Update to ASC 718: Transition

For my first blog entry of 2016, I look at the transition methods that will apply under the FASB's Accounting Standards Update (ASU) to ASC 718.  (If you've forgotten what this is all about, read Part I and Part II of my update on the FASB's decisions on the ASC 718 simplification project.) Also, see my handy chart showing how FASB voted on each issue in the exposure draft and the required transition method for it.

Prospective

The prospective transition method is perhaps the easiest to understand. Under this method, the company just changes its accounting procedures on a go-forward basis, with no restatement of prior periods or cumulative adjustments.

The prospective transition method will be used for the tax accounting provisions. For transactions that occur after a company adopts the ASU, the amounts that would have been recorded to additional paid-in capital will now simply be recorded to tax expense. It's that easy: no adjustments to paid-in capital or tax expense for past transactions and the ASC 718 APIC pool calculation is no more.

Retrospective

Retrospective transition is also fairly straightforward. With this method, the company changes its accounting procedures going forward, but also adjusts any prior periods reported in its current financials. For example, most companies show three fiscal years in their annual financial statements.  Where retrospective transition is required, a company that adopts the ASU in 2016 would not only change their accounting procedures for 2016, but would go back and adjust the 2015 and 2014 periods as if the new rules had applied in those periods.

The adjustment is presented only in the current financials; the company does not reissue any previously issued financial statements or re-file them with the SEC.

The only provisions in the ASU that are subject to retrospective transition are the provisions related to classification of amounts reported in the cash flow statement (and for the classification of excess tax benefits, the company can choose between prospective and retrospective).

Modified Retrospective

This transition method is used when a cumulative adjustment is necessary.  Accounting for forfeitures is a good example. A company can't just switch from applying an estimated forfeiture rate to accounting for forfeitures as they occur on a prospective basis: since previously recorded expense was adjusted based on estimated forfeitures, companies would end up double-counting forfeitures when they occur.  Retrospective restatement wouldn't fix this problem because some of the prior expense may have been recorded outside of the periods presented in the company's current financials.

It also doesn't make sense to make companies record a big change in expense in their current period; this would be confusing (and possibly alarming) to investors and isn't reflective of what is happening.  So instead, the transition is handled with a cumulative adjustment that is recorded as of the start of the fiscal period.  This adjustment is recorded in retained earnings (which is the balance sheet account where net earnings end up) with an offsetting entry to paid-in capital.

In the case of forfeitures, the company calculates the total expense it would have recognized as of the start of the period if it had been accounting for forfeitures as they occur all along and compares this to the actual amount of expense recorded to date (which should generally be lower).  The difference is then deducted from retained earnings, with a commensurate increase to paid-in capital.

In addition to the forfeitures provision, modified retrospective is used for private companies that take advantage of the opportunity to change how they account for liability awards.  It is also used theoretically for the share withholding provisions if companies have been allowing employees to tender shares in payment of taxes in excess the minimum statutorily required withholding and has outstanding awards that are subject to liability treatment as a result.  But I doubt anyone has been doing that, so in practice, I don't think a transition will be necessary for the share withholding provisions.