Share-Based Payment Accounting Simplifications Executive Summary In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-09 Compensation Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, to address clarity, comparability and the economics of stock-based compensation transactions. The amendments are applicable to all companies that issue share-based payment awards to their employees, and could have a significant impact on net income, earnings per share (EPS) and the statement of cash flows upon adoption. The new guidance requires recognition of the income tax effects of share-based payment transactions in the income statement upon award vesting or settlement, eliminating additional paid-in capital (APIC) pools and revising the amount of employee shares an employer is allowed to withhold to meet the employer s minimum statutory withholding obligation without triggering liability classification, e.g. awards with repurchase features. The update also changes the classification of excess tax benefits, clarifies the classification of employee taxes paid in the statement of cash flows and offers a simplified accounting alternative for award forfeitures. In addition to the amendments applicable to all entities, ASU 2016-09 adds two practical expedients to simplify accounting for nonpublic entities. A nonpublic entity is defined in Topic 718 generally as an entity whose equity securities do not trade in a public market. The practical expedients will allow nonpublic companies to more easily estimate the expected term for all awards with performance or service conditions that have certain characteristics; it may make a one-time change in accounting principle to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. Public business entities must apply the amendments in ASU 2016-09 for annual periods beginning after December 15, 2016, and interim periods within those annual periods. All other entities must apply the amendments for annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Companies are permitted to early adopt in any interim or annual period, provided it adopts all the amendments in the same period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the interim period s fiscal year. Entities will adopt the new guidance on a prospective, retrospective or modified retrospective basis, depending on the provision. In addition to the simplifications, the update eliminates the guidance in Topic 718, Compensation Stock Compensation, which was indefinitely deferred shortly after the issuance of FASB Statement No. 123 (revised 2004), Share-Based Payment. This should not change current practice since the superseded guidance was never effective. Accounting for Income Taxes upon Award Settlement or Vesting Immediate Recognition of Excess Tax Benefits & Deficiencies The largest potential benefit the ASU offers to companies is simplifying the accounting for the income tax consequences of a stock compensation award upon settlement or vesting. FASB is eliminating the requirement to recognize excess tax benefits in APIC pools, and instead requiring companies to record all excess tax benefits and deficiencies at settlement/vesting or expiration in the income statement.
As an overview, for all awards companies recognize compensation expense on stock compensation awards throughout the vesting period of the award and simultaneously recognize the future tax benefit of taking the tax deduction upon award exercise or vesting as a deferred tax asset. Excess tax benefits and deficiencies are due to the differences between the deferred tax asset recognized throughout the compensation period and the actual tax benefit calculated based on the fair value of the award when the shares vest, the options are exercised or expire. Under current standards, stock compensation excess tax benefits and deficiencies are recorded under a split model. Upon settlement, if the deduction for a share-based payment award for tax purposes exceeds the compensation cost for financial reporting purposes, the extra tax deduction is recognized in APIC and referred to as a windfall. The basis for the current approach is that share-based payment awards are considered two transactions, compensatory at the grant date and equity relating to changes in the fair value of the award after the grant date. In essence, the tax effects of excess tax benefits are allocated between equity and income tax expense. Current and future tax deficiencies, or shortfalls, are recorded as an offset to accumulated excess tax benefits, commonly referred to as the APIC pool or windfall pool. Shortfalls occur when the actual tax deduction is based on a stock that has declined in value, and the tax benefit is less than the amount accumulated as a deferred tax asset. Shortfalls are recognized in equity to the point where they offset accumulated windfalls in the APIC pool; at which point, they are recognized in the income statement as a reduction of tax expense. ASU 2016-09 requires entities to recognize the tax effect of the difference between the deduction for an award for tax purposes and the cumulative compensation cost of that award as income tax expense or benefit in the income statement eliminating the complications of tracking an APIC or windfall pool to determine amounts to be charged to APIC and to income tax expense for tax deficiencies. Current model critics expressed the methodology, which requires special tracking of settlements, may result in disparate outcomes for the same economic transactions based solely on whether a company has built up a windfall pool. However, under the new standard entities may experience increased volatility of income tax expense, net income and earnings per share. Effective Tax Rate Companies should recognize the tax effects of exercised or vested awards as discrete items in the reporting period in which they occur, e.g., quarterly, and, to avoid volatility, should not consider them in determining the annual estimated effective tax rate. Earnings per Share Because companies will no longer recognize windfall tax benefits in APIC, the amount is excluded from the hypothetical proceeds used to repurchase shares under the treasury stock method when computing EPS. Transition Companies will prospectively apply these provisions. FASB concluded the cost to determine the cumulative-effect adjustment between APIC and retained earnings for the amount of excess tax benefits and tax deficiencies recognized in APIC would not be justified by potential benefits. Thus, APIC existing at the transition date will remain in APIC. 2
An entity must still determine for each share-based payment award whether the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes results in either an excess tax benefit or deficiency. Although entities will recognize excess tax benefits or deficiencies in the income statement immediately, amounts should be recorded as a deferred tax asset on the balance sheet until the related tax benefit is actually realized. The ASU will ease a company s administrative burden, but will increase income statement volatility because the tax effects of a stock-based compensatory arrangement will be reflected in an entity s results of operations, with no portion to equity. The ASU will impact a company s income tax expense, effective tax rate and EPS. It should be noted that under existing income tax disclosure requirements users should have the information to understand the reason for the volatility of income tax expense, effective tax rate and EPS. In addition, budgeting and forecasting may become more of a challenge. Immediate Recognition of Deferred Tax Asset Under current standards, only realized benefits of tax return deductions in excess of compensation cost recognized are a credit to APIC. Thus, a share option exercise that results in a tax deduction before the actual realization of the related tax benefit payable, e.g., when an entity has a net operating loss, is not recognized as a credit to APIC until that deduction reduces taxes. Instead, the windfall is tracked off-balance sheet. ASU 2016-09 requires entities to recognize excess tax benefits, regardless of whether the tax deduction reduces taxes payable, eliminating the burden of tracking the reduction in income taxes payable off-balance sheet. The update aligns the requirement for entities to immediately recognize deferred taxes to the overall principle in income tax accounting to recognize the effects of a temporary difference as a deferred tax asset or liability. Companies will apply this part of ASU 2016-09 using a modified retrospective transition method. Upon transition to the new guidance, entities will make a one-time adjustment to create a deferred tax asset to recognize windfalls not previously recorded as a cumulative effect adjustment to retained earnings. An entity will need to assess whether a valuation allowance should be booked against the asset, which would also flow through retained earnings. Entities would account for any subsequent release of the valuation allowance in accordance with the standards on accounting for income taxes. Classification of Excess Tax Benefits on the Statement of Cash Flows An entity must still determine for each share-based payment award whether the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes results in either an excess tax benefit or deficiency. Under current standards, entities are required to present excess tax benefits as hypothetical cash inflows from financing activities, under the premise they represent cash retained because of the tax deductibility of increases in the value of the equity instruments. Likewise, entities classify cash it would have paid for income taxes if the increase in the value of equity instruments had not been deductible in determining taxable income as a hypothetical cash outflow from operating activities. New requirements simplify the cash flow presentation. Companies will present the cash flows related to excess tax benefits combined with other income tax cash flows as an operating activity. Entities may elect to implement the change retrospectively for all periods presented or a prospective transition method. 3
Accounting for Income Taxes Upon Vesting or Settlement of an Award Current U.S. Generally Accepted Accounting Principles Accounting for Excess Tax Benefits & Deficiencies: Excess tax benefits windfalls are recognized in APIC, and tax deficiencies shortfalls are recognized either as an offset to APIC, if any, or in the income statement. APIC recordkeeping is maintained outside the primary system. Excess Tax Benefits That Do Not Decrease Income Taxes Payable: When an option is exercised or a share vests and the related tax deduction does not decrease income taxes payable, e.g., increases a net operating loss carryforward, companies postpone recognition of the excess tax benefits. Income taxes payable record keeping is maintained outside of the primary accounting system. Statement of Cash Flows: Companies are required to present excess tax benefits separate from other income tax cash outflows as a cash outflow from operating activities and a cash inflow from financing activities. ASU 2016-09 Accounting for Excess Tax Benefits & Deficiencies: Companies will recognize all excess tax benefits windfalls and deficiencies shortfalls as income tax expense or benefit in the income statement. APIC recordkeeping is no longer required. Excess Tax Benefits That Do Not Decrease Income Taxes Payable: Companies will recognize excess tax benefits, e.g., recognize a deferred tax asset, on the balance sheet regardless of whether the benefit reduces income taxes payable in the current period. Income taxes payable recordkeeping is not maintained outside the primary accounting system. Statement of Cash Flows: Companies will present cash flows related to excess tax benefit as operating activities along with other income tax cash flows. Transition Requirements Transition Method Prospective transition method Transition Method Modified retrospective transition method with a cumulative effect adjustment to retained earnings for excess tax benefits not previously recognized Transition Method An entity may elect to apply the amendments using either a prospective transition method or retrospective transition method for all periods presented Minimum Statutory Tax Withholding Requirements Employee share-based payment arrangements often contain provisions for either direct or indirect (through a netsettlement feature) repurchase of shares issued upon exercise of options (or the vesting of non-vested shares). These provisions permit or require an entity to deduct from the total number of shares that would otherwise be issued to the employee a sufficient number needed to equal the monetary value of the employee s tax obligation. In essence, the company is settling the share-based award partially in stock and in cash. 4
One of the requirements for an award to qualify for equity classification is that an entity cannot partially settle the award in cash in excess of the employer s minimum statutory withholding requirements. Thus, if the fair value of the shares withheld exceeds the employer s minimum statutory withholding requirement, companies are currently required to measure and classify the entire award as a liability versus equity. FASB is changing the exception threshold, making it easier for an entity to qualify for equity classification as well as gather the required tax rate information. Under the amendments, a partial cash settlement of an award for taxwithholding purposes would not result, on its own, in liability classification of the entire award provided the amount that is withheld or may be withheld at the employee s discretion does not exceed the withholding amount calculated using the employee s maximum individual statutory tax rate in the applicable jurisdictions. The maximum statutory tax rates are based on the applicable rates of the relevant tax authorities, e.g., federal, state and local, including the employee s share of payroll or similar taxes, as provided by tax law, regulations, or the authority s administrative practices. The maximum statutory rates should not exceed the highest statutory rate in that jurisdiction, even if it exceeds the highest rate that may be applicable to the specific award grantee. To qualify for equity classification, the employer must have a statutory obligation to withhold taxes on the employee s behalf. Amendments on minimum statutory holding requirements should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. When determining the cumulative-effect adjustment, an entity shall assess only liability classified awards that have not been settled by the effective date. Companies are faced with a new maximum threshold and will want to consider how to best adopt the standard and evaluate its withholding policy. For example, a company could apply the threshold on an employee-by-employee basis and choose not to withhold at the maximum rate for all employees. ASU 2016-09 is intended to simplify the arduous exercise of determining and tracking minimum statutory tax withholding requirements. However, companies also are cautioned to be aware of the minimum amount required under tax law. Many agreements do not allow withholding more than the minimum amount required to be withheld under tax law. Statement of Cash Flows The amendments require an employer to classify the cash paid to a taxing authority on the employee s behalf when directly withholding shares for tax-withholding purposes as a financing activity on the statement of cash flows. In substance, the employer issues a gross number of shares to the employee and then repurchases a portion of those shares; the economics are consistent with other repurchases of an entity s equity instruments. Current Generally Accepted Accounting Principles (GAAP) does not include specific guidance about the cash flow classification for those transactions. Entities presenting the cash flow as an operating outflow will be required to make an adjustment upon adoption. Entities should adopt amendments on the presentation of employee taxes paid on the statement of cash flows when an employer withholds shares to meet minimum statutory withholding requirements retrospectively. 5
Statutory Tax Withholding Requirements Current U.S. GAAP ASU 2016-09 Transition Requirements Liability Classification Threshold For an award to qualify for equity classification, the entity cannot partially settle the award in cash in excess of the employer s minimum statutory withholding requirements. Statement of Cash Flows No guidance Liability Classification Threshold Companies may withhold up to the employee s maximum statutory rate (marginal tax rate) in a given jurisdiction without triggering the liability classification of the award. Statement of Cash Flows Cash paid by an employer when directly withholding shares from an employee award for tax-withholding purposes, should be classified as a financing activity, consistent with the repurchase of an entity s equity instruments. Liability Classification Threshold Companies would apply the proposal to outstanding liability awards at the date of adoption using a modified retrospective transition method, with a cumulative-effect adjustment to retained earnings. Statement of Cash Flows Apply retrospectively Accounting for Forfeitures ASU 2016-09 allows an entity to make an entity-wide accounting policy election to recognize the impact of forfeitures on compensation cost in the period the award is forfeited or to estimate the effects of forfeitures in its initial accrual of compensation cost, as currently required. Under either method, entities accrue compensation cost over the requisite service period only for share-based awards with performance or service conditions expected to vest and ultimately recognize compensation cost for all awards that vest. Under current standards, an entity estimates at the grant date the number of awards, which the requisite service period is expected to be rendered, and the amount of estimated award forfeitures, i.e., awards that will not vest because employees do not provide the necessary service to earn the awards. Entities revise the estimates if subsequent information indicates the actual number of instruments likely to be rendered differs from previous estimates. Entities adjust compensation cost in the period of change for the effect of the change in estimated rate of forfeitures, and the differences between expectations and actual experience. Forfeiture estimates are trued-up through the vesting date, so the total amount of compensation costs are only for those awards that ultimately vest. Adjusting compensation costs to reflect the entity s best estimate of vested awards entails tracking forfeiture estimates, often complex and costly. However, this method generally provides a more accurate reflection of periodic compensation cost from the grant date forward. Conversely, reversing previously recognized compensation cost in the period the award is actually forfeited (the option available under ASU 2016-09) may lead to increased financial statement volatility. 6
The entity-wide election would apply to all share-based awards with service conditions. For awards with a performance condition, when determining accrued compensation cost, an entity will continue to assess at each reporting period whether it is probable the performance condition will be achieved, as well as whether the employee will render the requisite service period. Entities are required to recognize compensation cost in the period it becomes probable the performance target will be achieved and represent the compensation cost attributable to the period(s) for which the requisite service period has already rendered. The optional accounting policy to account for forfeitures when they occur does not change an entity s requirement to record compensation cost based on a determination of whether an award with a performance condition will vest. For awards that vest upon the satisfaction of both a service condition and one or more performance conditions, the entity must initially determine which outcomes are probable of achievement. Companies will recognize the compensation expense most probable on the grant date, or on a date after the grant date when the condition becomes probable. An entity with an accounting policy for forfeitures when they occur would assume the achievement of a service condition is probable when determining the amount of compensation cost to recognize unless the award has been forfeited. Companies would implement the guidance using the modified retrospective transition method, with a cumulativeeffect adjustment to beginning retained earnings. Entities electing to account for forfeitures as they occur will be subject to new disclosure requirements in Topic 718 to include information about unvested awards rather than awards expected to vest. Transition to the actual method of accounting for forfeitures requires a cumulative effect adjustment to beginning retained earnings in the year of adoption. Because of this, companies will want to ensure their stock compensation vendor has the ability to get the required information. After initial implementation, companies will need to update processes and controls to track and record actual forfeitures. Companies will want to consider this change carefully; any change back to the estimation method will be a change in accounting principle (requiring a preferability assessment and retrospective application). In addition, the policy election does not apply to the exchange of replacement awards in a business combination. Entities active in business acquisitions would need to maintain a dual approach of accounting if electing to expense forfeitures when they occur; which may not result in simplification. 7
Accounting for Forfeitures with Service Conditions Current U.S. GAAP ASU 2016-09 Transition Requirements Companies are required to estimate forfeitures resulting from employees failure to satisfy service conditions in awards, so accruals of compensation cost over the vesting period are based on the number of awards expected to vest. Companies could do either in an entity-wide accounting policy election: Estimate the number of awards expected to vest (current GAAP), or Recognize forfeitures as they occur Companies would apply the proposal using the modified retrospective transition method with a cumulative-effect adjustment to retained earnings. The company would make an entity-wide accounting policy election of its choice when implementing the guidance. Nonpublic Entity Provisions FASB is proposing two updates for entities that meet the definition of a nonpublic entity as defined in Topic 718 and as an entity whose equity securities do not trade in a public market. Estimating the Expected Service Term Under U.S. GAAP, all companies are required to estimate the period of time that an option will be outstanding until exercised, assuming that it vests, e.g., the expected term. The estimate should incorporate experience about employees behavior, which is often challenging for nonpublic companies and private equity firms. ASU 2016-09 allows nonpublic companies to elect a practical expedient to estimate the expected vesting period, commonly referred to under SEC guidance as the simplified method allowable for certain plain vanilla share options. If an entity elects this practical expedient, the entity must apply it to all qualifying awards. If a qualifying award only includes a service condition, an entity would estimate the expected term as the midpoint between the vesting date and contractual term. If vesting of an award includes a performance condition, an entity would first assess at the grant date whether the performance condition is probable of being achieved. If probable, an entity would estimate the expected term as the midpoint between the requisite service period and the contractual term of the award. If not probable, an entity would estimate the expected term as the contractual term if the requisite service period is implied. An implied service period is one that is not explicitly stated, but inferred based on the achievement of the performance condition at some undetermined point in the future. If not probable and the service term is explicitly stated, the entity would estimate the expected term as the midpoint between the requisite service period and the contractual term. The practical expedient codifies a method often used by nonpublic companies when sufficient historical experience is unavailable. It extends the simplified method to all private companies even where historical information may be available and expands the practical expedient to awards with performance conditions. The practical expedient applies to all awards except those with market conditions. The practical expedient applies only if the award is granted at the money, the employee has a limited time to exercise the award if the employee terminates service after vesting, and the employee cannot sell or hedge the award,. employee can only exercise the award). 8
Nonpublic companies would transition to the new rules using the prospective transition method, applied to all awards measured at fair value after the effective date. If an entity does not make the accounting policy election to apply the practical expedient, the private company must use historical exercise data to develop the expected term assumption. Nonpublic Company Measurements When the Award Includes a Performance Condition At the grant date, the performance condition is probable to occur Estimate the expected term as the midpoint between the requisite service period and the contractual term At the grant date, the performance condition is not probable to occur If the requisite service period is implied, estimate the expected term as the contractual term If the requisite service period is explicitly stated, estimate the expected term as the midpoint between the requisite service period and the contractual term Measurement of Liability-classified Awards at Intrinsic Value Under Topic 718, nonpublic entities were provided an option to make a policy election for a finite period of time to measure all share-based payment liabilities at intrinsic value instead of fair value. Intrinsic value is the difference between the fair value of the underlying shares and its exercise price. Companies are generally not permitted to switch from measuring all liability-classified awards at fair value to intrinsic value because fair value is preferable under ASC 718. ASU 2016-09 permits a one-time change in accounting principle without assessing preferability and restating financial statements. Non-public companies will still use fair value for equity-classified awards. Companies will transition to the new rules using the modified retrospective method with a cumulative-effect adjustment to retained earnings, reflecting the carrying amount of liability-classified awards that have not been settled as of the effective date from fair value to intrinsic value. Disclosure Requirements FASB decided to require only some of the transition disclosures for a change in accounting principle, as required in ASC 250, Accounting Changes and Error Corrections. In the first interim and annual period of adoption, an entity would include the nature and reason for the change in accounting principle and, quantitative information about the cumulative effect of the change on retained earnings, or other components of equity or net assets as of the beginning of the adoption period. An entity is not required to quantify the income statement effect of a change (direct and indirect) in the period of adoption. Next Steps ASU 2016-09 is part of FASB s ongoing simplification initiative designed to reduce cost and complexity of accounting standards while maintaining or improving the usefulness of financial statement information. The amendments call for simplified share-based payment accounting guidelines, but implementation may be a daunting task. For example, a company making an accounting policy election to account for forfeitures when they occur will need to calculate the effect on beginning retained earnings in the year of adoption, and review its processes and controls around tracking actual forfeitures. Companies will need to consider operational considerations on processes and controls necessary to implement and sustain the accounting requirements of ASU 2019-06, and prepare for the impact of immediately recognizing excess tax benefits/deficiencies and forfeitures on an actual basis, if elected. 9
FASB will continue to address various aspects of income tax reporting in 2016. Among items on its agenda is a review of income tax disclosures and a research agenda project to address the presentation of tax expense/benefit. In 2015, FASB issued exposure drafts proposing to simplify income tax rules for intra-entity asset transfers and the balance sheet classification of deferred taxes. For more information on the 2015 exposure drafts, refer to BKD s article Simplifying Income Tax Accounting. For more information on how the amendments could affect your organization, contact your BKD advisor. Contributor Connie Spinelli Director 303.861.4545 cspinelli@bkd.com 10