A new accounting standard on share-based payments that creates volatility in companies’ effective tax rates may mislead investors who use corporate financial statements to make decisions, analysts caution.
By tethering earnings to stock prices, the standard can cause a company’s effective tax rate and other important financial figures to fluctuate. While many companies today are seeing the positive effects of the accounting change in the form of tax benefits, they may see the reverse in a bear market.
The Financial Accounting Standards Board guidance, issued in March 2016, relates to the way share-based payments to employees are accounted for and presented in companies’ financial statements. It requires excess tax benefits and tax deficiencies to be recorded in the income statement when stock awards vest or are exercised.
Accounting Standards Update 2016-09 became effective for public companies this year, with opportunities for early adoption.
A Bloomberg BNA analysis of the top 50 companies in the Fortune 500 found that beginning as early as the first quarter of 2016, 24 out of 42 disclosed more than $1.7 billion in total excess tax benefits for the quarter in which they adopted ASU 2016-09. The analysis excluded private companies, public companies that don’t offer stock-based compensation, public companies that plan to adopt at a future date, and any government-sponsored entities.
In addition, 12 early adopters that have filed an annual report since adopting the standard disclosed more than $2.3 billion in excess tax benefits. Alphabet Inc., the corporate home of Google, was the largest contributor, reporting $1 billion in excess tax benefits for the fiscal year ended Dec. 31, 2016.
Companies with significant excess tax benefits saw favorable changes to their effective tax rates as a result of adopting the standard.
The effects of the standard can vary drastically depending on the amount of stock-based compensation that companies offer and whether their stock price is falling or rising, said Takis Makridis, president and CEO of Equity Methods LLC. The accounting change “was heralded as a simplification initiative,” but in reality FASB has inserted more variables “that cause financial statement numbers to move in different directions,” he said. This greater volatility creates “more of a tinder box for confusion and flawed comparability” for stakeholders, he said.
Prior to ASU 2016-09, tax benefits in excess of compensation cost — sometimes called windfalls — were recorded in equity. Tax deficiencies — shortfalls — were recorded in equity to the extent of previous windfalls, and then to the income statement.
Five-percentage-point tax rate drop
The accounting change for share-based payments led to an average decrease of almost 5 percentage points in effective tax rates across almost 200 companies that adopted the standard early — and provided enough information to compute the figure, according to Derek Johnston, an associate professor of accounting at Colorado State University.
Johnston cited preliminary findings of research that he is conducting with Colorado State assistant professors James Stekelberg and James Brushwood and professor Lisa Kutcher. The four are studying tax-related reporting by 271 companies that applied the FASB rules early. That number excludes utility and financial service companies and companies that reported negative pre-tax income.
The average impact on the “GAAP effective tax rate,” or average rate at which pre-tax income is taxed, was -5.76 percentage points for 192 early adopters that disclosed information necessary to draw up a number, Johnston said. After controlling for outliers that could distort the average, the average is about -4.75 percentage points, he said. “That’s pretty significant.”
One notable early adopter, Facebook Inc., reported a seven-percentage point drop in its effective tax rate according to generally accepted accounting principles after it adopted the standard last year. The company also said that the new accounting rules reduced its provision for income taxes by $934 million for the year ended Dec. 31, 2016.
The Bloomberg BNA analysis of top Fortune 500 companies found a similar trend among both early and non-early adopters.
Bank of America Corp., which reported $222 million in excess tax benefits in the first quarter of fiscal year 2017, saw its effective tax rate drop 4.2 percentage points in the same quarter. It attributed the decline in part to adoption of the new standard. Similarly, Wells Fargo & Co., which disclosed an excess tax benefit of $183 million in the first quarter of 2017, saw its tax rate drop 4.6 percentage points from the previous year. The bank attributed the drop primarily to the accounting change.
Of the companies Bloomberg BNA analyzed, Bank of America, Wells Fargo, and Alphabet disclosed some of the largest excess tax benefits.
Those results make sense because the biggest stock grantors are traditionally companies in the technology, financial services, and life sciences industries, Makridis said.
Makridis said that investors should be aware that these significant decreases in effective tax rates for accounting purposes don’t actually translate to lower taxes being paid to the Internal Revenue Service. “The actual checks written to the IRS are unchanged,” he said. ASU 2016-09 only changes how the tax effects of stock compensation are reflected in a company’s financial statements.
Jack Ciesielski, president of R.G. Associates Inc., an asset management and research firm in Baltimore, took a deep dive late last year into the financial disclosures of 343 early adopters. In an Oct. 25, 2016, edition of The Analyst’s Accounting Observer — a research service published by R.G. Associates —Ciesielski found that the early adopters experienced “delight” in using the new accounting rules for share-based payments. They were able to report good news — windfalls in the form of income tax benefits and substantial drops in effective tax rates, cutting their current-year tax provisions.
But Ciesielski dampened the party-like mood with cautionary notes for investors and companies, explaining that a simple accounting change was responsible for these fluctuations. “Unless it’s spelled out clearly, investors won’t understand that an improvement might be less exciting than it seems,” he said.
Makridis agreed that unless companies are clear in their disclosures, investors could misconstrue the tax windfalls and effective tax rate changes as something they’re not.
Yosef Barbut, national assurance partner and a CPA with Top 10 Firm BDO USA LLP, said that ASU 2016-09 brings the accounting for the tax effects of stock compensation into closer alignment with the “cash tax” that is actually paid to the IRS. Stakeholders who are reviewing financial statements can now base decisions off of information that is closer to actual cash tax reality, he said. “The reality is you are getting a benefit,” he said. A profitable company that pays tax to the IRS will get a deduction when share-based payment awards are exercised or vest.
ASU 2016-09 requires that companies disclose the income tax effects of adopting the new standard in “first interim and annual period of adoption,” meaning the quarter in which they adopted the standard and the annual report thereafter.
Outside of those disclosures, the companies only need to report the tax effects of the accounting change if they are material.
Ciesielski wrote that as of Oct. 10, 2016, the 343 early adopters he studied hadn’t disclosed the effects of their adoption very well. When given a choice on how to shift to the new reporting — either by what is known as the “modified retrospective” method, with limited look-backs in the accounting, or the prospective method — “most picked prospective with poor disclosure of effects.”
Nine months later, his analysis of the quality of disclosures still holds, Ciesielski said. Companies probably won’t put much of a spotlight on the accounting change in their income tax disclosures, which are known for being complex and ignored by investors, he said.
In addition, Ciesielski said that he doesn’t foresee that accounting watchdogs at the Securities and Exchange Commission will pay close attention to the disclosures, “because it’s not a recurring footnote,” he said, and therefore not suitable for timely reminders by regulators going forward.
The SEC declined to comment.
Companies’ footnote disclosures on income taxes “are usually purposefully murky,” said Ciesielski, who has helped advise FASB on various panels and served on the accounting rulemaking committee of the American Institute of CPAs.
Detailed disclosures about taxes can help draw road maps for taxing authorities such as the IRS, said Ciesielski and a Big Four firm auditor interviewed by Bloomberg BNA. The auditor sought anonymity because he isn’t 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 disclosures, the majority at least noted that they had adopted the new accounting standard and disclosed the excess tax benefits — none reported deficiencies — or claimed that the standard had an immaterial impact. Out of the 42 relevant companies, 31 percent said that adopting the standard had an immaterial impact in the quarter of adoption. Fifty-seven percent disclosed an excess tax benefit amount when they adopted the standard. However, these percentages may be higher than average.
“This group of companies should represent the honor roll, so my suspicion is that we’d see even more heterogeneity as we exit the” top 50 Fortune 500 companies, Makridis said.
It’s imperative that companies are as clear and transparent as possible, he stressed. If companies don’t provide detailed reporting for investors, they risk creating more volatility in the stock market when the stock compensation accounting change is already volatile enough, Makridis said. All it takes is a pullback in the market to turn a $1 billion windfall today into a much smaller windfall or a shortfall, depending on how many stock compensation awards vest or are exercised in a reporting period, he said.
Surprises “rattle the capital markets,” Makridis said. Companies should give investors “this information up front so there aren’t these surprises down the road when someone correctly or incorrectly expected one result and got a very different result.”
—With assistance from Steve Burkholder