As I noted back in May (“An Expensive Tax Cut“), companies will have to adjust the deferred tax assets recorded for stock compensation as a result of the new corporate tax rate. Because the tax reform bill was enacted in late December, companies don’t have as much time to record these adjustments as we might have originally expected, so the SEC has issued Staff Accounting Bulletin No. 118 to provide some relief.
What Adjustments?
The DTAs you’ve recorded for stock awards represent a future tax savings that the company expects to realize when the awards are eventually settled. When you recorded the expected savings, you based it on a 35% corporate tax rate. Now that the corporate tax rate has been reduced to 21%, the expected savings is a lot less (40% less, to be exact).
For example, say you recorded a DTA of $3,500 for an award worth $10,000 (the DTA was 35% of the $10,000 fair value of the award). Assuming that no portion of the award has been settled, you now need to adjust that DTA down to $2,100 ($10,000 multiplied by the new 21% corporate tax rate). You make the adjustment by recording tax expense for the difference between the new DTA and the original DTA. In my example, you would record tax expense of $1,400 ($3,500 less $2,100).
When Do Companies Record the Adjustments?
The adjustments have to be recorded in the period that the change in the corporate tax rates is enacted, not when it goes into effect. Once you know the tax rate is going to change, there’s no point in continuing to report based on the old rate; you immediately adjust your expectations. Since the bill was signed into law on December 22 and most companies have a fiscal period that ended on December 31, most companies will record the adjustments in that period. That doesn’t give companies much time to calculate the adjustments.
SAB 118
My example was very simple; things are a lot more complex in the real world, so it might not be quite that easy for companies to figure out the total adjustment they need to record for their DTAs. In addition, in some cases, it may not be clear what the adjustment should be. For example, the tax reform bill also makes changes to Section 162(m) (see “Tax Reform Targets 162(m)” and grandfathers some compensation arrangements from those changes (see “Tax Reform: The Final Scorecard“). There are currently some questions about which arrangements qualify for the grandfather; for arrangements that don’t qualify, the DTA may have to be reduced to $0. Companies may not be able to determine the adjustments they need to make to their DTAs until the IRS provides guidance.
Which brings us to SAB 118. The SEC issued SAB 118 to provide guidance to companies who are unable to determine all of the tax expense adjustments necessary in time to issue their financials. The SAB allows companies to make adjustments based on reasonable estimates if they cannot determine the exact amount of the adjustment. Where companies cannot even make a reasonable estimate, they can continue to report based on the laws that were in effect in 2017.
The SAB also provides guidance on the disclosures companies must make with respect to the above choices and provides guidance on how companies should report the correct amounts, once they are known.
– Barbara
P.S.—For more information about how the tax reform bill impacts DTAs and SAB 118, don’t miss today’s webcast “Tax Reform: What’s the Final Word?“
It’s not uncommon for public companies that grant stock compensation widely to report non-GAAP earnings that back out the expense for their stock compensation programs. This is a supplement to their reported GAAP earnings (which they are required to report) of course. The practice arose after the adoption of ASC 718, before which companies rarely recognized any expense for their stock compensation programs. But, though the transition to ASC 718 has long been complete, the practice continues.
Google’s Announcement
Earlier this year, Google decided to stop backing stock compensation expense out of its earnings. Ruth Porat, Alphabet’s chief financial officer, explained the decision during an analyst conference call:
SBC [stock-based compensation] has always been an important part of how we reward our employees in a way that aligns their interests with those of all shareholders. Although it’s not a cash expense, we consider it to be a real cost of running our business because SBC is critical to our ability to attract and retain the best talent in the world. Starting with our first quarter results for 2017, we will no longer regularly exclude stock-based compensation expense from non-GAAP results. Noncash stock-based compensation will continue to be reported on our cash flow statement, but we will no longer be providing a reconciliation from GAAP to non-GAAP measures that reflects SBC and related tax benefits.
Will Other Companies Follow Suit?
A Bloomberg article urges more companies to take a similar approach (“Shame on Silicon Valley’s Stock Expense Stragglers”) and praises tech companies such as Facebook, Amazon, Google, and Electronic Arts, which are all either starting or planning to move away from excluding stock compensation expense from earnings.
Likewise, the Financial Times, calls this move a “watershed moment in Google’s financial maturity and the evolution of the Valley” (“Alphabet Opts to Spell Out Its Stock Options”). The article notes, however, that while Google’s consistent growth and profitability make this a “smooth transition,” it will be harder for other tech companies that need to back out this expense in their non-GAAP earnings to appear profitable.
And profitability is the name of the game. As noted in the Bloomberg article, many tech companies would be significantly less profitable (and some would report a loss) if they include stock compensation expense in earnings. These companies are probably pretty attached to their non-GAAP reports.
Under ASU 2016-09, all windfall and shortfall tax effects of stock compensation will run through earnings in the P&L. When vesting in performance awards is tied to earnings per share, this could make it harder to set the targets in the future because it will be harder to forecast earnings. And, for awards that have already been granted, it might make the current targets easier to achieve (or harder to achieve if the company is experiencing tax shortfalls).
Adjusting EPS Targets
Companies might be tempted to adjust EPS targets for existing performance awards, to reflect the company’s new expectations in light of ASU 2016-09. But, unless the terms of the award already address what happens when there is a change in GAAP prior to the end of the performance period, this could be hard to do. Modifications of targets could cause the awards to no longer be exempt from Section 162(m) and could have other implications.
If the targets aren’t modified, companies will likely have to adjust their forfeiture estimate for the awards.
Non-GAAP EPS
Many companies use a non-GAAP calculation of EPS for purposes of their performance awards. Where the EPS calculation already excludes expense from stock compensation, it should also exclude any tax effects attributable to stock awards. And where this is the case, ASU 2016-09 won’t impact the likelihood of the targets being achieved.
Survey Says
In our May quick survey, we asked what companies plan to about their performance awards in which vesting is tied to EPS. Here’s what they said:
16% use a non-GAAP measure of EPS that already excludes stock compensation expense
2% are planning to adjust their EPS targets
35% are not planning to adjust their EPS targets
48% don’t know what they are going to do about their EPS targets
For today’s blog entry I have a couple of recent developments that don’t really warrant a blog entry of their own.
T+2: It’s Happening
The SEC has adopted an amendment to the Settlement Cycle Rule (Rule 15c6-1(a) of the Exchange Act) to move to T+2. The new settlement cycle will commence on September 5 (the day after Labor Day). I already blogged about this—twice—so I don’t really have any more to say on the topic (see “T+2: What’s It to You” and “Progress Towards T+2“). We hosted a great webcast on it in April (“Be Prepared for T+2“); if you aren’t up to date on this development, be sure to check it out.
FASB Issues Modification Accounting ASU
Yesterday the FASB issued ASU 2017-09 (not to be confused with ASU 2016-09—right, no one is going to get these confused), which redefines when modification accounting is required under ASC 718.
All companies have to adopt the ASU by their first fiscal year beginning after December 15, 2017. Early adoption is permitted. Once adopted the ASU applies prospectively. Unlike with ASU 2016-09, if ASU 2017-09 (yep, not confusing at all) is adopted in an interim period, prior interim periods in the same year are not adjusted.
One of the primary ways in which ASU 2016-09 changed stock plan accounting practices is to require that all tax effects be recognized in the income statement. Excess tax savings increase earnings (by reducing tax expense) and tax shortfalls reduce earnings (by increasing tax expense). For some companies, this results in a lot of volatility in earnings, earnings per share, and effective tax rates. It also makes it harder to forecast earnings.
PwC found that some companies are providing detailed commentary on the impact of ASU 2016-09 on earnings per share. Here is a sample disclosure that PwC found:
“[The Company] anticipates fiscal year 2017 diluted EPS from continuing operations to be in the range of $5.38 to $5.58, which includes an expected benefit of about 25 to 30 cents from the adoption of ASU 2016-09. Excluding the benefit of adopting the updated accounting standard, [The Company] anticipates fiscal year 2017 diluted EPS from continuing operations to be in the range of $5.13 to $5.28.”
Effective Tax Rates
PwC found similar disclosures for effective tax rates. From another company:
“We expect an effective tax rate of 26% – 27.5%, after a projected reduction of 350 – 450 basis points related to the implementation of the new accounting standard for the tax benefit of employee share-base compensation.”
Earnings Guidance
Finally, PwC found some companies that had updated previously disclosed earnings and tax rate forecasts:
“[The Company] now anticipates its effective fiscal year 2017 tax rate to be between 32 percent and 33 percent versus its previous assumption of 30 percent and 31 percent, reflecting a 2-point reduction versus year ago compared to the previously assumed 4-point reduction from adopting ASU 2016-09. The company’s updated assumptions for its fiscal year effective tax rate reflect lower than anticipated exercises of [the Company’s] stock options in the first quarter and the company’s revised outlook for full-year stock option exercises. As noted, the company had previously communicated that the benefit to be realized from the adoption of ASU 2016-09 could vary significantly.”
I have another riddle for you: When does a tax cut result in more tax expense? When you’ve been recording deferred tax assets for years based on a higher tax rate, that’s when.
What the Heck?
As I noted in last week’s blog, the Trump administration has suggested lowering the corporate tax rate to 15% (from 35%). In the long term, that will certainly result in welcome tax savings for corporations. But in the short term, it could result in some unanticipated tax expense, particularly when it comes to stock compensation.
A quick refresher: when companies record expense for nonqualified awards (NQSOs, RSUs, PSAs, etc.) they also record a deferred tax asset (DTA) that anticipates the tax savings the company will ultimately be entitled to for the award. This DTA is based on the company’s current tax rate and reduces the current tax expense reported in the company’s P&L.
For example, let’s say a company records expense of $1,000,000 for nonqualified awards in the current period. The company will also record a DTA of $350,000 ($1,000,000 multiplied by the corporate tax rate of 35%—to keep things simple, ignore any state or local taxes the company might be subject to). Even though the DTA represents a future tax savings, it reduces the tax expense reported in the company’s P&L now.
But if the corporate tax rate is reduced to 15%, the tax savings companies can expect from their awards is also reduced. In this case, the anticipated savings of $350,000 will be reduced too only $150,000 ($1 million multiplied by 15%). The company told investors it expected to realize a savings of $350,000 but now it expects to only realize a savings of $150,000. That $200,000 shortfall will have to be reported as additional tax expense.
What Should You Do?
At this point, nothing. We have a way to go before the administration’s tax proposal becomes a reality. And while I can think of plenty of reasons cutting the corporate tax rate might not be a great idea, having to write off a bunch of DTAs isn’t one of them. Regardless of the DTAs, a lower corporate tax rate will lower taxes for companies.
But it’s good to understand how this works, so that if the proposal does become more likely, you know this is something you’ll need to prepare for.
The FASB has issued an exposure draft of the proposed accounting standards modification to bring awards granted to nonemployees under the scope of ASC 718. Here are six things to know about it.
It’s Long. At 166 pages, the exposure draft is longer than I expected. Partly it’s so long because there a million places in ASC 718 where the FASB has to replace the word “employee” with “grantee” and the word “employer” with “grantor.”
No More Mark-to-Fair Value Accounting. This is the most significant change: awards granted to nonemployees that are settled in stock will receive equity treatment, the same as awards granted to employees. This means the expense will be determined on the grant date and will be recognized over the service period, with adjustments only for forfeitures and modifications. No more mark-to-fair value accounting until the awards vest.
Contractual Term Is Still Required for Valuation Purposes. The FASB is under the impression that all options granted to nonemployees are fully transferable (seriously, I kid you not—they really think this). So they require that when computing the fair value of options granted to nonemployees, companies have to use the contractual term, not the expected term. The NASPP will be commenting about this, for sure. (If you are a company that grants options to nonemployees, I would like to know if your options are transferable or not—email me at bbaksa@naspp.com).
The Expense Attribution Rules are Confusing. I had expected that expense for awards to nonemployees would be attributed in the same manner as awards to employees, but the exposure draft requires the expense to be attributed as goods or services are received, in the same manner that expense would be recorded for cash compensation. I don’t know beans about accounting for cash compensation (unless its in the form or SARs or RSUs), so I don’t know what that means. Ken Stoler of PwC assures me that it simply provides more flexibility for awards to nonemployees and that companies can probably record expense in the same way they record expense for their employee awards.
Performance Award Accounting is Improved. Currently, ASC 505-50 requires that expense for (non-market) performance awards granted to nonemployees be recorded at the lowest possible payout, which is frequently $0. The exposure draft proposes to align the treatment of nonemployee performance awards with that of employee awards: that is, expense would be recorded based on the expected payout, which makes infinitely more sense.
Comments Are Due By June 5. You can submit comments via the FASB website or email them to director@fasb.org. You can also mail a letter to the FASB but I’m not going bother listing the address here because who actually mails letters anymore?
Now that ASU 2016-09 allows companies to record expense for service-based awards without applying an estimated forfeiture rate to the accruals (see “Update to ASC 718: The FASB’s Decisions“), some our readers may be wondering how to make the transition to accounting for forfeitures as they occur. This is done by recording a cumulative adjustment to retained earnings in the period you adopt the ASU. In today’s guest blog entry, Elizabeth Dodge of Equity Plan Solutions explains how to calculate this adjustment (which she refers to as a “true-up amount”).
How to Get Rid of Your Estimated Forfeiture Rate
By Elizabeth Dodge, Equity Plan Solutions
So, you’ve decided to get rid of your estimated forfeiture rate… or at least decided to consider it. Congratulations! I recommend the elimination of an estimated forfeiture rate to all my clients. It simplifies equity accounting in so many ways.
Now how do you DO it? And better yet, do it without the auditors crawling all over you with time-consuming questions?
The short answer to the first question is:
Run an expense report, life-to-date WITH your current estimated forfeiture rate.
Run an expense report, life-to-date with a ZERO forfeiture rate.
Compare “To Date” (aka cumulative) expense (or, if your report doesn’t give you To Date, add prior and current expense and compare that).
The difference is your true up amount. Yes, it’s that easy. Yes, proving it’s correct is a little harder. More on that later.
Note: If you are using a system that delays the reversal of expense to the VEST DATE, it’s not QUITE this easy, but that is outside the scope of this article.
Why life-to-date?
Can’t I just run the current period report with and without the rate and take the difference in To Date (aka cumulative) Expense. Yes, you SHOULD be able to do that, but your auditors will want to kick the tires on your analysis and having ALL your grants on the report will help them do that. And life-to-date (LTD) should be from your adoption of FAS 123(R) (now known as ASC 718)—January 1, 2006 for many companies—until the end of your most recent reporting period—December 31, 2016 for many companies.
So now how do you tick and tie the numbers to your auditors’ satisfaction?
The approach I’ve used thus far with all my clients that have early adopted or considered adopting is to create a spreadsheet with four tabs:
LTD Expense Report With a Forfeiture Rate
LTD Expense Report Without a Forfeiture rate
Comparison tab
Summary tab
The Comparison tab has one row per grant and indicates the grant date, unvested shares (optional), final vest date and cancel date, if any, for each. It also pulls in expense from tab 1 and tab 2 and compares them in a “Variance” column. Then I add a “Reason” column that categorizes the grants into (generally) three categories:
Fully Vested, No Cancellation: These grants should have no expense variance.
Cancelled: These grants should have no expense variance (unless you are using True Up at Vest).
Still Vesting, No Cancellation: All grants should have higher expense on the Without Forfeiture Rate tab
You could assign these categories by using formulas. I usually use the low-tech method of filtering for a given criteria and then pasting the Reason down through all the rows to which it applies.
On the Summary tab, I summarize the expense totals from both tabs and then use a pivot table to summarize the reasons (or categories) and the associated variances (or lack thereof):
Thus far no auditors have had an issue with this approach. (Of course, now that I’ve said that, I’ve jinxed myself.) Have at it! And have fun!
Elizabeth is a Principal for Equity Plan Solutions, LLC, providing equity compensation consulting services to companies from startups to large public corporations. Previously, Elizabeth was a consultant and Vice President for Stock & Option Solutions, Inc. and held product management roles in stock plan services at BNY Mellon and ETRADE Corporate Services. Elizabeth became a Certified Equity Professional in 1999 and co-authors the chapter on accounting in The Stock Option Book. She also serves on the Executive Advisory Committee of the National Association of Stock Plan Professionals and was honored with the NASPP Individual Achievement award in 2012. You can contact Elizabeth at edodge@equityplansolutions.net.
Last week, I blogged about the FASB’s recent update to ASC 718, which clarifies when modification accounting is required for amendments to outstanding awards. The genesis for this update is the amendments companies are making to their share withholding provisions in light of ASU 2016-09. So the question is: will the update be final in time for companies to rely on it for their share withholding amendments?
Timing of Share Withholding Amendments
Calendar-year public companies have to adopt ASU 2016-09 by this quarter and presumably will want to amend the share withholding provisions in their plan at the same time or shortly thereafter. Unfortunately, the update on modification accounting (which doesn’t have an official number yet) won’t be issued until April, at the earliest.
Consider Waiting
One obvious alternative is to wait until the update is issued to amend plans and award agreements. But companies with major vesting events happening before then may want to amend their plans and awards sooner.
Hope for the Best
Once the update is issued, companies can adopt it early. The update clearly won’t be issued in time for it to be adopted in calendar Q1, but companies should be able to adopt it in calendar Q2. When companies adopted ASU 2016-09 in an interim period, they were required to apply it to prior interim periods in the same year. We don’t know for sure that this requirement will apply to the update on modification accounting, but it seems reasonable to assume that it will (it applies to many, if not all, ASUs issued lately by the FASB).
Thus, if calendar-year companies amend their awards in Q1 and account for the amendments as modifications, it’s possible that early adopting the modification accounting update would allow them to reverse that treatment.
Maybe Auditors Won’t Make Companies Wait for the Update
Lastly, my understanding is that—even without the FASB’s update—some auditors don’t think amending a share withholding provision requires modification treatment. The few comment letters that opposed the update did so on the basis that it is unnecessary because this conclusion can already be reached under the current standard.
The FASB’s recent vote on the update (which was unanimous with respect to the question of when modification accounting should be required) provides a clear indication of the board’s attitude. Given that, perhaps the actual issuance of the final update is a mere formality and most (maybe all) auditors will come to the conclusion that modification accounting isn’t required for share withholding amendments even without the final update. But I wouldn’t assume this without discussing it with your auditors.
In late February, the FASB met to review the comments received on the exposure draft of the proposed update to modification accounting under ASC 718 (see “ASC 718 Gets Even Simpler“) and voted to go ahead with the changes.
What’s Changing
The update clarifies that when the terms of an award are amended, modification accounting is required only if the amendment causes one of the following things to change:
The current fair value of the award
The vesting provisions
The equity/liability status of the award
The Comment Letters
The FASB received only 15 comment letters on the exposure draft and 12 of those were in support or it. The three letters that opposed the proposal did so at least in part because they felt that the above conclusion can already be drawn from the current standard. (Although, board member James Kroeker noted that one of the firms that opposed the proposal had previously contacted the FASB with technical inquiries as to what types of amendments require modification and had suggested that the FASB issue the update because they felt that there is diversity in practice. Go figure—perhaps the people writing the letters don’t communicate with the people actually doing the work.)
The FASB’s Decision
The FASB voted to go ahead with the proposed update, with only a few clarifications:
The determination of whether the fair value has changed should be consistent with the approach used to determine incremental cost for modifications. In general, this is determined on an award basis (rather than a per-share basis or an aggregate basis for all awards modified at one time).
The disclosures related to material modifications are required even if the amendment doesn’t trigger modification accounting.
Not So Fast; This Isn’t Final Yet
The FASB staff still has to draft the final language of the update and the FASB has to approve it. The staff anticipates issuing the final update in April 2017. Public companies will have to adopt it by the start of their first fiscal year beginning after December 15, 2017. Early adoption is permitted, but not before the official ASU is issued.
Could I Possibly Use the Word Modification More in One Blog Entry?
I doubt it. Here is this blog entry in a nutshell: As a result of technical questions that arose in the context of the prior modification to ASC 718, the FASB voted to go forward with a proposed modification to ASC 718 to stipulate that award modifications are subject to modification accounting only when the fair value, vesting conditions, or status of awards are modified, but the FASB had a few modifications to the proposed modification. The next time the FASB decides to update ASC 718, I hope the change doesn’t have anything to do with award modifications.
