A 10-Step Checklist for ASU 2016-09 Preparation

Takis Makridis Xiao Yu

For most companies, Accounting Standards Update (ASU) 2016-09 is about to go live. Hundreds of companies have already adopted the revised standard. If yours isn’t one of them, and you’re not sure where to start, this post is for you. Here are 10 steps you can take to get your organization ready.

1. Forecast excess tax benefits and deficiencies across different stock price scenarios.

With the elimination of the APIC pool, excess tax benefits and shortfalls will flow directly through earnings, therefore also influencing the effective tax rate. Because these will be classified as discrete items, the effective tax rate may become particularly volatile in periods where a lot of awards are being settled.

As a result, it’s essential to get senior management familiar with earnings and effective tax rate volatility. Help them understand how sensitive both variables are to movements in the stock price by showing them examples of favorable, unfavorable, and moderate outcomes. Also consider setting up quarterly tax settlement forecasting procedures.

2. Forecast how removing excess tax benefits from the treasury stock method can affect dilutive shares.

Since excess tax benefits are being removed from the treasury stock method, awards will appear more or less dilutive depending on the current stock price. They’ll likely appear more dilutive if you have overall positive excess tax benefits.

To gauge materiality, forecast future dilutive EPS using different stock price scenarios. You can also backtest what prior diluted EPS would have been had the methodology revision been in place historically. Explain the implications to senior management.

3. Decide whether to continue applying a forfeiture rate.

Forfeiture rates have their pros and cons. We like them because they help reduce budget-to-actual variances and are still required under IFRS and modification accounting. At the same time, we’re biased because we’ve programmed forfeiture rate applications for well over a decade. Once a forfeiture rate is automated, there’s nothing to be gained from removing it.

If you do decide to get rid of it, there’s some work to do:

  • Calculate a one-time true-up to expense and deferred tax asset (DTA). The true-up to expense flows through retained earnings.
  • Adjust the language in your footnote disclosure to reflect unvested awards instead of awards expected to vest.
  • Verify that your reporting process and systems will still apply a forfeiture rate for IFRS reporting and for any assumed awards in a business combination.

4. Decide whether to decide on changing tax withholding protocols.

That’s not a typo. You don’t need to make a decision on whether to change your tax withholding procedures, since FASB’s revision merely relaxes the trigger that causes liability classification. Now, equity classification is preserved as long as withholding occurs below the statutory maximum rate. However, the IRS guidance governing withholding procedures (within the US) has not been changed or affected by the ASU. At the 2016 NASPP conference, the IRS participated in a panel discussion and conveyed that they expect companies to continue following the existing withholding procedures.

Many companies are struggling with this issue, though. We’ve discussed these concerns in our survey on the topic. But since ASU 2016-09 doesn’t require a change, you can simply decide to reassess tax withholding methods later. We think stasis is perfectly fine. The only reason to push for a change now is if executives are clamoring to withhold more shares—and this really varies from company to company. Either way, just be sure everyone (tax, payroll, executive compensation, and finance) is on the same page.

5. Recognize any suspended excess benefits for a net operating loss (NOL).

ASU 2016-09 eliminates the realization requirement in the original ASC 718. Now, excess tax benefits are recognized immediately for financial reporting regardless of whether the associated tax benefit reduces taxes payable. If an excess tax benefit is recognized ahead of a reduction to taxes payable, a DTA is set up to capture the temporary difference. That DTA needs to be tested for a valuation allowance.

Upon adoption of ASU 2016-09, companies in a NOL situation with excess benefits held in a suspense account should run those benefits through retained earnings. Then evaluate whether you need to establish a valuation allowance given the realizability of the tax benefits.

6. Make sure all financial reports have been updated and all stakeholders understand the new reporting structures.

In general, ASU 2016-09 doesn’t introduce substantially different calculations. The treasury stock method changes slightly. Abandoning a forfeiture rate doesn’t alter the inner workings of an expense attribution process. Neither does eliminating the APIC pool change the way temporary differences between book and tax rules are resolved. Even so, your financial reports will look and function differently

Specifics to be on the look-out for include:

  • Make sure that excess tax benefits are not being counted as a form of assumed proceeds in the EPS treasury stock method calculation.
  • Verify you are capturing excess tax benefits and deficiencies in your current tax expense.
  • Ensure excess tax benefits and deficiencies are included when determining your annual estimated effective tax rate (as a discrete item in the period the deduction occurs).
  • If electing to recognize forfeitures as they occur, make sure your disclosure no longer uses the “share options (or share units) expected to vest” terminology, but rather, refers to the number of “unvested share options (or share units)”.
  • If recognizing suspended excess tax benefits due to the elimination of the realization requirement, assess the need for a valuation allowance to the DTA set up.

In short, go through each element of ASU 2016-09 one by one, and review how your reports and booking procedures need to change. Map out how each revision will affect your processes. For example, excess tax benefits will be captured in the operating cash flow section of the statement of cash flows. The calculation doesn’t change, but the result is obviously going to hit the ledger in a different way.

Next, update your process documentation. Our issue brief on the revisions may be a helpful resource.

Finally, walk periphery functions (e.g., tax) through the decisions made and how they may be affected. For example, if transitioning from a static forfeiture rate application to recognizing forfeitures as they occur, this would require educating your tax team on how their numbers will likely change in the months ahead.

7. If you permit higher withholding, forecast the incremental cash burn that may materialize.

Higher withholding levels mean the company needs to write a larger check to the IRS on each award settlement. Since very few companies actually issue shares in the open market to cover the withholding checks they cut to the IRS, any uptick in withholding will translate into higher cash burn. This may be immaterial, but model it under different stock price scenarios to be sure.

8. Update control procedures in light of your policy elections and risk drivers.

A hallmark of good controls is that they reflect risk factors. In this context, then, look at how and where you should update your controls. For example, now that excess tax benefits and deficiencies will flow through earnings, you might need new controls to manage the risk of disconnects between expense reporting and tax processes. One control we expect auditors to ask for is a process to periodically prove the cumulative DTA balance by reconciling it to expense booked in the general ledger.

Alternatively, because the EPS treasury stock method computation is changing, you might need to update the control procedures that involve reperforming the calculation. The same is true if changes are being made to tax withholding policies.

Often, advanced forecasting processes can also serve as controls. For example, your tax settlement forecasts will clarify the likely boundary parameters of excess tax benefits and deficiencies. Therefore, a control could be that you will validate that current period tax effects are within the bounds of prior period forecasts.

9. If your adoption occurs in an interim period, take note of the extra calculations you need to perform.

Adoption in an interim period requires showing the full year (year-to-date) effect of the revisions. For example, isolate excess tax benefits and shortfalls recorded to APIC in prior fiscal quarters, and reclassify these amounts from APIC to the tax provision. When showing a 9-month EPS, for example, be sure it’s computed as if ASU 2016-09 had been adopted at the start of the year.

While early adoption has its benefits, it does introduce a few extra steps. And that’s a good segue to our last item.

10. When crafting your disclosure, slow down and make sure you’re making all the right points.

By October 2016, there were over 300 early adopters. We reviewed each disclosure and noticed some quality issues. Most of these involved lack of disclosure, such as not stating the forfeiture rate election or whether the excess benefit disclosure revision was being adopted prospectively or retrospectively.

You can find links to early adopter disclosures filed through October 2016 in the back of our report. After reviewing 15 to 20 of these, you will begin to get a feel for what a comprehensive and clear disclosure looks like (or doesn’t look like).

Closing Thoughts

ASU 2016-09 will certainly change stock compensation accounting. Back in 2014, we called the revisions a “mixed bag.” After supporting many of the largest early adopters, we still think so. Some companies are excited by the greater tax withholding flexibility. Others are deeply concerned about the long-run earnings volatility of recording excess tax benefits and shortfalls to earnings.

Whatever ASU 2016-09 means to you, now is the time to ensure your transition is smooth and seamless. We hope this checklist helps you get started. Give it a try and tell us what you think.