to an automatic plan in a Form 4 footnote may go miles in helping to ease some of the rampant speculation around transactions that could occur absent this information.
We won’t know anytime soon if CEO was operating under a 10b5-1 plan when he exercised his stock options, but if he did, a footnote on the Form 4 could have alleviated some of the speculation about the timing of the transaction and its relationship to earnings and other important company events.
Submit a Speaking Proposal for the 24th Annual NASPP Conference
The NASPP is now accepting speaking proposals for the 24th Annual NASPP Conference. Proposals can be submitted online and will be accepted through Friday, February 26.
Tip #1 to Submit a Success Speaking Proposal: Many Egg and Many Baskets
Don’t put all your eggs in one basket. Smart submitters know that the more proposals they are on, the more likely they will get to speak at the NASPP Conference. Each company can submit up to three proposals and can be included in proposals submitted by other speakers. Don’t wait to be invited; proactively reach out to your network now to let your colleagues know that you are interested in speaking and would be happy to join them on any proposals where you have something to add. Note, however, that individual speakers can participate in no more than two panels and firms can be represented on no more than six panels; if you are included on proposals in excess of this number that we have designated for acceptance, we will ask you to step down from a panel(s).
CEP Institute Seeks Public Comments on GPS
The CEP is asking for people to submit comments on its newly revised GPS|Stock Options document. The GPS series provides unbiased, university based research to address risk assessment and identify best practices for the equity compensation community. Review the Stock Options draft today.
NASPP To Do List
Here’s your NASPP To Do List for the week:
Register for the NASPP’s acclaimed online course, “Stock Plan Fundamentals“—early-bird rate available until February 26.
Submit a speaking proposal for the 24th Annual NASPP Conference. We are accepting proposals through February 26.
A recent IRS Chief Counsel Memorandum indicates that smaller reporting companies must treat their CFO as a covered employee under Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.
Wait a Minute! The CFO Isn’t Subject to 162(m)?
Yep, that’s right. For larger reporting companies, it may seem crazy, but the CFO isn’t ever a covered employee under Section 162(m). This is because the definition of a named executive officer under Item 402 of Reg S-K for purposes of the executive compensation disclosures in the proxy has evolved and the definition of a covered employee under Section 162(m) hasn’t kept pace.
Section 162(m) applies to the following executives:
The CEO
The top four highest paid executives other than the CEO, as determined for proxy disclosure purposes.
Back when 162(m) was adopted, this was the same group of people that were considered NEOs for purposes of the proxy disclosures. But in 2006, the SEC changed Item 402 to carve out a separate requirement for CFOs. So now, the NEOs in the proxy are:
Anyone serving as CEO during the year
Anyone serving as CFO during the year
The top three highest paid executives other than the CEO and the CFO.
Up to two additional executives that would have been in the top three except that they terminated before the end of the year.
Unfortunately, only Congress can change the statutory language under Section 162(m), so the IRS can’t modify the definition of a covered employee to match the SEC’s new definition of an NEO. (When Congress drafted Section 162(m), they probably should have just said that it applies to all NEOs as determined under Item 402 of Reg S-K.)
All the IRS can do is interpret the requirement under 162(m) in light of the SEC’s definition. Their interpretation is that the SEC’s change exempts CFOs from Section 162(m) (see the NASPP alert “IRS Issues Guidance on ‘Covered Employees’ Under Section 162(m),” June 9, 2007). (If you are wondering, former employees are also not subject to Section 162(m); this is another evolution in the SEC definition that hasn’t been implemented in the tax code.)
What Gives With Smaller Reporting Companies?
Smaller reporting companies are subject to abbreviated reporting requirements, including fewer NEOs for proxy reporting purposes. Thus, the SEC’s new definition in 2006 never applied to smaller reporting companies. Instead, NEOs in smaller reporting companies are defined as:
The CEO
The top two highest paid executives other than the CEO.
Per Chief Counsel Memorandum 201543003, because the CFO isn’t separately required to be included in the proxy disclosures for smaller reporting companies, he/she is still a covered employee for Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.