Accounting for ESPPs: Part III: True Ups, Tax Accounting, and Diluted EPS

Part III of Accounting for ESPPs: True-ups, Tax Accounting, and Diluted EPS

True Up at Purchase

Since you’ve estimated the number of shares that will be purchased upfront (see previous blogs), you’ll want to true up to the actual shares once the purchase occurs, right? Not so fast! In only a few cases are true ups appropriate under ASC 718.

  

Tax Accounting

As with Incentive Stock Options (ISOs), 423-qualified ESPP do not afford the company a tax deduction at “exercise” (at purchase). A tax deduction is only triggered by the disqualifying disposition (DD) of the purchased shares. Due to this treatment, a deferred tax asset may not be booked in anticipation of the tax deduction, since the DD cannot be assumed.[3]

Instead, if a DD occurs, the company treats the ensuing tax deduction as a reduction to tax expense.[4]

Basic Earnings per Share

In the period in which each purchase occurs, the issued shares should be weighted for the time they were outstanding as common stock during the period and included in your basic earnings per share.  Only purchased shares are included in Basic EPS, not shares that will be purchased in the future.

Diluted Earnings per Share

Just as with stock options, ESPP plans are potentially dilutive to your company’s earnings per share, therefore they should be included in your dilutive shares.

The Treasury Stock Method (TSM) defined by ASC 260 also applies to these awards. A high-level summary of the TSM for ESPPs is outlined below:

Please forgive the wonky numbering/formatting on the footnotes. That's what happens when you covert a Word document to blogger.

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[7] A reset is a feature in some plans with multiple purchase periods within an offering. If the price of the stock is lower on the date the next purchase period begins, all enrolled participants are automatically reset to the new, lower price.

[8] A rollover is a feature in some plans with multiple purchase periods within an offering. If the price of the stock is lower on the date the next purchase period begins, all enrolled participants are automatically re-enrolled in a new offering with the new, lower price.

[3] Regardless of the fact pattern of dispositions at your company.

[4] Prior to the adoption of ASU 2016-09, the actual tax deduction was compared to the expense for the award, but that was eliminated, greatly simplifying the process.

[5] The TSM assumes that all shares are vested and exercised/purchased/issued as a worst-case scenario, then mitigates that worst case by assuming that the hypothetical proceeds from the hypothetical issuance are used to purchase back stock on the open market, thereby lessening the dilution resulting from the purchase. 

Accounting for ESPPs: Part II: Contributions & Recognition

Part II of our Accounting for ESPP White Paper:


Estimated Contributions

Once the fair value has been established, the total expense must be calculated and then the expense recognized over the vesting period (time until purchase).

To calculate total expense, you must estimate the contributions for the period. This should be calculated at the employee level so that (in some cases) after the purchase the expense can be adjusted based on the actual shares purchased.

Generally, you should calculate the estimated contributions with the assistance of payroll. When the participant enrolls in most plans they will specify what percentage of included pay types they would like deducted from their pay[1] and used to purchase shares. Once that % is known, the % is multiplied by the estimated pay for the purchase period. 

Example of Estimated Contributions

Some companies attempt to calculate a different estimate for each employee for each purchase period based on planned pay increases. We discourage this practice since it complicates the process and can more easily be performed with the true-up at the purchase date.

Limits

Nearly all plans apply a limit on the number of shares that can be purchased by an employee on any given purchase date. For 423-qualified ESPPs, each participant is limited to purchasing $25,000 of value within a calendar year.[3] These limits should be applied to the contribution estimate to reduce variability in expense and make the estimates more accurate.

Once estimated contributions are calculated, the contributions at the participant level are divided by the estimated purchase price to arrive at an estimated number of shares purchased. Total expense is derived by multiplying estimated shares by the fair value per share calculated on the enrollment date.  

Recognition

Once the total expense for the ESPP is calculated (see prior blog post), the expense is recognized over the service period: the time from enrollment to vest/purchase. 

Originally under FTB 97-1, accelerated recognition was required, meaning that each purchase period was expensed from the enrollment date to the respective purchase date, resulting in front-loaded expense.

Accelerated Recognition

When FAS 123(R) was released in 2005, the requirement for accelerated recognition was eliminated. So, the majority of companies now use straight-line attribution.

Straight-line Recognition

Please note that whichever method you are using for your employee stock options and/or restricted stock/units (accelerated or straight-line), you should use the same method for your ESPP expense recognition. 

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[1] Remember that purchase plans vary widely in which pay types they include in ESPP deductions. Some plans include commissions, overtime, and bonuses, which can make estimating pay extremely challenging. Some companies exclude these pay types from the estimate and simply perform a true up process after the purchase occurs. This simplifies the process and may reduce variability in expense but may not be acceptable to some auditors. Including only regular wages in included pay types simplifies the process without requiring the true up. 

[2] Rounded down to the nearest whole share.

[3] For offering periods that span a calendar year any unused limit from the prior year may be “carried forward” to subsequent calendar years. Calculating these limits is complex and generally estimating the maximum shares under the limit is best practice followed by a true up after the purchase occurs. 

Accounting for ESPPs: Basics: Fair Value Components & Inputs

EPS recently wrote an article on accounting for ESPPs. We will post it here over the next few blog entries:

Employee Stock Purchase Plans (ESPPs) are a wonderful employee benefit and can even provide a significant inflow of cash for the issuing company. However, many of these plans are complex and can present substantial challenges when calculating and recognizing expense for them.

Background

Accounting for most ESPPs is similar to accounting for stock options, with a grant-date fair value and recognition of expense over the vesting period. However, some features of ESPP cause divergences from the typical option expensing methodologies.

FASB Technical Bulletin (FTB) 97-1, released in 1997 and codified into ASC 718-50-30, -35 and -55 in 2009, clarified the treatment of many of the special features of these plans, but further developments have evolved in practice since that time.

Basics

Fair Value

Fair value for ESPPs is calculated as of the enrollment date of plan.[1] In some literature (and on some tax forms) this is also referred to as the grant date. And, just as with options, an option-pricing model is needed to calculate this value for most plans. However, since these plans offer features not available in typical employee stock options, the fair values can contain up to three components, depending on the features of the plan.[2]

Feature	Fair Value  Component	Notes
Discount	Discount (Enrollment Date Market Value x Discount %)
Lookback	Call output of Black-Scholes Model	Ability to benefit from an increase in stock price. Inverse of discount x Call output
Ability to purchase more shares if price declines during purchase period	Put output of Black-Scholes Model	Ability to benefit from a decrease in stock price.

If your plan does not contain all these features, then not all the components would be included in your fair value.

Note that FTB 97-1 also mentions that an “option” where the purchase price is paid before the exercise date is less valuable than an option where the price is paid on the exercise. Therefore, the standard does allow the inclusion of “interest foregone” as a discount to the fair value. However, the examples do not include this component, nor do most systems and spreadsheets include it.

For plans with multiple purchase periods within an offering period, generally, a different fair value is calculated for each purchase period. Some audit firms require that the different fair values be calculated and then averaged together to arrive at a single fair value for the entire offering. Other companies use the different fair values specific to each purchase period for both expense recognition and true up at the time of purchase.[3]

Think of these plans as an option grant with multiple vest dates and with a known and fixed exercise date (the purchase date) and a potentially variable number of shares (since in many plans the number of shares finally purchased will depend on the stock price on each purchase date).

Option-pricing Model Inputs

As with employee stock options, an option-pricing model must be used to create a fair value. A Black-Scholes is not required but, as for options under ASC 718, at least the following six factors are required to be used by the option-pricing model selected.

Example of Fair Value for a Two-year ESPP Offering Period with Four Purchases

Enrollment Date	Purchase Date	Market Value	Price	Expected Term	Volatility	Interest Rate	Dividend Rate	Fair Value per Share
Jan-1-2019	May-30-2019	$10	$10	.5	50%	2.15%	0%	$2.9336
Jan-1-2019	Dec-31-2019	$10	$10	1	45%	2.35%	0%	$3.3428
Jan-1-2019	May-30-2020	$10	$10	1.5	40%	2.45%	0%	$3.5310
Jan-1-2019	Dec-31-2020	$10	$10	2	35%	2.55%	0%	$3.5891
Average Fair Value								$3.3491

As stated above, please note that some auditors will require the averaging of the fair values for each tranche and the expense recognized to be based solely on the average fair value. In other cases, companies will recognize expense using the fair value specific to that tranche.

In our next blog entry: Using ESPP Estimated Contributions to calculate ESPP expense. (And after that, true ups and modification accounting, what fun!)

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[1] To be perfectly clear, this is not the date that the employee signs up to participate in the plan, but the first date of the offering period. All employees enrolled in a particular offering should have the same enrollment date.

[2] Other features can also trigger modification accounting and fair values computed after the initial enrollment date, these features will be explained later in this article.

[3] True ups at purchase are discussed in more detail later in this article.  

DTA Updates for Tax Reform – A New Wrinkle

DTA Updates for Tax Reform – A New Wrinkle

A client pointed out to me yesterday, that should Tax Reform pass on or before December 31, 2017, our DTA balances will all need to be adjusted.

A Quick Review

DTA stands for Deferred Tax Asset, the accounting way to anticipate the tax deduction your company will get when your non-qualified awards settle. As you already know, when NQs are exercised or when RSUs are released, your company receives a tax deduction in the US and potentially in some other jurisdictions as well. To anticipate this, your company takes the expense that you book for NQs, RSUs, and RSAs for the jurisdictions in which you are entitled to a tax deduction at settlement, multiplies that by your corporate tax rate and books that amount to DTA. This is why your tax group asks you for an expense report grouped by grant type and country. Then when the shares are exercised or release (or NQs expire), the DTA is reversed because you are no longer anticipating a tax deduction.

Private companies often do not book a DTA. Companies in a Net Operating Loss (NOL) position often skip this step as well.

What’s the Issue Again?

So, under Tax Reform, if the new tax rates don’t take effect until 2019, DTA balances will take on a new level of complexity, since we will have one corporate tax rate for shares we expect to vest and settle in 2018 and a different tax rate for those that will settle after 2019.

For those shares vesting in 2019 and beyond, this is an easy bifurcation when you do your regular DTA balance at the end of the year. Just designate those tranches with a formula in Excel and when you summarize the DTA on the books, summarize these tranches into a separate category. Multiply the 2018 amounts times your current corporate tax rate (often 40% ish). Multiple the 2019 amounts times the new tax rates (20%? 30%? TBD).

For those of you that still have a substantial number of options outstanding, it’s likely you will continue to use the current tax rate for your vested options, since it’s difficult to predict when they which settle and under which tax rate they will fall.

Dust off those spreadsheets, or talk to your vendor to make sure they are getting ready for this change!

For more information on DTA Balance Services from Equity Plan Solutions, please contact us at info@equityplansolutions.net. 

Private Companies! It's Not Too Late to Dump Your Forfeiture Rate!

(Please forgive the formatting and spacing issues, blogger creates challenges when formatting text.)

It's not too late for you private companies! You really, really, really, should consider dumping your forfeiture rate! It will make your audits easier and faster, and therefore your life better. Every company we've worked with that has adopted this change is glad they did. And it's not hard, and it doesn't take much time.

For public companies, the ship has sailed. They were forced to adopt earlier this year, and make the one-time election to keep or eliminate their forfeiture rates. But for private companies, there is still time! Private companies must adopt for their first fiscal period that begins after 12/15/2017! So many of you have until 3/31/2018 to calculate the variance and book the true up. You won't be sorry!

How to Dump Your Estimated Forfeiture Rate

Now how do you calculate the true up to book? And better yet, do it without the auditors crawling all over you with time-consuming questions?

The short answer to the first question is:

1. Run an expense report, life-to-date WITH your current estimated forfeiture rate.
2. Run an expense report, life-to-date with a ZERO forfeiture rate.
3. Compare “To Date” (aka cumulative) expense (or, if your report doesn’t give you To Date, add prior and current expense and compare the total).
   

The difference is your true up amount or adjustment. Yes, it’s that easy. Yes, proving it’s correct is a little harder. More on that later.

Note: If you are using a system that delays the reversal of expense to the VEST DATE, it’s not QUITE this easy, but that is outside the scope of this article. (But ping us and we can explain that as well.)

Why life-to-date?
You ask: "Can’t I just run the current period report with and without the rate and take the difference in To Date (aka cumulative) Expense?"

Yes, you SHOULD be able to do that, but your auditors will want to kick the tires on your analysis and having ALL your grants on the report will help them do that. And life-to-date (LTD) should be from your adoption of FAS 123(R) (now known as ASC 718)—January 1, 2006 for many companies—until the end of your most recent reporting period—December 31, 2017 for many companies.

So now how do you tick and tie the numbers to your auditors’ satisfaction?

The approach we’ve used thus far with all our clients is to create a spreadsheet with four tabs:

1. LTD Expense Report With a Forfeiture Rate
2. LTD Expense Report Without a Forfeiture rate
3. Comparison tab
4. Summary tab

The Comparison tab has one row per grant and indicates the grant date, unvested shares (optional), final vest date and cancel date, if any, for each grant. Please ensure that EVERY grant in your system is on this tab. On this tab you pull in expense from tab 1 and tab 2 and compares them in a “Variance” column. Then add a “Reason” column that categorizes the grants into (generally) three categories:

1. Fully Vested, No Cancellation:
   These grants should have no expense variance. Any grants with no future vesting should have been trued up to actual expense on the final vest date.
2. Canceled:
   These grants should have no expense variance (unless you are using True Up at Vest).
3. Still Vesting, No Cancellation:
   All grants should have higher expense on the Without Forfeiture Rate tab. 

You could assign these categories by using formulas. However, we usually use the low-tech method of filtering for a given criteria and then pasting the Reason down through all the rows to which it applies.

On the Summary tab, we summarize the expense totals from both tabs and then use a pivot table to summarize the reasons (or categories) and the associated variances (or lack thereof):

Thus far no auditors have had an issue with this approach. Have at it! And have fun!