FASB's issuance of Accounting Standards Update (ASU) No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, received significant attention during the comment letter process, as adoption can have a significant impact on a company's financial statements. Under current GAAP, an entity must account for stock-based compensation from share-based payments in accordance with the fair-value-based method set forth in FASB Accounting Standards Codification (ASC) Paragraph 718-10-30-3.
Compensation cost generally is measured on the grant date the equity instrument is issued and is recognized over the requisite service period under ASC Paragraph 718-10-35-2. For tax purposes, the tax deduction related to stock-based compensation varies depending on the type of stock option. In general, the tax effect related to stock-based compensation is measured at the intrinsic value of the shares on the date of exercise for regular stock options (i.e., nonqualified stock options) and of vesting for restricted stock units.
Prior to adoption of ASU No. 2016-09, the excess tax benefit under ASC Paragraph 718-740-35-3 over the recognized deferred tax asset would be credited to additional paid-in capital (APIC) under ASC Paragraph 718-740-45-2 and tracked as part of the tax windfall pool. Any tax deficiencies generally would be charged to APIC to the extent of the tax windfall pool, with the excess recognized or expensed through the income statement under ASC Paragraph 718-740-45-4; this required the company to calculate and track its existing pool every year.
The excess tax benefit, under current GAAP, is not permitted to be recognized until the cash benefit is realized (i.e., reduction to current taxes payable) under ASC Paragraph 718-740-25-10. This left some companies with "off-balance sheet" tax attributes—such as net operating losses and credits that were created as a result of large stock-based compensation tax deductions—that were tracked separately. In these scenarios, the tax attributes that were "on-balance sheet" for financial statement purposes would be less than those recorded on the company's tax return.
ASU No. 2016-09
FASB issued ASU No. 2016-09 on March 30, 2016, amending ASC Topic 718, Compensation—Stock Compensation. The new standards are effective for fiscal years beginning after Dec. 15, 2016, for public filers and will be effective in fiscal years beginning after Dec. 15, 2017, for private companies, under ASC Paragraph 718-10-65-4. ASU No. 2016-09 permits early adoption for both private and public entities in any interim or annual period.
In general, adoption of ASU No. 2016-09 requires recognition of excess tax benefits and tax deficiencies arising from settlement or vesting of stock-based compensation to be recorded as income tax expense or benefit through the income statement instead of APIC under the prior rule. The recognition of excess tax benefits or tax deficiencies over book compensation cost through the income statement is done on a prospective basis per ASC Paragraph 718-10-65-4. This new rule eliminates the need for companies to continue to track their windfall pools, and the existing windfall pools effectively disappear.
The requirement to recognize a benefit only to the extent that it reduces current taxes payable no longer applies, and the total amount should be recorded as the awards are settled or vested. Upon adoption of ASU No. 2016-09, a company is required to record only the unrecognized tax benefit on a modified retrospective basis through a cumulative-effect adjustment to beginning retained earnings under ASC Paragraph 718-10-65-4. As a result, many companies will be required to bring any off-balance-sheet attributes onto the balance sheet through a cumulative-effect adjustment to beginning retained earnings. This requirement will create additional deferred tax assets for companies that previously had any off-balance-sheet attributes.
Further, any deferred tax assets recognized as a result of adoption are assessed for realizability in accordance with ASC Topic 740, Income Taxes. If a valuation allowance on the deferred tax asset is necessary, it is recorded through retained earnings on the date of adoption as part of the cumulative-effect adjustment under ASC Paragraph 718-10-65-4. However, if a valuation allowance is recorded in a later year, the valuation allowance would be recorded as a tax expense through the income statement.
While the new ASU allows for simplification by eliminating the need to track a windfall pool, it may create greater income-statement volatility as companies record tax effects related to stock-based compensation through the income statement on a quarterly basis. Companies that make extensive use of share-based awards may experience volatility in earnings as well as the annual effective tax rate, which ultimately may affect the stock price. As a result, many companies are considering additional disclosures that present net income and the effective tax rate on a normalized basis without any stock-based compensation deductions.
As a result of the implementation and internal processes, additional reporting requirements to stakeholders should be implemented to allow for timely reporting. For example, public companies will be required to record the excess tax benefit through income tax expense on a quarterly basis as a discrete item. Forecasting earnings may be an area that requires further collaboration between corporate tax and accounting departments as a result of this change.
As companies adopt the standard, they should increase focus on internal processes and whether the appropriate departments are providing sufficient data to comply with the new standards. The transition under ASU No. 2016-09 has presented many complexities that companies should carefully consider from reporting, internal process, and controls perspectives.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
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