Accounting is one of the most crucial areas in the equity compensation field. This book is not a general guide to the subject (for that, see our book Accounting for Equity Compensation by Barbara Baksa) but rather is an advanced study of some of the most important topics that arise. Author Takis Makridis, a leading expert in the field, selects a handful of issues spanning valuation and financial reporting. The seventh edition includes updated commentary on the FASB's revisions to ASC 718, which are staged to go into effect in fiscal years and interim periods beginning after December 15, 2016, plus other changes throughout the book.
Table of Contents
Chapter 1: Valuation Models
Chapter 2: Expected Term
Chapter 3: Volatility Estimation
Chapter 4: Expense Recognition for Market, Performance, and Service Conditions
Chapter 5: Making Sense of Forfeiture Rates
Chapter 6: Modification Accounting
Chapter 7: IFRS 2: Today and Tomorrow
Chapter 8: Design Features Driving the Fair Value of a Relative TSR Award
Chapter 9: Accounting for Assumed Awards Under ASC 805
Chapter 10: FASB's Revisions to ASC 718 Under ASU 2016-09
From Chapter 5, "Making Sense of Forfeiture Rates" (footnotes omitted)
One major element of ASC 718 has been the derivation of a forfeiture rate and its correct application within an amortization model. Under SFAS 123, companies did not estimate forfeitures, and instead merely reversed expense previously disclosed or recognized upon an actual forfeiture event. ASC 718 changed that, requiring companies to estimate expected forfeitures, base their accruals on the corresponding value of awards they expect to vest, and true-up to the value of awards actually earned.
ASC 2016-09 has changed that requirement by giving companies a choice whether they apply a forfeiture rate or simply record forfeitures as they occur. This optionality is discussed in greater detail in chapter 10, which is entirely devoted to ASU 2016-09. Since a majority of large companies and 60% of companies overall are so far choosing to keep using a forfeiture rate, this chapter will discuss estimation and application considerations.
For those companies choosing to stop using a forfeiture rate, their processes become relatively simple: As forfeitures occur, previously recognized expense on those awards is reversed. While simple, this will worsen forecasting precision and is not extendable to situations involving modifications, business combinations, and IFRS 2 statutory reporting.
Therefore, this chapter aims to demystify confusion surrounding forfeiture rates. How does the process of deriving a forfeiture rate differ from that of applying a forfeiture rate? What is meant by a "static" versus "dynamic" forfeiture rate approach? We begin with the conceptual objective of applying a forfeiture rate. Thereafter, we review certain best practices in deriving or estimating a forfeiture rate. Finally, the core content of this chapter evaluates the different techniques for applying a forfeiture rate within an amortization model, including the comparative merits of the "static" and "dynamic" approaches.
From Chapter 9, "Accounting for Assumed Awards Under ASC 805" (footnotes omitted)
In general, ASC 805 provides a cleaner income tax accounting model than its predecessor, FAS 141. Upon assuming acquiree awards and issuing replacement awards, the acquirer should set up a deferred tax asset (DTA) based on the tax-effected value recorded in goodwill. As the acquirer then proceeds to recognize costs in its financial statement for post-combination services, a corresponding DTA should also be established. Therefore, there is a build-up of the DTA in the post-combination financial statements that needs to be synchronized with the recognition of expense; similarly, the one-time recognition of consideration transferred automatically gives rise to a corresponding DTA. Therefore, by the time awards are settled, every settled award can be traced back to a corresponding DTA in the balance sheet.
Upon settlement, the standard ASC 740 calculations are performed. The actual tax benefit is compared to the cumulative DTA recorded in the acquirer's balance sheet on the settled awards. Under the new ASC 805 accounting model, that DTA will reflect the entire replacement award—both the portion that was recorded to goodwill (pre-combination services) and the portion recorded in the acquirer's post-combination financial statements. With the release of ASU 2016-09, which eliminated the APIC pool concept, any excess between the actual tax benefit and the cumulative DTA is a tax benefit recorded to earnings, and any shortfall will be recorded as tax expense in earnings.
From Chapter 10, "FASB's Revisions to ASC 718 Under ASU 2016-09"
Under the old ASC 718 guidance, differences between the cumulative deferred tax asset (DTA) and intrinsic value at settlement (the actual tax benefit) were recorded to what was commonly referred to as the APIC pool. A tax shortfall exists when the DTA is larger than the actual tax benefit, and a tax windfall exists when the opposite is true. Net windfalls (cumulative windfalls less cumulative shortfalls) comprised the APIC pool. Only if the APIC pool was depleted via cumulative shortfalls surpassing cumulative windfalls would shortfalls be recognized in the income statement.
Despite its complexity, the APIC pool has allowed companies to offset current tax shortfalls by netting them against prior windfalls, thus shielding the income statement from volatility. The decision in ASU 2016-09 to eliminate the APIC pool and run all tax windfalls and shortfalls through the income statement will introduce considerable volatility to both earnings and the effective tax rate.
Already, companies are rushing to implement tax settlement forecasting procedures so they can create visibility into how future stock price fluctuations would affect earnings and the effective tax rate (ETR). For many, the effort and precision needed in tax settlement forecasting easily exceed that invested in maintaining the APIC pool.