For today’s blog entry I have a couple of recent developments that don’t really warrant a blog entry of their own.
T+2: It’s Happening
The SEC has adopted an amendment to the Settlement Cycle Rule (Rule 15c6-1(a) of the Exchange Act) to move to T+2. The new settlement cycle will commence on September 5 (the day after Labor Day). I already blogged about this—twice—so I don’t really have any more to say on the topic (see “T+2: What’s It to You” and “Progress Towards T+2“). We hosted a great webcast on it in April (“Be Prepared for T+2“); if you aren’t up to date on this development, be sure to check it out.
FASB Issues Modification Accounting ASU
Yesterday the FASB issued ASU 2017-09 (not to be confused with ASU 2016-09—right, no one is going to get these confused), which redefines when modification accounting is required under ASC 718.
All companies have to adopt the ASU by their first fiscal year beginning after December 15, 2017. Early adoption is permitted. Once adopted the ASU applies prospectively. Unlike with ASU 2016-09, if ASU 2017-09 (yep, not confusing at all) is adopted in an interim period, prior interim periods in the same year are not adjusted.
The FASB has issued an exposure draft of the proposed accounting standards modification to bring awards granted to nonemployees under the scope of ASC 718. Here are six things to know about it.
It’s Long. At 166 pages, the exposure draft is longer than I expected. Partly it’s so long because there a million places in ASC 718 where the FASB has to replace the word “employee” with “grantee” and the word “employer” with “grantor.”
No More Mark-to-Fair Value Accounting. This is the most significant change: awards granted to nonemployees that are settled in stock will receive equity treatment, the same as awards granted to employees. This means the expense will be determined on the grant date and will be recognized over the service period, with adjustments only for forfeitures and modifications. No more mark-to-fair value accounting until the awards vest.
Contractual Term Is Still Required for Valuation Purposes. The FASB is under the impression that all options granted to nonemployees are fully transferable (seriously, I kid you not—they really think this). So they require that when computing the fair value of options granted to nonemployees, companies have to use the contractual term, not the expected term. The NASPP will be commenting about this, for sure. (If you are a company that grants options to nonemployees, I would like to know if your options are transferable or not—email me at bbaksa@naspp.com).
The Expense Attribution Rules are Confusing. I had expected that expense for awards to nonemployees would be attributed in the same manner as awards to employees, but the exposure draft requires the expense to be attributed as goods or services are received, in the same manner that expense would be recorded for cash compensation. I don’t know beans about accounting for cash compensation (unless its in the form or SARs or RSUs), so I don’t know what that means. Ken Stoler of PwC assures me that it simply provides more flexibility for awards to nonemployees and that companies can probably record expense in the same way they record expense for their employee awards.
Performance Award Accounting is Improved. Currently, ASC 505-50 requires that expense for (non-market) performance awards granted to nonemployees be recorded at the lowest possible payout, which is frequently $0. The exposure draft proposes to align the treatment of nonemployee performance awards with that of employee awards: that is, expense would be recorded based on the expected payout, which makes infinitely more sense.
Comments Are Due By June 5. You can submit comments via the FASB website or email them to director@fasb.org. You can also mail a letter to the FASB but I’m not going bother listing the address here because who actually mails letters anymore?
Last week, I blogged about the FASB’s recent update to ASC 718, which clarifies when modification accounting is required for amendments to outstanding awards. The genesis for this update is the amendments companies are making to their share withholding provisions in light of ASU 2016-09. So the question is: will the update be final in time for companies to rely on it for their share withholding amendments?
Timing of Share Withholding Amendments
Calendar-year public companies have to adopt ASU 2016-09 by this quarter and presumably will want to amend the share withholding provisions in their plan at the same time or shortly thereafter. Unfortunately, the update on modification accounting (which doesn’t have an official number yet) won’t be issued until April, at the earliest.
Consider Waiting
One obvious alternative is to wait until the update is issued to amend plans and award agreements. But companies with major vesting events happening before then may want to amend their plans and awards sooner.
Hope for the Best
Once the update is issued, companies can adopt it early. The update clearly won’t be issued in time for it to be adopted in calendar Q1, but companies should be able to adopt it in calendar Q2. When companies adopted ASU 2016-09 in an interim period, they were required to apply it to prior interim periods in the same year. We don’t know for sure that this requirement will apply to the update on modification accounting, but it seems reasonable to assume that it will (it applies to many, if not all, ASUs issued lately by the FASB).
Thus, if calendar-year companies amend their awards in Q1 and account for the amendments as modifications, it’s possible that early adopting the modification accounting update would allow them to reverse that treatment.
Maybe Auditors Won’t Make Companies Wait for the Update
Lastly, my understanding is that—even without the FASB’s update—some auditors don’t think amending a share withholding provision requires modification treatment. The few comment letters that opposed the update did so on the basis that it is unnecessary because this conclusion can already be reached under the current standard.
The FASB’s recent vote on the update (which was unanimous with respect to the question of when modification accounting should be required) provides a clear indication of the board’s attitude. Given that, perhaps the actual issuance of the final update is a mere formality and most (maybe all) auditors will come to the conclusion that modification accounting isn’t required for share withholding amendments even without the final update. But I wouldn’t assume this without discussing it with your auditors.
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.
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.