The Financial Accounting Standards Board (FASB) recently issued a new standard that directly affects banks and financial services organizations that provide share-based compensation to their employees. Accounting Standards Update (ASU) No. 2016-09, “Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting,” simplifies some aspects of the financial accounting and reporting for stock compensation awarded to employees,1 but also could create more income statement volatility for some banks.
Treatment of Excess Tax Benefits and Tax Deficiencies
Most notably, the ASU changes the location and timing for recording the tax consequences of share-based compensation, eliminating the concept of “additional paid-in capital (APIC) pools” that exists under current U.S. generally accepted accounting principles (GAAP).
Under current GAAP, an entity must determine on an award-by-award basis whether share-based compensation creates an excess tax benefit (sometimes called a “windfall”) or a tax deficiency (“shortfall”). Windfalls and shortfalls result because the costs of a share-based award are recognized on an entity’s financial statements as an expense over the award’s vesting period, but the entity can’t deduct the costs for income tax purposes until the award is taxable to the employee and therefore deductible by the employer (typically when it is settled).
Specifically, an excess tax benefit results if the employer’s income tax deduction turns out to be more than the cumulative costs of the award recognized on the entity’s financial statements (“book expense”). Excess tax benefits currently are recognized as APIC when they’re realized – when their presence reduces the entity’s cash taxes payable or increases its tax refund. If an entity can’t yet realize an excess tax benefit, typically because it also has net operating losses (NOLs), it can’t book the windfall immediately but instead must treat it as an off-balance-sheet benefit.
A tax deficiency results if the tax deduction is less than the cumulative book expense recorded.2 The current guidance requires entities to recognize a tax deficiency as an offset to the APIC pool to the extent of accumulated excess tax benefits; if it can’t be offset, the tax deficiency is recognized as income tax expense on the income statement.
Under the new ASU, entities will recognize all excess tax benefits (including the tax benefits of dividends paid on share-based payment awards while the awards are outstanding) and tax deficiencies in the income statement, not through APIC. In addition, entities no longer will be required to wait until an excess tax benefit is actually realized to record it; any excess tax benefit will be recorded in the period the tax deduction arises. This eliminates the need for off-balance-sheet tracking of excess tax benefits. Of course, to the extent that currently recording any excess tax benefit deduction creates an NOL carryforward, the resulting deferred tax asset should be analyzed for realizability and any need for a valuation allowance.
To illustrate, suppose a bank has expensed $1,000 for a restricted stock award to an employee. When the restrictions lapse (the award settles), the stock is worth $1,500, resulting in a $1,500 tax deduction to the bank. At a 40 percent tax rate, the $500 tax deduction that is in excess of book expense creates an excess tax benefit of $200. Under current GAAP, the excess tax benefit is recognized as APIC on the balance sheet when it’s actually realized. Under the new ASU, the excess benefit is immediately recorded as a current tax benefit on the income statement.
Alternatively, suppose a tax deficiency of $200 results when the award settles. Current GAAP requires the deficiency to be recognized as an offset to the APIC pool on the balance sheet or, if that’s not possible, as current tax expense. The bank always will record the deficiency as a current tax expense under the new ASU.
Although it’s welcome news that entities no longer will need to track the APIC pool or worry about when tax benefits are realized, recording all excess tax benefits and deficiencies through tax expense could increase income statement volatility.
Treatment of Forfeitures
The ASU also provides an option regarding the accounting for forfeitures that can affect the tracking needed to account for the tax benefits of any dividends paid on outstanding awards that are later forfeited.
Current GAAP requires an entity to estimate how many restricted shares and options for shares will be forfeited and how many will vest. Dividends paid on the shares expected to vest are posted to retained earnings, and dividends for those expected to be forfeited are posted to compensation expense if the dividends aren’t required to be paid back. The entity can take an immediate tax deduction for all of the dividends, resulting in an excess tax benefit.
The ASU allows an entity to elect to adopt an accounting policy to not recognize forfeitures until they occur. All dividends initially would be recorded to retained earnings; as forfeitures occur, the dividends that had been paid on the forfeited awards would be reclassified to compensation expense in the period of the forfeiture.
Careful tracking will be required by entities making the election so they don’t deduct the affected dividends twice or record the tax benefit twice.
The ASU also simplifies or clarifies the reporting of tax benefits of share-based compensation in the statement of cash flow.
Excess tax benefits currently are presented separately from other income tax cash flows, as a cash inflow from financing activities and a cash outflow from operating activities. Under the new ASU, the benefits will appear with other income tax cash flows as an operating activity.
In addition, current GAAP specifies that when an entity allows employees to surrender award shares to satisfy tax withholding amounts in excess of the minimum statutory withholding requirement, the entity can’t account for the award as an equity award but must treat it as a liability award. The new ASU allows entities to withhold up to the maximum statutory rates without jeopardizing equity award treatment. The withholding taxes will appear on the statement of cash flows as a financing activity cash outflow.
The 121-page ASU addresses several other important issues, including the effect of share awards on calculation of diluted earnings per share. The ASU also includes some simplifications for private companies.
Effective Date and Transition
For calendar-year entities, the ASU generally becomes effective in 2017 for public entities and in 2018 for all other entities, although early adoption is permitted for any entity in an interim or annual period for which the financial statements have not been issued or made available to be issued. An entity that elects early adoption must adopt all of the amendments in the same period – cherry picking isn’t allowed.
Entities considering early adoption should consider all of the implications. For example, if an entity adopts in the second quarter after recording some excess tax benefits and tax deficiencies through APIC in the first quarter, it will need to unwind that first-quarter reporting and report everything through the income statement as if the ASU had been adopted on the first day of the year. On the other hand, any balance of excess tax benefits net of deficiencies recorded to APIC in years prior to adoption shouldn’t be moved out of APIC and into retained earnings.
Look Before You Leap
The new ASU simplifies the accounting for share-based compensation in some ways but also creates more volatility in the income statement. Banks and financial services organizations must give careful thought to whether to early adopt and, if so, when.
In This Issue
- IRS Releases Final Regulations on Private Foundation Program-Related Investments
- FASB Tackles Accounting for Share-Based Compensation
- South Carolina’s Attempt to Clarify Economic Nexus (Sort Of)
- Proper Treatment of Retained Servicing Fees on Originated Mortgages Can Reduce Your Taxable Income
1 Note that this ASU also applies to stock awards made to an entity’s board of directors.
2 Note that a tax deficiency will not occur in the case of qualified stock options that don’t result in employee taxable income or employer tax deduction, unless the employee disposes of the shares received upon exercise in a disqualifying disposition. This is because, generally, the employer wouldn’t record any tax benefit to the financial statement until and unless a disqualifying disposition occurs.