As part of an ongoing Simplification Initiative, the Financial Accounting Standards Board (the “Board”) recently issued an Update to Accounting Standards Codification (ASC) Topic 718, which deals with stock-based compensation.  The update is meant to reduce cost and complexity while maintaining or improving the usefulness of the information provided in financial statements.  The areas for simplification include the income tax consequences of stock compensation, the classification of stock-based awards as either equity or liability, and the classification on the statement of cash flow.  The changes are summarized below.

1.    Accounting for Income Taxes

Generally, for any stock-based award, a positive or negative difference between a tax deduction and the compensation cost that is recognized for financial reporting purposes results in an excess tax benefit or a tax deficiency, respectively.  Currently, excess tax benefits are recognized as paid-in capital when the tax deduction reduces the taxes that are payable, while tax deficiencies either are used as an offset to accumulated excess tax benefits or are recognized in the income statement.  The Board decided that all excess tax benefits and tax deficiencies should be recognized as income tax benefit or expense in the income statement, and should be treated as discrete items in the reporting period in which they occur.  The recognition of a tax benefit is no longer delayed until the benefit is actually realized through a reduction to taxes payable.

This change certainly simplifies the accounting rules as it effectively eliminates the need to account for additional paid-in capital (APIC) pools, but some expressed concern that this may increase volatility in reported income tax expenses and effective tax rates.  The Board actually recognized that fact, but concluded that this could be explained in tax disclosures.  As a result, entities may feel the need to provide an explanation for any volatility that may be perceived as excessive.

The Board also decided to remove the requirement to present excess tax benefits as cash inflows from financing activities and outflows from operating activities.  As a result, excess tax benefits are to be classified as operating activities.

2.    Forfeitures

Entities are currently required to estimate the number of forfeitures that are expected to occur, and base the compensation cost on the estimated number of awards that will vest.  Going forward, entities will be permitted to make an entity-wide accounting policy election to either continue to apply that methodology, or recognize forfeitures in compensation cost when they occur.  Note, however, that the Board concluded that this election only applies to vesting conditions that are service-based, and therefore would not apply to awards with performance conditions.

3.    Tax Withholding (Classification of Awards As Either Equity Or Liability)

Currently, the partial cash settlement of an award for tax withholding purposes results in the classification of that award as a liability if an the amount in excess of the employer’s minimum statutory tax withholding requirements is withheld or may be withheld at the employee’s discretion.  The Board decided that equity classification will be maintained going forward so long as the amount that is withheld (or that may be withheld at the employee’s discretion) does not exceed the maximum statutory tax rates in the applicable jurisdictions (even if the relevant rate is higher than the highest rate actually paid by the employee).  This requires an entity to determine only one rate in each jurisdiction, rather a rate for each employee using this exception.

Certain plan documents may need to be revised as a result of this change.  Equity incentive plans may specify explicitly the extent to which awards may be partially settled in cash for withholding tax purposes, by stating the old accounting rule and referring to the minimum tax rate.  These plan provisions may be revised to allow for a broader use of partial cash settlements.

The Board also clarified that if an employer is withholding shares for tax withholding purposes, the cash paid to a taxing authority on behalf of the employee is a financing activity on the statement of cash flows.   Current GAAP do not provide specific guidance about the cash flow classification of these transactions.

4.    Expected Terms of Awards (Practical Expedient)

Under current GAAP, an entity must adopt a valuation method that takes into account the expected term of an award if there are no market prices that can be used to determine the fair value of the award.  The Board decided to allow non-public entities to adopt a practical expedient for purposes of estimating expected terms of awards.  The midpoint between the vesting date and the contractual term can be used for awards that include service conditions and generally for awards that include performance conditions.  However, if there is a performance condition and it is not probable that the condition will be achieved, the expected term will be the contractual term if the requisite service period is simply inferred based on the achievement of the performance condition at some undetermined point in the future.

5.    Fair Value Or Intrinsic Value for Liability-Classified Awards

Current guidance states that fair value is preferable to intrinsic value for purposes of measuring liability-classified awards.  While there actually is a choice for non-public entities to select intrinsic value, very few believe it is possible to demonstrate that intrinsic value is preferable.  The Board explicitly stated that non-public entities can make an accounting policy election to change its measurement of all liability-classified awards from fair value to intrinsic value without determining which methodology is preferable.

6.    Effective Dates

For public companies, the changes made by the Update are effective for annual periods beginning after December 31, 2016, and interim periods within those annual periods.  For all other entities, the changes are effective for annual periods beginning after December 31, 2017, and interim periods within annual periods beginning after December 31, 2018.  Early adoption is permitted.  Note, however, that the transition for each of these changes varies.  Some changes become effective prospectively, such as the changes relating to APIC.  Other changes apply on a modified retroactive basis (meaning that they also apply to outstanding awards), such as forfeitures.