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.
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.
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.
This is the most controversial aspect of the exposure draft. The volatility that this change introduces to the P&L is likely to be significant for companies that rely heavily on stock compensation. We performed a very quick analysis of a handful of companies and found that, for several of them, recognizing excess tax benefits in their P&L would have increased EPS by 10%. In one case, EPS increased by 60%. Ultimately, we think this will be incredibly confusing to investors and other financial statement users. We also feel that it is highly unintuitive for changes in a company’s stock price to generate significant profits and losses for the company. While eliminating the ASC 718 APIC pool is very attractive, ultimately, we felt that the impact on earnings and effective tax rates would offset the benefits of simplifying this area of the standard. Because of this, we recommended against this amendment.
We suggested that companies record all excess tax benefits and shortfalls to paid-in capital, rather than tax expense. This would eliminate the need to track the APIC pool without impacting the P&L.
Forfeitures
We supported the proposal to allow companies to make a policy election to account for forfeitures as they occur. Our only comment on this topic was to suggest that the FASB provide a mechanism for companies to change their election without treating it as a change in accounting principle (which requires a preferability assessment and retrospective restatement).
Share Withholding
We supported the proposal to amend the standard to provide that shares can be withheld to cover taxes up to the maximum individual tax rate without triggering liability treatment.
We asked the FASB to provide additional guidance on how this requirement applies to mobile employees and suggested that share withholding be allowed up to the combined maximum tax rate in all jurisdictions that the transaction is subject to.
We also asked the FASB to remove the requirement that the tax withholding be mandated by law.
Practical Expedient to Expected Term
We supported allowing private companies to treat the midpoint of the vesting period and contractual term of an option as the option’s expected term for valuation purposes. We asked the FASB to remove the condition that the option be exercisable for only a short period of time after termination of employment and also requested removal of the conditions applicable to performance-based options.
The Rest of It and Thanks
We supported the remaining proposals in the exposure draft without comment.
Thanks to everyone that completed the NASPP’s quick survey on the exposure draft—I hope to have the results posted by the end of this week.
Thanks also to individuals who agreed to serve on our task force for this project: Terry Adamson of Aon Hewitt, Dee Crosby of the CEP Institute, Elizabeth Dodge of SOS, Sean Kelly of Morgan Stanley, Ken Stoler of PwC, Sean Waters of Fidelity, Thomas Welk of Cooley, and Jason Zellmer of Bank of America Merrill Lynch. Their help was invaluable.
Last week, I blogged that the FASB has issued the exposure draft of the proposed amendments to ASC 718. In this week’s blog entry, I cover some of the additional issues addressed by the amendments.
Cash Flow Statement
The proposed amendments suggest changes to how a couple of items should be categorized in the cash flow statement. Most significantly, excess tax benefits realized from stock plan transactions would be presented as an operating activity. Currently, excess tax benefits are reported twice in the cash statement: as a cash inflow in the financing activities and a cash outflow in operating activities. In her “Meet the Speaker interview” last summer, Ellie Kehmeier highlighted the failure to do this as a very common error that companies make, so this change will clearly be helpful.
Private Companies
It is often very difficult for private companies to estimate the expected term of option grants. To assist with this, the proposed amendments would allow private companies to use a method similar to simplified method allowed under SABs 107 and 110. I think a lot of private companies are already doing this, so I’m not sure how revelatory this is. Also, the FASB imposes the same limitations that the SEC does, (i.e., the approach can only be used for options that are exercisable for only a short time after termination of employment), making this somewhat less than helpful.
The FASB is also under the impression that there are a bunch of private companies with liability awards that did not know that they could have elected to value these awards using the intrinsic value method back when they adopted the standard and are now stuck with using the fair value method for them. The proposed amendments would give these companies a one-time opportunity to change the measurement of liability awards from fair value to intrinsic value without having to justify the change.
I don’t encounter a lot of liability awards at either public or private companies, so I am skeptical about how helpful this is, but maybe there are a bunch private companies that just cannot wait to change over to the intrinsic value method for their liability awards. Assuming they are paying attention and don’t miss this opportunity. Considering that they apparently already missed the opportunity once, I’m not optimistic. Are we going to have to go through this all again in another ten years? Maybe the FASB should just give private companies a free pass on changing the valuation method for liability awards once every ten years so we don’t have to discuss this again.
FSP FAS 123(R)-2
In somewhat more exciting news, the amendments would make permanent the guidance in FSP FAS 123(R)-2. This means that we no longer have to worry that, in the future, options that are exercisable for an extended period of time after termination of employment will be subject to liability treatment. I know you probably had forgotten that this was even a possibility, but it’s something I’ve been thinking about as I see FASB alerts that seem to indicate that the FASB is making progress on the other projects that would have impacted this. Now we all have one less thing to worry about. I also think this might be a sign that the FASB may eventually allow awards to non-employees to receive the same treatment as awards to employees—how awesome would that be!