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?“
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.
I’m going to start this discussion from the end and start with the company’s tax deduction. Certain employee stock compensation transactions that result in taxable income (e.g., non-qualified stock option exercises and restricted stock vests) are eligible for a corresponding company tax deduction. For example, if an employee realizes $1,000 income on an NQSO exercise and the company’s applicable tax rate is 40%, the company is eligible for a tax deduction of $400.
However, under FAS123(R), a company can’t just wait for the transaction to take place and then book the entire tax deduction. Instead, it must try and anticipate what that tax benefit will be and book it over the same schedule as the expense accrual for the award. Because the company can’t know for sure what income will result from eligible transactions, FAS123(R) details how to go about anticipating that unknown with as a deferred tax asset (DTA).
Calculating DTA
DTA, unlike the actual tax deduction, is calculated based on the FAS123(R) valuation of the grant using the company’s current tax rate and is generally booked over the vesting schedule. For example, if the company is expensing $5,000 for an NQSO each year over a four-year vesting schedule and the company’s tax rate is 40%, the company books a DTA of $2,000 each year of the same schedule (adjusted for expected forfeitures until the actual vest date).
Back to the End
When a transaction does take place the company can calculate the actual tax deduction, which will most likely be either more or less than the DTA amount. The company reverses the DTA that was previously booked and takes the actual tax deduction. However, the difference between these two numbers must also be reconciled. If the DTA is less than the actual tax deduction (i.e., the company realized more than the anticipated tax benefit), the company adds the excess tax benefit to the paid in capital account–often referred to as the APIC pool. However, if the actual tax deduction turns out to be less than the booked DTA (i.e., the company anticipated more tax benefit than it realized), then the company reduces the existing APIC pool by the unrealized tax benefit amount–or takes a tax expense if the APIC pool isn’t sufficient.
Get More
This is, of course, just the beginning of tax accounting for equity compensation under FAS123(R)–or even just a full conversation on deferred tax assets. We have a wealth of information on the NASPP’s Stock Plan Expensing portal. We also have an in-depth webcast in the NASPP webcast archive, “Practical Guide to Tax Accounting Under FAS 123(R).” However, if you are looking for the total information package on financial reporting, including accounting for tax effects, I highly recommend the NASPP’s course, Financial Reporting for Equity Compensation. The first class is today at 12:00 PM PT, but if you miss it, don’t worry. Not only are there four more fact-filled sessions, you can catch up on the recording of today’s class and take advantage of all the bonus materials. Register now!