| EXECUTIVE SUMMARY | 
FASB Statement no. 123(R), Share-Based Payment, poses a potential dilemma for companies with net operating losses (NOLs) that award nonqualified stock options (NQSOs) as compensation. If a company’s allowable tax deduction for stock option compensation exceeds the related book expense, it can realize an excess tax benefit.
But because with an NOL the company may have no current tax liability to reduce, the tax benefit may be deferred. The company then must determine when the benefit should be recognized for financial reporting purposes.
Two methods for making that determination have been identified by the FASB 123(R) Resource Group, an advisory group to the FASB staff: the “tax-law-ordering” and “with-and-without” methods. The tax-law-ordering method recognizes an excess tax benefit when the stock option deduction is used on the company’s tax return, before an NOL or another tax attribute. The with-and-without method recognizes the excess tax benefit only when the stock option deduction provides an incremental benefit after considering all other tax benefits (including NOLs) available to the company.
Companies may be more likely to avoid a charge against income if they elect the tax-law-ordering approach. This is because it results in recording windfall tax benefits to APIC sooner than the with-and-without approach and thus provides a larger pool to offset future shortfalls. David Randolph, CPA, Ph.D., is an assistant professor of accounting at the University of Dayton, Ohio. His e-mail address is david.randolph@notes.udayton.edu . The author wishes to thank Brett E. Cohen and Jeffrey S. Hemman of PricewaterhouseCoopers LLP for their review and suggestions. | CPAs who assist clients or employers with implementing FASB Statement no. 123(R), Share-Based Payment, face myriad accounting issues, including income tax accounting implications. In their article “Options and the Deferred Tax Bite” (JofA, March 06, page 71), Nancy Nichols and Luis Betancourt summarized the statement’s tax accounting implications and suggested that companies with net operating losses (NOLs) be wary of possible implementation pitfalls. This article elaborates on how CPAs can help NOL companies avoid those pitfalls by examining the methods companies may use to determine when excess tax benefits are realized. It also illustrates how the choice of method will affect a company’s recordkeeping and the resulting pool of excess tax benefits—that is, the additional paid-in capital (APIC) pool—and thus the likelihood that an NOL company will incur a charge against income. This article is not relevant to companies that have NOLs with a full valuation allowance and are in a loss position prior to the consideration of NOLs and excess stock option deductions. Such companies generally do not need to consider the discussion in this article until they have pretax book income prior to the consideration of NOLs and excess stock option deductions.
DEFERRED TAX ACCOUNTING
When a company grants an employee equity-based nonqualified stock options (NQSOs) under Statement no. 123(R), it records compensation expense over the requisite service period in an amount equal to the estimated grant date fair value of the options and credits APIC. The accounting for the income tax consequence is principally addressed by FASB Statement no. 109, with specific guidance in Statement no. 123(R). As the company will not receive a tax deduction for the stock option until it is exercised, the recognition of compensation expense generally occurs prior to the related tax deduction being recognized. Statement no. 123(R)’s general principle is that a deferred tax asset (DTA) needs to be established as the company recognizes compensation cost for book purposes. Thus, as the company recognizes compensation expense related to the equity award, the company will contemporaneously record a DTA and a credit to deferred tax benefit in the profit and loss statement in an amount equal to the compensation expense multiplied by the company’s applicable income tax rate. When the NQSOs are exercised, the company compares the allowable tax deduction to the related compensation expense recorded earlier for financial statement purposes. If the tax deduction exceeds the compensation expense, the tax benefit associated with any excess deduction is considered an excess tax benefit, or “windfall.” In the case of a company with sufficient NOLs to offset current taxable income in a year, however, there may be no current tax liability to reduce, and thus a company would theoretically be recording an additional NOL for the windfall. Statement no. 123(R), paragraph A94, footnote 82, provides that the windfall and corresponding credit to APIC should not be recognized for financial statement purposes until the period in which the tax benefit (windfall) reduces income taxes payable (that is, provides for cash savings to the company). Applying this concept to a typical company’s situation is often very complex. This is generally due in part to a company’s having built up NOLs from past operations as well as stock option deductions that may include windfall. While a company can recognize deferred tax assets for NOLs and stock option deductions exclusive of windfalls (assuming they are deemed more likely than not of being realized, in accordance with Statement no. 109), a company may not recognize windfalls pursuant to footnote 82 of Statement no. 123(R). Thus, when a company starts to generate taxable income and can begin using its tax benefit attributes, the question is, which deduction is being used first: prior NOL losses from operations or current-period deductions from stock option exercises? The importance of this evaluation is to determine when the APIC credit should be recorded from the windfalls. The ultimate question is, when has the windfall reduced taxes payable? The guidance to this difficult question was discussed at a meeting of the FASB Statement 123(R) Resource Group, an advisory group to the FASB staff created specifically to discuss certain Statement no. 123(R) implementation issues. The Resource Group consisted of individuals from accounting firms, the preparer community, benefits consulting firms and FASB staff. Consensus positions reached by the Resource Group do not represent authoritative guidance. However, the FASB staff has publicly stated that it would not expect diversity in practice to develop in regard to a particular issue if the Resource Group was able to reach a consensus on that issue. The Resource Group discussed how to determine when windfall tax benefits are considered realized and identified two methods that would be acceptable for making this determination: a tax-law-ordering approach and a with-and-without approach. The Resource Group concluded that companies may use either approach, provided the method elected is disclosed and consistently applied (see FASB Statement 123(R) Resource Group Discussion Document, Meeting no. 3, Sept. 13, 2005, available at www2.fei.org/download/FASB_9_13_2005.pdf). TAX-LAW-ORDERING APPROACH
Under the tax-law-ordering approach, a company would look to the provisions within the tax law for determining the sequence in which the NOLs (and, potentially, other tax attributes) are utilized for tax purposes. This concept is similar to the guidance in paragraph 268 of Statement no. 109 regarding whether a tax benefit recognized in years after a business combination occurs is attributable to an amount (NOLs, for example) that was acquired in the business combination or generated after the acquisition date. This guidance indicates that a company would follow the tax law to determine the sequence of tax benefits being utilized for book purposes. Following this concept, a windfall would be considered “realized” if it is used on the company’s tax return prior to an NOL or another tax attribute. Under U.S. tax law, the current-year stock compensation deduction (which would include the windfall) would be used to offset taxable income before the NOL carryforwards because all current-year deductions take priority over NOL carryforwards. Thus, for current-year stock option deductions, this would result in a credit to APIC being recorded in the financial statements in the year in which the windfall reduces taxable income. If a company does not have any current-year stock option deductions but has prior-year stock option deductions embedded in NOL carryforwards, a company would follow the tax law to determine which year’s NOL or stock option deductions would be used first. Within a particular year, if a company has both NOL and stock option deduction carryovers, it could not be determined under tax law which tax attribute is utilized first. The Resource Group did not address this question, and thus there may be alternatives a company could consider in determining which attribute within the year is being utilized. WITH-AND-WITHOUT APPROACH
Under the with-and-without approach, the windfall is considered realized and recognized for financial statement purposes only when an incremental benefit is provided after considering all other tax benefits (for example, NOLs) available to the company. This approach follows the guidance of FASB Emerging Issues Task Force Topic D-32, Intraperiod Tax Allocation of the Tax Effect of Pretax Income From Continuing Operations . In contrast to the tax-law-ordering approach, the with-and-without approach results in the windfall from share-based compensation awards always being effectively the last tax benefit to be considered. Consequently, the windfall attributable to share-based compensation will not be considered realized in instances where the company’s NOL carryover that is unrelated to windfalls is sufficient to offset the current year’s taxable income before considering the effects of current-year windfalls. A HYPOTHETICAL EXAMPLE
ABC Corp. has an NOL carryover of $5,000 into 2007. The company generates $3,500 of taxable income in 2007, before considering the tax effects of the company’s share-based compensation deduction of $3,000 (which includes a windfall of $2,000). Assume a tax rate of 35%.
Under the tax-law-ordering approach, the tax benefits for current-year exercises of share-based compensation awards (which include the windfall) are considered realized in 2007 because such deductions offset taxable income on ABC’s tax return, thereby reducing the amount of income subject to tax. For financial statement purposes, the windfall portion of the share-based compensation deduction reduces income tax payable and is credited to APIC. The windfall credited to APIC increases the company’s APIC pool available to offset future tax deficiencies (“shortfalls”). Under the with-and-without approach, the windfall is not considered realized in 2007 because ABC would have utilized the prior-year NOL carryforwards and reduced taxable income to zero, regardless of the current-year share-based compensation deduction, which included the windfall. Accordingly, no amount is recorded to APIC for the windfall of the current-year share-based compensation deductions, and thus there is no increase to the APIC pool that would be available to offset future shortfalls. One outcome of these entries is that the NOL DTA recognized in ABC’s financial statements will not equal the actual NOL carryover that is available to reduce future taxable income. It would be expected that this difference would be explained in the footnotes of the financial statements. CHOICE OF METHOD
CPAs can help clients and employers analyze how the method used to determine the realization of windfalls will affect the company’s financial statements. Because the with-and-without approach effectively treats the windfall portion of the share-based compensation deduction as the last tax benefit to be considered, its use will tend to create a relatively smaller APIC pool and, as a result, increase the likelihood that a future charge against income will be required for future shortfalls related to share-based compensation awards. Also, because under the with-and-without approach the windfall portion of share-based compensation deductions that preserve existing—or add to newly created—NOLs typically will not be recognized as a tax benefit in the year generated, companies using this method likely will record an NOL DTA that does not equal the actual (tax-return) NOL multiplied by the company’s applicable income tax rate. This could cause additional recordkeeping to track NOLs for tax purposes versus NOLs recorded in the financial statements. For these reasons, NOL companies that do not have a valuation allowance may conclude that the tax-law-ordering approach is easier to implement and could provide a larger APIC pool, as compared with the with-and-without approach. The difference in approaches can also create significant differences for NOL companies that have a full or partial valuation allowance and generate pretax income that is fully offset by their tax attributes (NOL and/or current-year share-based compensation deductions). Although the choice of method does not change the fact there are no income taxes payable, the tax-law-ordering approach generally would result in a company’s showing a tax provision in continuing operations with an offsetting credit to APIC (to the extent that the windfall is deemed realized), while the with-and-without approach would show no income-tax provision, because the valuation allowance reversal would be deemed to relate to realization of NOLs from operating losses.  | |  Deferred Tax Accounting for NQSOs—NOL Companies | | On Jan. 1, 2006, ABC Corp. grants John Smith options on 100 shares. The options have a fair value of $10 per share, an exercise price of $25 (stock price on date of grant), and fully vest at the end of the year. Assuming a 35% tax rate, ABC records a $350 deferred tax asset (DTA) and corresponding credit to deferred income tax benefit, in recognition of the future tax benefit associated with the $1,000 (100 shares X $10) compensation expense being recorded over the year. The company does not require a valuation allowance against its recorded DTAs. Assume that Smith exercises the options during 2007 when the fair value is $55 per share, resulting in a share-based compensation deduction of $3,000 [($55 share price – $25 exercise price) X 100], which includes a windfall of $2,000 [($55 – $25 exercise price – $10 of compensation expense previously expensed for financial statement purposes) X 100]. ABC generates $3,500 taxable income in 2007, before considering its share-based compensation deduction of $3,000 (which includes a $2,000 windfall), and ABC has a $5,000 net operating loss carryover into 2007 recorded as a DTA (unrelated to prior windfalls). The $350 “FAS 123(R)” DTA (relating to the $1,000 compensation expense previously recorded, multiplied by the company’s income tax rate) is reversed to deferred tax expense, and an “NOL” DTA is created, regardless of which method is used to determine the realization of windfalls. The following entry would be recorded: | Dr. DTA—NOL | $350 | | Cr. DTA—stock compensation | $350 | | To reverse the deferred tax asset and create an additional NOL. | The accounting for the $2,000 windfall, however, differs under the alternative approaches. Tax-Law-Ordering Approach
| Dr. Income tax provision | $1,225 | | Cr. DTA—NOL | $525 | | Cr. Additional paid-in capital | $700 | | To record the annual tax provision of $1,225 ($3,500 X 35%), which has been discharged by the windfall portion of the share-based compensation deduction of $700 (tax-effected) and the utilization of NOL carryovers of $525 (tax-effected). | With-and-Without Approach No entry is made in the current period for the windfall. The company incurs no tax liability. Because the previous NOL carryforwards are considered used first, the windfall is not considered realized. The future tax benefit for the windfall should be noted in a footnote disclosure to explain why the reported NOL carryforward DTA is not equal to 35% of the company’s actual tax NOL carryforward. | Dr. Income tax provision | $1,225 | | Cr. DTA—NOL | $1,225 | | To record the annual tax provision of $1,225 ($3,500 X 35%) which has been discharged by the utilization of NOL carryforwards . | In addition to the contrasting balance sheet effects illustrated above, different income statement effects may be realized in subsequent years due to the difference in APIC pools created under the two approaches. Assume that prior to John Smith’s exercise, the company had zero APIC pool available to offset future shortfalls. Assume the same facts as above for ABC Corp., as well as the following: On Jan. 1, 2007, ABC Corp. grants Jane Doe options on 50 shares. The options have a fair value of $10 per share and an exercise price of $55 (stock price on date of grant) and fully vest at the end of the year. Assuming a 35% tax rate, ABC records a $175 deferred tax asset and corresponding credit to deferred tax benefit, in recognition of the future tax benefit associated with the $500 (50 shares X $10) compensation expense recorded. Jane exercises the options during 2008 when the fair value is $57 per share, resulting in a 2008 tax deduction of $100 [($57 share price – $55 exercise price) X 50]. In this case, ABC’s book expense is greater than its tax deduction, which creates a shortfall (that is, the amount of deduction realized is less than the deferred tax asset previously recorded). The entries required for this circumstance will differ depending on the approach used to determine realization of windfalls. For simplicity, assume there is no pretax income or loss during 2008. Tax-Law-Ordering Approach | Dr. NOL— DTA | $35 | | Dr. Additional paid-in capital | $140 | | Cr. DTA—stock compensation | $175 | | To reduce the $175 DTA that was recorded, which corresponded to the $500 financial statement compensation expense previously recorded, and record the $35 tax deduction for the $100 share-based compensation deduction as additional NOLs. The $140 shortfall is written off first against the APIC windfall tax benefit pool ($700 generated from the windfall attributable to John Smith’s NQSO exercise); the balance, if any, is recognized in the income statement. | With-and-Without Approach | Dr. NOL— DTA | $35 | | Dr. Income tax provision | $140 | | Cr. DTA—stock compensation | $175 | | To reduce the $175 DTA that was recorded, which corresponded to the $500 financial statement compensation expense previously recorded, and record the $35 tax deduction for the $100 share-based compensation deduction as additional NOLs. Because there is no APIC windfall tax benefit pool, the charge for the shortfall of $140 is recognized in the income statement. | | | | |
