Editor: Annette Nellen, Esq., CPA, CGMA
In its November 2021 20-year review of financial restatements, Audit Analytics reports that accounting for income taxes has been among the top five issues causing restatements for the last decade (ranking fourth in 2020). It continues to be an important area of knowledge for practicing accountants and for students entering the field. An earlier Campus to Clients columnprovides a comprehensive discussion of FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, for classic temporary and permanent differences including construction of the effective tax rate reconciliation (the rate rec) (Evans, "Constructing the Effective Tax Rate Reconciliation and Income Tax Provision Disclosure," 50 The Tax Adviser 600 (August 2019)).
Stock options, as well as other types of stock-based equity compensation, are unique within the category of book-tax differences. While companies treat incentive stock options (ISOs) in the same manner as other permanent differences, nonqualified options (NQOs) present a more complex case. Not only is the timing of book and tax expense different for NQOs, so is the ultimate expense amount. Further, the tax deduction is unknowable until the future point in time when the employee exercises the options. NQOs are therefore a unique case of a temporary difference that will also have a permanent component. This column presents the process of accounting for stock options, a mainstay in the equity compensation portfolio, in detail.GAAP stock option treatment
For financial reporting purposes, FASB Accounting Standards Codification (ASC) Paragraph 718-10-35-2 requires companies to expense the fair value of the stock options granted over the requisite service period the employee must provide to be entitled to the stock award, typically the vesting period. Entities can recognize the expense straight line over the entire vesting period, or straight line for each separately vesting portion of the award if the company has a graded vesting schedule (see ASC Paragraph 718-10-35-8).
While there are other aspects of granting options that will affect the ultimate options compensation expense for book purposes (e.g., projected number of options that will vest), to retain focus on the income tax accounting analysis this column makes some simplifying assumptions throughout. Specifically, it will assume the corporation correctly estimates 100% of the options granted will be exercised after they vest. It also assumes a cliff vesting plan, where all options vest in full after a certain number of years of employment. While expanding these simplifying assumptions would change the mathematical computation of compensation expense each year, the conceptual underpinnings related to income tax accounting under ASC Topic 740 remain the same.
Tax stock option treatment
For tax purposes, the appropriate treatment depends on whether the options qualify as ISOs or NQOs. For simplification, this column assumes options have no readily ascertainable fair market value (FMV) at grant, which is most often the case. Note that the GAAP treatment is the same regardless of the option's tax classification.
Per Secs. 421(a)(2) and 422, ISOs do not generate a tax deduction for the granting company. Since the company does have an expense for financial purposes each year over the vesting period, it has a permanent book-tax difference each of those years. As such, it will appear as a reconciling item on the rate rec in each of the vesting years. Because it is an unfavorable difference (i.e., the company will never enjoy a tax deduction for it), the company's current (and therefore total) income tax expense will be higher, resulting in an effective tax rate (ETR) increase each year in the vesting period.
Unlike the nondeductibility of ISOs, Sec. 83(a) and Regs. Sec. 1.83-7(a) allow companies a tax deduction when an employee exercises an NQO. This deduction equals the bargain element enjoyed by the employee upon exercise (equal to the stock's FMV at exercise minus the lower purchase price enjoyed by the employee by using the option to purchase shares).
Because NQOs generate a future tax deduction, the issuing company will originate a temporary book-tax difference at issuance. This difference will create a deferred tax asset (DTA) since the financial expense (recognized over the vesting period) precedes the income tax expense (recognized at exercise). But unlike DTA items where book and tax expense equal over time (e.g., depreciation or other cost recovery), the total NQO tax expense will differ between book and tax. This difference is the permanent component of the temporary book-tax difference. While companies know there will be a permanent component to the difference, they are not able to determine the magnitude or direction of it until exercise. At that future point in time, the company will know whether the tax expense is greater or lesser than the total book expense, and to what degree.
As initially set forth by FASB in Accounting Standards Update (ASU) No. 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, companies account for the permanent component of the NQO temporary difference directly through income tax expense (versus additional paid in capital, which companies used prior to the ASU simplification). Once the options are exercised, the company will remove the DTA from the books in full, whether it overestimated or underestimated the ultimate value of the tax deduction. The permanent component of the temporary difference will either positively or negatively affect the company's income tax expense and ETR at exercise, depending on the stock's share price when the employee exercises the options.Comprehensive illustrations
The two examples that follow illustrate the computation and related disclosures of stock options under Topic 740. The accompanying downloadable Excel file provides additional examples for further practice.
Example 1: O Inc., a calendar year-end public company, grants 60,000 options to its employees on Jan. 1, year 1. These options have an exercise-date strike price of $19 per share, which equals the share price on the date of grant. At grant, the company estimates the options have a fair value of $10 per option. The options are subject to a three-year cliff vesting provision, and the company projects that 100% of the options will vest. After three years have passed and all options are fully vested, the employees exercise the options. At exercise, the share price has risen to $23 per share. The currently enacted federal income tax rate for all years is 21%. O Inc. has $1,000,000 pretax financial income each year before considering options expense and has no other book-tax differences.
Financial accounting expense and tax expense assuming ISOs
Regardless of the tax classification as an ISO or NQO, financial accounting compensation expense totals $600,000 ($10 per option fair value × 60,000 options). O Inc. will recognize this expense on its income statements evenly over the three-year cliff vesting period, equaling $200,000 of expense each in years 1, 2, and 3. The company will not recognize financial expense in year 4 or beyond. Because the options are ISOs, O Inc. has no tax compensation expense for the options in any year. As such, the book-tax difference in years 1-3 is permanent, and O Inc. will not create any deferred tax accounts. Table 1, below, summarizes these expenses throughout the life of the option.
Table 2, below, incorporates the expenses reported in Table 1 and shows the book-tax reconciliation for O Inc. in each year under the ISO assumption. Pretax financial income in years 1-3 will equal $800,000 ($1,000,000 pretax financial income before options expense − $200,000 option compensation expense). Because book income in those years includes a financial accounting expense that is not deductible for tax purposes, O Inc. will reverse out the effect of the options expense in its annual book-tax reconciliation, yielding an addition to reconcile to O's $1,000,000 taxable income. Taxable income is $1,000,000 each year because O Inc. has no tax options expense with the ISO and no other book-tax differences. In year 4, financial income will equal $1,000,000 because O Inc. has already fully expensed the now-vested options in years 1-3.
Applying the 21% tax rate to taxable income yields a current income tax expense in each year of $210,000 with a corresponding increase to income taxes payable, so O Inc. records the journal entry (also below) in each of the four years. Again, because the difference in an ISO scenario is always permanent, O Inc. will not create a deferred tax entry to recognize deferred income tax expense (or benefit) for it in any year.
Tables 3A and 3B, below, show O Inc.'s current/deferred income tax expense breakout and its rate rec, both required public company disclosures in the income tax footnote per ASC Paragraphs 740-10-50-9 and 740-10-50-12, respectively. For O Inc., the expense breakout is the same across all years, and it reports only current expense, consistent with the preceding journal entry and lack of temporary differences.
The rate rec in Table 3A incorporates the unfavorable effect of the ISO permanent difference in each vesting year. To better understand the direction of the income tax effect in the rate rec, note that the hypothetical starting point of all rate recs (pretax book income hypothetically taxed at the 21% rate) embeds the assumption that all items of income and expense for financial purposes will be taxable and deductible, respectively, for tax purposes. Thus, the rate recs in years 1-3 begin at $168,000 ($800,000 × 21% current-year tax rate).
Because this embedded assumption does not hold true for O's ISO book compensation expense, the year 1, year 2, and year 3 rate recs show the effect of reversing out this nondeductible expense. Note that adding this item in the rate rec is also consistent with its addition in the book-tax reconciliation. Thus, O Inc. adds the incremental $42,000 tax burden of this item being nondeductible in each vesting year ($200,000 permanent difference × 21% current-year rate) and the ETR will exceed the statutory rate. In year 4, there is no permanent book-tax difference, so there is no reconciling item in the rate rec that year.
Financial accounting expense and tax expense assuming NQOs
As in the ISO case, financial accounting compensation expense related to stock options in Example 1 equals $200,000 in each of years 1, 2, and 3. However, the tax treatment is very different between ISOs and NQOs. Assuming NQOs, O Inc. deducts tax compensation expense in the year of exercise (year 4 in this example) equal to the $4 bargain element calculated at exercise ($23 per share market value at exercise — $19 per share strike price) for each option. The bargain element reflects the magnitude of the reduction in the stock purchase price received by the employees exercising the options. Therefore, O's year 4 tax compensation expense deduction equals $240,000 ($4 per share bargain element × 60,000 shares purchased). Table 4, below, presents the book and tax expense figures.
Because both financial and tax accounting will recognize an expense for the NQOs, O Inc. originates the book-tax difference as a temporary one. As such, the book-tax difference in years 1-3 increases the related DTA each year, as shown in the final two columns of Table 4. The annual DTA increase for each vesting year equals $42,000 ($200,000 annual book-tax temporary difference × 21% tax rate at reversal).
In year 4, O Inc.'s book-tax difference equals $240,000, reflecting $0 book expense after vesting and tax expense based on the $4 per share bargain element. However, for its Topic 740 analysis, O Inc. must break this difference into both a temporary and a permanent component. First, the $240,000 year 4 difference must reflect O Inc. fully reversing the DTA to an ending balance of zero because the book-tax difference is fully resolved that year (i.e., neither set of books will have any more expense related to the exercised options in future years). So, a portion of the $240,000 book-tax difference includes the effect of the $600,000 cumulative temporary difference reversing. The reversal yields a $600,000 subtraction in the year 4 book-tax reconciliation (offsetting the $200,000 addition in each of the first three years), as shown in Table 5, below.
The $240,000 year 4 book-tax difference also includes the effect of the permanent component, which O Inc. finally knows in year 4 is an incremental $360,000 of financial expense (in total). In this example, the permanent element is unfavorable because O Inc. will never get a tax deduction for that portion of its total book expense. In other words, over time it got less tax expense than book expense. Therefore, it will add the $360,000 permanent difference in the book-tax reconciliation. The final column of Table 5 shows the two-pronged effect in year 4. Again, note that combining these two effects results in a net $240,000 subtraction (-$600,000 + $360,000), which ties to the difference between year 4 book compensation expense ($0) and year 4 tax compensation expense ($240,000) for the NQOs.
Under the NQO assumption, O Inc. will record the Topic 740 journal entries shown below each year. As before, current tax expense is calculated by multiplying taxable income by the current 21% tax rate. The deferred entry corresponds to the tax effect of the origination and reversal of the temporary component of the book-tax difference.
Tables 6A and 6B, below, show O's income tax footnote current/deferred income tax breakout and rate rec for Example 1 under the NQO assumption in years 1-4. Because the book-tax difference in the vesting years is temporary, its effect is detailed in the current/deferred expense breakout, but it does not shift ETR and does not appear on the rate rec. Similarly, the $600,000 portion of year 4's book-tax difference that reflects the complete reversal of the $126,000 DTA also does not trigger a reconciling item on the rate rec but does affect the current/deferred breakout that year.
In contrast, the $360,000 permanent component of year 4's $240,000 book-tax difference does affect ETR and requires O Inc. to make an adjustment on its rate rec. Only by separating the book-tax difference in year 4 into the temporary and permanent components can one clearly see the effect of the permanent component of the NQO at exercise. The year 4 NQO effect increases the hypothetical tax on book income in the rate rec by $75,600 ($360,000 × 21% current-year rate) because O Inc. deducts $360,000 less in total for tax purposes than it expenses for financial purposes (which is the same reason the permanent difference is an addition in the book-tax reconciliation).
Example 2: Example 2 keeps the same assumptions as Example 1 with one exception. Instead of assuming the stock's market price on the exercise date is $23 per share, now assume that it is $30 per share.
Financial accounting expense and tax expense assuming ISOs
If the options are ISOs, the result is the same in all ways between this fact pattern and Example 1. Financial accounting does not use exercise-date information as an input, so book compensation expense still totals $600,000 spread evenly over the vesting years ($200,000 of the expense in each of years 1, 2, and 3). And again, there is never a deduction for ISOs for tax purposes. Therefore, Tables 1, 2, 3A, and 3B are correct for this fact pattern, as well.
Financial accounting expense and tax expense assuming NQOs
If one assumes the options are NQOs, the effect in the three vesting years is the same as in Example 1 because the identical book expense is recognized in those years and O Inc. will not recognize tax expense until NQO exercise. Therefore, the DTA account will be originated in years 1, 2, and 3 identically to Example 1. At exercise in year 4, the tax compensation expense deduction will equal $660,000 ([$30 per share market price — $19 per share strike price] × 60,000 shares purchased at exercise), reflecting the larger bargain element enjoyed by the employee in this example ($11 per share in Example 2, versus $4 per share in Example 1). Table 7, below, reports the expense numbers and Topic 740 effects for Example 2.
At exercise, O Inc. finally knows it will expense an additional $60,000 for tax purposes beyond what it previously recognized for financial purposes over the vesting period. Therefore, year 4's $660,000 book-tax difference must include both the $600,000 reversal of the cumulative temporary difference (as discussed with Example 1) as well as the $60,000 permanent difference. Unlike Example 1, in this example the permanent difference is a favorable one because O Inc. deducts more, in total over time, for tax than for book. As such, the permanent component is a subtraction in the book-tax reconciliation shown in the final column of Table 8, below, and the $12,600 tax effect of it ($60,000 permanent component × 21% current-year tax rate) will benefit the company's total income tax expense and ETR as a subtraction in the rate rec in the year of exercise, illustrated in Table 9, also below. (The disclosures for years 1-3 are the same as shown previously in Table 6A, so they are not replicated in Table 9.)
O Inc.'s current/deferred income tax expense breakout in Table 9 reflects the Topic 740 journal entries, below. As in each previous analysis, current tax expense is computed by multiplying taxable income by the 21% tax rate in each year. The deferred entry reflects the origination and full reversal of the DTA related to the temporary component of the book-tax difference.
Drawing conclusions from an income tax footnote
When studying a company's rate rec disclosure, any options-related effect is typically described as "stock-based compensation" or the like, without the line item specifically denoting whether the item stems from an ISO vesting (which is always an addition because it is a permanently nondeductible expense), an NQO being exercised (which could be an addition or subtraction depending on the magnitude of the bargain element at exercise relative to the fair-value estimate at grant), or the effect of other types of stock-based compensation such as restricted stock or restricted stock units. It could also be a combination thereof.
Similar to NQOs, restricted stock and restricted stock units under Topic 718 are valued at grant for financial purposes and expensed over the vesting period on the income statement. Both later yield a deduction for the company, but the computation and timing for the tax deduction is different than NQOs and is beyond the scope of this column. However, the same general principles apply, in that the temporary difference over vesting will create a DTA that will be fully reversed when an expense is recognized for tax purposes. The permanent component will be a reconciling item in the rate rec in the year of the tax expense. The SEC Form 10-K reader will be able to find more detail regarding what a company has included in a "stock-based compensation" reconciling item by searching the stock compensation footnote.
Bridging the classroom to professional practice
To further reinforce the importance of detailed Topic 740 knowledge, instructors should strongly consider inviting a Topic 740 practitioner to class to discuss its various provisions. While the subject-matter expert could discuss accounting for income taxes in broad terms, that person's expertise would be best used by covering a more nuanced topic within the field, such as stock-based compensation income tax effects.
This column can also be used to add valuable insight into classroom policy discussions surrounding NQOs, namely the significantly larger tax deduction these options can generate relative to the fair-value estimate expensed for financial purposes and the related decrease in the company's ETR. (Also relevant in that policy discussion is the change to the types of compensation included in the $1 million deduction limit for covered employees, which the 2017 law known as the Tax Cuts and Jobs Act, P.L. 115-97, expanded to include the exercise of newly issued NQOs and other types of performance-based pay.) Further, firms can use this column to complement their own training materials for new hires, or for those transitioning into the Topic 740 practice area.
|Allison L. Evans, CPA, Ph.D., is EY Faculty Fellow and associate professor of accounting at the University of North Carolina Wilmington. Annette Nellen, Esq., CPA, CGMA, is a professor in the Department of Accounting and Finance at San José State University in San José, Calif., and is a past chair of the AICPA Tax Executive Committee. For more information about this column, contact firstname.lastname@example.org.|