Stock based compensation guidance to increase income statement volatility (see update note below)

Stock based compensation guidance to increase income statement volatility (see update note below) No. US2016 03 April 19, 2016 (Revised April 25, 2016) What s inside: Background. 1 Key provisions 2 Income tax effects of share based payments 2 Forfeitures 5 Minimum statutory tax withholding requirements 7 Nonpublic entity only simplifications 8 Other notable items 9 What s next? 9 At a glance The FASB issued its final stock based compensation simplification guidance. It is meant to simplify and improve the accounting and statement of cash flows presentation for income taxes at settlement, forfeitures and net settlements for withholding tax for all entities. It also simplifies the accounting for nonpublic entities through the use of policy elections for expected term and intrinsic value. These changes will significantly impact net income, earnings per share, and the statement of cash flows. Note: The FASB staff has recently clarified its view on a particular matter related to changes entities might make to tax withholding provisions in share based payment awards as a result of the new guidance. This In depth has been updated to reflect the most recent thinking on this matter. The section affected by the revision is the PwC Observation following paragraph 21. Background.1 On March 30, 2016, the FASB issued Accounting Standards Update (ASU) 2016 09, Improvements to Employee Share Based Payment Accounting, which amends ASC 718, Compensation Stock Compensation. The ASU includes provisions intended to simplify various provisions related to how share based payments are accounted for and presented in the financial statements..2 The ASU is part of the Board s broader initiative to reduce complexity in accounting standards. The FASB initiated this project last year as a result of findings from the Financial Accounting Foundation s post implementation review of FASB Statement No. 123(R), Share Based Payment, pre agenda research for the FASB Private Company Council, and stakeholder concerns communicated in response to the Board s outreach. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 1

Key provisions Income tax effects of share based payments.3 Generally speaking, the amount of compensation cost recognized for financial reporting purposes varies from the amount a company can ultimately deduct on its tax return for share based payment awards. Currently, the tax effects of deductions in excess of compensation cost ( windfalls ) are recorded in equity, and tax deficiencies ( shortfalls ) are recorded in equity to the extent of previously recognized windfalls, with the remainder recorded in income tax expense. This required tracking of a windfall pool as a memo account, which often was a complex process..4 The new guidance requires all of the tax effects related to share based payments to be recorded through the income statement. The new guidance also removes the present requirement to delay recognition of a windfall tax benefit until it reduces current taxes payable; instead, it is required to be recognized at the time of settlement, subject to normal valuation allowance considerations. While the simplification will eliminate some administrative complexities, it will increase the volatility of income tax expense. These changes will likely simplify the bookkeeping and recordkeeping for companies by eliminating the need to track the windfall pool. However, companies should consider whether their administrative systems and processes need to be updated or changed as a result of the new guidance. Companies that use third party service providers for share based payment awards should contact their systems administrator to prepare for the change..5 The tax effects of awards will be treated as discrete items in the interim reporting period in which the windfalls or shortfalls occur. Entities should not consider them in determining the annual estimated effective tax rate used in interim periods..6 The following example illustrates the impact of the new guidance on the financial statements. Company A grants 10 million equity classified, nonqualified stock options on 1/1/2015 with a $30 exercise price equal to the grant date stock price. The options have three year cliff vesting. The grant date fair value is $15. Management has a policy to estimate forfeitures and expects eight million options to vest. Eight million options vest on 1/1/2018 and are exercised when the stock price is $50. The applicable tax rate is 40% and Company A has sufficient taxable income for deductions to reduce income taxes payable in all periods. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 2

Current Accounting Compensation Cost 8 million options x $15 = $120 million = $40 million per year over three years New Accounting No change Annual deferred tax asset recognized Treatment of taxes upon settlement $40 million x 40% = $16 million Deferred tax asset (DTA) on 12/31/2017: $120 million x 40% = $48 million Tax deduction: $50 (stock price upon exercise) $30 (exercise price) x 8 million options = $160 million Current tax benefit: $160 million (tax deduction) x 40% = $64 million Accounting for windfall benefit: Credit to APIC [calculated as $160 million (tax deduction) $120 million (book compensation cost) = $40 million (excess) x 40% = $16 million] Pool of windfall tax benefits: Increased by $16 million No change DTA: No change Tax deduction: No change Current tax benefit: No change Accounting for windfall benefit: Credit to income tax expense for $16 million No windfall pool There is no change to the point at which the windfall or shortfall should be recorded. Companies should continue to record them when the award generates a tax deduction for the company (which, depending on the type of award and the jurisdiction involved, could be upon grant, vesting, exercise, settlement, or certain disqualifying dispositions) or the award legally lapses without generating a tax deduction. It should not be based on anticipated actions or events. For example, an out of the money stock option that expires in January 2018 should not be assumed to generate a shortfall as of December 2017. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 3

Earnings per share.7 Typically, under the current guidance, anticipated windfalls and shortfalls are included in the calculation of assumed proceeds when applying the treasury stock method for computing the dilutive effect of share based payment awards in the calculation of diluted earnings per share (EPS). Because there will no longer be any excess tax benefits recognized in additional paid in capital (APIC) under the new guidance, when applying the treasury stock method for computing diluted EPS, the assumed proceeds will not include any windfall tax benefits. As a result, fewer hypothetical shares can be repurchased under the treasury stock method, resulting in an assumption of more incremental shares being issued upon the exercise of share based payment awards. Therefore, equity awards will have a more dilutive effect on EPS..8 The following example illustrates the impact of the new guidance on EPS. Company A grants one million restricted stock units (RSUs) on January 1, 2016, which cliff vest in five years. The grant date fair value was $20, the average stock price for 2016 is $25, and the applicable tax rate is 30%. No shares were forfeited during 2016. The diluted EPS calculation as of December 31, 2016 is as follows: Diluted EPS calculation Calculation of hypothetical repurchased shares Current Accounting 1,000,000 grant shares 780,000 hypothetical repurchased shares = 220,000 dilutive shares [$0 exercise price + $18m average unrecognized compensation ($20m+$16m/2) +$1.5m anticipated windfall tax benefit ($25m $20m*30%)] / $25 average stock price = 780,000 shares New Accounting 1,000,000 grant shares 720,000 hypothetical repurchased shares = 280,000 dilutive shares [$0 exercise price + $18m average unrecognized compensation ($20m+$16m/2)] / $25 average stock price = 720,000 shares Other.9 Under the current guidance, an income tax benefit from dividends or dividend equivalents that are charged to retained earnings and paid to employees for nonvested shares/share units or outstanding share options is recognized as an increase to APIC. However, under the revised guidance, the income tax benefit from dividends on stock awards will be recorded in the income statement..10 Additionally, under the current guidance, disqualifying dispositions of shares acquired through incentive stock options and/or employee stock purchase plans, stock settled stock appreciation rights, and liability classified awards for which an employee elected to have their tax liability measured on the grant date (i.e., an 83(b) election), may have resulted in a tax benefit recorded as an increase to APIC, to the extent that the tax deduction exceeded the compensation cost for financial reporting purposes. Under the revised guidance, the income tax benefit of these awards (if any) will be recorded in the income statement as a credit to income tax expense. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 4

Transition.11 The above changes will be required to be applied prospectively to all excess tax benefits and tax deficiencies resulting from settlements (or dividends declared that result in a tax deduction) after the date of adoption of the ASU. No adjustment is recorded for any windfall benefits previously recorded in APIC. Entities are no longer required to track the windfall pools upon adoption. The impact on earnings per share calculations will also be effective prospectively upon adoption of the ASU. Previously unrecognized windfalls.12 Under current guidance, the excess tax benefit and the credit to APIC for windfalls is not recorded until the deduction actually reduces income taxes payable. For example, if the company was in a taxable loss position and the windfall added to a net operating loss (NOL) carryforward, the windfall benefit would not be recorded until that NOL was actually utilized by the company to reduce its current income tax liability, even if the company could establish the recoverability of the NOL. These unrecognized tax benefits have historically been tracked separately off balance sheet but were required to be disclosed with all other available NOL carryforwards in the footnotes..13 The new guidance requires all windfalls and shortfalls to be recognized when they arise. Excess tax benefits that were not previously recognized because the related tax deduction had not reduced current taxes payable are to be recorded on a modified retrospective basis through a cumulative effect adjustment to retained earnings as of the beginning of the period in which the new guidance is adopted. The deferred tax assets recognized as a result of this transition guidance will need to be assessed for realizability in accordance with ASC 740, Income Taxes. A valuation allowance recognized for deferred tax assets recognized as a result of this transition guidance should be recognized as part of the cumulative effect adjustment to retained earnings. Any subsequent release of the valuation allowance would be accounted for in accordance with ASC 740. Statement of cash flows.14 All tax related cash flows resulting from share based payments will be reported as operating activities in the statement of cash flows under the new guidance, rather than the current requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities. The Board believes this will improve consistency, since other income tax cash flows are treated as an operating activity. Either prospective or retrospective transition of this provision is permitted for the classification of excess tax benefits on the statement of cash flows. Prospective transition is consistent with the prospective transition for the treatment of excess tax benefits in the income statement. Since excess tax benefits would continue to be recognized in APIC in historical periods, the classification of excess tax benefits in the statement of cash flows can also be adopted on a prospective basis. However, given that the information is readily available and can easily be presented, retrospective transition is also permitted. Forfeitures.15 Compensation cost is ultimately only recognized for awards with performance and/or service conditions that vest (or for awards with market conditions for which the requisite service period is satisfied). Under the new guidance, entities are permitted to make an accounting policy election related to how forfeitures will impact the recognition of compensation cost. Currently, entities are required to develop an assumption regarding the forfeiture rate on the grant date, which impacts the estimated amount of compensation cost recorded over the requisite service period. The forfeiture estimates are updated throughout National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 5

the requisite service period so that compensation cost is recognized only for awards that vest..16 Under the new guidance, entities will be permitted to make a company wide accounting policy election to either estimate forfeitures each period, as required today, or to account for forfeitures as they occur. However, there will be certain circumstances, such as at the time of a modification or issuance of a replacement award in a business combination, when it will still be necessary to estimate forfeitures. This accounting policy election only relates to the service condition aspects of awards; the likelihood of achieving performance conditions will still need to be assessed each period. If an entity modifies an award, it must still consider whether the award is expected to vest (or expected to be forfeited). If an award is expected to be forfeited (for example, it is probable that an employee will be terminated), that will impact the type of modification (e.g., Type I, II, III or IV) under ASC Topic 718 and therefore the measurement of the incremental compensation cost. Additionally, entities that are acquisitive may still need to estimate forfeitures even if the entity has adopted the policy to account for forfeitures as they occur. If replacement awards are provided in an acquisition, forfeitures must be estimated to attribute the acquisition date fair value of the replacement awards between precombination service (which is included as part of the consideration exchanged in a business combination), and the amount attributable to postcombination service (which is recorded as compensation cost). The amount attributed to precombination service is reduced for awards that are expected to be forfeited. The postcombination compensation cost then includes the amount excluded from the consideration transferred, which is exacerbated if the entity elects to account for forfeitures when they occur..17 If an entity makes an accounting policy election to account for forfeitures when they occur, an entity will need to reclassify the amount of non forfeitable dividends and dividend equivalents originally charged against retained earnings to compensation cost for awards that are forfeited in the period in which the forfeitures occur..18 If an entity elects to account for forfeitures when they occur, the entity will record a higher initial amount of compensation cost for new awards (i.e. 100% of the cost, as opposed to a lower amount assuming forfeitures), with subsequent reversals of that cost in subsequent periods as forfeitures arise. Transition.19 If elected, the new forfeiture guidance is required to be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to retained earnings for any differential between the amount of compensation cost previously recorded and the amount that would have been recorded without assuming forfeitures. Any subsequent decisions to change the accounting policy would be considered a change in accounting principle, requiring the assessment of preferability and, if preferable, retrospective application. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 6

We believe some entities may continue to estimate forfeitures, as they have sufficient historical data and processes in place to do so, while others may elect to account for forfeitures as they occur to ease some of the burden of preparing estimates. When determining the path forward, entities should carefully consider their history of modifications and replacement award issuances. Entities should consider the calculations necessary to recognize the cumulative effect adjustment upon transition, and any coordination with third party stock plan administration vendors necessary to make system adjustments. Minimum statutory tax withholding requirements.16 A stock based compensation plan may permit shares that are issued upon an employee s exercise of an option (or settlement of a stock award) to be withheld as a means of meeting tax withholding requirements. The company then remits the value of those withheld shares in cash to the tax authorities on the employee s behalf. Under current guidance, in order for a company to classify the share based award as equity, the company must not withhold taxes in excess of the employer s statutory minimum tax rate, or allow such excess withholding at the employee s discretion. Otherwise, the entire award is classified as a liability, not just the amount withheld for tax purposes..17 The new guidance allows entities to withhold an amount up to the employees maximum individual tax rate in the relevant jurisdiction, without resulting in liability classification of the award. In order to qualify, the employer must still have a statutory obligation to withhold some amount of taxes on the employee s behalf. Transition.18 This change is required to be applied on a modified retrospective basis, with a cumulative effect adjustment to opening retained earnings for any outstanding liability awards that qualify for equity classification under the ASU. Statement of cash flows.19 The ASU clarifies that all cash payments made to the taxing authorities on the employees behalf for withheld shares should be presented as financing activities on the statement of cash flows. This change should be applied retrospectively..20 The new guidance will eliminate current diversity in practice regarding classification of these cash payments, which some entities reflected as operating cash flows and some as financing outflows. Stakeholders indicated that the existing guidance was complex, as certain jurisdictions have minimum statutory withholding rates that vary by an employee s income level or may not have a minimum statutory withholding rate, resulting in any withholding driving liability classification. Additional complexities were associated with employees moving from one jurisdiction to another, increasing the burden of recordkeeping and the use of systems, processes, and controls to monitor the applicable rates. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 7

While the new guidance raises the bar for requiring liability classification by allowing the use of the highest marginal rate applicable to any employee in a particular jurisdiction, it does not remove the requirement to monitor rates and the potential impact of employees moving to other jurisdictions..21 Awards that are currently liability classified due to withholding above the statutory minimum rates, but that qualify under the revised guidance for equity classification, will need to be adjusted on a modified retrospective basis, with a cumulative effect adjustment to opening retained earnings. The adjustment is calculated as the difference between (1) the compensation cost that has been recognized based on the current fair value at the latest balance sheet date and (2) the grant date fair value (assuming the award would have qualified for equity classification at that date under the ASU). This adjustment is only required for awards still outstanding as of the date of adoption; no adjustment is required for awards that have previously been settled. Companies may want to consider changing existing tax withholding limits related to outstanding awards as a result of this new guidance. Preparers should keep in mind that a change to any term of an award could be considered a modification. There would be no impact to awards that do not have a performance condition or for which the performance condition is currently probable of occurring, as this type of change would not create any incremental fair value. However, modifications of awards that are not probable of vesting either before or after the modification typically would be considered a Type IV improbable to improbable modification, which effectively establishes a new measurement date for the award. Based on recent discussions, we understand that the FASB staff s view is that changing existing awards to allow for higher levels of tax withholding as a result of the expanded provisions in the ASU need not be evaluated as a modification. The level of tax withholding upon settlement of an award does not change the current or potential economics of the award; rather, it only changes the form of settlement. The spirit of the simplification is to make it easier for an entity to comply with the guidance it was not intended to result in a change in compensation cost. However, this accommodation is limited to changes to existing tax withholding rates in an award, and should not be applied by analogy to other situations (e.g., it would not apply if withholding provisions that had not previously existed were added to an award). We understand that the SEC staff would not object to this approach. Nonpublic entity only simplifications.22 There are two provisions that are only available to nonpublic companies: (1) a practical expedient for determining the expected term of certain share based awards, which is to be adopted prospectively and (2) a one time opportunity for a nonpublic entity to change its measurement basis for all liability classified awards to intrinsic value. For further information on the changes for nonpublic companies, see the April 12, 2016 edition of PwC s Private Company Reporter..23 For purposes of determining which entities can adopt the two nonpublic company practical expedients, the ASU uses the existing public entity definition included within ASC 718, which differs in some respects from the FASB s broader definition of a public business entity. Therefore, entities should continue to follow the ASC 718 public entity scope guidance, which includes subsidiaries of public companies, to determine the whether they are eligible to apply the nonpublic company provisions. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 8

.24 In contrast, the effective dates for the new guidance are based on the FASB s definition of a public business entity. Therefore, an entity could be prohibited from adopting the nonpublic entity practical expedients because it qualifies as a public entity under the ASC 718 definition. However, if that entity is not a public business entity, (which, for example, does not include a subsidiary of a public company), it would not be required to adopt the new guidance until the nonpublic entity effective date, discussed below. Other notable items.25 The Board decided not to finalize its proposal to align the classification guidance (i.e., whether an award is classified as equity or as a liability) for awards with repurchase (put and call) rights that are contingent on a future event within the employee s control. Several questions and concerns were raised during the comment letter process on the original Exposure Draft regarding the proposed changes. The Board indicated that it may address the accounting for repurchase features as part of a separate project focused on the guidance used to distinguish liabilities from equity..26 The Board decided to add a separate project to research potential simplifications and improvements to the accounting for share based payment awards granted to nonemployees. What s next.27 ASU 2016 09 is effective for public business entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. For all other entities, it is effective for annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Early adoption will be permitted in any interim or annual period, with any adjustments reflected as of the beginning of the fiscal year of adoption..28 The following table illustrates the required periods of adoption for a calendar year end entity. Public Business Entity Other than Public Business Entity Annual financial statements 2017 2018 Interim financial statements Q1 2017 Q1 2019 * Effective date of adoption January 1, 2017 January 1, 2018 * Assuming the entity presents interim financial information. Comparative interim financial information for Q1 2018 would be revised to reflect the new guidance at the time of issuance of the Q1 2019 interim financial information..29 If an entity adopts the ASU early, all adjustments should be reflected as of the beginning of the fiscal year of adoption. For example, if the entity adopts the guidance in the third quarter, and had windfall activity in the first and second quarter, the activity during the first and second quarter would have been recorded following current guidance (i.e., recorded to APIC). Once the ASU is adopted in the third quarter, the entity would need to recognize all excess tax benefits/deficiencies during the nine month period in the year to date income statement, as though the ASU had been in effect since the beginning of the year. When the entity next reports first and second quarter numbers (such as in the National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 9

quarterly data table in the annual report or in the following year's Form 10 Q's), the entity will need to revise the financial statements to reflect the new guidance (i.e., reflecting all windfalls and shortfalls in income). Any cumulative effect adjustments (for example, for excess tax benefits that were not previously recognized because the related tax deduction had not reduced current taxes payable) would also be calculated as of the first day of the fiscal year of adoption and recognized in opening retained earnings for the period..30 As with all newly issued accounting guidance, SEC registrants should provide the relevant disclosures required by Staff Accounting Bulletin Topic 11.M, Disclosure of the Impact that Recently Issued Accounting Standards will have on the Financial Statements of the Registrant When Adopted in a Future Period in all filings prior to adoption. While the guidance allows for early adoption, it requires that all provisions of the guidance be adopted at the same time. We encourage entities to discuss their adoption plans internally, as well as with any vendors or service providers, as there are expected to be administrative and other challenges to implementing the guidance for companies with significant share based payment activity. Questions? PwC clients who have questions about this In depth should contact their engagement partner. Engagement teams who have questions should contact the Compensation team in the National Professional Services Group (1 973 236 7802). Authored by: Jay Seliber Partner Phone: 1 973 236 7277 Email: jay.seliber@pwc.com Scott Allender Senior Manager Phone: 1 973 236 4049 Email: scott.r.allender@pwc.com Nicole Berman Director Phone: 1 973 236 4202 Email: nicole.s.berman@pwc.com Lindsey Morris Senior Manager Phone: 1 973 236 7866 Email: lindsey.morris@pwc.com 2016 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, visit www.cfodirect.pwc.com, PwC s online resource for financial executives. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 10