Get Out of the Pool: Changes to ASC 718 are Making Companies Billions!
Get Out of the Pool: Changes to ASC 718 are Making Companies Billions!

Get Out of the Pool: Changes to ASC 718 are Making Companies Billions!

As we noted in this post and this one, the accounting for share based payments under ASC 718 is changing as a result of the issuance of ASU 2016-09 – Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. However, at the time, I don’t think we fully realized the financial statement impact that these accounting changes would have on financial statements!

An example of one of the changes to share-based payment accounting that we show in our current U.S. GAAP Update course is about Facebook, which reported a $934 million decrease in their 2016 provision for income taxes as a result of the adoption of ASU 2016-09 in the fourth quarter of 2016! A recent article in Accounting Today noted a similar windfall for Google’s parent, Alphabet, Inc.

What gives? How are these companies recognizing billions in income as a result of an accounting change? In short, it’s the elimination of the APIC pool within ASC 718. Using an example, this post will illustrate the previous accounting, as well as the changes within ASU 2016-09 that is requiring companies to record these benefits immediately.

With the APIC pool gone, companies are now required to record excess tax benefits and tax deficiencies immediately in the P&L in the period they are deducted on the company’s income tax return. Previously, excess tax benefits were recorded in additional paid-in capital (the “APIC pool”). Tax deficiencies were recorded in the P&L, except to the extent of any remaining paid-in capital in the “pool” from excess tax benefits of previous awards. Let’s take a look at a simplified example to illustrate the accounting for excess tax benefits under both existing GAAP and new GAAP under ASU 2016-09:

Background Information

Selfie Journal, Inc. (SJ) grants 1,000,000 equity-classified share options to employees on January 1, 2013. The strike price of the options is $30, which is the price of the shares at grant date. Using an appropriate option pricing model, SJ determines the grant date fair value of each option is $20. Employees have to work for four years in order to receive the awards. If they leave before the vesting period, they receive nothing (i.e. cliff vesting). No forfeitures are expected. As the award is equity-classified, total compensation cost to be recognized over the four-year period is $20 million ($20 x 1,000,000 options). Based on its current assessment, SJ would not be required to record a valuation allowance on deferred tax assets. SJ’s tax rate is 35%.

All options vest on December 31, 2016 (i.e. no forfeitures). At that time, the share price is $120 and all employees decide to exercise on that date. As a result, the ultimate tax deduction to be taken in SJ’s 2016 tax return is $90 million (($120 - $30) x 1,000,000 options), resulting in a tax benefit of $31.5 million ($90 million x 35%).

Accounting under Existing GAAP

Entry at End of Each Year (2013-2016)

Dr. Compensation expense                            $5 million

Cr. APIC                                                                                       $5 million

Dr. Deferred tax asset                                    $1.75 million

Cr. Deferred tax benefit (P&L)                                                   $1.75 million

Entry for Excess Tax Benefits (Upon Exercise at December 31, 2016)

Dr. Income taxes payable                               $31.5 million

Cr. Deferred tax asset                                                                 $7 million

Cr. APIC (excess tax benefits)                                                    $24.5 million

Accounting under New GAAP (ASU 2016-09)

Under ASU 2016-09, the entries recorded for the first four years are the same. The only difference is the entry upon exercise. As previously mentioned, the APIC pool is eliminated. Therefore, instead of crediting APIC, all excess tax benefits should be immediately recognized as income tax benefit in the income statement.

Entry for Excess Tax Benefits (Upon Exercise at December 31, 2016)

Dr. Income taxes payable                                $31.5 million

Cr. Deferred tax asset                                                                   $7 million

Cr. Current tax benefit (P&L)                                                        $24.5 million

Note: It is this entry which Facebook recorded a $934 million decrease in the 2016 tax provision as a result of adopting ASU 2016-09 in the fourth quarter of 2016!

Transitioning to the New Standard

The amendments to ASC 718 as a result of ASU 2016-09 are effective for public business entities for annual periods beginning after December 15, 2016, including interim periods within those annual periods. For all other entities, the effective date is annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018.

Is early adoption possible? Yes! Facebook and Alphabet adopted early, but why wouldn’t they with a cool billion increasing the bottom line! Note that if an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. Have other entities early adopted too? Some have, but the phenomenon experienced by Facebook, and illustrated in our example, only occurs when a company’s stock price rises significantly during the period that the share-based payment awards are outstanding.

ASU 2016-09 requires prospective transition, except for previously unrecognized excess tax benefits. Those should be recognized on a modified retrospective basis. Therefore, entities should record a deferred tax asset for previously unrecognized excess tax benefits outstanding as of the beginning of the annual period of adoption, with an offsetting adjustment to retained earnings. This is the $1.67 billion increase to retained earnings noted in Facebook’s fourth quarter 2016 press release.

Does an entity have to reclassify its prior-year APIC pool upon transition? No, according to Deloitte’s Head Up published June 20, 2016. An entity’s prior-year APIC pool is not affected because those excess benefits have already been recognized in the financial statements, and the recognition of excess tax benefits and tax deficiencies in the income statement is prospective only in the fiscal year of adoption. As a result, there is no reclassification between APIC and retained earnings in the fiscal years before adoption.

Are you an investor in Facebook? Are you dreaming of how you’re going to spend the extra cash? As Lee Corso famously says on College GameDay, “Not so fast, my friend!” This accounting change doesn’t affect cash at all. The payments made to the IRS remain unchanged. As noted in the Accounting Today article, “ASU 2016-09 only changes how the tax effects of stock compensation are reflected in a company’s financial statements.” Bummer!

Disclaimer 

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.

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