It is common for boards and compensation committees to have discretion over clawback provisions, either over determining whether the clawback provision has been triggered or, once triggered, whether it should be enforced. While this discretionary authority is useful from a design and implementation standpoint, it can sometimes be problematic from an accounting perspective.
Background
Under ASC 718, expense associated with an equity award is determined on the grant date, which cannot occur before an employee and employer reach a mutual understanding of the key terms and conditions of the award. Where a key term is subject to discretion, a mutual understanding of the key terms and conditions of the award may not exist until the point at which this discretion can no longer be exercised.
In the case of clawback provisions, if the circumstances under which the board/compensation committee might exercise their discretion are not clear, this could lead to the conclusion that the service or performance necessary to earn the award is not fully defined. This, in turn, prohibits a mutual understanding of the terms and conditions of the award and delays the grant date. This delay would most likely result in liability treatment of the award.
Recent Comments from SEC Accounting Fellow
Sean May, a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed this concern in a speech at the 2016 AICPA Conference on Current SEC and PCAOB Developments, held in Washington, DC. May distinguished objectively applied clawback policies from policies that “may allow those with the authority over compensation arrangements to apply discretion.” In addition, he made the following comments:
If an award includes a key term or condition that is subject to discretion, which may include some types of clawback provisions, then a registrant should carefully consider whether a mutual understanding has been reached and a grant date has been established. When making that determination, a registrant should also assess the past practices exercised by those with authority over compensation arrangements and how those practices may have evolved over time. To that end, registrants should consider whether they have the appropriate internal control over financial reporting to monitor those practices in order to support the judgment needed to determine whether a grant date has been established.
Clawbacks and Discretion are Common
68% of respondents to the NASPP’s 2016 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting) indicate that their equity awards are subject to clawback provisions. 83% of those respondents, indicate that the board or compensation committee has some level of discretion over enforcement of the provisions.
If you are among those 83%, it might be a good idea to review the comments May made at the AICPA conference with your accounting advisers to make sure your equity awards receive the accounting treatment you expect.
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.
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.
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.
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.
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!
A recent IASB proposal to amend IFRS 2 offers hope that life under IFRS, if it ever happens for US companies, may not be quite so bad after all.
Background: Share Withholding and the IASB
One area where IFRS 2 differs from ASC 718 is that the US standard incorporates a practical exception that allows share withholding to be used to cover taxes due upon settlement of awards without triggering liability treatment, whereas IFRS 2 has never provided this exception. Thus, awards that allow for share withholding are technically subject to liability treatment under IFRS 2 (although, I’ve heard that compliance with this requirement among US companies is spotty). This seems like such a small thing but it’s actually quite significant and vexing. According to the NASPP’s data(1), share withholding is, by far, the dominant approach to collecting taxes on awards, with around 80% of respondents reporting that this method is used for over 75% of all tax events.
This requirement makes share withholding fairly unattractive under IFRS 2. If US accounting standards are ever brought into convergence with IFRS, this could have been a death knell for share withholding. The amount of variability it would introduce to the P&L could be untenable for many companies.
IASB Backs Off
I’m excited to report, however, that the IASB has issued an exposure draft of an amendment to except share withholding from liability treatment under IFRS 2, similar to the exception that currently exists in ASC 718.
For companies that use share withholding for awards issued to employees in foreign subsidiaries for which they must prepare financial statements in accordance with IFRS, this is one less item to reconcile between the IFRS and US GAAP financials. And, should the SEC ever adopt IFRS here in the US, there will be many things to worry about, but this won’t be one of them. To paraphrase Iggy Azalea (with Ariana Grande in a song that is played way too often my gym): “I got 99 problems but share withholding won’t be one!” (You had no idea they were even singing about IFRS, did you?)
Some People Are Never Happy
But wait, you say—didn’t FASB just announce an amendment to ASC 718 related to share withholding? The IASB’s amendment will align with the current ASC 718, which provides an exception for share withholding for the statutorily required tax withholding. By the time the IASB finalizes their amendment, the FASB may have amended ASC 718 to allow share withholding up to the maximum individual tax rate (even if this exceeds the statutorily required withholding). If so, IFRS 2 and ASC 718 still wouldn’t align on this point. But at least it’s a step in the right direction and maybe someone will point this little nit out to the IASB before they finalize their amendment.
More Information
For more info on the IASB’s proposed amendment and a link to their exposure draft, see the NASPP alert “IASB Proposes Amendments to IFRS 2.” Thanks to Bill Dunn at PwC for alerting me to the IASB proposal.