On March 30, the Financial Accounting Standards Board (FASB) published an updated standard to simplify some provisions in share-based compensation accounting. The update — Accounting Standards Update (ASU) No. 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting — makes it easier for employers to report the tax deductions for paying employees with stock options and restricted shares. The update also provides practical expedients for private companies that offer share-based compensation.
Accounting for income taxes
Under the updated guidance, the most significant change relates to how companies will report the tax consequences of share-based compensation. Under current U.S. Generally Accepted Accounting Principles (GAAP), for each share-based payment, employers must determine whether the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes results in either an excess tax benefit or a tax deficiency.
Currently, when the deduction for a share-based payment for income tax purposes exceeds the compensation cost for accounting purposes, the employer recognizes an excess tax benefit in additional paid-in capital, an equity account on the balance sheet. Conversely, tax deficiencies are recognized either as an offset to accumulated excess tax benefits, if any, or in the income statement. Excess tax benefits aren’t recognized until the deduction reduces taxes payable.
The updated guidance moves all accounting for income tax consequences of share-based payments to the income statement. Under the simplified rules, all excess tax benefits and tax deficiencies will be recognized as income tax expense or benefit. The tax effects of exercised or vested awards will be treated as discrete items in the reporting period in which they occur. Additionally, employers will recognize excess tax benefits regardless of whether the benefit reduces taxes payable in the current period.
Classification of excess tax benefits on the statement of cash flows is also more straightforward under the new guidance. It calls for excess tax benefits to be classified as an operating activity with other income tax cash flows. Under current GAAP, employers are required to separate excess tax benefits from other income tax cash flows and classify them as financing activities.
Practical expedients for private companies
Many people associate share-based compensation with public companies. But private companies also may offer employee stock options and restricted shares, especially if they’re strapped for cash to pay executives. It’s usually more challenging to value share-based awards for private companies, however, because their shares don’t trade in the public markets.
One of the most subjective elements to reporting share-based payments for private companies under existing GAAP is estimating the expected term. That’s the period of time that an option is expected to be outstanding, assuming that it vests. The updated guidance provides a simplified formula for estimating the term for nonpublic entities that issue share-based payments based on a service or performance condition.
For a private company that elects this practical expedient, the expected term of a share-based payment will generally be the midpoint between the requisite service period and the contractual term of the award, if vesting is dependent only upon a service condition. That formula also applies if the award is dependent upon satisfying a performance condition that’s probable of being achieved.
In addition, the revised guidance allows private companies to elect a one-time switch from measuring all liability-classified awards at fair value to intrinsic value, without having to evaluate whether intrinsic value is preferable. Many private companies were unaware of this optional reporting method when it originally was adopted under Accounting Standards Codification Topic 718, Compensation — Stock Compensation (formerly known as FASB Statement No. 123(R), Share-Based Payment).
FASB simplification project
These narrow-scope changes are part of the FASB’s ongoing efforts to simplify the accounting rules. In a recent statement, FASB Chair Russell Golden said, “Both public and private company stakeholders identified a few aspects of accounting for employee, share-based awards that are unnecessarily complex. Based on input from those stakeholders, including the Private Company Council, the FASB has issued a standard that we believe will simplify the accounting, while maintaining the usefulness of information provided to investors.”
Public companies must apply the changes for fiscal years that start after December 15, 2016. Private companies will have an extra year to implement them. Early adoption will be permitted.