Just when you thought it couldn’t
get any more complicated. EXECUTIVE SUMMARY
| Implementation of
FASB Statement no. 123(R) goes
beyond selecting a method to value
employee stock options. CPAs also must
help companies make the necessary tax
accounting adjustments to properly track
the tax benefits from stock-based
compensation.
Statement no.
123(R) requires companies to
use deferred tax accounting for employee
stock options. An option’s tax
attributes determine whether a
deductible temporary difference arises
when the company recognizes the
option-related compensation expense on
its financial statements. Companies will
treat nonqualified and incentive options
differently.
Companies that did
not follow the fair value
approach of Statement no. 123 must
establish an opening pool of excess tax
benefits for all awards granted after
December 15, 1994, “as if” the company
had been accounting for stock options
under this statement all along. To do
this CPAs must do a grant-by-grant
analysis of the tax effects of options
granted, modified, settled, forfeited or
exercised after the effective date of
Statement no. 123.
Certain unusual
situations may require
special handling. These include cases in
which employees forfeit an option before
it is vested, the company cancels an
option after vesting or an option
expires unexercised, typically because
it is underwater. CPAs also need to be
cautious of possible pitfalls when
options are underwater, when the company
operates in other countries with
different tax laws or has a net
operating loss.
Calculating the
beginning APIC pool and the
ongoing tax computations required by
Statement no. 123(R) is a complex
process requiring careful recordkeeping.
The newly approved simplified method
adds yet another set of computations
companies need to perform. CPAs should
encourage companies to begin making
these calculations as soon as possible
as some require tracking down historical
information.
Nancy Nichols,
CPA, PhD, is associate professor of
accounting at James Madison University
in Harrisonburg, Va. Her e-mail
address is
nicholnb@jmu.edu
.
Luis Betancourt,
CPA, PhD, is assistant professor of
accounting at James Madison
University. His e-mail address is
betanclx@jmu.edu
.
|
ou’ve made the
necessary valuation methodology decision and
helped the company select an adoption method. Now
it’s time to sit back and relax while other
companies struggle to finish implementing FASB
Statement no. 123 (revised), Share-Based
Payment. But wait…. Before you get too
comfortable, there are other concerns companies
that issue stock-based compensation must deal
with. While valuation issues have received the
lion’s share of the attention, CPAs also must help
unwary companies cope with Statement no. 123(R)’s
tax implications.
Change Is Inevitable In
anticipation of mandatory expensing of
stock options, 71% of companies were
revising or planning to revise their
long-term employee incentive programs.
Source: Hewitt Associates,
Lincolnshire, Ill.,
www.hewitt.com .
| The tax
rules under Statement no. 123(R) are complex. They
require tracking tax benefits from stock-based
compensation on a grant-by-grant and
country-by-country basis. Plus, to reduce the
income statement impact of future transactions,
companies need to prepare a 10-year history of
stock option activity to determine the amount of
the additional-paid-in-capital (APIC) pool. This
article describes the relevant tax and accounting
so CPAs can help employers and clients comply with
the new requirements more easily.
THE BACKGROUND
FASB issued Statement no. 123(R) in December
2004. Under the earlier Statement no. 123,
companies had the choice of accounting for
share-based payments using the intrinsic value
method of APB Opinion no. 25, Accounting for
Stock Issued to Employees, or a fair value
method. Most used the intrinsic value method.
Statement no. 123(R) eliminated that choice and
requires companies to use the fair value method.
To estimate the fair value of employee options,
companies must use an option-pricing model such as
Black-Scholes-Merton or lattice. In
addition to selecting a pricing model, companies
need to consider the deferred tax accounting
impact of expensing options based on fair value.
With FASB Staff Position no. 123(R)-3 allowing
most companies until at least November 11, 2006,
to determine a method for computing the pool of
excess tax benefits, there is still time for CPAs
to help companies prepare for the deferred tax
issues Statement no. 123(R) creates.
DEFERRED TAX ACCOUNTING
Statement no. 123(R) requires companies to
use deferred tax accounting for employee stock
options. An option’s tax attributes will determine
whether a deductible temporary difference will
arise when a company recognizes the option-related
compensation expense on its financial statements.
Nonqualified stock options (NQSOs).
When a company grants an employee an
NQSO, it recognizes the related compensation
expense and records a tax benefit equal to the
compensation expense multiplied by the company’s
income tax rate. This creates a deferred tax asset
because the company is taking a financial
statement deduction that is not currently
deductible for income tax purposes. When
an employee exercises an NQSO, the company
compares the allowable tax deduction with the
related financial statement compensation expense
computed earlier and credits the tax benefit
associated with any excess tax deduction to APIC.
In other words, CPAs should compare the actual tax
benefit with the deferred tax asset and credit any
excess to stockholders’ equity instead of to the
income statement. If the tax deduction is
less than the financial statement compensation
expense, the write-off of the remaining deferred
tax asset is charged against the APIC pool. If the
amount exceeds the pool, the excess is charged
against income. A company’s deferred tax
asset usually differs from its realized tax
benefit. Think of the deferred tax asset as an
estimate based on the compensation cost recorded
for book purposes. Companies should not expect the
deferred tax asset to equal the tax benefit they
ultimately receive. Exhibit 1 illustrates
the accounting for NQSOs and deferred taxes.
|
|
On January 1,
2006, XYZ Corp.
grants Jane Smith
options on 100
shares. The options
have an exercise
price of $10 (stock
price on date of
grant), vest at the
end of three years
and have a fair
value of $3. All the
options are expected
to vest. Thus, the
compensation cost to
be recognized over
the three year
period is $300 (100
options X $3).
Assuming a tax rate
of 35%, the same
journal entries
would be made each
year in 2006, 2007
and 2008 to record
compensation cost
and the related
deferred tax:
|
Dr.
Compensation
Cost
|
$100
|
|
|
Cr.
Additional
paid-in
capital
|
|
$100
|
(To
recognize
compensation
cost)
|
|
Dr.
Deferred
tax asset
|
$35
|
|
|
Cr.
Tax
expense
|
|
$35
|
(To
recognize
a deferred
tax asset
for the
temporary
difference
related to
compensation
cost)
| |
At the end of
2008 the balance in
the deferred tax asset
is $105 and $300 in
additional paid-in
capital. Assume Smith
exercises her options
in 2009 when the stock
price is $30 per
share. If XYZ’s common
stock is no-par stock
it would record the
exercise as follows:
|
Dr.
Cash ($10
exercise
price X
100)
|
$1,000
|
|
Dr.
Additional
paid-in
capital
(balance
from
above)
|
300
|
|
|
Cr.
Common
Stock
|
|
$1,300
|
(To
record
issuance
of stock
upon
exercise
of
options)
| |
For tax
purposes, XYZ Corp.
has a deduction of
$2,000 (($30 share
price – $10 exercise
price) X 100).
Assuming XYZ has
sufficient income to
realize the deduction,
the deduction yields a
tax benefit of $700
($2,000 X .35), which
exceeds the $105
benefit recorded in
the deferred tax asset
by $595. This $595 is
the tax benefit of the
excess of the
deductible amount over
the recognized
compensation cost. XYZ
would make the
following entries:
|
Dr.
Tax
expense
|
$105
|
|
|
Cr.
Deferred
tax asset
|
|
$105
|
(To
write off
the
deferred
tax asset
upon
exercise
of
options)
|
|
Dr.
Current
taxes
payable
|
$700
|
|
|
Cr.
Tax
expense
|
|
$105
|
|
Cr.
Additional
paid-in
capital
|
|
595
|
(To
adjust
current
tax
expense
and taxes
payable to
recognize
the
current
accounting
tax
benefit
upon
exercise
of
options)
| |
If all the same
facts as above hold
true except the
options expire
unexercised, there
would be no deduction
on the company’s tax
return. Under
Statement no. 123(R)
any write-off of the
deferred tax asset
would first offset, to
the extent remaining,
any additional paid-in
capital from excess
tax benefits from
previous awards
accounted for in
accordance with
Statement no. 123(R)
or Statement no. 123.
The remaining balance,
if any, would be
recognized in the
income statement.
Thus, assuming no
additional paid-in
capital from excess
tax benefits from
previous awards, XYZ
would make the
following entry:
|
Dr.
Tax
expense
|
$105
|
|
|
Cr.
Deferred
tax asset
|
|
$105
|
(To
write off
the
deferred
tax asset
upon
expiration
of
options)
| | | |
Incentive stock options (ISOs).
ISOs do not ordinarily result in a
tax deduction. Accordingly, companies recognize no
tax benefit when they record the compensation
expense under Statement no. 123(R). When a
disqualifying disposition of an ISO occurs—when an
employee disposes of the stock within two years of
the option grant date or within one year of the
option exercise date—the company gets a tax
deduction equal to the difference between the
option’s fair value and the exercise price on the
date the disqualifying disposition took place.
The tax effect of a disqualifying
disposition results in a financial statement
deduction in the year it occurs. The recognized
tax benefit may not exceed the total compensation
expense under Statement no. 123(R) for that option
grant. Any excess is credited to APIC. Exhibit
2 illustrates the accounting for an ISO with
a disqualifying disposition. |
|
for
ISOs With
Disqualifying
Disposition |
Assume XYZ
Corp. grants 1,000
ISOs on January 1,
2006. The exercise
price of $25 equals
the fair value of a
share on the grant
date. All the options
are expected to vest
under one-year cliff
vesting. The fair
value of an option is
$15, resulting in a
compensation deduction
of $15,000 ($15 X
1,000 options). On
April 1, 2007, all
the options are
exercised and
immediately sold
when the stock price
is $45. The
immediate sale
results in a
disqualified
disposition. The
company’s tax
deduction is $20,000
(($45 fair market
value (FMV) – $25
exercise price) X
1,000 options).
The tax benefit
recognized in the
income statement
equals $5,250 ($15
fair value X 1,000
options X 35% tax
rate). The excess
tax benefit of
$1,750 [($20,00 tax
deduction – $15,000
compensation expense
recorded) X 35% tax
rate] is credited to
APIC.
| | |
THE APIC POOL
Statement no. 123(R) provides two transition
alternatives: the modified prospective method and
the modified retrospective method with
restatement. In addition, Staff Position no.
123(R)-3, which FASB posted on its Web site on
November 11, 2005, offers a third simplified
option. In all cases CPAs must help companies
calculate the amount of eligible excess tax
benefits (the APIC pool) on the adoption date.
This is important because is helps avoid an
additional income statement hit to earnings for
future option exercises or cancellations.
Companies that did not follow the fair value
approach of the original Statement no. 123 must
establish an opening pool of excess tax benefits
included in APIC related to all awards granted and
settled in periods beginning after December 15,
1994, “as if” the company had been accounting for
stock awards under the Statement no. 123 approach
all along. These companies also should determine
what their deferred tax assets would have been had
they followed Statement no. 123’s recognition
provisions. If, after adopting Statement
no. 123(R), a company’s book expense on an option
exercise is greater than the tax deduction, the
difference, adjusted for taxes, is applied against
the existing APIC pool. It does not have an impact
on the current-year financials. Without the APIC
pool, the tax-adjusted difference would be an
additional income statement expense.
Obviously, calculating the beginning APIC pool
and the deferred tax asset will take some time.
CPAs must do a grant-by-grant analysis of the tax
effects of all options granted, modified, settled,
forfeited or exercised after the effective date of
the original Statement no. 123. (That statement
was effective for fiscal years beginning after
December 15, 1995. For entities that continued to
use the Opinion no. 25 approach, pro forma
disclosures needed to include the effects of all
awards granted in fiscal years beginning after
December 15, 1994.) For companies that
were using the recognition provisions of Opinion
no. 25, a good starting point will be the
information used previously for Statement no. 123
disclosure purposes. The tax return preparation
files should include information on NQSOs
exercised and ISO disqualified dispositions. Human
resource department files may be another good
source of information. Although
recordkeeping must be done on a grant-by-grant
basis, ultimately the excess tax benefits and the
tax-benefit deficiencies for each grant are netted
to determine the APIC pool. Awards granted before
the effective date of Statement no. 123 are
excluded from the computation. SEC Staff
Accounting Bulletin no. 107 says a company needs
to calculate the APIC pool only when it has a
current-period shortfall. Given the difficulty of
obtaining 10-year-old information, companies
should start this calculation as soon as possible
in case it is needed.
THE SIMPLIFIED APPROACH
A recent FASB staff position allows
companies to elect a simpler approach to
calculating the beginning balance of the APIC
pool. Under this method the beginning balance
equals the difference between
All increases in additional paid-in
capital recognized in the company’s financial
statements related to tax benefits from
stock-based compensation during the periods
following adoption of Statement no. 123 but before
the adoption of Statement no. 123(R).
The “cumulative incremental”
compensation expense disclosed during the same
period, multiplied by the company’s current
blended statutory tax rate when it adopts
Statement no. 123(R). The blended tax rate
includes federal, state, local and foreign taxes.
Cumulative incremental compensation is the expense
calculated using Statement no. 123 minus the
expense using Opinion no. 25. The expense should
include compensation costs associated with awards
that are partially vested at the date of adoption.
Companies have one year from the later of
the date they adopt Statement no. 123(R) or
November 10, 2005, to select a method for
computing the APIC pool.
THE IMPACT OF GRANT-BY-GRANT TRACKING
Companies determine whether an employee’s
exercise of an NQSO creates an excess tax benefit
or deficiency on a grant-by-grant basis by looking
at the compensation expense and related deferred
tax asset they recorded for each specific grant to
see the amount of deferred tax asset “relieved”
from the balance sheet. The deferred tax assets
related to all unexercised awards are not
considered. If the employee exercises only a
portion of an option award, then only the deferred
tax asset related to the exercised portion is
relieved from the balance sheet.
STRADDLING THE EFFECTIVE DATE
Many companies using the modified
prospective application method will have NQSOs
that were granted and at least partially vested
prior to adopting Statement no. 123(R). When
employees exercise these options, the company
should record the reduction in current taxes
payable as a credit to APIC to the extent it
exceeds the deferred tax asset, if any.
Exhibit 3 , below, illustrates the impact of
NQSOs that straddle the effective date.
|
Exhibit
3
|
NQSOs
Straddling
the
Effective
Date
| |
Assume ABC
Co. had a partially
vested award when it
adopted Statement no.
123(R) on January 1,
2006. The total book
compensation cost is
$1,500 ($500 in
Statement no. 123 pro
forma disclosure and
$1,000 recorded in the
income statement under
Statement no. 123(R)).
Assuming a 35% tax
rate, the company has
a $175 pro forma
deferred tax asset and
a $350 recognized
deferred tax asset.
Assume that all
the options are
exercised, resulting
in a tax deduction
of $2,000. The first
calculation results
in a $350 credit to
APIC [($2,000 tax
deduction X 35%)
less ($1,000
recognized
compensation expense
3 35%)]. The second
calculation
determines the
addition to the APIC
pool. This amount
equals $175 [($2,000
tax deduction –
$1,500 total
compensation
expense) X 35% tax
rate)].
| | |
UNUSUAL SITUATIONS
CPAs implementing the tax aspects of
Statement no. 123(R) may encounter some unique
circumstances.
Forfeiture before vesting.
Employees who leave a company
frequently forfeit their options before the
vesting term is complete. When this happens, the
company reverses the compensation expense,
including any tax benefit it previously
recognized.
Cancellation after vesting.
If an employee leaves the company
after options vest but does not exercise them, the
company cancels the options. When NQSOs are
canceled after vesting, the compensation expense
is not reversed but the deferred tax asset is. The
write-off is first charged to APIC to the extent
there are cumulative credits in the APIC pool from
the prior recognition of tax benefits. Any
remainder is expensed through the company’s income
statement.
Expiration. Many
nonqualified options expire unexercised, usually
because the options are “underwater” (meaning the
option price is higher than the stock’s current
market price). The same rules apply as with
cancellation after vesting; the compensation
expense is not reversed but the deferred tax asset
is. The write-off is first charged to APIC to the
extent there are cumulative excess tax benefits.
Any remaining amount is expensed through the
company’s income statement.
POSSIBLE PITFALLS
When implementing Statement no. 123(R) CPAs
need to exercise some caution in certain areas.
Deferred tax rates.
Companies that operate in more than
one country need to be especially careful
computing the deferred tax asset. Such
computations should be performed on a
country-by-country basis, taking into account the
tax laws and rates in each jurisdiction. Tax laws
about stock option deductions vary around the
world. Some countries do not allow deductions
while others permit them at the grant or vesting
date.
Underwater options. When
an option is underwater, Statement no. 123(R) does
not permit the company to record a valuation
allowance against the deferred tax asset.
Valuation allowances are recorded only when a
company’s overall tax position shows future
taxable income will not be sufficient to realize
all of the benefits of its deferred tax assets.
The deferred tax asset related to underwater
options can be reversed only when the options are
canceled, exercised or expire unexercised.
Net operating losses. A
company may receive a tax deduction from an option
exercise before actually realizing the related tax
benefit because it has a net operating loss
carryforward. When that occurs, the company does
not recognize the tax benefit and credit to APIC
for the additional deduction until the deduction
actually reduces taxes payable.
CASH FLOW IMPACT
The method a company selects to compute the
APIC pool also has an impact on how it represents
realized tax benefits in its cash flow statement.
Under Statement no. 123(R) companies must use a
“gross” approach to reporting excess tax benefits
in the cash flow statement. The excess tax benefit
from exercised options should be shown as a cash
inflow from financing activities and as an
additional cash outflow from operations. Excess
tax benefits cannot be netted against tax-benefit
deficiencies. The amount shown as a cash inflow
from financing will differ from the increase in
APIC due to excess tax benefits when the company
also records tax-benefit deficiencies against APIC
during the period. Companies that elect
the simplified approach will report the entire
amount of the tax benefit that is credited to APIC
from options that were fully vested before they
adopted Statement no. 123(R) as a cash inflow from
financing activities and a cash outflow from
operations. For partially vested options or those
granted after adopting Statement no. 123(R), the
company will report only the excess tax benefits
in the cash flow statement. |
A good starting
point for calculating the
beginning APIC pool and deferred
tax asset is the information the
company used for Statement no.
123 disclosure purposes. Tax
return preparation files and
human resource records also may
include information on exercised
NQSOs and any ISO disqualified
dispositions.
Companies need to
calculate the APIC pool only
when they have a
current-period shortfall.
However, given the difficulty
of obtaining 10-year-old
information, it’s a good idea
to start this calculation as
soon as possible in case it is
needed.
If a company
operates in more than one
country, be careful when
computing the deferred tax
asset. Perform the
computations on a
country-by-country basis,
taking into account the tax
laws and rates in each
jurisdiction.
| |
FINAL THOUGHTS
Many companies are still considering
modifications to their existing stock option plans
before they adopt Statement no. 123(R). Those with
underwater stock options are deciding whether to
accelerate the vesting to avoid recognizing
compensation expense. Although the compensation
expense deduction can be avoided under the
modified prospective method, the impact on the
APIC pool cannot be avoided. When the options
eventually expire unexercised, the company must
write off the “as-if” deferred tax asset against
the APIC pool to the extent of net excess tax
benefits. Depending on the size of the option
grant, this may reduce the APIC pool to zero.
The income tax accounting requirements of
Statement no. 123(R) are very complex. Both the
computation of the beginning APIC pool and the
ongoing calculations require companies to develop
a process for tracking individual stock option
grants. The newer simplified method only adds
another set of computations companies will have to
perform. Public companies also must focus on
designing the proper internal controls to meet the
requirements of section 404 of the Sarbanes-Oxley
Act. Combined with the potential difficulty of
tracking down 10-year-old information, the obvious
conclusion is to start now. |