Four Accounting Challenges US-Based Multinationals Face with IFRS 2
It’s unclear if or when IFRS will be adopted in the United States. Still, a majority of other countries have already taken the plunge and adopted IFRS in place of their local GAAP. That means most multinational US-based firms probably have foreign subsidiaries currently complying with IFRS, raising some of the issues I describe below.
1. Compliance Strategy
Parent companies face a choice in how to manage IFRS reporting for their subsidiaries.
With a low control strategy, the parent tracks award data but leaves the task of performing any calculations to the foreign-filing subsidiaries. This saves work for the US parent, but creates a lot of duplication among subsidiaries as each one creates its own process to apply the same accounting. Furthermore, the low control strategy is risky. In our experience, subsidiaries are light in stock-based compensation expertise and prone to variations in their accounting, raising the potential for error.
Given these drawbacks, we believe high control is better. With this strategy, the parent creates financial reports and provide them to subsidiaries. The non-US subsidiaries merely need to review, adjust (if appropriate), and then book. It’s more work for the parent company, but much more efficient.
2. Valuation Techniques
IFRS 2 creates a number of new accounting challenges not currently seen under US GAAP.
IFRS 2 requires separate estimation of expected life for each tranche within a grant. Because the only permitted amortization method is graded (which treats each tranche as a standalone grant), each tranche must be separately valued using a distinct expected life assumption. By contrast, under US GAAP most companies develop an overall expected term assumption for a grant (that represents an average of the tranches).
Exercise and Forfeiture Assumptions
Exercise and forfeiture assumptions need to be developed at the country level as per IFRIC 11. This requires companies to test whether employees in each country exhibit distinct exercise patterns and/or forfeiture rate patterns instead of pooling them together.
The challenge that arises is that such an approach may not improve the reliability of the estimate when sample sizes are low within countries. Judgment must be applied as to whether and how country data are pooled together when building valuation assumptions.
Lattice models may be required more frequently under IFRS 2. The reason is that the language in IFRS 2, coupled with it being a principles-based standard, makes it probable that auditors will require companies to formally compare and contrast different valuation models, then select the one that yields the best estimate of fair value.
Academic research, including that quoted within ASC 718, does note that the Black-Scholes formula can yield similar values to those produced by best-of-breed lattice models. But the research also shows that under many circumstances, the lattice model is clearly preferable over another.
3. Expense Reporting
Graded Attribution Model
Under IFRS 2, all awards must be amortized using a graded attribution model, which treats each award tranche as a standalone grant. Typically, this results in an accelerated amortization schedule, as each tranche begins vesting on the same date but ends on its own vesting date. Fortunately, this requirement is generally straightforward and shouldn’t be too burdensome for companies to adopt.
Share withholding requires subsequent selling of withheld shares in the open market to avoid liability accounting. Net-settlement provisions require that the net settlement portion of the award be accounted for as a liability. It’s unclear whether the re-measurement occurs on a fair value or intrinsic value basis.
Payroll charges are recognized as liabilities and thus remeasured each period. It’s unclear whether the re-measurement occurs on a fair value or intrinsic value basis.
4. Deferred Tax Reporting
Accounting for deferred taxes is arguably the greatest area of difference between ASC 718 and IFRS 2 (and ASC 740, formerly SFAS 109, and IAS 12, the IFRS equivalent of SFAS 109).
Deferred Tax Asset (DTA)
The first major difference is with the cumulative DTA recorded on non-statutory awards in a jurisdiction where a tax deduction is permitted. Under IFRS 2—and unlike ASC 718—the DTA is not equal to the statutory tax rate in that jurisdiction times the grant-date fair value of the awards granted. IFRS 2 requires companies to continuously update (remeasure) the DTA based on changes in the share price. Remeasurement of the DTA each period should occur on an intrinsic value basis.
IFRS 2 also eliminates the concept of the APIC pool, which exists only under US GAAP. With no APIC pool concept under IFRS, all tax deficiencies result in increased tax expense. Windfalls are thus recorded in the balance sheet (equity), but shortfalls are recorded in the income statement (in tax expense).
An important implication is that requisite period-to-period remeasurements will result in significant income statement volatility relative to the ASC 718 and FAS 109 accounting model. The absence of an APIC pool means the income statement will be directly affected. As a result of the IFRS 2 deferred tax accounting model, a company will see more frequent changes in its effective tax rate.
A number of accounting policy issues also remain unresolved. If a company finds that empirically many employees liquidate their ISOs through a disqualifying disposition, should deferred tax assets be set up during vesting (on the basis of IFRS being a principles-based standard)? Should an APIC pool be tracked at the tranche level or the award level? Should the presentation of tax windfalls and shortfalls be reported in operating cash flows or financing cash flows?
Abandoning GAAP for IFRS could be the single greatest accounting regime change ever implemented. By that, I mean it would make SOX look like a walk in the park. For that reason, it’s worth thinking through the issues companies with foreign-filing subsidiaries are facing today.
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