Gear Up—FASB’s ASC 718 Revisions Are Coming Soon
On November 23, the FASB board completed re-deliberations of the proposed amendments to ASC 718. In the end, the board affirmed all of its proposals except the one addressing reclassification of awards with repurchase features. Based on decisions made in the meeting, the FASB staff will now draft a final Accounting Standards Update for vote by written ballot.
So what was the upshot of the FASB board’s decisions?
First, the FASB board went ahead with its proposal to eliminate the APIC pool and run excess tax benefits and deficiencies through the income statement. This 5 – 2 vote really took us by surprise.
Even though this was the initial proposal, only two of the financial statement preparers that submitted comment letters agreed with it. Mostly, the reaction to the proposal was negative and intense. Running excess tax benefits and deficiencies through the income statement, respondents argued, would trigger problematic P&L volatility and trump any minor time savings created by eliminating the APIC pool tracking exercise.
The consensus among preparers of financial statements submitting comment letters was to retain the “two transactions” theory introduced in Appendix B of SFAS 123R, which suggests that the grant of a share-based payment instrument is a compensatory act that should be recognized using fair value, but the settlement of the same instrument is an equity transaction that should not have P&L implications. Get rid of the APIC pool, said commenters, but allow excess tax benefits and shortfalls to flow through APIC permanently.
So how did we end up here? The FASB was adamant that income statement volatility should not be equated with complexity if it’s the right conceptual answer. Tom Linsmeier summed it up: “The equity approach may be more supported in 123(R), but the income approach is more consistent with how we think about taxes overall.” Said differently, the board held that tax events are a function of the law and not an equity transaction the company is entering into, thus rejecting the merits of the ASC 718 two transactions theory. Supporting its position, the board argued that the earnings approach is more consistent with the recognition of other tax items where there is a permanent value difference between book and tax revenue or expense.
But the board did agree that excess tax benefits and shortfalls should be called discrete items for purposes of estimating the effective tax rate for interim reporting periods.
Eliminating the APIC pool could cause income statement volatility by requiring companies to estimate operating income as part of the estimated effective tax rate (ETR) used in interim reporting periods. Preparers could be charged with estimating future stock prices and settlement event timings, thus introducing new complexity and noise to what is already a relatively tricky process. The so-called “rate-rec” would become a giant moving target from quarter to quarter as stock prices bounce up and down.
Fortunately, the board addressed this dimension of the problem by permitting excess tax benefits and deficiencies to be considered “discrete” items that don’t need to enter the ETR calculation. There was some debate as to whether it’s conceptually correct to say stock prices are non-recurring discrete items, but the board was able to accept that the specific stock price estimates themselves are non-recurring and thus sufficiently fit the framework of a discrete item.
The net-net is that the FASB’s decision will introduce P&L volatility via settlement events that give rise to excess tax benefits and deficiencies that are recorded in earnings, but will not introduce volatility in the estimated ETR while awards are still outstanding.
That said, P&L volatility will still result from FASB’s decision to record excess tax benefits and shortfalls through earnings. Below are some ideas on how to prepare.
FASB’s decision means the APIC pool will no longer serve as a buffer to excess tax benefits and deficiencies hitting the P&L. While in our opinion volatility in the effective tax rate would have been catastrophic, even the more normal volatility from excess tax benefits and deficiencies may prove to be quite material.
To manage this, we recommend tax settlement forecasting. We’re finding that accounting departments are more sensitive to budget-to-actual surprises than they ever were in the past. Be sure to project future excess tax benefits and deficiencies across three to five different stock price scenarios (and, if issuing options, different exercise rates and prices). Since FASB’s revision will trigger much more erratic P&L activity from share-based payment instruments, scenario-based forecasts are the best way to socialize the magnitude and timing of these potential surprises.
Second, because excess tax benefits and deficiencies will flow through the P&L, we suggest that tax departments relying on overly manual and spreadsheet-based processes use this as an opportunity to reengineer and automate. The income tax accounting for share-based payment awards will come under more audit focus. Also, more flexibility will be needed to support forecasting requirements.
Forfeiture rate is now a company policy election.
The board decided to allow companies to make an accounting policy election as to whether they will estimate forfeitures or account for forfeitures when they occur. Most respondents agreed with this proposed revision. But some objected on the basis that they do not like optionality in accounting and that forfeiture rates may serve other purposes for management or users of financial statements.
The board was not overly concerned with the incremental reduction to comparability. It also felt the benefits of choice would outweigh the costs. We support the FASB staff’s views that large companies that are already familiar with forfeiture rates probably won’t take this new option, whereas smaller companies with less robust processes may appreciate the flexibility.
Because forfeiture rates are easy to use, we don’t expect any changes among companies with automated processes. Forfeiture rates add a lot of value to forecasting and budgeting exercises. They also help reduce budget-to-actual variances. A policy of recognizing forfeitures only as they occur would lead to more forecasting imprecision and higher forecast variances.
If you’re on the fence, proceed with caution. Companies that elect to stop using a forfeiture rate now will need a preferability letter if they ever want to return to using forfeiture rates in the future. Since forfeiture rates play valuable roles in more mature stock compensation accounting processes, and in practice are easy to implement and maintain, we expect to see mostly small and midcap companies choosing to record forfeitures only as they occur.
Equity classification is preserved as long as companies withhold less than or equal to the maximum statutory rate in applicable jurisdictions.
The board decided that withholding taxes up to the maximum individual statutory rate in applicable jurisdictions will preserve equity classification. Judging from the public comments, this was a popular move.
The board did raise a concern about reduced transparency of potential cash outflows if the threshold of equity classification for tax withholding is relaxed. The cash paid to withhold shares from employees is not a required footnote disclosure, which could hinder information quality. But the concern was addressed on the basis that the cash outflow will be a separate line item as a financing activity on the cash flow statement, and therefore still available to users of financial statements.
We’ve pointed out a couple of other challenges before. First, suppose two employees in the same jurisdiction have taxes withheld at the highest statutory rate, and that rate is above the applicable rate for one of those employees. At first it was unclear whether a situation like this could trigger liability accounting. The board clarified that the liability test is to be performed at the jurisdiction level. Using the US as an example, if two employees have taxes withheld at 39.6% even though one of those employees has not exceeded the $1 million supplemental income tax threshold, equity accounting is still preserved.
The other wrinkle is that this simplification may result in political complexity for stock plan administration departments. Plan administrators have spent the last decade explaining to executives that a higher withholding level is impossible because it would trigger liability accounting. Now that this argument is going away, what should the administrator say?
It turns out that withholding above the statutory minimum is also made very difficult under IRS Publication 15 and IRS Information Letter 2012-0063, none of which are affected by FASB revisions. The IRS spells out a process requiring the employee to submit an updated W-4, which will then apply to all other wage payments until replaced by a new W-4. This is only permissible for employees who have already exceeded the $1 million supplemental wage threshold. Ultimately, requests to withhold at higher levels mean much more tracking complexity, inconsistency in withholding levels, and room for error. Companies will thus need to form tight policies that fit their appetites for flexibility and standardization.
Classification of awards with repurchase features is off the table—at least for now.
The board decided not to finalize a decision regarding the classification of awards with repurchase features, for three reasons. First, the previously proposed revision would have forced companies to assess the probability of employees’ exercise actions. Second, the board agreed with the staff’s suggestion to defer this discussion until they tackle the broader debt and equity project. Last, some users argued that regardless of whether it is contingent upon the employees control, the mere existence of a put right should be classified as a liability because it requires cash outflow from the entity.
In general, awards with repurchase features are not commonly seen in public companies. We don’t think the current guidance is burdensome to our client base, but will stay tuned to future updates on this topic.
These changes are happening fast. Public companies have less than a year to get ready.
For public companies, the changes are effective for annual and interim reporting periods beginning after December 15, 2016. For private companies, the amendments will be effective for annual reporting periods beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. Early adoption will be allowed in any interim or annual period.
Early preparation is a must. Here’s our top 10 list of things to do now:
10. Get trained on the Accounting Standards Update.
9. Identify any gaps in capabilities and/or controls, as the release of new guidance may drive heightened audit focus.
8. Automate inefficient, manual processes, focusing particular attention on the tax accounting and its linkage to expense reporting.
7. Decide whether to switch away from using a forfeiture rate. (Since a forfeiture rate is useful in minimizing forecast variances, be careful when making this decision since it will be tough to switch back in the future.)
6. Consider adopting early if any of the current guidance burdens your process.
5. Form a policy on whether you will continue to withhold at the statutory minimum in the US or permit higher withholding levels for employees that request them.
4. Backtest the scope of P&L volatility you would have experienced had excess tax benefits and deficiencies always been recognized in earnings.
3. Develop a forecasting process to estimate the impact of excess tax benefits and deficiencies to the P&L across a range of future stock price scenarios.
2. Promptly socialize the results of #3 with management to make sure they are not blindsided when the volatility begins hitting.
And the number-one action you should take to prepare for FASB’s ASC 718 revisions…
1. Organize a working group to systematically work through each revision; reach out to your external provider for help.
Happy holidays, everyone! For a more comprehensive look at all the issues on the table, be sure to download our Issue Brief.
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