The Rules Are In! ASC 718 Simplified...Sort Of?
How will ASU 2016-09 change your equity accounting?
Tuesday, January 24, 2017
Webcast Materials
Audio Archive
The amendments to ASC 718 are final; if you haven't already adopted ASU 2016-09, chances are you soon will. Calendar-year public companies will be adopting the standard effective January 2017 and other public companies will follow suit when their next fiscal year begins. It's time to determine exactly how your company will implement the changes and define best practices for a smooth transition. This webcast will focus on the revisions to the tax accounting model and share-withholding policies, including actionable ideas such as using tax settlement forecasting to reduce P&L volatility and how to respond to requests to customize the withholding rate.
Featured panelists:
- Raenelle James, CPA, Senior Manager Financial Reporting, Equity Methods
- Michael Roswog, CPA, Director of Tax Reporting, Dr. Pepper Snapple Group
Index
Kathleen Cleary, Education Director, NASPP: Good afternoon, everyone. Welcome to our first webcast of 2017, "The Rules Are In! ASC 718 Simplified ... Sort Of?"
I imagine many of you are currently trying to answer that question, as you begin to adopt the changes FASB announced with ASU 2016-09. So today, we'll talk about those changes and considerations for your company as you adopt this new standard.
But first, introductions. My name is Kathleen Cleary, and I'm the Education Director for the NASPP. Today, I'm happy to welcome Raenelle James, CPA, Director, Financial Reporting for Equity Methods; and Michael Roswog, CPA, Director of Tax Reporting with Dr. Pepper Snapple Group.
The slide presentation for this webcast is posted on NASPP.com, if you'd like to download the slides. We're using a new format this year to present the webcast, so you should also be seeing the slides as we are speaking and if you're logged into GoToWebinar.
You also will have the opportunity to ask questions throughout the presentation, by typing your question into the GoToWebinar panel on the right side of your computer screen. We will attempt to get to your questions as we go along, but if we are unable to address your question during the webcast—if we're running short on time—I will follow up with you afterwards by e-mail.
We will post an archive of today's program within the next day or two, and a transcript will be posted on our website in about two weeks.
Now, let's go ahead and dive into the webcast. Raenelle, I will turn it over to you to get us started.
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ASU 2016-09
Raenelle James, CPA, Director, Financial Reporting for Equity Methods: Thank you, Kathleen.
Going over to the agenda slide really quickly, ASU 2016-09 is real, right? Last year in most companies, people were thinking it's next year, I don't really need to worry about this, I'm not going to early adopt. But adoption is here and you need to start implementing this.
Unless your fiscal year end is not December 31st, or you're a private company, you definitely need to start applying this standard in the January, February and March months. It is here and now.
A lot is going on with the ASU, but today we're going to look at a couple of things. We'll go through a high-level introduction on the ASU in general, take a look at excess tax benefits and the APIC pool elimination, touch on withholding rates, forfeiture rates, and then look at adoption in general and what to think about as we start working through the adoption.
So moving on to the next slide, number four, we have some high level background on ASU 2016-09 and the changes. Let's take just a quick 60 seconds to recap what the changes are in ASU 2016-09. The first and biggest one, the most controversial one in our opinion is the APIC pool elimination. This revision was highly controversial amongst all of our clients, for the most part. Now excess tax benefits and deficiencies will flow through the P&L instead of being buffered by the APIC pool.
The next bullet point, slightly related, companies who are in a net operating loss situation have had to track their excess benefits in a suspense account. Going forward, excess benefits will be recognized right away.
Bullet number three, ASC 260 will be revised and going forward excess tax benefits will no longer be a component of assumed proceeds under the treasury stock method.
Number four is forfeiture rates, which was probably one of the toughest things to implement back in 2006. But now this is optional. You'll have the choice to keep the forfeiture rate, or stop using it all together.
The other big one here is number five, especially for multinational companies. Under the new guidance, withholding above the minimum rate will no longer trigger liability accounting, which is definitely a good thing. Private companies get some expense relief, so once they build a case to estimate expected term using the SEC's simplified method on plain vanilla options, they now have the one-time option to use intrinsic value when marking to market liability classified options.
Looking at the cash flow, number seven and eight, under ASU 2016-09, excess benefit will be captured in the operating cash flow section, and taxes paid on withheld shares now needs to be shown as a financing cash flow. So that's a recap and we're mainly going to focus on number one, four and five today.
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The Transition
James: So let's look at the transition. When is this going to happen?
As I mentioned earlier, unless you are a private company, or your fiscal year end is not December 31st, you're going to have to adopt in Q1. If you're a private company or your fiscal year end is not 12/31, you're going to have some time to still think about this, so this is definitely more informational for you.
If you are thinking about early adopting—for those of you who still have that luxury—a few of my clients are actually trying to adopt in December 2016, that's still technically early adoption. It's a late early adoption, but it's still early adoption, so you have that option.
Just remember tat you need to recast your entire full year when you early adopt, year-to-date figures.
So we know when, the next step is how. At a high level, each of these changes has an adoption method. For the most part, everything here is going to be self-explanatory. You've got modified retrospective, retrospective, and prospective. And for the most part, FASB is going to tell you exactly which one you need to apply to all of the changes.
So let's take a quick look at the comment letters and the initial public reaction to FASB's original exposure draft.
When we look at the exposure draft and the comment letters early last year or late 2015, most of the companies had positive feedback on almost everything except APIC pool elimination. And that's not really surprising. Those who had positive comments on the APIC pool were predominantly auditors and a couple of consultants. I think we only found two issuers supporting the APIC pool elimination as a positive change.
Despite the strong opposition to the APIC pool elimination, the FASB did it anyway. If you listen to the FASB's speech on this, Tom Lismeyer at the FASB made entirely technically accounting arguments for this change. This is the one area where we don't really think that the decision had anything to do with a simplification, but more looking from a technical accounting perspective. Mike, what did your company, DPS, think about this?
Michael Roswog, CPA, Director of Tax Reporting, Dr. Pepper Snapple Group: I think our reaction was similar to most companies. The FASB has just introduced a lot of volatility into the tax rate and made the forecasting process extremely difficult, because you have to try to forecast what your stock price is going to be, as well as the option exercise behavior of individuals. And those are two things that are very much out of your control.
James: Yes, I definitely agree on that one. Mike, I'm going to turn it over to you to talk a little bit more about the excess tax benefits.
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Excess Tax Benefit
Roswog: Sure. I think the first thing is to go over some terms and definitions to set the landscape. The first is the grant date fair value and for options, this basically comes from a Black Scholes or possibly lattice model. For restricted stock, it's fairly easy because it's the fair market value on the grant date.
The other item is the settlement intrinsic value, and in the case of an RSU, it is simply the fair market value on the vesting date. If it's an option, then you're looking at the difference between the fair market value at settlement and the strike price for that option.
Most importantly, a windfall occurs if the intrinsic value at settlement is greater than the grant date fair value. Conversely there's a shortfall situation if the intrinsic value at settlement is less than the grant date fair value.
In less technical terms, I would say you're really comparing the realized tax benefit on your tax return to the cumulative book compensation expense that you recognized on that option or restricted stock unit award.
On the next slide, we have an actual numerical example to set the landscape as to why this could be good or bad for your company. In the example, the fair value of the option at grant is $20, the strike price is $100, and the stock price on vest date is $150. In this case, the settlement intrinsic value is $50, which is the difference between the stock price of $150 and the strike price of $100, and that is then compared to the grant date fair value of $20, which yields a pre-tax windfall of $30 (actual windfall or reduction to the tax expense is $12 assuming a federal/state tax rate of 40%).
In this example, your stock price has increased, you're going to get a benefit, and this windfall will be recorded as a benefit in tax expense. So it's a good item for you.
Conversely if the stock price on the vest date was only $115, you would compare that and say, "OK, Mike, my intrinsic value shortfall is $15". You have a shortfall which then impacts actual tax expense by $2 (40% of $5) because the intrinsic value is $15, the fair value for GAAP purposes was $20, which is $5 under. So that is going to increase your tax expense and that is the situation where in the past, those windfalls and shortfalls were run through additional paid-in-capital or equity so they were not hitting the P&L. And now that is changed with the new ASU.
So kind of a pre/post discussion, prior to the ASU 2016-09 becoming effective, windfalls and shortfalls were recorded to additional paid-in-capital which is a balance sheet account. Most importantly, if you had shortfalls, the only way it hit the P&L was if your cumulative APIC pool went to zero. Post the ASU, these windfalls and shortfalls will go directly to the tax expense and the APIC pool is eliminated.
Another interesting note about the recording and the P&L is that it will happen in the actual quarter that the vesting or exercise occurs. For many companies, and in fact, in Dr. Pepper's example, there is a mass employee vesting in Q1. So we will recognize a significant benefit in Q1. Then the benefits that will come through in Q2, Q3, and Q4 will actually be very minimal.
If we go to the next slide, what does this mean? We touched on some of these points already. You have P&L volatility because the balance sheet item in the past is now going to go through tax expense. And as I mentioned, that benefit is dependent on two main variables. One, what is the stock price on the date of vesting or exercise. If you're an option heavy company, you're also trying to understand when you think your employees will actually exercise. If there are more exercises than you forecasted, you'll potentially have a much bigger benefit. On the converse side, if many people wait and are not exercising their options, you could be in a situation where your tax benefit is much less than you forecasted.
The last thing is just in terms of the treasury stock method, the excess tax benefit will be removed from that calculation. And I think Raenelle will provide some more color on that later in the presentation.
James: Yes. So as we talked about, most companies in the comment letters responded negatively to the APIC pool elimination. When we look at a survey that Equity Methods did in May of 2016, we asked companies, "Are you happy about this, or are you not happy about it?" And it seems like attitudes softened a bit and I think most clients that I talked to early adopted because of the impact the APIC pool had on their earnings. Mike talked about all people who had stock price depreciation last year, and because of that, something they couldn't control, stock price appreciation and how many shares employees are exercising, has given them a significant tax benefit. As a result, they chose to early adopt.
But overall, companies are still displeased. This is more prevalent in larger companies, which make sense, right? The larger the company is, the more sensitive they are to forecasting, which is exactly what Mike was alluding to earlier.
So if you look at the next slide, the biggest thing with the APIC pool elimination that we've been talking about so far is just the volatility that you'll see in your income statement. With the tax benefit, you have an increase in net income and a decrease in the effective tax rate. Thumbs up, that's great for you. If stock price decreases, you're going to have tax expense. The decrease in that income and an increase in effective tax rate. Not so good.
But again, it's really beyond your control, your stock price and your employees' exercise behavior. So that's the big concern.
Our largest clients tend to be the most conservative when it comes to budget to actual method. They don't really like volatility, even though technically they have a huge materiality cushion.
So this change in the APIC pool has forced a lot of companies to really just take stock and look at their tax processes and say, well, "What are we going to do now?" Forty-one percent of responses to the survey we ran in May of last year said that this new guidance will prompt them to actually automate and enhance the manual elements of their tax processes. And this completely makes sense because anytime something is going to hit the P&L, your auditors, your CEO and CFO, everyone is going to be putting more scrutiny on something like this. So manual processes are now out the door for the most part.
Most of our clients already have that underway. What our clients are really trying to do now is manage the uncertainty, manage the volatility. One way we see that happening is trying to project excess benefits and deficiencies into the future. Whether that's one year out, three years out, or five years out.
So this is what we call tax settlement forecasting. Essentially, this is going to build out a waterfall of the current and future awards that will settle and exactly what fair market value they will settle at.
As Mike was talking about, if you are option heavy, it's really challenging to figure out exactly when and how many shares your employees are going to exercise. This is all based on human behavior that you can't predict, and that is especially challenging to forecast.
What we have done for some of our clients is actually build out a robust process for that. So moving on to the next slide, let's take a look at some of the components of tax settlement forecasting.
The first component is going to be new grants. Depending on how far in the future you are looking and how far out your awards vest, you may or may not want to consider projecting out new awards. If your award cliff vests over five years and you're only projecting out the next year or two, then definitely new awards aren't going to be your biggest concern. You're going to be more concerned with activity. That brings us to our second bucket, releases or vesting or exercises.
Restricted stock is easy, right? You know exactly when they're going to vest and exactly when they'll be released to the employees because they have a fixed date. And upon vesting, shares get released to the employees.
As I mentioned, an option is going to be a bit trickier to forecast, since these are based on human behavior. Getting down to the most granular approach, what we've seen our clients do is apply different exercise rates for different grant years, or different populations, because if something is going to be more in the money or out of the money, they'll automatically have different exercise rates.
You can try to figure out exactly how your executives are going to exercise their options. They may have some sort of historical patterns, and you can try to plug those into your model as well. What we've also looked at for our broader based employers is looking historically at their option holders, how many shares did they typically exercise on an annual basis and then plugged that number into their process.
The next thing you need to factor in to the process is going to be expirations and cancellations. Some awards are going to be out of the money so they're going to expire out of the money. Some awards just won't vest, they're going to cancel. So those shouldn't even go into the actual process in the windfall/shortfall computations, and those will have no benefit for you.
After you've done all of the data processing side of it, the next thing is going to be looking at scenario analysis. Every time you're doing a forecast, scenario analysis is going to be pretty crucial.
The biggest thing here is going to be your stock price. Typically what we tell our clients to do is have a base case, and know exactly what you want to have as your guide post for your stock price. Then you're going to have to do plus or minus something against that to give you some bumper guards to work against.
Our clients typically ask me "What should I use as my bumper guard? What should I have with my high, what should I have with my low?" In this case, I would typically say, 5 to 10 percent is a good range, but at the same time, it really depends on your buffer and your materiality threshold. So there are going to be different answers.
Mike, I know you guys had done something on your side that was similar to this, correct?
Roswog: We did. We wanted to show the impact of the range. We had a base case and we showed plus or minus $2, what is the impact for that? We wanted to show for every $2 how much that means in EPS.
James: Right. It can be difficult, especially if you have options, to do the plus or minus a certain dollar amount, because an option can swing in or out of the money. RSUs are easier to do when you're looking at the sensitivity analysis, and options are a little bit more complex, especially since someone could choose not to exercise because the stock price falls by $2, or falls by $5 or $10, right?
You definitely need to be working with your forecasting team, or your FP&A team because they'll be able to tell you at least what that green circle is, what is your base case. That's something that they'll be really good at. I got a question from a client who asked me, "Hey, what should I use as my base case?" I said, "I actually don't know, you should go talk to FP&A about that."
Going forward, there are a couple of additional inputs that can be used in your forecasting process. You're going to need to look at tax rate. This is going to be more crucial for multinationals. The second thing you're going to need to look at is performance outcome. If you have a performance award or a market award, your payout could be 0 percent, or your payout could be 200 percent. Those different payouts will have a different impact on your actual tax benefit, your windfall/shortfall, therefore impacting your volatility and your P&L all the more.
When we go back to our survey and look at what companies are trying to do, over 60 percent respond that they would actually implement tax settlement forecasting. I can say for the majority of my clients, they either asked us to do it, or there's some high level back of the envelope calculations on their side.
Other companies are definitely looking at revisiting their processes, trying to make them more robust and more versatile, because as I said, when auditors come knocking on your door, you better have a good answer for them. They won't like, "Oh, that's just the back of the envelope calculation." It doesn't really bode well when they come looking for answers.
Roswog: I wanted to provide a couple of insights as to what we did at Dr. Pepper, that I think are important for tax professionals or stock plan professionals. This needs to be a multi-functional team effort. You mentioned the forecasting group, and you also need treasury involved because a lot of times treasury is the one who is setting the stock price forecast. What you don't want to do is have HR or tax making a stock price assumption that's inconsistent with what your company is doing. So you want to make sure you're talking with the correct groups.
And then most importantly, from a communication aspect, you need to make sure that your investor relations team is in the room and your CFO, because they're the ones who ultimately will have to explain this new tax benefit or expense to shareholders and explain the impact it's had on your earnings. There needs to be a lot of communication and education, and the sooner you do that, the better.
Raenelle, going back to the beginning, you mentioned it's important to be on top of this now. The one thing that I would say is that as people issue their earnings release for fourth quarter of 2016, companies will be issuing their 2017 guidance for earnings as well, and you will need to include information about the impact of this change. Is it going to make your tax greater or lower than expected? It is very difficult to forecast.
Here's an easy example—if you're at an RSU-heavy company and all your RSUs vest in the first quarter, that takes some risk off the table. If for some reason your company has a sudden sharp decrease right before the vesting date, you could lose a lot of the benefit you're expecting. So you might want to project a range, for example, I expect my tax rate to be 35 percent plus or minus 1 percent given the stock comp impact of the new guidance.
James: To that point, Mike, where you said if you're an RSU-heavy company, actually that's a little bit easier. I've had clients who actually think it will be easy for them to do this, but then they realize that even though they grant broad based restricted stock, when they look at their executives and how many shares they're getting, even if they only grant to say, 16 people, the number of shares those senior people are getting is actually the same as the number of the broad base population.
So number of participants is not what you need to look at. It really is the number of shares that they're getting.
Roswog: That's right. Very good point, Raenelle.
James: I like that someone else was on my soapbox for a little bit, it definitely needs to be a cross-functional discussion. So often we're going to companies and they're very siloed. I think this new ASU, in my opinion, has brought together companies that in the past were just so separated—this is the tax function, this is the accounting function, the HR function—holistically, all teams should be talking. But that's all I'll say for my soapbox now. I'll come off now because we have more things to cover.
Roswog: Raenelle, the last caution I wanted to give, and you partly alluded to it, financial statement auditors. Once we adopt, we've had this benefit that's been going through the balance sheet and now that you are taking that benefit to the P&L, I think your financial statement auditors are going to scrutinize harder. If you're in a situation where you are calculating your deferred tax assets and your tax benefit in spreadsheets, maybe massive spreadsheets, I think you need to be very cognizant that you will get a lot of pushback. For example, how do you know you don't have errors in your spreadsheet, and can you really prove your ending DTA on a cumulative basis or are you just kind of rolling it?
If you're not in a system solution, you should really start thinking about whether now is the time to move to something that's automated and has less risk.
James: Definitely agree. We've already seen a lot of that as well, I think about 40 percent of respondents said they were going to try and automate their processes and make them more robust because of that reason exactly.
OK, let's move on forward a little bit. Another impact of the APIC pool elimination is the impact to earnings per share.
Pre-2016-09, total proceeds for EPS comprised three things: exercise proceeds, unamortized expense, and excess tax benefit. Now, excess tax benefit is going to be in the numerator already, so it should not be in the denominator as well. With the new guidance, that's going to go away. Excess tax benefits have a big "X" through it, it will no longer be applicable going forward.
This means lower total proceeds, higher buybacks and higher dilution. As Mike was saying, you definitely need to start issuing your 2017 guidance with your 2016 earnings release. Start looking at what the impact of this change will be if you start moving forward, especially if you're an RSU-heavy company. Now you only have your average unrecognized expense as your total proceeds through the EPS treasury method computation.
All right, moving on forward to the next slide, Cash Flow Disclosure for Excess Tax Benefits.
Another related ETB change was the cash flow classification. Originally, ASC 718 pre-2016-09 required companies to record excess tax benefits as an inflow from financing activities and outflow from operating activities.
Post-2016-09, you need to classify excess tax benefits as operating activities because all the tax and profit should be in the same category. Stock comp should not be an exception to the rules. So this is more of a let's go ahead and align everything.
Earlier I said the FASB was giving you guidance as to how to roll this forward, whether it's prospective, modified, or retrospective.
This is one aspect where they give you a choice, either retrospective or prospective. Every time I see choices being given in accounting policies, it's actually pretty interesting for me. In my opinion, it gives rise to a comparability disconnect because for example, you may have Microsoft doing one thing and Google doing something else. Both large tech firms, but you really can't compare them anymore if they adopt different accounting policies.
Mike, have you guys thought of what you're going to do on this one, prospective or retrospective?
Roswog: We are going to go prospective.
James: OK. If you go to the next slide, it's another question I get quite often from clients, "What should I do?"
A lot of companies are not disclosing how they're transitioning. So what we did was looked at all the adopters as of the June-July timeframe in 2016 and said, "Of the early adopters, really what are they doing?"
When we look at what companies are actually doing, you find that prospective adoption definitely dominates retrospective adoption, and that's across all different sizes of companies. But as we go from small cap to large cap, the biggest change is the green bar, that's the prospective one.
We have a slight preference towards retrospective, but I think actually it's easy enough to do both.
Roswog: Raenelle, do you find it interesting that there's a lot of companies not disclosing?
James: Yes, and that's more common in smaller companies. We'll get to that at the end as well. But since you bring it up that point, I find that as we went through the 10-Ks and 10-Qs of companies who early adopted last year whether it's Q1, Q2, Q3, and a little bit of Q4 for those who have already filed, it's just amazing to me how companies just aren't disclosing much. They aren't talking about their forfeiture rates or what their elections are. There are a couple of companies who I would put a gold star next to as actually having good standards. They don't necessarily have to be our clients, we actually went through all companies. But Zylum is one, Columbia Sports is another one, Microsoft is another one, and they all have really good disclosures. But more often than not, we found, especially in smaller companies, the disclosures are very vague.
I don't think FASB meant for you to just go make a policy election and not actually say what you're doing, especially when they give you choices. That was actually pretty interesting for me to see.
Roswog: Raenelle, as people started to adopt each quarter in 2016, I was reading the Q's, and like you, I was quite surprised about the lack of disclosures.
James: Yes, when there's a new standard, everybody wants to know what everybody else is doing. It's very hard to figure it out what each company is doing when no one is disclosing.
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Tax Withholding
James: All right, let's move on to tax withholding. When the guidance first came out on this one, we were positive that tax withholding was one of the areas where the change would be a true simplification. The APIC pool was one that may not really be a simplification, more of an accounting technical policy that needs to be realigned to everything else. But we thought this one – withholdings - actually made sense.
So what was the change? Pre-2016-09, if you withheld above the minimum statutory rate, then you would automatically trigger liability accounting for the entire award. Now, with ASU 2016-09, only withholding above the maximum will trigger liability accounting. This sounds like wonderful news from an international perspective, right? A lot of times, different countries across the world don't have a specified or stated minimum rate, so it's really challenging for companies to know what the applicable rate is to avoid triggering liability accounting. I think where this has caused the most concern is domestically, in the U.S.
Moving on to the next slide, if you look at your typical executive, let's say, for example, that their annual grant is going to vest earlier in the year, February or March timeframe. At that time, they haven't hit the $1 million supplemental threshold for income. So they get taxed at the 25 percent minimum rate, right? But in reality, their marginal tax rate is going to be much higher than 25 percent. So what now? Mr. Executive now has to pay estimated tax payments for the under withholding. Not a fun process for him, but they figured it out – with the help of their tax advisors.
Now with the new guidance, it should be easier on your executives, right? Let's go to the next slide to see how this will work. If you systematically allow an executive to withhold above 25 percent before they hit the $1 million threshold, it's frowned upon by the IRS—this is called over-withholding. The IRS issued an information letter back in 2012 that technically over-withholding wasn't going to work and they didn't want individuals doing that.
But I think automatically or systemically, doing this across the board and saying, "You can choose your own rates" is really frowned upon.
There are technically two ways to withhold and what we're talking about right now is flat rate withholding. They're either at 25 percent or 39.6 percent, you really don't have any choices.
The second methodology is going to be the W4 rate, the aggregate method, on the next slide. I don't know how many of you attended the NASPP conference last October in Houston, but the IRS actually spoke on this particular topic during one of their sessions, about 10 percent of their session was dedicated to this. They said the IRS wouldn't complain about getting their money sooner, right? So hey, if you want to do it, the only way they're going to approve doing it is the W-4 method.
Let me kind of explain to you what the W-4 method is. Mr. Executive has an award vesting. His W-4 is already on file in the payroll system. Before the award vests, he's going to have to submit a new W-4, and on that form, fill out a specific dollar amount to be withheld. Once the vesting is processed, he has to go through again and submit a new W-4 to revert back to his old withholding.
I don't think this sounds like fun for anybody. First of all, the executives are going to have to remember to do something—change their W-4 rate—on regular basis. Not fun. Second of all, payroll winds up being stuck in the middle of a manual process. So for the most part, companies are not going to want to roll this out for everybody, it won't work very well.
I haven't seen this done successfully on a broad basis, but I have seen it done successfully on a pared down basis, to only a few people—your CEO or your CFO—just top level execs.
Mike, are you guys thinking about doing anything like this on your side?
Roswog: I think our approach, Raenelle, is going to be staying at 25 percent except for a small select group of people, which it's interesting because you mentioned, Mr. Exec is the one who needs more than 25 percent. But I would actually say it often goes down below that level and other people do have to make estimated tax payments, or just have more withheld from all their normal paychecks. So it is definitely is an issue to be dealt with.
I think because the W-4 process is not very automated for most companies and it's not only within your payroll department, the challenge becomes how does your payroll and your stock administration system handle it? It's going to have to go from one to the other and then back, and that's just going to be a very difficult process. Plus, if you have a lot of employees who want to do new W-4s, how many changes are you going to have to process? That's just a lot of time and effort. So we have made the decision to just offer it to a very select group of employees.
James: Yes. And if you think about it, for most companies, people who are getting stock are above the 25 percent minimum rate. Their marginal tax is at least 30 percent for the most part, if not higher. So companies are going to have more than just the executives who need to make estimated tax payments.
But again, the IRS was actually pretty clear at the conference. I actually went to one of the panelists, and asked them specifically, "So you're telling us that the W-4 rate is the one that you guys are going to condone?" And he said, "Yes, that's really the only way to do it."
So I believe there is more to come here. I think people often hope that the FASB and the IRS are going to have coffee every time one makes a change and get on the same page, but that's not going to happen anytime soon.
Roswog: Right. If you do go the W-4 route, then you need to absolutely make sure that you do not withhold any federal income taxes above the 39.6 percent rate. That's critical. You're going to have to have some sort of automated system to check and make sure that doesn't happen. You don't want to be the person telling your CFO that you triggered liability accounting because you over-withheld.
The other thing I would mention, in terms of supplemental income rates, the 25 percent versus the 39.6 percent, there is a special provision. On the supplemental wage payment, the general default rule is withhold 25 percent up to the million dollars, and then 39.6 percent on the excess payment over a million dollars. On the payment that triggers the $1 million, you can actually decide to withhold at the full 39.6 percent. That's not a very well-known rule, but if you dig into the treasury regulations around withholding, that option is out there.
But your execs often have other sources of income, too, so they are looking to have more withholding and they are wanting to get 36.9 percent withheld as much as possible.
James: Agreed, definitely.
Cleary: Raenelle, I wonder if I could just interrupt with a couple of questions and clarifications?
We have one comment requesting clarification that when we're talking about the 25 percent minimum rate, we're talking about federal taxes? So if applicable, you would also be withholding state taxes, and of course FICA?
James: Yes, this is federal only.
Roswog: That is correct, federal income tax, 25 percent.
Cleary: Exactly, thank you. Just another question and comment, if you do share rounding and the withholding amount happens to move up above that 39.6 percent, maybe it's 39.7 percent, are we looking at liability accounting again?
James: I think the answer there is yes, I would round down if possible.
Roswog: I do know of a company who—to avoid the situation of tipping over the maximum—set the maximum rate that they would use somewhere below 39.6 percent, so they could ensure they would never trigger it.
Cleary: For the share rounding, right? That's sounds like a good practice.
One other comment, that if you read the language on the W4, it actually cautions against constantly changing your rate. Raenelle and Mike, I think that's exactly what you're saying, it's really not practical to be updating this form all the time.
James: It does need be signed every time it goes through, right? It's a manual process. I have to go get a new form, sign it and date it, and then do it again to change it back. So I will have to do it at least three times for the year if I only have one vesting.
Roswog: Some people have automated W-4s where you can complete a new form electronically. It's interesting because often times they will say, "This may take up to two payroll periods to be effective." So when do you exactly need to put that new W-4 in place and then change it back? You have risks that you put it in and it doesn't get processed in time. And then you still get the 25 percent withholding, which was not what you're expecting.
James: It is definitely a serious conversation to be had with HR and payroll at that point and say, "Hey, what do I need to do to get this to work?" Even if I am going to do it for just a handful of employees.
Cleary: OK, thank you. Let's go ahead and go forward with award agreements.
James: OK. One other wrinkle with the withholding process is that it may sound like a good idea, and you may decide that for your executives, you want to go ahead with it. When you pop open your award agreement, what does it say? It might just say that you have to withhold at the minimum rate. I've seen award agreements where they are written to withhold at the minimum rate, and I've seen award agreements where they're written to withhold at the applicable rate. Applicable definitely gives you a lot more flexibility, right?
Then you can say, "Well, applicable is no longer minimum, right? In the U.S., I can do whatever I want technically as long as it's not above maximum."
But some companies still have this minimum rate written into their award agreements, and that was done so that executives couldn't come and ask for something more because they knew it would trigger liability accounting.
Mike, do you guys have minimum or applicable on yours?
Roswog: We are actually very fortunate to have applicable.
James: Right. So you can change the withholding rate for your executives with their vesting and it is actually allowed, right? It's not something you are prevented from doing.
So companies who have minimum in their plan agreements or in their plan documents, what then? You have a couple of options. Option one is to just change it for the next issuance of the grant, but then you have all your legacy awards you really can't do anything with. Option two is to modify your current awards too, to allow maximum withholding.
The biggest question is if you modify the terminology, is that going to trigger modification accounting? Our opinion has always been no on this. If you go to the next slide, you'll see that FASB has actually issued an exposure draft, late last year. And I think it was really due to this whole new ASU 2016-09 as well.
Before, any change in the terms of share-based awards would be considered a modification and would possibly trigger modification accounting. The new guidance, however, states that modification accounting must be applied unless the modification leaves these attributes unchanged: the fair value, the vesting conditions, or the classification of the award between liability and equity.
So if we look at this holistically, this award agreement change is not changing the fair value, the vesting conditions, or the classification because you're not switching it to be a liability award by saying you can withhold at the maximum or the applicable rate.
I've seen some companies do it, but now we know with the exposure draft, it's not likely to trigger modification accounting. So no downside there.
Going back to one of our surveys from earlier last year, we looked at what companies would do for tax withholding flexibility and if there were any plans for flexibility. A lot of companies said they weren't going to do anything. Some companies said that they're just going to sit tight and investigate the best ways of withholding above 25 percent.
I did talk to one company—and I don't recommend this approach—who said that they were going to automatically default to 39.6 percent unless an employee objected and wanted to do something less. Again, the IRS says the W-4 rate is the best approach to use, so I recommend doing that in the short term until they give some more guidance, which I'm hoping will come soon.
Roswog: Raenelle, I'm actually quite surprised that 37 percent of companies said they weren't going to do anything, because this is clearly a big issue for your C-Suite and I'm very surprised that there are so many companies saying they're not going to make some accommodations.
I can say my personal experience with my execs, one of the first questions they asked me is, "Does that mean that you can withhold for me at 39.6 percent and not trigger liability accounting?" And I said "Yes".
James: Exactly. You have some execs whose tax advisors are very in tune with everything that's going on, and so they're telling them there's change, even though it isn't something they may know about.
A couple of companies I have personally talked to have a firm stance on this. They have come out and said, "Listen, these execs have been doing estimated tax payments for how long now? They've gotten the process down, or at least should have by now, so there's no ‘sympathy' for them to a certain extent. So they have their process, let's not do it on our side and create more work for us which is not necessarily going to be easy." And then they felt "Where do you draw the line at that point?" They felt if they did it for employee A, then they would have to do it for employee B, C, and D. At some point, someone is going say "It's not fair to me." They're going to deal with the ramifications anyway, so they figured they would have everyone complain, as opposed to just having a few employees stop complaining.
I feel that the 37 percent in the survey will actually change by the time there are more companies starting to do something. This survey was in May of last year, when people were still a bit unsure as to what to do, and what are other companies were doing. But I really do think as the year unfolds, we'll find more companies saying you know what, executive A, B, and C are really complaining and really pushing for this, so we did it.
Roswog: it would be very interesting to do your survey again in two years and I think you'll find that a lot more are at least giving flexibility to their top executives. And maybe even going to a threshold below that. I think there will be a lot of pressure to make sure that at least the C-suite is accommodated.
James: I definitely do agree.
Cleary: Raenelle and Mike, it's interesting that we have several listeners who are saying "How is it we can allow this W4 withholding rate changes for some people and supplemental for others? Don't you have to treat everybody the same?" Quite a number of people listening are asking that and it seems to be exactly what you're addressing. Some companies are going to make accommodations for their C-suite, but it may not be fair to other employees.
James: That is a company HR/payroll preference and they need to take a stance. Executives do tend to get favorable treatments for one reason or another. Mike, I don't know if you have any advice from that side, but I've seen companies treat rank and file versus their executives differently.
Roswog: I would definitely agree on that. I did see a different survey, where companies showed a little more willingness to help out the execs. And I think that's pretty common. I think you might find if you actually have some questions, not even related to the stock compensation, there might be some payroll situations that are a little unequal in favor of the executives already. Because executives typically get bonuses, what are they doing on the bonus front? Again, they might be accommodated differently than your other employee population.
James: Yes. It doesn't always seem fair, but that's the way the world works sometimes. All right, let's talk about the disclosure for cash paid to withhold shares by the company.
The process wasn't really clear in the old ASC 718 guidance. But since the cash paid to the IRS when shares are withheld is essentially repurchasing shares from the employees, the cash outflow should technically be classified as a financing activity. This portion of the guidance is really just adding some clarity to this.
And the method here is retrospective, so at least that's clear.
Talking about cash flows and going to the next slide really quickly, the one most folks are not really thinking about holistically is the potential cash burn. If you're withholding shares and the company is paying the tax at settlement, it can be a material cash outflow. So if you begin withholding at a high level, then you might be writing larger checks to the IRS. So definitely take a look and if that's going to be an issue for you, try and forecast your cash burn.
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Forfeiture Rates
James: All right, the next topic that we're going to cover here is going to be forfeiture rates and I think this is probably one of our last topics for the day before we get into adoption. For me, at least personally, this revision was a little bit ironic. I think it more reflects the fingerprints of the Private Company Council, the PCC, it's one of their really hot button agenda items per se.
I don't know for you, Mike, and for DPS, but I think it's easier for you than for other companies. For larger companies, at least the ones that we deal with, forfeiture rates are easy, right Mike?
Roswog: I would agree with that. We are going to adopt in Q1 and we are going to keep our forfeiture rate.
James: Right, so they may have presented some problems to even Dr. Pepper Snapple 10 years ago, upon the adoption of 123R (now ASC 718), because at that point everyone was trying to figure out exactly how to compute their forfeiture rate. But at this point in time, as far as we can see, they have definitely worked well. We don't have any issues here.
The interesting thing about what the FASB is doing here is again, they are giving you a choice. You can choose to keep the forfeiture rate or you can choose to do away with it.
The dynamic forfeiture rate—most of you are familiar with that—has typically won out in the market and static shows up really infrequently. Under the dynamic approach, what you're simultaneously doing is estimating future forfeitures and also reversing expense on actual forfeitures. So it works really well. That's what most of our clients are doing and most companies that we know are doing as well.
So we recommend that companies actually stick with the forfeiture rate. One of the reasons is that it's a pretty good thing to have built into your processes from a forecasting perspective.
Out of all of the companies that we work with, I would say about 95 percent of them have chosen to keep the forfeiture rate. And the few that haven't have been smaller companies where their forfeiture process is manual, or in some cases larger companies where the forfeiture rate was something executives just couldn't wrap their hands around it.
I had one client where it was a really onerous process every quarter to prove the forfeiture rate, and so they said, "You know what, enough is enough, let's just do away with this. At least, we have the option." Their forfeiture was actually pretty small anyway, around 1 percent or 2 percent, so it's a very small number for them.
If we go to the next slide, the one thing to be aware of, is that if you decide to go down the path and remove forfeiture rates, there are going to be a couple of one-time entries that you are required to do for the adjustment. So just be aware of this.
You will need to do a one-time debit to retained earnings for the cumulative expense adjustment and this will need to be done for tax as well. So definitely make sure your team is aware of this, that they will need to book a cumulative adjustment to retained earnings as well.
So going to the next slide, we're going back to our survey results again. When we asked respondents whether or not their intention was to keep or remove the forfeiture rate or if they are not sure yet. More large caps expressed that they were going to keep the forfeiture rate. And again, these weren't just our clients, so this data is not biased towards our clients.
But in our opinion, if you're on the fence, we'd really suggest keeping the forfeiture rate. It's going to reduce forecasting variances. If you're a larger multinational company, you're still going to need it for IFRS2 purposes; and if you do away with it, you're going to have a larger gap now between U.S. GAAP and IFRS reporting.
And then also on assumed awards, you're still going to need it. Let's think about this, the turning back isn't going to be easy. So if you ask us, we'll tell you to keep it, if it's not a difficult process. If it is a difficult process for you, you can think about taking it out, but definitely think about the downstream implications, IFRS, forecasting precision and assumed awards comparability.
So looking at the early adopters and going through all of the 10-K's—Mike, back to your comment that companies are not disclosing what they are going to be doing. If we go to the next slide, you'll actually see that large and small companies really aren't disclosing, so it's kind of across the boards.
For those who do disclose, they found that more companies—especially larger ones—are keeping it. If you look at the right side of the graph, twice the number of larger companies are keeping it, as opposed to 17 percent who are not keeping it.
If you look at the smaller-cap companies, under a billion dollars, only a handful of them, 13 percent, are keeping them and then 35 percent not keeping them. Again, the majority of companies are not really saying one way or another.
Whatever you decide to do, I would definitely recommend disclosing your policy election even if you're holding everything constant.
ASU 2016-09 gives you the option to make an election. It doesn't say that you shouldn't disclose what you're doing. I don't know, Mike, you guys are keeping your forfeiture rate, and you are adopting in Q1 of this year, are you disclosing what your choices are?
Roswog: That's correct. I think we were planning to make the affirmative statement that we are retaining our forfeiture rate methodology.
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Adoption
James: That's good to hear. All right, let's start talking about adoption.
So, again, we went through the early adopters last year, and for the 10-K's and Q's that we had seen through September, what affects adopting? It seems like across the board, all sectors were adopting so we haven't really seen a trend one way or another.
I think as of September last year, we have seen about 300-plus cases of early adopters. If you look at the next slide, you can see a couple of those companies listed. You've got Boeing, McDonalds, McKesson, Leidos, T-Mobile, American Airlines, some really large companies and some smaller ones too.
Next, I want to go through what you need to think about when you're adopting, what should you really be doing and focusing on.
If you go to the next slide, you'll see there are a couple of things. First of all, make sure cross-functional meetings are being held. I know Mike mentioned this earlier and I talked about it briefly as well, but this is an all-encompassing adoption.
If you have the choice to early adopt, don't operate in vacuum where it looks like it will be a good thing for HR to do it, or tax to do it. Make sure everyone knows because you can't adopt one piece of the guidance and then choose something else later on for the rest of it. You have to adopt everything holistically.
Definitely make sure you're having cross-functional meetings between accounting, HR and tax. This has impact to the P&L and EPS with the APIC pool elimination, so you actually need to start thinking about forecasting. As Mike was talking about earlier, with your earnings release to the street for 2017, what will your future predictions will be, that's really important to know? Start looking at what you think your expenses are going to be and what you think your P&L impact is going to be.
For some companies, option grants aren't going to do a whole lot to your P&L because they're not a huge chunk of what you're looking at. From an expense perspective, they are not material. So that's OK. But if they are, definitely starting thinking about that.
You also need to start looking at the computation for retained earnings and what that needs to be, if you are going to take out the forfeiture rate. Make sure if you're taking out the forfeiture rate, that forecasting isn't important to you. Again, another conversation to have with accounting, making sure everyone here is on the same page.
If you are using a stock plan provider or any system to run your reports, make sure that they are able to help you with that adjusted number and that number to retained earnings. I know we've had to provide several of our clients with that adjusted entry for January because they went live in January or because they early adopted. So make sure you're talking to your stock plan providers or your system administrators to help you through this transition as well.
We talked a little about like cash burns, if that's really going to be crucial for you, start taking a look at that.
If your adoption is going to occur in an interim period, definitely take note of the extra calculations that you need to perform. I talked about early adoption as not really being an option for most companies. It is still an option for non-fiscal year end companies and some companies who have a longer tail for their filings are still trying to early adopt in December 2016. You can still do it, but please do not rush into any decision, really make sure about the entire process.
At the end of the day, make sure you update all of your procedures in line with your policy elections and risk drivers. If you have manual processes, definitely try and look at them and see where you can button them up.
If you need to start looking for an outsourced solution or a system to handle the steps for you, start thinking about it now, as opposed to later. You're going to have a lot of scrutiny on certain tax processes now going forward.
Mike, do you have any more advice for anybody who is adopting that I didn't really talk about just yet?
Roswog: No. I think that list was very encompassing and it gives you a lot of the factors that you should be considering.
James: OK. So really looking at "late" early adoption, if you are going to adopt in Q4 of 2016, if that's your fiscal year-end, remember that you need to show everything for the year-to-date as if the ASU have been adopted at the beginning of the fiscal year.
You don't go back and restate Q3, Q2 and Q1, but your full year-to-date needs to show everything, as of nine months after March 31st. So make sure you're looking at them, recasting your numbers.
Roswog: Raenelle, do you think that it will cause many companies to adopt in Q4 because they've now have nine months to get their processes in order and if they want to take the benefit for 2016, they can adopt in Q4 and still get the full year benefit. I think we're going to see a flood of filers come in that have adopted in Q4. Would you agree with that?
James: I would agree. I actually have some clients right now and we are working on it for them because they're filing their 10-K in a couple of weeks.
It was curious to me that in Q1 we saw so many companies early adopt, but I think the ones that we saw adopting in Q1 of last year were definitely smaller companies, newer companies. But by the end of the September/October time frame, we had approximately 300. I really think that's going to more than double.
And Mike, if you want to share your resources, we can pool our resources together and see if we can decide how many companies went live by December of last year. Just a curious thing, but then no companies have a choice come January, right? Everyone has to be live.
I have a couple of clients who just said, "You know what, we don't really want do anything." And you're one of them, right, Mike? You just don't want to do anything in Q4, you're going to do everything in Q1, right?
Roswog: That's right. We are going to be adopting in Q1 of '17.
James: Right. I would really be curious how many companies try to do something at 12/31/16. Still have a little time to figure that one out. OK, the last couple of slides before we close today are going to be about disclosures.
We talked about how companies really weren't disclosing, in our opinion, the way they should have been. What we did is pulled Columbia's disclosure and put it here in the presentation, so you can easily reference this.
We also have a list of early adopters, if any one needs it, as of as of August or September of 2016 and the link to all of their filings. If you want to look at what your competitors are doing, or what your peers are doing as of Q3 of last year, we're happy to provide that to you; just ask Kathleen and I can have her forward that over to you.
Columbia actually did a really good job of putting everything in. They gave some background as companies normally need to do about the new ASU, then they noted that they made the policy election to early adopt and their effective date was as of January 1st, 2016, so they adopted in Q1.
They talked about excess tax benefits and how that resulted in $401,000 for the quarter and $4.4 million in income tax expense within the three, and six months, ended June 30th respectively. They talked about their excess tax benefits and deficiencies; and the income that change meant for them.
Then in the next paragraph, on the next slide, you'll see that they talked about the forfeiture rate election. In that paragraph they said that the company has elected to continue to estimate the number of stock based awards expected to vest, as permitted by ASU 2016. They explicitly say that they will choose the forfeiture rate.
If you go to the next slide, they talked about the financing activities and the impact to the cash flow, and you can see that note in green.
I think that really covers what we wanted to talk about today. Mike, do you have any parting notes or comments?
Roswog: I was just going to mention on the Columbia Sportswear disclosure, the first one where it highlights the excess tax benefit of $400,000 in the quarter, but $4.5 million in year-to-date six months.
That really highlights the volatility issue that is upsetting to a lot of individuals. In this example, in one quarter, you had a $4.1 million benefit, and then in the other quarter you only had a $400,000 benefit.
As you think about the volatility and the tax rate, you have the full year this year, compared to full year last year, this quarter versus the previous quarter. All of those even have a lot more volatility than you ever had before, and that is why back to the beginning where you mentioned the comment letters, Raenelle, most were about the APIC pool and they were basically all negative. This is why—because there is going to be a lot of volatility.
Frankly, if you are in a shortfall situation because your stock price has not gone up over the last few years, you're also going to have a drag on your earnings where it used to be a balance sheet disclosure. I think those are the things that really standout in terms of the new tax classification.
James: Right. And I think—to your point—what this is touching on is that most of the vestings are going to occur in Q1 or Q2, which is probably what happened to Columbia; they had a huge hit in Q1.
Roswog: That's correct. A lot of companies will come out with a Q1 tax rate that is going to be significantly lower than their Q2, 3 and 4, as well as their full year rate. I think it's going to be interesting to see how the market reacts over time to that volatility.
Even though stock prices for lots of companies today are doing well, it's hard to predict what the economy is going to be, say three years from now. Whether it's a macro event or something specific to your company or your industry, you could see huge changes where you've had a couple years of benefits. All of a sudden you can have pretty significant shortfalls and then it's going to hit expense—how is everybody going to react to that? I think it will be very interesting.
James: Yes, so I think more to come. It's still too new to really say what's going to happen in the future, but it's something we will have to get used to. I think after a year we're still trying to decide what we think, what companies are doing, what people are saying, and what the street is really saying.
And hopefully stock prices do continue to go up as they have been for the past couple of years. To your point, Mike, lots of things are happening, so we don't know what that's going to mean for this year or next year.
I think that's all that we had for today on our side.
Cleary: I do have a couple of accumulated questions, if you don't mind, since we have a couple of minutes before our webcast closes. We talked about adjusting tax rates with the W-4 and staying below the maximum rate, and the discussion was primarily about the federal rate. Any comments about state rates or how companies should handle state rates?
Roswog: I think the first comment I would have is, again the key is to not exceed the maximum rate in the states and that's another complexity if you are a multi-state company doing business within 50 states. You're going to have to have some sort of process in place. If you don't use supplemental rates, you're going to have to make sure you do not exceed the maximum in that jurisdiction; otherwise, again, you would trigger the liability accounting.
Raenelle, do you have anything to add?
James: No, I think that's about right. States get pretty complex, though to Mike's point, if you have employers operating across the entire country, just be sure you know what all the rules are across all the different states, which on some level, you should already know.
Roswog: If it's a state where there are supplemental rates, I think a lot of companies are just going to say, "You know what, I'm just going to use the supplemental rate because it's just more work, it's more time, et cetera."
And you know, state tax liability is obviously significantly less than your federal tax liability, so I think a lot of companies will want to stay as simple as possible. If the state has a supplemental rate, I think it will be used.
James: Yes, for the most part.
Cleary: Of course, some states don't even have a supplemental tax rate, so that creates some challenges.
Roswog: That's right. That's a bad state.
Cleary: Oh, we won't say that because maybe they are listening. But the great states are the ones that don't have income tax at all, right?
Roswog: That's right. Those are very good.
Cleary: I don't happen to be in one of those.
James: I think, Mike, you might be in one of them.
Cleary: Yes, I think you're right. Ok, another question, if you've currently got an APIC balance, what will happen there as companies convert to this new ASU?
James: Nothing. You don't do anything with it at this point and just ignore it going forward. You don't write it off. You don't get to run anything through it; you don't get to do anything with it.
Roswog: Yes, I would agree with Raenelle. I think we say it's essentially frozen.
Cleary: Right. I spoke with one company that actually uses the APIC pool for some sort calculation to determine new grants. I don't recall all the details and the ins and outs of it, but they will continue to calculate the APIC pool going forward. Although it was such a complex calculation when we first started doing it back in 2006, they've evidently become so used to it, they're going to continue, at least to help determine their new grants.
One last question, do you have any feedback on private companies whether they are electing to use forfeiture rates or not?
James: The private companies that I see on my side, some of them already had a zero percent forfeiture rate. They were not using a forfeiture rate anyway. But the private companies that I do see still using the forfeiture rate, those tend to be small numbers anyway. It's kind of across the board there, I've seen more smaller private companies do away with it, but I do have a handful who still use it.
Cleary: OK. I just want to say thank you so much to Raenelle and Mike. They've given us quite a lot of practical advice today which I'm sure our listeners can take back and apply as they adopt the changes to ASC 718.
Just a reminder to everyone listening, we'll be posting the audio and video archive within the next day or two. If you need to listen to any part or all of the webcast again, it will be posted and you can listen as many times as you need to.
The transcript will also be posted in the next couple of weeks, and that will help you to address any questions that may come up.
Again, thank you so much to our expert panelists, Raenelle James and Michael Roswog, for their time preparing and presenting this webcast today. I really appreciate both of you.
I also want to thank our audience for joining us today and I hope that you will submit all your performance award questions so that they can be answered for our next webcast, on February 16th, "Ask the Experts: Performance Awards".
Thank you, everyone.
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