Although the FASB recently simplified some aspects of the accounting for stock-based compensation, it continues to be complex. As companies consider new or alternative plan designs for new awards or make modifications to current arrangements, they should be sure to consider the accounting guidance and the tax consequences.
– All of the tax effects of share-based payments will now be recognized in the income statement. Currently, tax benefits from deductions for tax purposes realized by an employer in excess of the compensation cost they recognize in the financial statements (so-called “windfall tax benefits”) are recorded in equity; similarly, any “shortfalls” (tax benefits realized that are less than book compensation cost) are recorded in equity to the extent of previous windfalls. Only if previous windfalls are insufficient are shortfalls recognized as a tax expense in the income statement. While the new guidance will reduce some of the administrative complexities under existing GAAP by eliminating the need to track a “windfall pool,” it may increase the volatility of income tax expense and the effective tax rate. This change is required to be applied prospectively to the tax consequences arising after the date of adoption of the new guidance.
– Windfall benefits will be reported as deferred tax assets when they arise, subject to normal valuation allowance considerations. This change is required to be applied on a modified retrospective basis, with a cumulative-effect adjustment to opening retained earnings for the recognition of all previously reported windfalls (on tax returns) that had not yet been recognized in the financial statements.
– All tax-related cash flows resulting from share-based payments will need to be reported as operating activities on the statement of cash flows. Either prospective or retrospective transition of this provision is permitted for the classification of excess tax benefits in the statement of cash flows.
– Currently, employers are permitted to withhold shares upon settlement of an award (net share settlement or “deemed” repurchases) to satisfy the employer’s requirement to withhold (and remit to the taxing authority) a portion of the employee’s tax obligation arising from the exercises of the award. However, in order for the award to be classified as equity (resulting in “fixed” grant-date fair value compensation expense), the amount of shares an employer may withhold is strictly limited to the minimum statutory requirement. The new guidance relaxes that restriction and allows entities to withhold shares having a value up to the maximum individual tax rate in the relevant jurisdiction without triggering liability classification of the award (which would require variable, mark-to-market accounting for compensation expense). This provision is required to be adopted using a modified retrospective approach, with a cumulative-effect adjustment to opening retained earnings for any outstanding liability awards that qualify for equity classification under the new guidance.
Additionally, the guidance clarifies that all cash payments made to taxing authorities on the employees’ behalf for withheld shares should be presented as financing activities on the statement of cash flows. This change should be applied retrospectively.
– When employees forfeit share-based payment awards by failing to meet the service conditions in the award, compensation expense is adjusted to the actual number of awards that vest. The new guidance permits an accounting policy choice between estimating the impact of forfeitures or simply accounting for forfeitures as they occur. Current GAAP requires entities to estimate forfeitures. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach, with a cumulative-effect adjustment recorded to opening retained earnings.
– The expected term of certain share-based awards, which is an input to determining grant date fair value, has been simplified to allow the use of a mathematical midpoint between the vesting date and the contractual term. If elected, the practical expedient is required to be adopted prospectively to awards measured at fair value after the adoption of the new guidance.
– Upon adoption of the new guidance, non-public entities will have a one-time opportunity to change the measurement basis for all liability-classified awards to intrinsic value (market price of shares less exercise price of options) instead of fair value as required today.