2015-Issue 14—The Financial Accounting Standards Board (FASB) is working on a project to simplify accounting and tax accounting for stock-based compensation under Accounting Standards Codification (ASC) Topic 718 (formerly known as FAS 123(R)). These proposed changes will have a significant impact on tax accounting related to stock-based compensation and are a significant departure from the rules that have governed accounting for stock compensation for the last 10 years.
The FASB is currently working on an exposure draft of the proposed rules, which it expects to release soon. The exposure draft will have a 60-day comment period, and the FASB hopes to have final rules in place before the end of 2015. This edition of Tax Advisor Weeklyprimarily discusses the proposed changes related to tax accounting, but also touches on other non-tax accounting items.
Overview of Tax Accounting for Equity Awards
Generally, equity awards are accounted for under ASC 718 by recognizing compensation expense based on the fair value of the award on the date of grant. The compensation expense is generally recognized over the vesting period of the award. As the compensation expense is recognized, a corresponding deferred tax asset (DTA) is established based on the compensation expense and the company’s tax rate. The DTA continues to accumulate until the award is settled (e.g., vesting of restricted stock, exercise of stock option).
Windfalls, Shortfalls and the APIC Pool
Current Rule: Companies account for the settlement of an award (e.g., restricted stock vesting, stock option exercise, etc.) by comparing the benefit of the company’s tax deduction related to the award to the DTA that has been established for the award. Under U.S. tax law, the benefit of the tax deduction is rarely equal to the DTA because the tax deduction is generally based on the price of the stock at vesting/exercise, while the DTA, under current GAAP, is generally based on the fair value of the award at grant. When the benefit of the tax deduction is greater than the DTA, the difference is booked as an increase to equity. This is known as a “windfall” or “excess” tax benefit. Conversely, when the benefit of the tax deduction is less than the DTA, the difference is booked as an increase to expense on the income statement. This is known as a “shortfall” or “deficient” tax benefit. However, to the extent a company has previous windfall tax benefits built up in additional paid-in capital (an APIC pool), shortfalls can be offset against the APIC pool, resulting in a decrease to equity, rather than recognizing additional tax expense.
Proposed Change: Rather than have windfalls result in an increase to equity and shortfalls result in increased tax expense (or decrease in equity if a sufficient APIC pool exists), the FASB is proposing that all windfalls and shortfalls would be recognized in the income statement.
Impact of the Change: On its face, it appears that this change would simplify a complicated area of tax accounting by essentially eliminating the need for an APIC pool, but would likely cause companies to have more volatile earnings because all windfalls and shortfalls will be flushed through the income statement rather than equity. There are still many unknowns about the proposed change, such as:
- Will existing APIC pools be eliminated immediately, or will they be phased out over some period of time?
- Will the DTA for an award be fixed at the grant date and not adjusted prospectively (current treatment for many awards), or will the DTA need to be re-measured periodically over the life of the award?
This change may be viewed negatively by some businesses, especially those with large APIC pools that have been built up over the last 10 years.
Windfall Tax Benefits and Net Operating Losses
Current Rule: In certain instances, an award can result in a windfall tax benefit (because the benefit of the tax deduction is greater than the DTA), but the corresponding tax deduction does not reduce cash taxes payable because the entity is not in a taxpaying situation due to a net operating loss position or foreign tax credit carryforward position. Current rules prohibit entities from recording the windfall tax benefit in APIC until the corresponding deduction reduces cash taxes payable. This requires companies to separately track these “suspended” windfall tax benefits and results in a complicated determination of when the windfall tax benefit can be realized.
Proposed Change: The FASB is proposing to eliminate this requirement and would allow companies to recognize the windfall tax benefit even if the tax deduction does not reduce cash taxes payable.
Impact of the Change: While there is still uncertainty as to how currently suspended amounts will be treated, this area is ripe for simplification. The proposed change will likely be welcomed with open arms by companies in this situation.
Presentation of Windfall Tax Benefits on the Statement of Cash Flows
Current Rule: Companies are required to present the gross amount of windfall tax benefits as a cash outflow from operating activities and a cash inflow from financing activities in the statement of cash flows.
Proposed Change: The FASB is proposing to eliminate this requirement, which will result in the gross amount of windfall tax benefits being shown as a cash inflow from operating activities.
Impact of the Change: This is an area of complexity for many companies. In our experience, we have seen companies incorrectly apply this rule by reclassifying the net amount of windfall tax benefits (i.e., netting windfalls and shortfalls) rather than the gross windfall tax benefits or by using the incorrect amount for the windfall tax benefits (hypothetical vs. actual). We believe this change will simplify this often misinterpreted rule.
Minimum Statutory Withholding Requirements
Current Rule: Companies are generally required to withhold taxes (federal, state, Social Security, Medicare, etc.) when share-based payments are included in an employee’s income. Many companies allow employees to pay for the tax withholding through a “net settlement” feature, whereby the company retains a portion of the employee’s shares and remits the appropriate value to the taxing authority. The accounting rules view this transaction as a partial cash-settlement of shares. Generally, if an award is settled in cash, it is classified as a “liability” award, which requires companies to re-measure compensation expense for the award at each reporting period, as opposed to the generally more preferable “equity” classified award that receives fixed accounting treatment (compensation expense is determined and fixed at the grant date).
When awards are partially cash-settled to cover tax withholding, current rules provide for an exception that allows such awards to maintain equity classification as long as the withholding is not more than the statutory minimum. If more than the statutory minimum is withheld, the entire award becomes liability classified.
Proposed Change: The FASB is proposing to simplify this rule by allowing companies to withhold up to the highest applicable marginal tax rate allowable in the jurisdiction without triggering a change to liability classification. The FASB is also proposing that companies classify the cash paid to meet the withholding requirements as a financing activity on the statement of cash flows.
Impact of the Change: This is an area of complexity for companies, especially when awards require withholding in multiple jurisdictions. In addition, some employees request that the company withhold more than the minimum to address their personal tax situation, which most companies will not accommodate because of the current accounting rules. We believe the proposed change will result in simplification that companies and employees will appreciate.
In addition to the issues presented above, the FASB is recommending changes to these other non-tax-related issues:
Accounting for Forfeitures: When recognizing compensation expense for share-based payments, companies are currently required to estimate the number of awards that will be forfeited prior to vesting, then true-up the estimate for actual forfeitures as they occur. The FASB is proposing to allow companies to make an accounting policy election to either (i) estimate the number of forfeitures (same as current rules) or (ii) recognize forfeitures as they occur. Companies will have to apply the selected treatment consistently for all awards, rather than on a grant-by-grant basis.
Classification of Awards With a Repurchase Feature: An award that contains a repurchase feature can require liability award classification, which would require compensation expense to be re-measured at each reporting period. The determination of whether an award with a repurchase feature will be classified as a liability is dependent on whether the issuer has the right to acquire the award (call) or the recipient can require the issuer to purchase the award (put) within a certain time period. Current accounting guidance provides a bias towards awards with a call feature, allowing the issuer the ability to assess whether it is probable that the award will be repurchased. While awards with a put feature that can be exercised within a certain time period will always require liability classification, FASB is proposing to simplify these rules by focusing on the probability that the award will be repurchased for awards with put and call features.
Intrinsic Value Election for All Liability-Classified Awards (Private Companies Only): Companies will be allowed a one-time election to value all liability-classified awards at intrinsic value rather than fair value.
Expected Term (Private Companies Only): The expected term of an award is used to value stock options in option pricing models (e.g., Black-Scholes). The FASB is proposing to allow private companies to use a simplified method that estimates the expected term based on the midpoint between the end of the vesting period and the end of the contractual term for awards with a service condition (vest based on an employee’s service) and for certain awards with performance conditions (e.g., sales, earnings per share, etc.). Currently, the use of the simplified method is allowed for awards with only a service condition that also meet other criteria.
Alvarez & Marsal Taxand Says:
There is still quite a bit of uncertainty over how the FASB will deal with the transition to the new rules, but the FASB’s exposure draft is expected to be released soon and will shed more light on the future of ASC 718. Even though the FASB’s ultimate goal is simplification, the proposed changes could be met with resistance from the business community, as the changes are significant and some companies will likely be affected differently from others. Only time will tell whether these changes will materialize or whether the FASB achieves its goal of simplification. In the meantime, companies should be aware of the upcoming changes and begin to think about how these will impact their company and current processes.
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Rob Casburn and Garrett Griffin contributed to this article.
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Transaction Issues With Equity Compensation