It is common for boards and compensation committees to have discretion over clawback provisions, either over determining whether the clawback provision has been triggered or, once triggered, whether it should be enforced. While this discretionary authority is useful from a design and implementation standpoint, it can sometimes be problematic from an accounting perspective.
Background
Under ASC 718, expense associated with an equity award is determined on the grant date, which cannot occur before an employee and employer reach a mutual understanding of the key terms and conditions of the award. Where a key term is subject to discretion, a mutual understanding of the key terms and conditions of the award may not exist until the point at which this discretion can no longer be exercised.
In the case of clawback provisions, if the circumstances under which the board/compensation committee might exercise their discretion are not clear, this could lead to the conclusion that the service or performance necessary to earn the award is not fully defined. This, in turn, prohibits a mutual understanding of the terms and conditions of the award and delays the grant date. This delay would most likely result in liability treatment of the award.
Recent Comments from SEC Accounting Fellow
Sean May, a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed this concern in a speech at the 2016 AICPA Conference on Current SEC and PCAOB Developments, held in Washington, DC. May distinguished objectively applied clawback policies from policies that “may allow those with the authority over compensation arrangements to apply discretion.” In addition, he made the following comments:
If an award includes a key term or condition that is subject to discretion, which may include some types of clawback provisions, then a registrant should carefully consider whether a mutual understanding has been reached and a grant date has been established. When making that determination, a registrant should also assess the past practices exercised by those with authority over compensation arrangements and how those practices may have evolved over time. To that end, registrants should consider whether they have the appropriate internal control over financial reporting to monitor those practices in order to support the judgment needed to determine whether a grant date has been established.
Clawbacks and Discretion are Common
68% of respondents to the NASPP’s 2016 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting) indicate that their equity awards are subject to clawback provisions. 83% of those respondents, indicate that the board or compensation committee has some level of discretion over enforcement of the provisions.
If you are among those 83%, it might be a good idea to review the comments May made at the AICPA conference with your accounting advisers to make sure your equity awards receive the accounting treatment you expect.
It will come as no surprise to any of you that accounting for modifications under ASC 718 is complicated. In the aftermath of the issuance of ASU 2016-09, the FASB has received a number of questions about whether amending a stock plan or award to allow shares to be withheld for more than the minimum statutorily required tax payment would trigger modification accounting under ASC 718. It probably seems crazy to you that we even have to consider this question and I guess it also seemed that way to the FASB, because they’ve issued an exposure draft to amend ASC 718 to clarify that this sort of change isn’t a modification.
ASC 718 currently says that any change whatsoever to an award is considered an modification and goes on to define four types of modifications: probable-to-probable, probable-to-improbable, improbable-to-probable, and improbable-to-improbable. The accounting treatment varies based on which type of modification you are dealing with and for some types of modifications, a new valuation of the award is required even if the value of the award isn’t changed as a result of the modification. Hence, the concern about the amendments relating to share withholding, even though these amendments arguably don’t materially increase the value of an award to the award holder.
So the FASB has proposed an amendment to ASC 718 that would clarify that not every change to the terms and conditions of an award requires modification treatment. Instead, a change to the terms and conditions of an award would require modification treatment only if at least one of the following conditions is met:
The fair value of the award is changed as a result of the amendment. For purposes of determining if there is a change in fair value, the fair value of the award immediately following the amendment would be compared to the fair value immediately beforehand (rather than to the grant date fair value). Generally, there would be no change in fair value if the amendment does not impact any of the inputs necessary to determine the award fair value.
The amendment modifies the vesting conditions of the award.
The amendment causes the classification of the award to change (from equity to liability or vice versa).
Amending a plan or award to allow additional shares to be withhold for taxes would not meet any of the about conditions (provided the share withholding is still limited to the maximum individual tax rate in the applicable jurisdiction) and, thus, under the proposed amendment, there would be no question that this is a modification. Even without the proposed amendment to ASC 718, I believe that many practitioners would not treat this as a modification.
Comments may be submitted on the exposure draft until January 6, 2017. The update would be applied prospectively only, thus the accounting treatment for any prior modifications of awards would not change. The exposure draft does not specify an effective date.
The good news from the FASB just keeps coming. First, the simplification of ASC 718 and now the board has decided to include awards granted to nonemployees under the scope of ASC 718.
Background
Well over a decade ago, before even the adoption of FAS 123(R), the FASB decided that awards granted to nonemployees (except outside directors), were fundamentally different than awards granted to employees and should be accounted for differently. “What,” you say, “that’s crazy! Why would they do that?” I agree, it’s totally crazy and I can’t explain why the FASB does anything that they do. Really, stop asking me to explain their behavior.
The upshot of this decision is that awards to nonemployees were subject to variable/mark-to-market/liability treatment until vested. And the accounting for situations in which individuals changed employment status were so complicated that no one really knew how it was supposed to work.
The FASB’s Decision
Around the same time that the FASB decided to simplify ASC 718, they also directed the staff to investigate whether it would make sense for awards granted to nonemployees to be included within the scope of ASC 718. Now, a year and a half later, they have decided that this does make sense.
This means that once the amendment is finalized, awards granted to all nonemployees (consultants, independent contractors, leased employees, etc.) will be accounted for in the same manner as awards to employees. No more complicated accounting when individuals change employment status (unless the individual’s awards are modified in connection with the change in status, in which case, modification accounting is still required). And there’s a bunch of even crazier stuff companies were supposed to be doing for nonemployee awards once the awards were vested and to account for performance conditions that no one seemed to know about; now we never need to know about that stuff.
Companies that are currently accounting for awards granted to nonemployees will use the modified retrospective method for the transition (which we are all now familiar with once again, because we had to figure it out for the simplification project, see “Update to ASC 718: Transition“).
Not So Fast
We still have a long ways to go on this. First, the FASB has to issue an exposure draft of the proposed amendment, we all have to read it and comment on it (oh joy), the FASB has to consider all our comments (or at least pretend to), the staff has to draft the final amendment, the FASB has to vote to approve it, and companies have to adopt it. So you aren’t going to be changing how you account for awards to nonemployees anytime soon.
Thanks to Elizabeth Dodge of Equity Plan Solutions for bringing this to my attention and to Ken Stoler of PwC for translating the FASB’s accounting-speak for me.
I’ve been getting a lot of questions about what tax withholding rate can be used for federal income tax purposes, now that the FASB’s update to ASC 718 is final and companies are free to adopt it. So I thought I’d take a blog entry to clarify what’s changed and what hasn’t.
Who’s the Decider on Tax Withholding Procedures
One thing that a lot of folks seem to have forgotten is that the FASB doesn’t determine tax withholding procedures; they just determine how you account for situations in which tax is withheld. The ultimate authority on how much tax you should (and can) withhold in the United States is the IRS, not the FASB.
Tax Withholding for Supplemental Payments
I’ve blogged about the rules for withholding on supplemental payments, which include stock plan transactions, quite a bit (search on the term “Excess Withholding” in the NASPP Blog). There are two choices when it comes to withholding taxes on stock plan transactions for employees who have received less than $1 million in supplemental payments for the year:
Withhold at the flat rate (currently 25%). No other rate is permissible.
Withhold at the employee’s W-4 rate. Here again, no other rate is permissible.
If employees want you to withhold additional FIT, they have to submit a new W-4 requesting the withholding (as a flat dollar amount, not a percentage) and you have to agree to withhold at the W-4 rate. This is stated in IRS Publication 15 and even more emphatically in IRS Information Letter 2012-0063. Whether you are using method 1 or 2, you can’t arbitrarily select a withholding rate.
Where Does the FASB Come Into This?
The FASB has no authority over these requirements and they didn’t amend ASC 718 to make is easier for you to ignore the IRS requirements. They amended ASC 718 to make it easier for companies that grant awards to non-US employees to allow those employees to use share withholding. Other countries don’t have a flat rate, making it challenging for the US stock plan administration group to figure out the correct withholding rate for non-US employees. This would allow companies to withhold at the maximum rate in other countries and refund the excess to employees through local payroll (who is more easily able to figure out the correct withholding rate).
The only change for US tax withholding procedures is that if you want to use the W-4 rate to withhold excess FIT, withholding shares for the excess payment will no longer trigger liability treatment once you adopt the update to ASC 718. But if you want to withhold excess FIT, you still have to follow the IRS procedures to do so. Previously, even if you had followed the IRS W-4 procedures, withholding shares for an excess tax payment would have triggered liability treatment.
Why Not Use the W-4 Rate?
No one wants to use the W-4 rate because it is impossible to figure out. You have to aggregate the income from the stock plan transaction with the employee’s other income for the payroll period, which the stock plan administration group doesn’t have any visibility to. The rate varies depending on the number of exemptions the employee claims on Form W-4. And the rate is complicated to figure out. I count at least seven official methods of figuring out this rate and companies can make up their own method (but if they make up a method, they have to apply it consistently, the stock plan administration group can’t make up a method that is different than the method the payroll group uses).
The upshot is that you literally can’t figure it out. You would have to run the income through your payroll system to figure out what the tax withholding should be. And that’s a problem because your stock plan administration system is designed to figure out the withholding and tell payroll what it is, not the other way around.
What’s the Penalty?
Members often ask me what the penalty is for withholding extra FIT without following the IRS procedures. Generally there isn’t a penalty to the company for overwithholding, provided there’s no intent to defraud the IRS (if you don’t understand how overwithholding could involve tax fraud, see “Excess Withholding, Part 2“) and the withholding is at the request of the employee. Doing this on a one-off basis, at the occasional request of an employee, probably won’t result in substantial penalties to the company, especially if the employee has appropriately completed Form W-4 for his/her tax situation. (Note, however, that I’m not a tax advisor. You should consult your own advisors to assess the risk of penalty to your company.)
But I’ve encountered a number of companies that want to create a system to automate electing a higher withholding rate without following the W-4 procedures (in some cases, for all of their award holders). I think that it could be problematic to create an automated system that circumvents the W-4 process, especially in light of Information Letter 2012-0063. That system is likely to be noticed if the company is audited, and I think it could have negative ramifications.
For today’s blog entry, I have the results of the NASPP’s Quick Survey on ASC 718, presented in a nifty interactive infographic (place your cursor over a section of each chart to see its label). (Click here if you don’t see the graphic below.)
BTW—if you are one of the 83% of respondents that haven’t yet figured out the impact of the tax accounting changes to your earnings per share, see my blog entry “Run Your Own Numbers,” for easy-peasy instructions on how most companies can figure this out in just 5 minutes. It’s a great opportunity to demonstrate your knowledge and value to your accounting/finance team.
Many companies are very excited about the expanded exception to liability treatment that is available under ASU 2019-06 (see my blog entry, “Update to ASC 718: The FASB’s Decisions,” December 1). In the NASPP’s quick survey on the ASU, about 30% of respondents so far have said that this is the amendment they are most excited about (to the extent that anyone can be excited about accounting).
Many plans (possibly even most plans, by a wide margin), include language prohibiting employees from tendering award shares to cover tax payments in excess of the minimum statutory required withholding. This language is included in the plan to make it abundantly clear that the company doesn’t allow share withholding in excess of the minimum required tax payment; liability treatment could be required if it appears that the company would allow this, even if it isn’t ever actually done. I’m sure the language is also included to protect companies from themselves—if anyone had ever gotten the bright idea to allow share withholding for a tax payment in excess of the minimum required, hopefully someone would have realized the plan prohibited this.
If this language exists in your plan, the plan has to be amended to change the limitation from the minimum required payment to the maximum payment before you can change your share withholding procedures.
Shareholder Approval May Be Required
At a minimum, the Board of Directors would need to approve the amendment to the plan. But for some companies, shareholder approval may be required as well. The NYSE and NASDAQ require shareholder approval of any material amendments to stock plans. As Mike notes:
From the perspective of the NYSE and NASDAQ, if the Stock Plan allows the recycling of shares surrendered or withheld to pay tax withholding (that is, puts those shares back in the authorized share pool and allows those shares to be re-used for future awards), then an amendment of that Plan that allows for tax withholding at the maximum rate, instead of the minimum rate, would be material because it will increase the number of shares available for issuance under the Plan!
According to the NASPP’s 2013 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting), close to 60% of respondents allow shares withheld for taxes to be recycled. These companies would need to obtain shareholder approval of this amendment.
Companies May Need to Wait Until After Adopting the ASU
Once you amend your plan, your auditors make take this as an indication that you plan to allow share withholding in excess of the minimum required tax payment. If so, and the amendment is approved before you adopt ASU 2016-09, that’s going to trigger liability treatment for all of the awards under the plan. This liability treatment will go away once you adopt the ASU, but until then, it could be a problem.
It might be possible to structure the amendment so that it is effective only after your company adopts ASU 2016-09, but it’s a good idea to consult with your legal and accounting advisors before rushing headlong into amending your plan.
Last week, I used an example to illustrate the impact the new tax accounting rules under ASU 2016-09 will have on companies’ P&L statements. If your company is profitable, this is something you can do using your own financials. In this week’s blog entry, I explain how.
Finding the Numbers
I found all the numbers for my example in the company’s 10-K. I didn’t even have to pull up the full 10-K; I used the interactive data on EDGAR—it took me about 5 minutes. Here’s where to look:
You can find your company’s net earnings, tax expense, and basic EPS in your income statement (“income statement” is the less cool way to say “P&L,” which is shorthand for “profits & loss statement”).
You can usually find your excess tax benefit or shortfall in your cash flow statement or the statement of stockholders’ equity (or you may already know this amount, if you manage the database that this information is pulled from).
The number of shares used in your basic EPS calculation will be indicated in either your income statement or your EPS footnote.
What To Do With the Numbers
Once you have collected that data, you can do the following:
Post-Tax Earnings: The tax benefit represents how much post-tax earnings would be increased (or, if you have a shortfall, how much earnings would be decreased).
Effective Tax Rate: Subtract the tax benefit (or add the shortfall) to tax expense and divide by pre-tax earnings to determine the impact on your effective tax rate.
Earnings Per Share: Divide the tax benefit (or shortfall) by the shares used in the basic EPS calculation to figure out the impact on basic EPS.
Do these calculations for the past several years to see how much the impact on earnings varies from year to year.
Stuff You Should Be Aware Of
This exercise is intended to give you a general idea of the impact of the new tax accounting rules for your company. There are lots of complicated rules that govern how earnings and tax expense are calculated that have nothing to do with stock compensation, but that, when combined with the rules for stock compensation, could change the outcome for your company. This is especially true if your company isn’t profitable—if you are in this situation, it may be best to leave the estimates to your accounting team.
Also, I’ve suggested calculating the impact only on basic EPS because it’s a little harder to figure out the impact on diluted EPS. In diluted EPS, not only will the numerator change, but the number of shares in the denominator will change as well, because excess tax benefits no longer count as a source of proceeds that can be used to buy back stock. See my blog entry, “Update to ASC 718: Diluted EPS” for more information).
For today’s blog entry, I use an example to illustrate the impact the new tax accounting procedures required under the recently issued ASU 2016-09 will have on companies’ P&L statements.
A Refresher
Under the old ASC 718, all excess tax benefits and most tax shortfalls for equity awards were recorded to paid-in-capital. An excess tax benefit occurs when the company’s tax deduction for an award exceeds the expense recognized for it; a tax shortfall is the opposite situation—when the company’s tax deduction is less than the expense recognized for the award. The nice thing about old ASC 718 is that paid-in-capital is a balance sheet account, so these tax effects didn’t impact the company’s profitability. Under the amended ASC 718, all excess tax benefits and shortfalls are recorded to tax expense, which ultimately impacts how profitable a company is.
Effective Tax Rates
Not only do changes to tax expense impact a company’s profitability, they also impact the company’s effective tax rate. This rate is calculated by dividing the tax expense in a company’s P&L by its pre-tax earnings. A company’s effective tax rate is generally different from the company’s statutory tax rate because there are all sorts of credits that reduce the tax a corporation pays without reducing income and there are items that can increase a company’s tax expense that don’t increase income.
An effective tax rate that is lower than the statutory tax rate is good; it shows that the company is tax efficient and is keeping its earnings for itself—to use to operate and grow the company or to pay out to shareholders—rather than paying the earnings over to Uncle Sam. Just like you want to minimize the taxes you pay, shareholders want the company to minimize the taxes it pays.
An Example
This example is based on a real-life company that grants stock compensation widely. I’ve rounded the numbers a bit to make it easier to do the math, but my example isn’t that far off from the real-life scenario.
The company reported pre-tax income of $900 million for their most recent fiscal year and tax expense of $250 million. That’s an effective tax rate of 28%, which is probably less than their statutory tax rate.
The company reported (in their cash flow statement) an excess tax benefit for their stock plans of $70 million. Under the old ASC 718, that tax benefit didn’t impact the company’s earnings. But if it had been recorded to tax expense as is required under the amended ASC 718, it would have reduced the company’s tax expense to just $180 million. That reduces the company’s effective tax rate from 28% to just 20%.
In addition, the company’s basic earnings-per-share is $1.30, with 500 million shares outstanding. The tax benefit would have increased basic earnings per share by 14 cents, which is an increase of just over 10%.
Next week, I’ll explain how you can apply this example to your own company.
I was planning to blog more about ASU 2016-09 this week, but the FASB’s Private Company Council discussed accounting for awards granted to nonemployees at their meeting on Tuesday, so I’ve decided to blog about that instead. While the changes the FASB is considering in this area may have their genesis in simplifying things for private companies, they ultimately would apply to both private and public companies, so it’s worth reading about the meeting even for public companies.
What the Heck is the PCC?
The Private Company Council is the primary advisory body to the FASB on private company matters.
Good News
There were two bits of good news. The first is that the FASB staff recommends aligning the treatment of awards granted to nonemployees with the treatment of employee awards. Moreover, their recommendation is for awards to all nonemployees, not just nonemployees providing similar services as employees (which the staff seemed to recognize would be a bit of a rat’s nest to figure out).
Secondly, overall, the PCC generally seemed to agree with the staff’s recommendation. That’s certainly the official position. From the “Media Meeting Recap“:
The PCC generally supported aligning the models for nonemployee and employee share-based payments under GAAP.
Stuff I Found Surprising/Concerning
When I listen to FASB meetings, I often end up shouting at my computer like I am watching a televised sporting event. Here are a few things that got a reaction from me.
I was a little surprised at how unfamiliar the PCC seemed to be with how start-ups use equity awards for nonemployees. One Council member suggested that it seemed to him that accounting for employee awards is harder than accounting for nonemployee awards. For a minute there, I thought he was going to suggest that the treatment of employee awards be aligned with that of nonemployees. Luckily, most of the other Council members did not seem to agree with him.
The Council also was very concerned about companies buying goods (the example tossed about was buildings) with stock. Does this actually happen? Enough that the PCC needs to be so worried about it? I will admit that buying a building with stock is far outside my wheelhouse, so maybe it does happen all the time and maybe there are all sorts of valid concerns over how the transaction is accounted for that justify keeping this situation outside the scope of ASC 718.
Another thing I didn’t know is that the current guidance on accounting for nonemployee awards stipulates that if vesting is contingent on performance conditions, the interim estimates of expense are based on the lowest possible aggregate fair value, which is $0 if the award will be forfeited in full if the performance conditions aren’t met. 1) Who knew? 2) Are companies actually granting performance awards to nonemployees?
The Most Surprising Thing
Only one member of the PCC is located west of the Mississippi, which explains A LOT. (And, in general, all of the FASB advisory groups seem to be heavily weighted towards the east coast, which explains even more.) The one Council member from the west coast is from Portland. Nothing against Portland, but given the proliferation of start-ups here in Silicon Valley, it seems like maybe the FASB ought to find an accounting practitioner from this area who works with starts-up to be on the Council. Equity compensation can’t be the only area where technology start-ups do things differently.
As noted last week, the FASB has issued the final Accounting Standards Update to ASC 718. Here are a few more tidbits about it.
The ASU Has a Name
Handily, the ASU now has a name that we can use to refer to it: ASU 2016-09. Now I can stop calling it “the ASU to ASC 718,” which was awkward—too many acronyms.
Transition Wrinkle
One surprise to me is how the transition works if the ASU is adopted in an interim period other than the company’s first fiscal quarter. When the ASU is adopted in Q2, Q3, or Q4, the update requires that any adjustments required for the transition be calculated as of the beginning of the fiscal year. Consequently, where companies adopt the ASU in these periods, they will end up having to recalculate the earlier periods in their fiscal year (and restate these periods wherever they appear in their financial statements), even if the transition method is prospective or modified retrospective, which normally would not require recalculation or restatement of prior periods.
For example, if a company adopts the ASU in its second fiscal quarter, the company will have to go back recalculate APIC and tax expense as required under tax accounting approach specified in the ASU for its first fiscal quarter. Likewise, if the company decides to account for forfeitures as they occur, the company will have to recalculate expense for the first fiscal quarter under the new approach and record a cumulative adjustment to retained earnings as of the beginning of the year, not the beginning of Q2.
While I can understand the rationale for this requirement, it is different than how I expected the transition to work for interim period adoptions.
No Other Surprises
The ASU 2016-09 seems to be an accurate reflection of the decisions made at the FASB’s meeting last November and documented ad nauseam here in this blog. I still haven’t read every last word of the amended language in the ASC 718, but I don’t think there are any other significant surprises.