FASB’s ASC 718 Revisions Might Happen a Lot Sooner Than We Think

On February 4, FASB met to discuss next steps and transition considerations for the proposed revisions to ASC 718, an event we discussed in our issue brief from November 2014 (FASB’s Proposed Changes to ASC 718), which we’ve now updated. After listening to the meeting and reviewing the minutes, it’s pretty clear FASB is 100% serious about moving forward quickly.

We expect to see an Exposure Draft in April or May. Most likely, public companies will get an effective date of December 15, 2016. Then again, one board member hinted that a full year sooner isn’t out of the question. We’ll see.

Meanwhile, here are some of our reactions.

ASC 718 Revision: Elimination of APIC Pool

Transition Method: Prospective

This is the topic we’re most concerned about, and we know many of our clients are too. Now that we’re 10 years into ASC 718 compliance, tracking an APIC pool shouldn’t be that hard. We’ve been automating these procedures for our clients since 2006. We look at this revision as trading a semi-easy tracking problem for income statement volatility, which our clients aren’t excited about.

Prospective transition means that starting on the effective date, all future settlements that would have been recorded to APIC under the current guidance will instead be run through the P&L. There will be no cumulative-effect adjustment.

Since it looks like this revision might actually go through, there are a few things you need to do. First, implement tax settlement forecasting processes. If stock price volatility and tax rate changes can trigger charges to the income statement, you’ll want to run quarterly or semi-annual forecasts of future settlement events across stock price and tax rate scenarios to understand sensitivities.

Second, we’re developing backtests for some of our clients so they can explain to senior management how their financials would have looked had the APIC pool never existed. While history doesn’t predict the future, a historical backtest can make an abstract regulatory change like this more tangible to stakeholders.

Third, while not relevant to our clients, companies with manual tax processes may view elimination of the APIC Pool as just the “spark” they need to streamline and automate their processes in order to avoid calculation errors or imprecision that will (going forward) directly affect the P&L.

ASC 718 Revision: Minimum Statutory Withholding

Transition Method: Modified Retrospective

We’re pleased with this revision since multinational companies have really struggled to prove that their withholding rates are below the minimum statutory level, especially considering some jurisdictions don’t have minimum levels or employee mobility.

For companies with aggregated expense-level data, determining the cumulative-effect adjustment might be hard. We think calculations should be done at the grant level. In other words, calculate cumulative expense for all liability-classified awards as if equity classification had been in place at grant. This way, any excess (shortfall) that you book over the cumulative expense will reduce (increase) equity.

ASC 718 Revision: Forfeiture Rate Option

Transition Method: Modified Retrospective

We’re still surprised by this one. While we remember those late nights back in 2006 struggling with how to apply a forfeiture rate in an algorithmic way, nine years later we think this area of ASC 718 compliance is easy. We don’t expect many of our clients to revert to recording forfeitures as they occur.

In fact, our clients like applying a forfeiture rate for a few reasons. One is that it lets you smooth expense. Another is because it helps to align actual expense values with forecasts; given how sensitive senior managers are to forecast variances, not using a forfeiture rate seems like a step in the wrong direction. Finally, forfeiture rate application is automated, so removing it doesn’t save time or money.

FASB staff suggested letting companies decide whether to transition via modified retrospective or prospective. The board didn’t like that idea. Tom Linsmeier said it created a “hornet’s nest” for users of financial statements. So FASB opted to permit only modified retrospective.

For companies electing to stop estimating forfeitures ex ante, modified retrospective transition means analyzing all outstanding awards and measuring, as of the effective date, the embedded forfeiture rate discount. This analysis should be performed on a grant-by-grant basis.

ASC 718 Revision: Removal of Realization Requirement

Transition Method: Modified Retrospective

The so-called “realization requirement” in ASC 718 serves to delay the recognition of excess benefits for companies that are currently in a loss position for tax purposes. It does likewise for companies that have current taxable income, but have tax loss and credit carryforwards available to offset any tax liability. Recognition of the excess tax benefit is suspended until it can serve to reduce taxes payable.

Modified retrospective transition will mean that settlements on all outstanding awards (both historical and future) that did not give rise to an excess benefit due to the benefit not being realizable need to be quantified and recorded through equity on a cumulative-effect basis. Going forward these windfalls will run through the P&L in the same way that shortfalls will.

ASC 718 Revision: Excess Benefit Reporting

Transition Method: Retrospective

We don’t have strong opinions about the decision to capture excess benefits entirely as an operating cash flow (instead of reclassifying excess benefits out of the operating section and into the financing section). We think retrospective transition will be easy since there’s no change in calculation methodology, only the location of the disclosure.

ASC 718 Revision: Withholding Taxes Disclosure

Transition Method: Retrospective

Consistent with the prior revision, we’re comfortable with the overall implications. Retrospective transition will also be straightforward for the same reason that the change affects only how information is presented and not how it’s calculated.

ASC 718 Revision: Awards with Repurchase Features

Transition Method: Retrospective

This revision will affect certain outstanding liability awards that can now receive equity classification. Transition will entail classifying the current carrying value of liability awards to equity where the revised guidance allows equity classification.

The board also asked FASB staff to research certain put rights that may trigger mezzanine classification (instead of pure liability classification). That means we’ll probably see more carefully written guidance that also covers any unique mezzanine classification situations.

ASC 718 Revision: Expected Term Estimation (Private Companies Only)

Transition Method: Prospective

Transition will be simple since companies will have the option to use the SEC Simplified Method to estimate expected term for new awards issued after the effective date. Since most private companies are already doing this for their service condition-only awards, the only change we anticipate is incremental simplification for options with performance conditions (where, technically, the SEC Simplified Method is not currently permitted).

ASC 718 Revision: Intrinsic Value for Liability Awards

Transition Method: Modified Retrospective

We don’t know a lot of private companies that have liability-classified awards, but this revision will be welcomed by those who do. Calculating the cumulative-effect adjustment won’t be hard so long as detailed backup exists for life-to-date expense recorded on outstanding liability awards. (The reason is that this amount will be subtracted from the total intrinsic value on all outstanding liability awards.)

What Most Companies Care About Most: TIMING

Finally, FASB discussed the timing of adoption and whether to offer an effective date in its exposure draft. Up until this point in the board meeting, all topics submitted for vote were resolved on a 7-0 basis. But this time, FASB voted 4-3 against including an effective date in the exposure draft. The idea floated in the meeting was to require revisions in all fiscal years and interim financial statements after December 15, 2016. But Linsmeier said that the exposure draft contained such a “potpourri of different sets of issues” that it would be best to give companies a chance to react before setting an effective date. He added that reactions might be so positive, adoption could occur in fiscal years and interim periods after December 15 of this year.

Our take? Transition to the revised guidance shouldn’t be excessively costly. We certainly don’t see any major difficulties transitioning our clients. The bigger problem is with companies reacting negatively to the APIC pool revision and the problems they associate with running excess benefits and shortfalls through the income statement.

By keeping silent on an effective date in the exposure draft, FASB will also gauge whether to implement one effective date for public and private companies or give private companies an extra year to transition. The current preference seems to be toward only one effective date.

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