A new accounting standard on share-based payments that creates volatility in effective corporate tax rates may mislead investors who use companies’ financial statements to make decisions, analysts warn.
By linking earnings to stock prices, the standard can cause a company’s effective tax rate and other important financial figures to fluctuate. While many businesses today see the positive effects of accounting change in the form of tax benefits, they may see the reverse in a bear market.
The Financial Accounting Standards Board guidelines, released in March 2016, address how share-based payments to employees are recorded and presented in companies’ financial statements. It requires that excess tax benefits and tax losses be recorded in the income statement when the share awards are vested or exercised.
The 2016-09 accounting standards update went into effect for public companies this year, with the potential for early adoption.
A Bloomberg BNA analysis of the top 50 Fortune 500 companies found that as of the first quarter of 2016, 24 out of 42 disclosed more than $ 1.7 billion in excess tax benefits for the quarter in which they adopted the ASU 2016-09. The analysis excluded private companies, public companies that do not offer stock-based compensation, public companies that plan to adopt at a future date, and any government-sponsored entities.
Additionally, 12 early adopters who have filed an annual report since the standard was adopted disclosed more than $ 2.3 billion in excess tax benefits. Alphabet Inc., the parent company of Google, was the largest contributor, reporting $ 1 billion in excess tax benefits for the fiscal year ended Dec.31, 2016.
Companies benefiting from significant excess tax benefits have seen their effective tax rates evolve favorably following the adoption of the standard.
The effects of the standard can vary widely depending on the amount of stock-based compensation offered by companies and whether their stock prices fall or rise, said Takis Makridis, president and CEO of the company. ‘Equity Methods LLC. The accounting change “was billed as a simplification initiative”, but in reality the FASB inserted more variables “that cause financial statement numbers to move in different directions,” he said. This greater volatility creates “more of a powder keg for confusion and flawed comparability” for stakeholders, he said.
Prior to ASU 2016-09, tax benefits in excess of the compensation cost – sometimes referred to as windfall gains – were recognized in equity. Tax losses – deficits – were recorded in equity up to the amount of previous exceptional gains, then in the income statement.
Five percentage point lower tax rate
According to Derek Johnston, associate professor of accounting at Colorado State University.
Johnston cited preliminary results from research he is conducting with Colorado State Assistant Professors James Stekelberg and James Brushwood and Professor Lisa Kutcher. The four are studying the tax returns of 271 companies that applied the FASB rules early on. This number excludes utilities and financial services companies and companies that reported negative profit before tax.
The average impact on the “GAAP effective tax rate”, or the average rate at which pre-tax income is taxed, was -5.75 percentage points for 192 early users who disclosed the information necessary to establish a number, Johnston said. After controlling for outliers that could skew the average, the average is around -4.75 percentage points, he said. “It’s pretty important. “
One of the notable early adopters, Facebook Inc., reported a seven percentage point cut in its effective tax rate under generally accepted accounting principles after adopting the standard last year. The company also said the new accounting rules reduced its provision for income taxes by $ 934 million for the year ended Dec.31, 2016.
Bloomberg BNA analysis of top Fortune 500 companies found a similar pattern among early and non-early adopters.
Bank of America Corp., which declared $ 222 million in excess tax benefits in the first quarter of fiscal 2017, saw its effective tax rate drop 4.2 percentage points in the same quarter. He attributed the decline in part to the adoption of the new standard. Likewise, Wells Fargo & Co., which disclosed a $ 183 million excess tax benefit in the first quarter of 2017, saw its tax rate drop 4.6 percentage points from the previous year. The bank attributed the decrease mainly to the accounting change.
Among the companies analyzed by Bloomberg BNA, Bank of America, Wells Fargo and Alphabet disclosed some of the most significant excess tax benefits.
These findings make sense because the biggest equity givers have traditionally been companies in the tech, financial services and life sciences industries, Makridis said.
“Pleasure” of early adoption
Makridis said investors should be aware that these significant cuts in effective tax rates for accounting purposes do not actually translate into lower taxes paid to the Internal Revenue Service. “The actual checks written to the IRS are unchanged,” he said. ASU 2016-09 only changes the way in which the tax effects of stock-based compensation are reflected in a company’s financial statements.
Jack Ciesielski, president of RG Associates Inc., a Baltimore-based asset management and research firm, took a deep dive late last year into the financial information of 343 early adopters. In an edition of October 25, 2016, The analyst’s accounting observer – a research service published by RG Associates —Ciesielski found that early adopters were “excited” to use the new accounting rules for share-based payments. They were able to announce good news: windfall profits in the form of tax benefits and substantial reductions in effective tax rates, reducing their tax provisions for the current year.
But Ciesielski toned down the festive mood with warnings for investors and businesses, explaining that a simple accounting change was responsible for the swings. “Unless it’s clearly explained, investors won’t understand that an improvement could be less exciting than it looks,” he said.
Makridis agreed that unless companies are clear in their disclosures, investors could misinterpret tax benefits and changes in effective tax rates as something they are not.
Yosef Barbut, National Insurance Partner and CPA of BDO USA LLP Top 10 Firms, said that ASU 2016-09 further aligns accounting for the tax effects of equity compensation with the “cash tax” which is effectively paid to the IRS. Stakeholders who review financial statements can now base their decisions on information closer to cash tax reality, he said. “The reality is you get an advantage,” he said. A profitable business that pays taxes to the IRS will get a deduction when share-based payments are exercised or vested.
ASU 2016-09 requires companies to disclose the tax consequences of adopting the new standard in the “first interim and annual adoption period,” that is, the quarter in which they adopted the standard and the annual report thereafter.
Apart from this information, companies only have to declare the tax effects of the accounting change if they are material.
Ciesielski wrote that as of October 10, 2016, the 343 early adopters he studied had not fully disclosed the effects of their adoption. When given the choice of how to switch to the new presentation – either by what is known as the “modified retrospective” method, with limited retrospectives in the accounts, or by the prospective method – “most chosen are prospective with poor disclosure of effects. “
Nine months later, his analysis of the quality of disclosures still stands, Ciesielski said. Companies are unlikely to place much emphasis on the accounting change in their income tax returns, which are known to be complex and overlooked by investors, he said.
In addition, Ciesielski said he did not expect the Securities and Exchange Commission accountant watchdogs to pay close attention to disclosures, “because it is not a recurring footnote,” a- he said, and therefore not appropriate for timely reminders from brazen-going regulators.
The SEC declined to comment.
Corporate income tax footnotes “are generally deliberately murky,” said Ciesielski, who has helped advise the FASB on various panels and served on the American Accounting Rules Development Committee. Institute of CPA.
Detailed tax information can help establish roadmaps for tax authorities such as the IRS, said Ciesielski and a Big Four auditor interviewed by Bloomberg BNA. The auditor sought anonymity as he is not authorized to speak to reporters.
Bloomberg BNA’s analysis of the Fortune 500 found that while companies provided varying degrees of specificity in their financial information, the majority at least noted that they had adopted the new accounting standard and disclosed the excess tax benefits. – none reported any shortcomings – or claimed that the standard had a negligible impact. Of the 42 companies affected, 31% said the adoption of the standard had a negligible impact in the adoption quarter. Fifty-seven percent disclosed an amount of excess tax benefit when they adopted the standard. However, these percentages may be above average.
“This group of companies should represent the honor roll, so I suspect we would see even more heterogeneity as we move out of the“ top 50 Fortune 500 companies, ”Makridis said.
It is imperative that companies are as clear and transparent as possible, he stressed. If companies don’t provide detailed reports to investors, they risk creating more volatility in the stock market when the accounting change in stock compensation is already sufficiently volatile, Makridis said. All it takes is a market pullback to turn a billion dollar windfall today into a much smaller windfall or shortfall, depending on the number of stock compensation awards acquired. or exercised during a reference period, he said.
The surprises “shake the capital markets,” Makridis said. Companies should give investors “this information up front so that there aren’t those surprises down the road when someone rightly or wrongly expected a result and got a very different result” .
—With help from Steve Burkholder