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.
For today’s blog entry, I have the results of the NASPP’s Quick Survey on ASC 718, presented in a nifty interactive infographic (place your cursor over a section of each chart to see its label). (Click here if you don’t see the graphic below.)
BTW—if you are one of the 83% of respondents that haven’t yet figured out the impact of the tax accounting changes to your earnings per share, see my blog entry “Run Your Own Numbers,” for easy-peasy instructions on how most companies can figure this out in just 5 minutes. It’s a great opportunity to demonstrate your knowledge and value to your accounting/finance team.
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.
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.
Just in the nick of time to make their Q1 deadline, the FASB has issued the Accounting Standards Update to ASC 718. Now that the ASU has been issued, companies are free to adopt it.
Here are answers to a few questions you might have:
When do companies have to adopt the ASU?
Public companies have to adopt it by their first annual and interim fiscal period beginning after December 15, 2016. Private companies get an extra year to adopt it for annual periods and an extra two years for interim periods.
Do companies have to adopt the whole ASU at once?
You betcha! I’ve said it before: this isn’t a salad bar! You can’t pick and choose the parts of the ASU that you like: it’s all or nothing.
Can we adopt the ASU this quarter even though the quarter ends tomorrow?
Yep, you sure can. If you are prepared to change over to the new tax accounting procedures, have already decided whether you want to change how you account for forfeitures (and, if you are changing approaches, are ready to go with the new approach), and are prepared to comply with any other aspects of the ASU that apply to your company, you can adopt it in this quarter. But if you aren’t ready to go on any aspects of the ASU, you might want to wait until at least Q2 to give yourself a little more time.
Do we have to adopt it in this quarter if we want to adopt early?
No, this is not required. Companies can adopt it in any interim period up until they are required to adopt the update.
Are there any surprises in the final ASU?
Got me. I’m actually on vacation this week. I’m at spring training in Phoenix—where ASU stands for Arizona State University and I’m sitting four rows back behind home plate. I wrote this last week, before the FASB had issued the ASU, just in case. With the end of the quarter imminent, I wanted to have a blog entry ready to go so that any NASPP members whose employers want to adopt the ASU in Q1 would know that it had been issued. But I haven’t had a chance to do anything more than skim the ASU between innings.
I plan to have more complete coverage when I’m back in the office next week. For now, go A’s!
For today’s blog, I have a few unrelated developments in stock compensation.
HSR Act Thresholds
Good news: now executives can acquire even more stock! Under the Hart-Scott-Rodino Act, executives that acquire company stock in excess of specified thresholds are required to file reports with the Federal Trade Commission and the Department of Justice. The FTC has increased the thresholds at which these reports are required for 2016 (the thresholds are adjusted every year). See the memo we posted from Morrison & Foerster for the new thresholds, which are effective as of February 25, 2016.
If you have no idea what I’m talking about, check out our handy HSR Act Portal.
Nonemployee Accounting
More good news! The FASB is still reconsidering the accounting treatment of awards issued to nonemployees. You may recall that, as second phase of the ASC 718 simplification project, the Board directed the FASB staff to research whether it would make sense to bring awards nonemployees under the scope of ASC 718, if not for all nonemployees, than at least for those who provide services that are similar to employee services. In December, the FASB staff presented its research to the Board and the Board directed the staff to continue its research. So the possibility of awards to nonemployees eventually being accounted for in the same manner as awards to employees is still on the table.
ASC 718 Update
And while we’re on the topic of ASC 718, no word yet on when the final update will be issued for phase 1 of the simplification project. As of 12:32 AM today, the FASB website still lists the estimated completion date for this project as Q1 2016, which means we could see it any day now. However, I have heard unsubstantiated rumors that it may push into Q2, so don’t start holding your breath just yet. Personally, I’m betting on the week of March 21, because I’m presenting on it twice that week: once at the 12 Annual CEP and Silicon Valley NASPP Symposium and later in the week for a Certent webinar.
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.