Just in the nick of time to make their Q1 deadline, the FASB has issued the Accounting Standards Update to ASC 718. Now that the ASU has been issued, companies are free to adopt it.
Here are answers to a few questions you might have:
When do companies have to adopt the ASU?
Public companies have to adopt it by their first annual and interim fiscal period beginning after December 15, 2016. Private companies get an extra year to adopt it for annual periods and an extra two years for interim periods.
Do companies have to adopt the whole ASU at once?
You betcha! I’ve said it before: this isn’t a salad bar! You can’t pick and choose the parts of the ASU that you like: it’s all or nothing.
Can we adopt the ASU this quarter even though the quarter ends tomorrow?
Yep, you sure can. If you are prepared to change over to the new tax accounting procedures, have already decided whether you want to change how you account for forfeitures (and, if you are changing approaches, are ready to go with the new approach), and are prepared to comply with any other aspects of the ASU that apply to your company, you can adopt it in this quarter. But if you aren’t ready to go on any aspects of the ASU, you might want to wait until at least Q2 to give yourself a little more time.
Do we have to adopt it in this quarter if we want to adopt early?
No, this is not required. Companies can adopt it in any interim period up until they are required to adopt the update.
Are there any surprises in the final ASU?
Got me. I’m actually on vacation this week. I’m at spring training in Phoenix—where ASU stands for Arizona State University and I’m sitting four rows back behind home plate. I wrote this last week, before the FASB had issued the ASU, just in case. With the end of the quarter imminent, I wanted to have a blog entry ready to go so that any NASPP members whose employers want to adopt the ASU in Q1 would know that it had been issued. But I haven’t had a chance to do anything more than skim the ASU between innings.
I plan to have more complete coverage when I’m back in the office next week. For now, go A’s!
For today’s blog, I have a few unrelated developments in stock compensation.
HSR Act Thresholds
Good news: now executives can acquire even more stock! Under the Hart-Scott-Rodino Act, executives that acquire company stock in excess of specified thresholds are required to file reports with the Federal Trade Commission and the Department of Justice. The FTC has increased the thresholds at which these reports are required for 2016 (the thresholds are adjusted every year). See the memo we posted from Morrison & Foerster for the new thresholds, which are effective as of February 25, 2016.
If you have no idea what I’m talking about, check out our handy HSR Act Portal.
Nonemployee Accounting
More good news! The FASB is still reconsidering the accounting treatment of awards issued to nonemployees. You may recall that, as second phase of the ASC 718 simplification project, the Board directed the FASB staff to research whether it would make sense to bring awards nonemployees under the scope of ASC 718, if not for all nonemployees, than at least for those who provide services that are similar to employee services. In December, the FASB staff presented its research to the Board and the Board directed the staff to continue its research. So the possibility of awards to nonemployees eventually being accounted for in the same manner as awards to employees is still on the table.
ASC 718 Update
And while we’re on the topic of ASC 718, no word yet on when the final update will be issued for phase 1 of the simplification project. As of 12:32 AM today, the FASB website still lists the estimated completion date for this project as Q1 2016, which means we could see it any day now. However, I have heard unsubstantiated rumors that it may push into Q2, so don’t start holding your breath just yet. Personally, I’m betting on the week of March 21, because I’m presenting on it twice that week: once at the 12 Annual CEP and Silicon Valley NASPP Symposium and later in the week for a Certent webinar.
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.
For my last installment (at least for the moment—expect another blog when the FASB officially adopts the new standard) in my series on the FASB’s ASC 718 simplification project, I answer a few questions relating to early adoption of the new standard.
Can companies adopt it early?
Yes, companies can adopt the amended standard in any interim or annual period after the FASB approves the official amendment. If the FASB approves the amendment as expected in this quarter, companies could adopt it in this quarter.
Can companies adopt it now?
No, not quite yet. Companies have to wait until the final amendment is approved by the FASB to adopt it.
Can companies adopt just the parts of the update they like early and wait to adopt the rest of it?
Heck no! This isn’t a salad bar; it’s all or nothing. You have to take the bad with the good.
If we start allowing employees to use shares to cover tax payments in excess of the minimum required withholding now, are my auditors really going to make me use liability accounting, given that we all know the rules are changing soon?
Well, I can’t really speak for your auditors, so you’d have to ask them—accounting-types do tend to be sticklers for the rules, however. If the FASB approves the amendment on time, you could adopt it this quarter and there’d be no question about liability treatment. But you’d have to adopt the whole standard, including the tax accounting provisions, so you would want to make sure you are prepared to do that.
If you don’t want to adopt the entire update as soon as the FASB approves it, liability treatment applies if shares are withheld for more than the minimum tax payment. For awards that are still outstanding when you adopt the update, this liability treatment will go away. You’ll record a cumulative adjustment at the time of adoption (see my blog last week on the transition) to switch over to equity treatment. But for the awards that are settled prior to when you adopt the standard, you won’t reverse the expense you recognize as a result of the liability treatment.
If the awards that will settle between now and when you expect to adopt the standard are few enough, the expense resulting from the liability treatment might be immaterial. Likewise, if your stock price is at or below the FMV back when the awards were granted, you might not be concerned about liability treatment because it likely wouldn’t result in any additional expense.
Note, however, that if you establish a pattern of allowing share withholding for excess tax payments, liability treatment applies to all awards, not just those for which you allow excess withholding. You could have liability treatment for all award settlements that occur before you adopt the amended standard.
For today’s installment in my series on the FASB’s ASC 718 simplification project, I explain what the next steps are in this process.
Is the update final now?
Not quite yet. For the most part, we know what the final update is going to look like because the FASB’s decisions with respect to each issue in the exposure draft are public. But the FASB staff still has to draft the actual amendment to ASC 718 and the FASB has to vote to adopt the amendment.
In addition, there are a few technical details in the exposure draft that were commented on and that we expect the staff to clean up, but we won’t know for sure until the amendment is issued. The FASB didn’t vote on these details because they don’t change the board’s overall position; it is merely a matter of clarifying what the board’s decision means with respect to some aspects of practical implementation. For example, the language of the proposed amendment relating to share withholding seemed to imply something different than the FASB’s explanation of what this change would be. I am assuming the staff will modify this language but we won’t know for sure until the final amendment is issued.
When will the FASB adopt the amendment?
According to the FASB’s Technical Agenda, this project is expected to be finalized in Q1 2016. Anyone who’s been in the industry for a more than a couple years knows, however, that these things tend to slip a bit. In my 20 years in this industry, I can’t think of a single regulation, rule, amendment, etc. that, when targeted for issuance during a specific time frame, came out earlier than the very last week or so in that time frame. (10 pts to anyone who can prove me wrong on this—I started in the industry in 1994, so stuff before that doesn’t count.) The FASB is no exception, so I’m guessing that we are looking at the end of March or maybe even Q2 2016.
When will companies be required to comply with the new guidance?
Public companies will have to adopt the update by their first fiscal year beginning after December 15, 2016 (and in the interim periods for that year). Private companies have a year longer to adopt for their annual period and two years longer for interim periods.
Will the standard now be called ASC 718(R)?
No. For people like me who write about accounting, that would be handy because it would make it easy to distinguish when I’m talking about the pre-amendment vs. the post-amendment ASC 718. Now I’ll have to use some sort of unwieldy clarification, like “ASC 718, as amended in 2016.” But under the FASB’s codification system, the existing standard is simply updated to incorporate the amendments. The name of the standard will stay the same.
If the Codification system didn’t exist, maybe we would call it FAS 123(R)(R). Or would it be FAS 123(R)2?
For my first blog entry of 2016, I look at the transition methods that will apply under the FASB’s Accounting Standards Update (ASU) to ASC 718. (If you’ve forgotten what this is all about, read Part I and Part II of my update on the FASB’s decisions on the ASC 718 simplification project.) Also, see my handy chart showing how FASB voted on each issue in the exposure draft and the required transition method for it.
Prospective
The prospective transition method is perhaps the easiest to understand. Under this method, the company just changes its accounting procedures on a go-forward basis, with no restatement of prior periods or cumulative adjustments.
The prospective transition method will be used for the tax accounting provisions. For transactions that occur after a company adopts the ASU, the amounts that would have been recorded to additional paid-in capital will now simply be recorded to tax expense. It’s that easy: no adjustments to paid-in capital or tax expense for past transactions and the ASC 718 APIC pool calculation is no more.
Retrospective
Retrospective transition is also fairly straightforward. With this method, the company changes its accounting procedures going forward, but also adjusts any prior periods reported in its current financials. For example, most companies show three fiscal years in their annual financial statements. Where retrospective transition is required, a company that adopts the ASU in 2016 would not only change their accounting procedures for 2016, but would go back and adjust the 2015 and 2014 periods as if the new rules had applied in those periods.
The adjustment is presented only in the current financials; the company does not reissue any previously issued financial statements or re-file them with the SEC.
The only provisions in the ASU that are subject to retrospective transition are the provisions related to classification of amounts reported in the cash flow statement (and for the classification of excess tax benefits, the company can choose between prospective and retrospective).
Modified Retrospective
This transition method is used when a cumulative adjustment is necessary. Accounting for forfeitures is a good example. A company can’t just switch from applying an estimated forfeiture rate to accounting for forfeitures as they occur on a prospective basis: since previously recorded expense was adjusted based on estimated forfeitures, companies would end up double-counting forfeitures when they occur. Retrospective restatement wouldn’t fix this problem because some of the prior expense may have been recorded outside of the periods presented in the company’s current financials.
It also doesn’t make sense to make companies record a big change in expense in their current period; this would be confusing (and possibly alarming) to investors and isn’t reflective of what is happening. So instead, the transition is handled with a cumulative adjustment that is recorded as of the start of the fiscal period. This adjustment is recorded in retained earnings (which is the balance sheet account where net earnings end up) with an offsetting entry to paid-in capital.
In the case of forfeitures, the company calculates the total expense it would have recognized as of the start of the period if it had been accounting for forfeitures as they occur all along and compares this to the actual amount of expense recorded to date (which should generally be lower). The difference is then deducted from retained earnings, with a commensurate increase to paid-in capital.
In addition to the forfeitures provision, modified retrospective is used for private companies that take advantage of the opportunity to change how they account for liability awards. It is also used theoretically for the share withholding provisions if companies have been allowing employees to tender shares in payment of taxes in excess the minimum statutorily required withholding and has outstanding awards that are subject to liability treatment as a result. But I doubt anyone has been doing that, so in practice, I don’t think a transition will be necessary for the share withholding provisions.
This week I provide additional coverage of the decisions the FASB made on the ASC 718 simplification project (see my blog from last week for Part 1).
Cash Flow Statement
The Board affirmed both of the proposals related to the cash flow statement: cash flows related to excess tax benefits will be reported as an operating activity and cash outflow as a result of share withholding will be reported as a financing activity. Nothing particularly exciting about either of these decisions but, hey, now you know.
Repurchase Features
The board decided not to go forward with the proposal on repurchases that are contingent on an event within the employee’s control. The proposal would have allowed equity treatment until the event becomes probable of occurring (which would align with the treatment of repurchases where the event is outside the employee’s control). The Board decided to reconsider this as part of a future project. The Board noted that this would have required the company to assess whether or not employees are likely to take whatever action would trigger the repurchase obligation, which might not be so simple to figure out (we all know how hard it is to predict/explain employee behavior).
Practical Expedient for Private Companies
The Board affirmed the decision to provide a simplified approach to determining expected term for private companies, but modified it to allow the approach to be used for performance awards with an explicitly stated performance period. I’m not sure that many private companies are granting performance-based stock options, but the few who are will be relieved about this, I’m sure.
Options Exercisable for an Extended Period After Termination
Companies that provide an extended period to exercise stock options after retirement, disability, death, etc., will be relieved to know that the FASB affirmed its decision to eliminate the requirement that these options should be subject to other applicable GAAP. This requirement was indefinitely deferred, but now we don’t have to worry about it at all.
Last Monday, the FASB met to review the comments submitted on the exposure draft of the proposed amendments to ASC 718. I have been watching the video of the meeting (and you can too) and have made it about half way through. After getting over my shock that no one on the Board has mentioned what a finely crafted comment letter I submitted, here’s what I’ve learned so far. (See the NASPP alert “FASB Issues Exposure Draft of ASC 718 Amendments” for a summary of the exposure draft).
Tax Accounting
The most controversial aspect of the exposure draft is the proposal to record all excess tax benefits and shortfalls in tax expense. Despite the fact that the overwhelming majority of letters submitted opposed this (see my Nov. 10 blog “Update to ASC 718: The Comments“)—including my own aforementioned finely crafted letter—and the FASB staff’s recommendation that the excess benefits and shortfalls be recognized in paid-in-capital instead, the Board voted to affirm the position in the exposure draft. I was a little surprised at how little time the Board spent considering the staff’s recommendation.
The Board decided that stock plan transactions could be treated as “discrete items” that do not need to be considered when determining the company’s annual effective tax rate. I don’t know a lot about effective tax rates, but I’m guessing that this is poor consolation for the impact this change will have on the P&L.
Estimated Forfeitures
The Board affirmed the proposal to allow companies to make an entity-wide decision to account for forfeitures as they occur, rather than estimating them. At one point, the board was considering requiring companies to account for forfeitures as they occur (without even re-exposing this decision for comment), which was a little scary. I think most of us have supported this proposal primarily on the basis that companies can keep their current processes in place if they want; I’m not sure it would have received as much support if accounting for forfeitures as they occur had been mandatory (this wasn’t even mandatory under FAS 123). Thankfully, the Board backed off from that suggestion.
Share Withholding
The Board affirmed the decision to expand the share withholding exception to liability treatment, in spite of concerns that the potential cash outflow without a recorded liability could be misleading for users. For one nail-biting moment, eliminating the exception altogether was on the table (in my amateur opinion, this would seem to go well beyond the scope of what is supposed to be a “simplification” project, given the considerable impact this would have on practices with respect to full value awards). Luckily, this suggestion did not receive any votes (not even from the Board member who suggested it, oddly enough).
Stay Tuned
More on the rest of the FASB’s decisions in a future blog entry.
What does Madonna have to do with the FASB? Well, nothing, except that they both use the term “material,” albeit to refer to different things. The FASB has issued two proposals relating to materiality recently; I read both of them today and now I can’t stop humming “Material Girl” by Madonna. That’s just the way my brain works.
Proposed Amendment to Financial Accounting Concepts
The first proposal would amend Statement of Financial Accounting Concepts No. 8 to remove the definition of materiality originally included therein and instead refer to the legal definition of materiality, as determined through “legislative, executive, or judicial action.” This would cause a misalignment with IFRS, but it seems preferable for the FASB’s definition of materiality to align with other definitions of this term as used in the United States. I’m not sure how significant an impact this change would have on stock compensation, but the FASB notes that IASB’s definition of materiality (which SFAC 8 originally aligned with) “generally would require disclosure of more information than would the legal concept of materiality in the United States.” I guess people outside the United States have a lot more time to read through tedious disclosures.
Proposed Accounting Standards Update
The second proposal would amend ASC 235 (Notes to the Financial Statements) to add a new section titled “Assessing Whether Disclosures Are Material.” This section would clarify that it is permissible to omit disclosures that are immaterial (apparently there has been a fair amount of confusion about this) and that this omission is not an error that must be disclosed to the company’s Audit Committee (there’s no point in omitting a disclosure if you still have to disclose it somewhere else). The amendment would further clarify that the materiality assessment applies to both quantitative and qualitative disclosures and is applied to each disclosure individually as well as in the context of the financial statements as a whole. The proposal states “Preparers…should be evaluating whether the disclosure is material, not the Topic itself.”
I read this to mean that, although overall, ASC 718 might be very material to a company’s financial statements (particularly where a significant portion of employee pay is in the form of equity), specific disclosures that would be otherwise required under ASC 718 can be omitted from the company’s financial statement notes if they are immaterial to that company.
The proposal would also amend each Topic in the Accounting Standards Codification that includes disclosures to refer to Topic 235 and remove any existing phrases that conflict with it. The proposal doesn’t describe how each individual Topic would be amended, but does include an example to generally demonstrate what the amendments might look like. Handily, the proposal uses ASC 718 as the example so I know what language would be changed therein:
In paragraph 718-10-50-1, the phrase “An entity with one or more share-based payment arrangements shall disclose information” would be changed to “Entities shall provide disclosures required by this Subtopic to the extent material.”
The phrasing in paragraph 718-10-50-2 that suggests that the disclosures identified in the standard are the minimum necessary would be eliminated. Instead, the new language would suggest that the identified disclosures are merely an example of how companies might satisfy the disclosure objectives of the standard.
Does it make me a nerd that I feel kind of special that, of the 40 Topics in the Codification that need to be amended, we were chosen to be the only example?
I leave you with “‘Cause we are living in a material world and I am a material girl. You know that we are living in a material world…”
As followers of this blog know, the FASB recently issued an exposure draft proposing amendments to ASC 718 (see “It’s Here! The FASB’s Amendments to ASC 718,” June 9, 2015). In today’s blog, I take a look at common themes in the comment letters on the exposure draft.
A Lot Less Controversial
The FASB received just under 70 comment letters on the exposure draft, making this proposal far less controversial than FAS 123 or FAS 123(R) (by contrast, the FASB heard from close to 14,000 commenters on FAS 123(R)). In general, the letters are supportive of the proposed amendments.
Opposition to Proposed Tax Accounting
The area of most controversy under the exposure draft is the proposal to require all tax effects (both excess deductions and shortfalls) to be recognized in the income statement. Virtually all of the letters submitted mention this issue and this was the only issue that a number of letters address. A little over 70% of the letters oppose the FASB proposal. About half of the letters suggest that all excess deductions and shortfalls should be recognized in paid-in capital, instead of in earnings.
Many commenters mention the volatility the proposed approach would create in the P&L and express concern that this would be confusing to the users of financial statements. This is the argument we made in the NASPP’s comment letter (see “The NASPP’s Comment Letter,” August 18).
Here are a few other arguments in opposition of the FASB’s proposal that I find compelling (and wish I had thought of):
Several commenters refer to the FASB’s own analysis (in the Basis for Conclusions in FAS 123(R)) that stock awards comprise two transactions: (i) a compensatory transaction at grant and (ii) an equity transaction that occurs when the award is settled. They point out that it is inconsistent to recognize the tax effects of the second transaction in income when the transaction itself is recognized in equity.
Several commenters point out that the increase or decrease in value between the grant date and settlement is not recognized in income, therefore it would be inconsistent to recognize the tax effects of this change in value in income.
One commenter points out that this would merely shift the administrative burden from tracking the APIC pool to forecasting the impact of stock price movements on the company’s earnings estimates, negating any hoped for simplification in the application of the standard.
Share Withholding
The comment letters overwhelming support the proposal to expand the exception to liability accounting for share withholding. Several letters point out what appears to be an inconsistency in the language used to amend the standard with the FASB’s described intentions. While the FASB indicated in its discussion of the exposure draft that it intended to permit share withholding up to the maximum individual tax rate in the applicable jurisdiction, the proposed languages refers to the individual’s maximum tax rate. Also, the exposure draft appears to have inadvertently excluded payroll taxes from the tax rate. Hopefully these are minor issues that will be addressed in the final update.
One commenter suggests that, for mobile employees, companies should also be allowed to consider hypothetical tax rates that might apply to individuals under the company’s tax equalization policy for purposes of determining the maximum withholding rate.
Forfeitures
While the letters also were very supportive of the proposal to allow companies to choose to recognize forfeitures as they occur, I was surprised to find that a couple of letters suggested that companies should be required to recognize forfeitures as they occur.
What’s Next?
The comment period ended on August 14, so the FASB has had close to two months to consider the comments. I heard a rumor at the NASPP Conference that the Board will discuss them at one of its November meetings but I haven’t seen anything on this in the FASB Action Alerts yet. I expect that we won’t see the final amendments until next year. Given the controversy of the tax accounting proposal, possibly late next year.