Chapter 18:
Income Tax Accounting for Stock-Based Compensation
Chapter Summary
This chapter discusses the income tax accounting effects related to stock-based compensation and the reporting of those effects in an entity’s financial statements. This chapter also covers other income tax accounting topics related to modifications of awards, transition provisions when adopting the stock-based compensation standard for income taxes, net operating loss carryforwards, valuation allowances, intraperiod tax allocation, multinational entities, and income tax disclosures. Unless otherwise noted, the discussion in this chapter addresses the income tax implications of stock-based compensation under U.S. tax law. Refer to PwC’s Guide to Accounting for Stock-based Compensation for further guidance on topics related to accounting for stock-based compensation under ASC 718, Compensation—Stock Compensation.
18.1 Background and Basics of Accounting for Stock-Based Compensation under ASC 718 and ASC 740
The fundamental premise of ASC 718 requires that entities recognize the fair value of employee stock-based-compensation awards as compensation cost in the financial statements, beginning on the grant date. Compensation cost is based on the fair value of the awards the entity expects to vest, recognized over the vesting period, and adjusted for actual forfeitures that occur before vesting.
ASC 718 provides specific guidance on income tax accounting and clarifies how ASC 740, Income Taxes, should be applied to stock-based compensation. Guidance also has been provided by the FAS 123(R) Resource Group (the “Resource Group”), an advisory group to the FASB staff that was created after the issuance of ASC 718 to discuss specific implementation issues. The objective of the Resource Group was to identify potential implementation issues, discuss such issues, reach a consensus (if possible), and elevate issues that could not be resolved to the FASB’s attention. Consensuses reached by the Resource Group on significant issues related to the accounting for income taxes for stock-based compensation have been incorporated into this chapter. These consensuses do not represent authoritative guidance, but 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 consensus on that issue.
For awards that are expected to result in a tax deduction under existing tax law, the general principle is that a deferred tax asset is established as the entity recognizes compensation cost for book purposes. Book compensation cost is recognized over the award’s requisite service period, whereas the related tax deduction generally occurs later and is measured principally at the award’s intrinsic value. For example, in the U.S., an entity’s income tax deduction generally is determined on the exercise date for stock options and on the vesting date for restricted stock. For equity-classified awards under ASC 718, book compensation cost is determined at the grant date and compensation cost is recognized over the service period. The corresponding deferred tax asset also is measured on the grant date and recognized over the service period. As a result, there will almost always be a difference in the amount of compensation cost recognized for book purposes versus the amount of tax deduction that an entity may receive. If the tax deduction exceeds the cumulative book compensation cost that the entity recognized, the tax benefit associated with any excess deduction will be considered a “windfall” and will be recognized as additional paid-in capital (APIC). If the tax deduction is less than the cumulative book compensation cost, the resulting difference (“shortfall”) should be charged first to APIC (to the extent of the entity’s pool of windfall tax benefits, as described later), with any remainder recognized in income tax expense.
Example 18-1 summarizes the key accounting events (from the grant date to the settlement date) that relate to a typical equity-classified, nonqualified stock option that generates the employer’s tax deduction upon the option’s exercise.
Example 18-1: Key Income Tax Accounting Events for an Equity-Classified, Nonqualified Stock-Based Compensation Award
Note that differences between the amount of the book compensation and the tax deduction for an award that result from factors other than increases or decreases in the fair value of an entity’s shares between the grant date (measurement date for accounting purposes) and the exercise date (measurement date for tax purposes) do not receive the same accounting treatment as a windfall or shortfall. This might occur, for example, in certain situations when a company concludes that the fair value of an award at the grant date is different under the applicable tax law than the fair value determined for book purposes at the same date. See Example 18-7 for further discussion.
Example 18-2 illustrates how, from the grant date to the settlement date, an enterprise should calculate a windfall tax benefit and account for the corresponding income tax for a typical equity-classified, nonqualified stock option.
Example 18-2: Recognition of a Deferred Tax Asset and Calculation of the Tax Deduction and Windfall Tax Benefit for an Equity-Classified, Nonqualified Stock Option
On January 1, 2006, a U.S. multinational entity grants to its U.S. employees 1,000 equity-classified, nonqualified stock options that have a fair value of $15 per option. The award has a one-year service condition and it is assumed that all options will vest. The entity has sufficient taxable income for the stock option tax deductions to reduce income taxes payable in all periods.
Step 1: Recognize compensation cost and the related deferred tax asset. During 2006, the entity records $15,000 in compensation cost (1,000 options x $15 fair value) and also records the related deferred tax asset of $5,250 (assuming that the applicable tax rate is 35 percent).
Step 2: Calculate the tax deduction, windfall, or shortfall. When the stock options are exercised on July 1, 2007, each option has a $20 intrinsic value (i.e., the shares have a quoted market price that exceeds the options’ exercise price by $20). The entity will receive a tax benefit of $7,000 (1,000 shares x $20 intrinsic value x the applicable tax rate of 35 percent). The tax benefit of the excess tax deduction is $1,750, ([$20,000 tax deduction – $15,000 compensation cost] x 35 percent) and is credited to APIC (rather than to income tax expense) as a windfall tax benefit. The remaining $5,250 of current tax benefit offsets a like amount of deferred tax expense from the elimination of the related deferred tax asset.
The above example illustrates the calculation of an excess tax benefit when an entity is a regular taxpayer. In certain situations, an entity may be subject to the alternative minimum tax (AMT). Section TX 12.2.3.2.5 discusses accounting for windfall benefits when an entity is subject to the AMT.
18.1.1 Income Tax Accounting for Liability-Classified Awards
The income tax accounting for liability-classified awards (e.g., cash-settled stock appreciation rights) is similar to the income tax accounting for equity-classified awards. The difference is that the liability for book purposes is remeasured each reporting period and thus the related deferred tax asset and tax expense also is remeasured to reflect the effects of remeasuring the book liability. Unlike an equity-classified award, a liability-classified award generally will not be expected to generate a windfall or shortfall upon settlement because the ultimate tax deduction will equal the cumulative book compensation cost as a result of the periodic remeasurements.
18.2 Accounting for Income Taxes Related to Various Awards
An understanding of how an entity’s tax deduction for stock-based compensation is measured in the U.S. requires an understanding of the nature of the instrument or award that is being granted to the employee and whether the employee has made any elections with respect to the award.
This chapter gives an overview of an entity’s accounting for income taxes related to stock-based-compensation awards with respect to nonqualified stock options, statutory stock options, restricted stock, restricted stock units, and stock appreciation rights. Under U.S. tax law, the ultimate tax deduction for these awards will almost always differ from the amounts recognized for financial reporting because nonqualified stock options, restricted stock, restricted stock units, and stock appreciation rights generally result in a tax deduction for an entity when the taxable event occurs (e.g., upon exercise or vesting). Statutory options, including incentive stock options (ISOs) and employee stock purchase plan (ESPP) purchases, however, ordinarily do not result in a tax deduction and therefore the tax effects from these awards will not be recorded unless a disqualifying disposition occurs (as described in Section TX 18.4.1).
18.3 Income Tax Accounting for Nonqualified Stock Options
18.3.1 Initial Recognition and Classification of a Deferred Tax Asset
An entity that grants a nonqualified stock option to an employee generally is entitled to a tax deduction equal to the intrinsic value of the option on the exercise date. Entities generally expense stock options for book purposes before a tax deduction arises, thus creating a temporary difference (and a deferred tax asset) under ASC 740. When an award is settled, the deferred tax asset is reconciled with the realized tax benefit.
For nonemployees, the fair value of a share-based payment award will generally be remeasured to reflect its current fair value on an ongoing basis until performance is complete (generally when the award is vested) or a performance commitment is reached, as discussed in more detail in SC 2.2 of PwC’s Guide to Accounting for Stock-based Compensation. This differs from equity-classified employee awards, which generally reflect the fair value as of the grant date. The deferred tax asset and income tax expense related to nonemployee awards will likewise reflect the changes in fair value of the award through the final measurement.
Balance sheet classification of a deferred tax asset related to nonqualified stock options as either current or noncurrent depends on whether the stock option is an equity-classified award or a liability-classified award. If the stock option is equity-classified, we believe that the related deferred tax asset generally should be classified as noncurrent. Other approaches to classifying the deferred tax asset based on the expected period of realization of the related tax deduction also may be acceptable. If the stock option is liability-classified, the related deferred tax asset should follow the classification of the stock option (e.g., if the stock option is classified as a current liability, the related deferred tax asset also should be classified as current).
18.3.2 Change in Tax Rates
A deferred tax asset is adjusted when an entity’s applicable tax rate changes. To determine the amount of the new deferred tax asset, an entity should multiply the new applicable tax rate by the amount of cumulative compensation cost that the entity has recorded for all outstanding stock-based compensation awards. The difference between the new deferred tax asset and the existing deferred tax asset should be recorded in the current-period income statement as a deferred tax benefit or expense. For example, if the applicable tax rate increases, the deferred tax asset should increase and the corresponding benefit would be reflected in the income statement in the period that the tax law change was enacted.
18.3.3 Employer Payroll Taxes
A liability for the employer’s portion of payroll taxes on employee stock compensation should be recognized on the date of the event triggering the obligation to pay the tax to the taxing authority (ASC 718-10-25-22). For a nonqualified stock option, payroll taxes generally will be triggered and recorded on the exercise date. Even though the employer’s payroll taxes are directly related to the appreciation of stock options, those taxes are part of the entity’s operating expenses and should be reflected as such in its income statement (ASC 718-10-25-23). SAB Topic 14 provides guidance on the presentation of compensation cost in a public entity’s financial statements. Under SAB Topic 14, as discussed in Section SC 1.17 of PwC’s Guide to Accounting for Stock-based Compensation, an entity should present the expense related to the stock-based-compensation awards in the same line item(s) as cash compensation paid to the same employees. We believe that employer payroll taxes payable upon the exercise of awards also should be charged to that same income statement line item.
18.3.4 Accounting for Options That Are Forfeited or Expire Unexercised
For a variety of reasons, employees might never exercise their stock options (e.g., the stock option is under water during its contractual term, or the employee might forfeit the option). When a stock-based-compensation award is forfeited or expires unexercised, the accounting for the related deferred tax asset depends on whether the employee had completed the award’s requisite service period at the time of settlement. If an award expires before the requisite service period has been completed and the related book compensation cost is reversed, then the deferred tax asset also is reversed in the current period to income tax expense. If an award expires after the requisite service period has been completed, the related book compensation cost is not reversed. However, the employer will no longer receive a tax deduction for the option and, therefore, there is no longer a temporary difference. Because there is no longer a temporary difference, the related deferred tax asset should be reversed. The entire deferred tax asset is a shortfall and should be recorded as a charge either to income tax expense or to APIC if there is a sufficient pool of windfall tax benefits available. Completion of the requisite service period often, but not always, coincides with the “legal vesting date.” An award is legally vested when an employee’s right to receive or retain the award is no longer contingent on satisfying the vesting condition. For the remainder of this chapter, the legal vesting date is assumed to be the same as the completion of the requisite service period, and therefore the word “vested” will be used to refer to the event that triggers the accounting for the deferred tax asset.
Example 18-3 summarizes the pre- and post-vesting accounting for such an award.
Example 18-3: Pre- and Post-Vesting Accounting for Awards That Are Forfeited or Expire
While the above example summarizes the accounting for individual awards, an entity that has a number of awards and is appropriately applying a forfeiture estimate when recording compensation cost would be recording compensation cost only for the number of awards it expected to vest. Accordingly, a deferred tax asset is only being recorded for the awards the entity expected to vest. As long as actual forfeitures are consistent with the entity’s forfeiture assumptions, there would be no adjustment to the compensation cost and the related deferred tax assets that have been recognized. However, if actual forfeitures caused the entity to change its original forfeiture assumptions, then an adjustment to previously recognized compensation cost and the related amount of deferred tax assets should be recorded.
Example 18-4 is a simplified illustration of the income tax accounting for a grant of an equity-classified, nonqualified stock option.
Example 18-4: Income Tax Accounting for Nonqualified Stock Options
Background/Facts:
On January 1, 2006, an entity grants 10 million equity-classified, nonqualified stock options. The $30 exercise price equals the grant-date stock price. The terms of the award specify three-year cliff-vesting. The grant-date fair value is $15 per option and only 8 million options are expected to (and do) vest. This grant is the first option grant in the entity’s history; therefore, it does not have a pool of windfall tax benefits. No additional awards are granted in 2006, 2007, and 2008. The stock price is $50 on January 1, 2009, when all 8 million vested options are exercised.
On January 1, 2009, the entity grants 10 million equity-classified, nonqualified stock options. The $50 exercise price equals the grant-date stock price. The terms of the award specify three-year cliff-vesting. The grant-date fair value is $25 per option and only 8 million options are expected to (and do) vest. On January 1, 2010, the stock price decreases to $45 and the options remain underwater until they expire.
The applicable tax rate for all periods is 40 percent, and the entity has sufficient taxable income for the stock option tax deductions to reduce income taxes payable in all periods.
The entity recognizes compensation cost on a straight-line attribution basis.
All the options have a contractual term of five years.
Analysis/Conclusion:
Computations of Compensation Cost, the Deferred Tax Asset, and the Windfall Tax Benefits for Options Granted on January 1, 2006, and 2009 are as follows:
18.4 Income Tax Accounting for Incentive Stock Options
ISOs provide an employee with significant tax benefits by allowing the employee to exercise the stock options, in limited amounts, without being taxed on the intrinsic value on the exercise date. To qualify as an ISO, an option must comply with certain Internal Revenue Code (IRC) requirements and restrictions.
Although an entity treats nonqualified stock options and ISOs the same way when recognizing book compensation cost under ASC 718, it treats ISOs differently when accounting for the related income taxes. An ISO does not ordinarily result in a tax benefit for the employer, unless there is a disqualifying disposition (as described below). Therefore, a deferred tax asset is not recognized when an entity recognizes compensation cost for book purposes for such options. Moreover, ISOs generally will not result in shortfalls, and windfalls can occur only upon a disqualifying disposition.
18.4.1 Disqualifying Dispositions
A disqualifying disposition for an ISO occurs if the employee does not hold the shares for the minimum holding period that is required by the IRC. When there is a disqualifying disposition, the employee recognizes ordinary income for U.S. tax purposes for the difference between the ISO’s exercise price and the fair value of the shares at the time the option was exercised. The employer will receive a corresponding tax deduction for the amount of income recognized by the employee. The tax benefit for the deduction that corresponds to the cumulative book compensation cost is credited to income tax expense. If the tax deduction is less than the cumulative book compensation cost, the amount credited to income tax expense is limited to the tax benefit associated with the tax deduction. If the tax deduction exceeds the cumulative book compensation cost, the tax benefit associated with the excess deduction (the windfall tax benefit) is credited to APIC.
One of the requirements of an ISO is that the employee must exercise the ISO within three months of terminating employment. If termination results from disability, ISO treatment may continue up to one year following termination. If an employee dies and the ISO is transferred by bequest or inheritance, the option may continue to be treated as an ISO for its full term. Aside from these exceptions, if the employee does not exercise the award within three months and one day, there will be a disqualifying disposition. It is not triggered, however, by the mere passage of time. Rather, the disqualifying disposition event does not occur until the employee exercises the underlying option. The employer should not anticipate this disqualifying disposition until the exercise actually occurs.
Example 18-5 illustrates the computation of the windfall tax benefit resulting from a disqualifying disposition. See Examples 18-11 and 18-12 for additional guidance on accounting for a disqualifying disposition of an ISO award granted before, but settled after, the adoption of ASC 718, depending on whether the long-form or short-cut method (which are discussed further in Section TX 18.11) was elected for determining the historical pool of windfall tax benefits.
Example 18-5: Income Tax Accounting for Incentive Stock Options
Background/Facts:
On January 1, 2006, an entity grants 10,000 equity-classified ISOs. The exercise price of $30 equals the grant-date stock price. The terms of the award specify one-year cliff-vesting. The grant-date fair value is $15 per option and all 10,000 options are expected to (and do) vest.
The stock-based compensation cost is calculated as follows: 10,000 options x $15 (grant-date fair value) = $150,000
The stock price is $50 on July 1, 2007, when all 10,000 vested options are exercised, and the employees immediately sell the stock in the open market, which causes a disqualifying disposition. Therefore, the option’s intrinsic value on the exercise date and the net amount realized on the sale of the underlying stock are the same.
The applicable tax rate for all periods is 40 percent, and the entity has sufficient taxable income for the stock option tax deductions to reduce income taxes payable in all periods.
Analysis/Conclusion:
$150,000 of compensation cost is recognized in 2006; no deferred tax asset or tax benefit is recorded.
Computations for the Tax Deduction, Tax Benefit, and Windfall Tax Benefit on
July 1, 2007:
Tax deduction: [$50 (stock price on date of disqualifying disposition) – $30 (exercise price)] x 10,000 shares = $200,000
Tax benefit: tax deduction of $200,000 x 40% tax rate = $80,000
Tax benefit recorded in income statement: $150,000 of book compensation cost x 40% tax rate = $60,000
Windfall credited to APIC: $80,000 tax benefit – $60,000 recorded in income statement = $20,000
Pool of windfall tax benefits: $20,000
18.5 Income Tax Accounting for Restricted Stock and Restricted Stock Units
Restricted stock represents shares that an entity grants to an employee and are generally subject to vesting conditions. If the employee fails to vest in the shares, the employee forfeits the right to the shares.
A restricted stock unit (RSU) represents an arrangement whereby an entity promises to issue share(s) either at the time that each underlying unit vests or sometime after vesting. RSUs do not consist of legally issued shares or comprise outstanding shares, and therefore do not give the holder voting rights. Not all RSUs are alike; some can be settled in cash or shares, and some have terms that include anti-dilutive features.
Generally, restricted stock and RSUs (a promise to deliver shares) generate a tax deduction to the employer on the vesting date because the employee has a substantial risk of forfeiture as a result of the award’s vesting condition until the vesting date.
18.5.1 Initial Recognition and Classification of the Deferred Tax Asset
Similar to the accounting for deferred taxes related to a nonqualified stock option discussed in Section TX 18.3.1, an entity recognizes a deferred tax asset based on the book compensation cost for restricted stock and RSUs over the requisite service period. The balance sheet classification of the deferred tax asset as either current or noncurrent should be based on the award’s vesting date (i.e., when the tax deduction generally occurs), absent the employee making an IRC Section 83(b) election, as discussed in Section TX 18.5.2.1.
18.5.2 Measurement of Tax Deduction for Restricted Stock
The tax deduction for restricted stock generally is measured as the restrictions lapse (i.e., as the employee vests in the award). At that time, the entity will determine its windfall or shortfall based on the current stock price. A shortfall occurs when the fair value of the shares decreases between the grant date and the vesting date.
18.5.2.1 IRC Section 83(b) Elections
Under IRC Section 83(b), employees may choose to have their tax liability measured on the grant date instead of the vesting date. An IRC Section 83(b) election enables an employee to pay tax on the fair market value of a restricted stock award on the date it is granted rather than on the vesting date, as required under the normal rule of IRC Section 83(a). An IRC Section 83(b) election, however, does not change the requirement that the employee satisfy the vesting condition. If the employee fails to satisfy the vesting condition, the award will still be forfeited.
If the employee makes an IRC Section 83(b) election, any appreciation in the restricted stock after the grant date will be taxed as either a long- or short-term capital gain instead of as ordinary income. The employer will be required to withhold applicable taxes at the grant date, and the employee will have to make arrangements with the employer to satisfy the withholding requirements. If the stock appreciates in value after the grant, the result of this election can be a significant reduction in the employee’s taxes as a result of favorable capital gains treatment.
If an employee makes an IRC Section 83(b) election, the entity measures the value of the award on the grant date and records a deferred tax liability for the value of the award multiplied by the applicable tax rate, reflecting the fact that the entity has received the tax deduction from the award before any compensation cost has been recognized for financial reporting purposes. In this case, the deferred tax liability offsets the current tax benefit that the entity is entitled to by virtue of the employee’s IRC Section 83(b) election. As the entity recognizes book compensation cost over the requisite service period, the deferred tax liability will be reduced (in lieu of establishing a deferred tax asset since the tax deduction has already occurred). If an IRC Section 83(b) election is made by an employee for an equity-classified award, there will not be a windfall or shortfall upon settlement because the tax deduction equaled the grant-date fair value. If, however, an IRC Section 83(b) election is made for liability-classified restricted stock, a windfall or shortfall likely would occur at settlement because the tax deduction is measured at the grant date, whereas the book compensation cost for a liability award is remeasured through the settlement date.
Example 18-6 illustrates the computation of book compensation cost and the corresponding deferred tax accounting for a grant of an equity-classified restricted stock award under two scenarios (comparing between when an IRC Section 83(b) election has been made and has not been made).
Example 18-6: Income Tax Accounting for Restricted Stock
Background/Facts:
On January 1, 2006, an entity grants 10 million equity-classified restricted shares that have a grant-date fair value of $15 per share and a three-year cliff-vesting requirement.
No forfeitures are assumed or occur during the vesting period.
The stock price is $25 on January 1, 2009, when the requisite service period is complete.
The applicable tax rate is 40 percent during all periods.
The entity recognizes compensation cost on a straight-line basis.
The entity has sufficient taxable income for the restricted stock tax deductions to reduce income taxes payable in all periods.
Analysis/Conclusion:
Computations of Compensation Cost and the Deferred Tax Asset for Restricted Stock Granted on January 1, 2006
Under either alternative, the entity will recognize $150 million of book compensation cost over the three-year vesting period.
The example above assumes that there are no differences between the amount of the book compensation and the tax deduction that result from factors other than increases or decreases in the fair value of the entity’s shares between the grant date and exercise date. For example, in the scenario in which an IRC Section 83(b) election is made, the grant-date fair value of the award is equal to the amount of the tax deduction. In the scenario in which an IRC Section 83(b) election is not made, the difference between the amount of the book compensation and the ultimate tax deduction is attributable entirely to increases in the stock price subsequent to the grant date. Example 18-7 illustrates the accounting for the tax effects of differences between the amount of book compensation and tax deduction that result from factors other than increases or decreases in the fair value of an entity’s shares between the grant date and exercise date. This might occur, for example, in certain situations when a company concludes that the fair value of an award at the grant date is different under the applicable tax law than the fair value determined for book purposes at the same date.
Example 18-7: Accounting for Tax Benefits when Differences Between the Book Charge and Tax Deduction Result from Factors Other Than Increases or Decreases in the Company’s Stock Price
Background/Facts:
Company X (the “Company”) grants fully vested restricted stock to its employees. The award includes restrictions on the transfer of the stock that survive vesting (for example, the employee is prohibited from transferring the stock for a period of five years after the delivery of the vested stock). The Company follows the accounting guidance of ASC 718, Compensation—Stock Compensation, appropriately classifying such awards as equity.
For financial reporting purposes, the grant date fair value reflects the impact of the restrictions that survive vesting.1 These restrictions are disregarded in determining the tax deduction. Therefore, the fair value of the restricted stock determined for financial reporting purposes was determined to be less than the value used for tax purposes. The difference between the book compensation and the tax deduction was due entirely to reasons other than movement in the stock price between the grant date and the measurement date for tax purposes.
1 ASC 718-10-30-19 states “A restricted share awarded to an employee, that is, a share that will be restricted after the employee has a vested right to it, shall be measured at its fair value, which is the same amount for which a similarly restricted share would be issued to third parties.”
How should Company X account for the difference between the book charge and the tax deduction?
Analysis/Conclusion:
A tax benefit should be recorded for the restricted stock related to the amount of the award that is tax deductible. The difference between the book compensation charge and the tax deduction results in a permanent difference in Company X’s income tax provision (i.e., a current tax benefit). The permanent difference would not constitute a “windfall” with a credit potentially reflected in additional paid-in capital because it arises from factors other than the movement of the Company’s stock price between the measurement date for accounting and the measurement date for tax purposes. ASC 718-740-45-2, supports this accounting by stating “. . . an excess of a realized tax benefit for an award over the deferred tax asset for that award shall be recognized in the income statement to the extent that the excess stems from a reason other than changes in the fair value of an entity’s shares between the measurement date for accounting purposes and a later measurement date for tax purposes.”
In the example above, the Company granted fully vested restricted stock. If the award had not been fully vested at the time of grant, but instead followed a vesting schedule in which the award vests over two years, the tax benefit would not be determined until the award is fully vested in the absence of an IRC Section 83(b) election. In this case, the Company would record the deductible temporary difference over the vesting period, which is measured based on the compensation cost recognized for financial reporting purposes in accordance with ASC 718-740-25-2. Once the award vests for tax purposes, the Company would need to analyze the excess tax benefit to determine the amount that is due to increases and decreases in the stock price (which would result in a windfall or shortfall) and the amount due to other factors (which would be recognized in the income statement).
The accounting treatment would also be consistent with the description above if instead the grant date fair value of the fully vested restricted stock award determined for book purposes exceeded the fair value determined for tax purposes. The resulting permanent difference would not constitute a “shortfall.” Rather, the debit would be recorded to the income tax provision.
18.6 Income Tax Accounting for Stock Appreciation Rights
A stock appreciation right (SAR) confers upon an employee the contractual right to receive an amount of cash, stock, or a combination of both that equals the appreciation in an entity’s stock from an award’s grant date to the exercise date. SARs generally resemble stock options in that they may be exercised at the employee’s discretion during the exercise period and do not give the employee an ownership right in the underlying stock. Unlike options, however, SARs generally do not involve payment of an exercise price. How the award is settled (in cash or in stock) also affects the classification of a SAR as either a liability or equity, as discussed in Section SC 1.12.8 of PwC’s Guide to Accounting for Stock-based Compensation.
18.6.1 Cash-Settled SARs
Under ASC 718, cash-settled SARs are classified as liability awards and therefore are remeasured at fair value each reporting period until the award is settled. The related deferred tax asset is adjusted when book compensation cost is recognized each reporting period as the cash-settled SAR is remeasured. When an employee exercises a SAR, the entity’s tax deduction will equal the fair value of the SAR, which is also the amount of the book compensation liability. If the SAR is cancelled prior to expiration, the liability is reversed and the deferred tax asset is reversed through income tax expense. If the SAR expires worthless, there would be no accounting entries at the expiration date because, prior to expiration, the SAR and the corresponding deferred tax asset would have been remeasured each reporting period and at some point in time before expiration, the SAR would have no value and there would be no liability or associated deferred tax asset on the books.
18.6.2 Stock-Settled SARs
Stock-settled SARs generally are equity-classified awards under ASC 718. The income tax accounting is identical to that for an equity-classified, nonqualified stock option. Accordingly, a deferred tax asset is recorded as book compensation cost is recognized. When an employee exercises a stock-settled SAR, the entity measures the amount of the tax deduction based on the award’s intrinsic value at that time, determining the amount of any windfall or shortfall.
Example 18-8 compares the income tax accounting for cash-settled SARs and stock-settled SARs.
Example 18-8: Income Tax Accounting Comparison of Cash-Settled SARs
and Stock-Settled SARs
18.7 Accounting for the Tax Benefit of Dividends on Restricted Stock and Options
Employees, as part of stock-based compensation awards, may receive dividends on their awards during their vesting periods or, in the case of options, during the period until the exercise of their options (so-called “dividend protection”). ASC 718 provides guidance on the accounting for these dividends and states that dividends paid on restricted stock and dividend-protected options that are expected to vest are factored into the fair value of the award. The fair value of dividend-paying stock already incorporates the expected payment of dividends and therefore the entity would make no adjustment to the fair value of restricted shares for the expected payment of dividends during the vesting period. However, the fair value of an option for stock that pays dividends should be adjusted to appropriately reflect the dividend protection. ASC 718 states that the payment of dividends on restricted stock or options should be accounted for in retained earnings if the shares are expected to vest. When the related award is not expected to vest, the payment of the dividends or dividend equivalents are recognized as additional compensation cost.
From a tax perspective, dividends paid to employees on restricted stock for which an employee has not made an IRC Section 83(b) election are not treated as dividends paid to a shareholder because the IRS does not recognize the employee as having received the restricted stock until the restriction lapses (that is, until the shares vest). Therefore, the IRC treats the payment of these dividends as compensation, and the entity is entitled to receive a deduction on the dividends paid. Likewise, dividends paid as part of a dividend-protection plan for option grants are treated as compensation for U.S. tax purposes.
Consequently, entities that pay dividends on options and restricted stock (when a Section 83(b) election is not made) during the vesting period will receive a tax benefit from the deduction on those dividends. ASC 718-740-45-8 states that a realized tax benefit from dividends, or dividend equivalents, that is charged to retained earnings and paid to employees for equity-classified restricted stock, restricted stock units, and outstanding options should be recognized as an increase to APIC. Those tax benefits are considered windfall tax benefits under ASC 718 and would be included in the pool of windfall benefits. Pursuant to the guidance in ASC 718-740-25-10, the tax benefit would not be recognized in APIC (or included in the pool of windfall tax benefits) until the tax benefit actually reduces income taxes payable. As an entity’s forfeiture estimate changes, the amount of tax benefits from dividends on awards no longer expected to vest should be reclassified from APIC to income tax benefit, with a related adjustment to the pool of windfall tax benefits. The amount reclassified should be limited to the amount of the entity’s pool of windfall tax benefits (i.e., the pool of windfall tax benefits should not be less than zero).
18.8 Modification of Awards
ASC 718 defines a modification as a change in any of the terms or conditions of a stock-based compensation award, for example, a repricing, an extension of the vesting period, or a change in the terms of a performance condition. A modification of an award under ASC 718 generally will be treated as an exchange of the original award for a new award. An entity should measure book compensation cost as the excess (if any) of the fair value of the new award over the fair value that the original award had immediately before its terms were modified. In addition, an entity also will assess the potential effect of the modification on the number of awards expected to vest, including a reassessment of the probability of vesting.
If the entity records additional book compensation cost as a result of the modification, there will be a corresponding increase in the deferred tax asset. To the extent an equity-classified award is modified to a liability-classified award, any deferred tax asset would need to be adjusted at the date of modification to an amount which corresponds with the recognized liability. Even if the book compensation continues to be based on the grant date fair value of the original award (for example, if the fair value at the modification date is lower than the fair value at the original grant date), the deferred tax asset should be calculated based on the value of the liability. Refer to ASC 718-20-35-3 and Section SC 1.13 of PwC’s Guide to Accounting for Stock-Based Compensation for further guidance related to modifications.
There also may be additional tax and legal ramifications of a modification. Certain modifications to an outstanding stock award at any time after the grant date may be considered a “material modification” as defined by the IRC and may impact the qualified status of ISOs. Additionally, a modification of an award may have potentially adverse tax implications to the employee under Section 409A.
Certain modifications could result in an ISO losing its qualified status and in the modified award being considered a nonqualified stock option. Whereas previously no deferred taxes were recorded on compensation expense recognized related to the ISO because it does not ordinarily result in a tax deduction, if, as a result of the modification, the award would no longer be an ISO, the entity would have to begin recording the related deferred taxes on the nonqualified award.
18.9 Repurchase of an Award
As further described in Section SC 1.13.4 of PwC’s Guide to Accounting for Stock-Based Compensation, the accounting for the repurchase of an award is affected by several factors, including whether the award is vested or unvested and probable of vesting. If the repurchased award is unvested and probable of vesting, the company should recognize the cash settlement as a repurchase of an equity instrument that vests the award. Accordingly, any unrecognized compensation cost measured at the grant date and related deferred tax asset should be accelerated and recognized on the settlement date.
If the award (either vested or unvested and probable of vesting) is cash-settled at its current fair value as of the settlement date, no incremental compensation cost should be recognized. If the award is cash-settled for an amount greater than its fair value, compensation cost for the difference should be recognized. If the award is cash-settled for an amount less than its fair value, the entire amount of cash transferred to repurchase the award should be charged to APIC.
From a tax perspective, the amount of the cash settlement is generally deductible by the employer to the extent the entity has not previously taken a tax deduction for the award. For example, a deduction would not have previously been taken by the employer for a nonqualified stock option that has not been exercised by the employee. The amount that is deductible may also be subject to the IRC Section 162(m) limitation for covered employees (see further discussion of the IRC Section 162(m) limitation in Section TX 3.2.8). Generally, the entity is not entitled to an additional deduction for the cash settlement if it has previously taken a deduction on the award (for example, a restricted stock award in which the employee made an IRC Section 83(b) election—see Section TX 18.5.2.1 for further discussion of IRC Section 83(b) elections).
When there is a repurchase of an award for cash, any remaining deferred tax asset (in excess of the tax benefit resulting from the repurchase, if any) related to the awards generally would be reversed as a shortfall. A cash settlement of ISOs will create a tax benefit reported in earnings (to the extent of book compensation) similar to a disqualifying disposition.
18.10 Clawback of an Award
Entities may include a “clawback” provision in stock-based compensation awards. Per ASC 718-10-55-8: “A clawback feature can take various forms but often functions as a noncompete mechanism. For example, an employee that terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing entity (former employer) equity shares granted and earned in a share-based transaction.” Other clawback features may require forfeiture of an award, or a portion of an award, if there is a termination for cause or as required by the Sarbanes-Oxley Act. In addition, the Dodd-Frank Act signed into law in 2010 requires stock exchanges to put rules in place requiring entities listed on the exchange to adopt certain clawback provisions in their incentive compensation plans, including stock compensation, for certain current and former executive officers. The Dodd-Frank Act and financial statement accounting considerations relating to clawback provisions are discussed in more detail in Chapter SC 8 of PwC’s Guide to Accounting for Stock-based Compensation.
The income tax accounting for a clawback that has been triggered depends on the status of the award at the time of the clawback and whether the entity has previously taken the tax benefit from the stock-based compensation award. If the clawback occurs prior to the exercise of a stock option (or the vesting of restricted stock for tax purposes) and no tax deduction has been taken for the clawed-back awards, the related deferred tax asset would be reversed through income tax expense and not considered a shortfall. If an entity has taken deduction(s) for a stock-based compensation award that is being clawed-back, taxable income resulting from the clawback would be allocated to the various components of the financial statements (e.g., continuing operations, APIC) in accordance with ASC 740-20. See Section TX 12.2 for further discussion of the basic intraperiod allocation model and Section TX 12.2.3.2.1 for discussion of the treatment of tax effects related to equity items other than items of comprehensive income (e.g., APIC).
18.11 Pool of Windfall Tax Benefits
18.11.1 General Guidance
When the stock-based compensation standard was most recently revised, the transition guidance provided public companies and nonpublic companies that used the fair-value-based method for either recognition or disclosure under the prior standard with three transition alternatives: (1) modified prospective application (MPA); (2) modified retrospective application (MRA) to interim periods in the year of adoption; and (3) modified retrospective application to all prior periods. Regardless of the transition alternative chosen, entities should have determined the amount of eligible windfall tax benefits (the pool of windfall tax benefits) that were available on the adoption date to offset future shortfalls. Subsequent to the adoption of the revised standard (now codified in ASC 718), an entity should continue to track the balance of the pool of windfall tax benefits based on windfalls or shortfalls incurred after the adoption date. Refer to Section TX 18.11.6 for a discussion of the method for determining the historical pool of windfall tax benefits for nonpublic companies that adopted the stock-based compensation standard under the prospective method.
Entities could have elected to calculate their historical pool of windfall tax benefits (i.e., the amount that would have accumulated as of the adoption date) using either of two methods. The “long-form method” is discussed in Section TX 18.11.2. Determining the pool of windfall tax benefits using the long-form method was complex and required an entity to conduct an extensive data-gathering exercise to compile information from various sources over an extended time period. Alternatively, a “short-cut method” was provided for determining the historical pool of windfall tax benefits. The short-cut method is discussed in Section TX 18.11.4. Once an entity has determined its historical pool of windfall tax benefits, the long-form method is utilized for all activity subsequent to the adoption of ASC 718.
Example 18-9 summarizes the key differences between the long-form and short-cut methods of calculating the historical pool of windfall tax benefits at the adoption date.
Example 18-9: Key Differences When Calculating the Pool of Windfall Tax Benefits Using the Long-Form or Short-Cut Methods
1 Applicable only to entities that adopted the stock-based compensation standard using the modified prospective application method (or the modified retrospective application method for interim periods in the year of adoption only).
ASC 718 does not require entities to disclose the amount of their pool of windfall tax benefits available to offset future shortfalls. However, the amount of the pool of windfall tax benefits is needed to determine whether shortfalls after adoption are recorded against APIC or charged to income tax expense. The pool of windfall tax benefits is not directly related to the balance in an entity’s APIC account. Therefore, an entity cannot assume that it has a sufficient pool of windfall tax benefits to offset shortfalls based on having a large credit balance in APIC. Likewise, an entity could have a zero balance in APIC and have a pool of windfall tax benefits.
Although ASC 718 implicitly requires that recordkeeping be on an award-by-award basis, it allows the windfall tax benefits of all awards accounted for under the prior standard and ASC 718 to be aggregated for purposes of determining the pool of windfall tax benefits. Thus, any windfalls resulting from employee stock options, restricted stock, and most ESPPs that are granted on or after the effective date of the prior standard are eligible for aggregation, whereas any windfalls generated by Employee Stock Ownership Plans (ESOPs) or other stock-based arrangements that are outside the scope of ASC 718 are excluded.
The pool of windfall tax benefits should be calculated for windfalls and shortfalls generated by all entities that are included in the consolidated financial statements, without regard to tax jurisdiction (i.e., windfalls in one jurisdiction may offset shortfalls from another jurisdiction). Deferred tax accounting for stock-based compensation, however, generally should be determined on a jurisdiction-by-jurisdiction basis (and potentially on a tax-return-by-tax-return basis) consistent with how taxes are computed and paid.
When calculating the pool of windfall tax benefits, the balance of the pool can never be less than zero. For example, assume that an entity has no pool of windfall tax benefits as of the adoption date of ASC 718. In the first year after adoption, the entity incurs a shortfall of $1,500. In this case, at the end of the first year, the pool of windfall tax benefits would still be zero and income tax expense of $1,500 would be recognized in the income statement. The entity would begin the next year with a balance of zero in the pool of windfall tax benefits.
In addition, entities may have windfall tax benefits and shortfalls from both employee and nonemployee awards and should have elected as an accounting policy one of two approaches to determining the pool of windfall tax benefits.
The Resource Group reached a consensus that either a one-pool approach (grouping employee and nonemployee awards together) or a two-pool approach (segregating employee and nonemployee awards into two separate pools) would be acceptable when accounting for the pool of windfall tax benefits. The accounting policy selected should be disclosed in the financial statements and followed consistently.
18.11.2 Determining the Pool of Windfall Tax Benefits Using the Long-Form Method
Under the long-form method, entities that did not adopt the recognition provisions of the prior stock-based compensation standard in the year that standard originally went into effect (January 1, 1995, for a calendar-year-end entity) needed to determine what their pool of windfall tax benefits and the related deferred tax assets would have been on ASC 718’s adoption date “as if” they had been following the recognition provisions of the prior standard since its effective date. Calculation of the pool of windfall tax benefits under the long-form method was subject to potential adjustment for net operating loss (NOL) carryforwards if such NOL carryforwards included windfall tax benefits that had not been realized (see Section TX 18.14). Thus, the pool of windfall tax benefits at the adoption date of ASC 718 consisted of the net credits to APIC (both windfalls and shortfalls) that an entity would have recorded under the prior standard (subject to potential adjustment for NOL carryforwards).
Using the long-form method required an entity to compile various data from the effective date of the prior standard through the date it adopted ASC 718 because calculating the pool of windfall tax benefits under this method implicitly required tracking each award separately and maintaining detailed information on an award-by-award basis. To obtain much of the information necessary to calculate the pool of windfall tax benefits on the adoption date, an entity needed to draw on historical records from human resources’ information systems, previously filed tax returns, records for stock-based compensation plans, and data from financial reporting systems dating back to the effective date of the prior standard. When using the long-form method, awards that were granted before the effective date of the prior standard should have been excluded from the analysis unless the awards were subsequently modified.
18.11.3 Considerations for Equity-Classified Awards Granted Before but Settled After Adoption of ASC 718 under the Long-Form Method
Numerous transition issues arise for equity-classified awards granted before but settled after an entity’s adoption of ASC 718 if the entity used the modified prospective application method (or the modified retrospective application method for interim periods in the year of adoption only). The transition considerations discussed in the following sections are not applicable to entities that adopted ASC 718 using the modified retrospective application method for all prior periods because these entities would have adjusted their financial statements for prior periods to give effect to the fair-value-based method of accounting for awards granted, modified, or settled in cash in fiscal years beginning after December 15, 1994.
Under the long-form method, there are two calculations that an entity needs to complete for awards exercised after the adoption of ASC 718 that were granted prior to the adoption of ASC 718. The following sections discuss when and how each of these calculations is performed for nonqualified stock options, ISOs, and restricted stock awards.
18.11.3.1 Nonqualified Stock Options—Long-Form Method
If an entity used the modified prospective application method (or the modified retrospective application method for interim periods in the year of adoption only), the deferred tax assets related to equity-classified, stock-based compensation awards should not have been adjusted at the date of adoption. If an equity-classified, nonqualified stock option was granted before but settled after the adoption of ASC 718, the first calculation is to determine the amount of the windfall the entity should recognize. The tax deduction an entity realizes should be compared with the amount of cumulative book compensation cost recognized in the entity’s financial statements (compensation cost both recognized after the adoption of ASC 718 and recognized under prior standards, if any). The windfall tax benefit of any excess deduction should be recorded in APIC. For stock options that were fully vested at the adoption of ASC 718 and did not result in any compensation expense being recorded under prior standards, the exercise of the option after adoption could not result in a recognized shortfall. However, the entity could have incurred an “as if” shortfall for purposes of calculating the impact on the pool of windfall tax benefits, as discussed below.
The second calculation that an entity should perform is to determine the impact of the tax deduction on the pool of windfall tax benefits. The entity should calculate the windfall or shortfall by comparing the tax deduction with the total cumulative book compensation cost both recognized in the financial statements under ASC 718 and disclosed in the pro forma footnote under the prior standard (the “as if” windfall or shortfall). This “as if” windfall (or shortfall) is the windfall (or shortfall) that the entity would have incurred if the entity had been following the recognition provisions of the prior standard since its effective date. Any resulting “as if” windfall would increase the pool of windfall tax benefits and any “as if” shortfall would reduce the pool of windfall tax benefits. If an entity does not have a pool of windfall tax benefits, there would be no further accounting for an “as if” shortfall because the pool of windfall tax benefits cannot be reduced below zero.
In some reporting periods, an entity may incur both recognized shortfalls and incremental “as if” shortfalls. In some cases, the total recognized shortfalls and “as if” shortfalls may exceed the entity’s pool of windfall tax benefits. It is important to understand the order in which shortfalls reduce the pool of windfall tax benefits. For example, consider an entity with a pool of windfall tax benefits of $1,400 that recognizes a shortfall of $1,000 in its financial statements and also incurs an “as if” shortfall of $2,500 as a result of several option exercises within one period. In this situation, the order in which the recognized and “as if” shortfalls reduce the pool may impact the amount of recognized shortfalls that are recorded as income tax expense. We believe that an entity should first reduce the pool of windfall tax benefits for any recognized shortfalls and then reduce the pool for “as if” shortfalls. In this example, the recognized shortfall of $1,000 would reduce the pool of windfall tax benefits to $400. The incremental “as if” shortfall of $1,500 would reduce the pool of $400 to zero and there would be no accounting consequence of the remaining $1,100 “as if” shortfall. Because the pool of windfall tax benefits is determined on an annual basis, recognized shortfalls should be prioritized within the annual period (i.e., within an annual period, an entity should reduce the pool of windfall tax benefits for recognized shortfalls before considering the impact of any “as if” shortfalls).
Example 18-10 illustrates the above guidance, using three different scenarios.
Example 18-10: “As If” Deferred Tax Assets and the Pool of Windfall Tax Benefits
Background/Facts:
A calendar-year public entity adopted ASC 718 on January 1, 2006, using the modified prospective application method. At the adoption date, it had only one stock-based compensation award grant outstanding. On January 1, 2004, the entity granted 100,000 equity-classified, nonqualified stock options with an exercise price of $25 (equal to the grant-date stock price) with a four-year cliff-vesting period. Because the options were at-the-money on the grant date, no compensation cost was recognized under prior standards. The grant-date fair value of each option as determined under the prior standard was $5. Upon adopting ASC 718, the entity determined it had a pool of windfall tax benefits of $60,000. The entity’s applicable tax rate for all periods is 40 percent. The entity has sufficient taxable income for the stock option tax deductions to reduce income taxes payable in all periods.
Assuming straight-line attribution of compensation cost, the entity would have recognized the following:
At the end of 2007, the entity has the following balances:
The sum of “as if” and recognized deferred tax assets at the end of 2007 is $200,000.
On January 1, 2008, all of the options are exercised. Below are three scenarios that illustrate the income tax accounting for the stock options described above.
The previous chart illustrates that the pool of windfall tax benefits and the recognized windfall tax benefits will not equal each other for awards granted before ASC 718’s adoption date.
In Scenario A, the tax deduction of $625,000 would be compared with the cumulative compensation cost (recognized and disclosed) of $500,000, resulting in a $125,000 excess deduction and a $50,000 ($125,000 x 40%) “as if” windfall tax benefit, which increases the pool of windfall tax benefits. As a result, the pool of windfall tax benefits would be $110,000 and the recognized windfall tax benefit would be $150,000 (see below).
In Scenario A, the entity’s pool of windfall tax benefits would be as follows:
In Scenario A, the entity would record the following journal entries:
In Scenario B, the tax deduction of $375,000 would be compared with the cumulative compensation cost (recognized and disclosed) of $500,000, resulting in a $125,000 deficiency and a $50,000 ($125,000 x 40%) “as if” shortfall, which decreases the pool of windfall tax benefits. As a result, the pool of windfall tax benefits would now be $10,000, and the recognized windfall tax benefit would be $50,000 (see below).
In Scenario B, the entity’s pool of windfall tax benefits would be as follows:
In Scenario B, the entity would record the following journal entries:
In Scenario C, the tax deduction of $200,000 would be compared with the cumulative compensation cost (recognized and disclosed) of $500,000, resulting in a $300,000 deficiency and a $120,000 ($300,000 x 40%) “as if” shortfall, which decreases the pool of windfall tax benefits. With the balance at $60,000, the entity exhausts its pool of windfall tax benefits. Additionally, the entity will have a recognized shortfall of $20,000 because the realized tax benefit of $80,000 is less than the recognized deferred tax assets of $100,000 (see below).
In Scenario C, the entity’s pool of windfall tax benefits would be as follows:
In Scenario C, the entity would record the following journal entries:
Note: As previously discussed, when determining how recognized and “as if” shortfalls will impact the pool of windfall tax benefits and the income statement, the pool of windfall tax benefits should be reduced by recognized shortfalls before “as if” shortfalls. Therefore, the recognized shortfall is recorded as a reduction of APIC, even though the “as if” shortfall exceeds the balance in the pool of windfall tax benefits.
18.11.3.2 Incentive Stock Options—Long-Form Method
As previously discussed, an ISO does not ordinarily result in a tax benefit for the employer unless there is a disqualifying disposition. Therefore, a deferred tax asset is not recognized when an entity recognizes book compensation cost for ISOs. If and when a disqualifying disposition occurs, the employer will receive a tax deduction generally equal to the intrinsic value of the ISO on the date of the disqualifying disposition.
If an ISO was vested at the date of adoption of ASC 718 and a disqualifying disposition occurs subsequent to adoption, an entity using the modified prospective application method should record the entire tax benefit in APIC. If an ISO was partially vested at the date of adoption (i.e., a portion but not all of the requisite service period has been completed) and a disqualifying disposition occurs in a period subsequent to adoption, there is a two-step process to the first calculation to determine where the tax benefit should be recognized, as follows:
Vested portion: The tax benefit allocated to the portion of the ISO that was vested at the date of adoption should be recorded in APIC.
Unvested portion: The tax benefit allocated to the portion of the ISO that was unvested at the date of adoption, up to the amount of compensation cost recognized after the adoption of ASC 718, is credited to income tax expense. If the pro rata portion of the tax deduction exceeds the recognized cumulative compensation cost, the excess is credited to APIC.
For example, if a calendar-year-end entity granted ISOs with a grant-date fair value of $2 for the purchase of 120,000 shares on June 1, 2005, that cliff-vest in 12 months, the “vested” portion of the award as of the ASC 718 adoption date of January 1, 2006, would be $140,000 (120,000 shares x 7/12 x $2) and the “unvested” portion would be $100,000.
The “as if” windfall that increases the pool of windfall tax benefits is calculated by comparing the tax deduction with the total cumulative book compensation cost, both recognized in the financial statements and disclosed in the pro forma footnote under the prior standard. The tax benefit associated with the excess deduction is the “as if” windfall and increases the pool of windfall tax benefits. As previously discussed, compensation cost recorded for an ISO does not result in the recognition of a deferred tax asset and therefore the settlement of an ISO will not result in either a recognized or an “as if” shortfall.
Example 18-11 illustrates the tax implications of an ISO granted before the adoption of ASC 718, when a disqualifying disposition occurs after the adoption of ASC 718, for an entity using the modified prospective application method.
Example 18-11: Disqualifying Dispositions and the Pool of Windfall Tax Benefits
This illustration uses the same assumptions as in Example 18-10, except the entity granted 100,000 equity-classified incentive stock options on January 1, 2005.
Assuming straight-line attribution of compensation cost, the entity would have recognized the following:
At the end of 2008, the entity has the following balances:
On January 1, 2009, all of the options are exercised when the market price of the entity’s common stock is $32. The employees immediately sell the stock in the open market, which causes a disqualifying disposition. The calculations of the tax implications resulting from the disqualifying disposition are summarized in the schedule below.
In this example, the entity’s pool of windfall tax benefits would be as follows:
In this example, the entity would record the following journal entries:
If the stock price was $28 on the date of the disqualifying disposition and the tax deduction was $300,000 (i.e., an amount less than the cumulative recognized and unrecognized compensation cost of $500,000), this tax deduction would be allocated between the compensation cost reflected in the pro forma footnote under the prior standard and the compensation cost recognized in the financial statements post adoption of ASC 718. As discussed earlier in this section, the settlement of an ISO will not result in an “as if” shortfall and thus the disqualifying disposition would have no impact on the pool of windfall tax benefits because the tax deduction was less than the cumulative recognized and unrecognized compensation cost. The vested and unvested portion of the award will be used to allocate the tax benefit received upon disqualifying disposition between the periods before and after the pre- and post-adoption of ASC 718. The calculations of the tax implications resulting from the disqualifying disposition are summarized in the schedule below and followed by the corresponding journal entries.
In this example, there would be no change to the entity’s pool of windfall tax benefits and the entity would record the following journal entries:
18.11.3.3 Restricted Stock—Long-Form Method
The transition considerations for an equity-classified restricted stock award are similar to those for a nonqualified stock option. As previously discussed, an entity generally receives a tax deduction for restricted stock as the restrictions lapse (i.e., as the employee vests in the award). If an equity-classified restricted stock award is granted before but vests after the adoption of ASC 718, the tax deduction an entity realizes should be compared with the cumulative compensation cost recognized in the entity’s financial statements (compensation cost recognized both before and after adoption). The windfall tax benefit of any excess tax deduction should be recorded in APIC. Because equity-classified restricted stock generally is granted with a zero exercise price, it was accounted for at fair value under prior standards. It generally will not be necessary to calculate an “as if” windfall or shortfall as a restricted stock award vests, because the recognized windfall or shortfall will be equal to the “as if” windfall or shortfall.
18.11.4 Determining the Pool of Windfall Tax Benefits Using the Short-Cut Method
As noted above, entities have the option to use a short-cut method to calculate the historical pool of windfall tax benefits upon adoption of ASC 718. This method was available to entities that used the modified retrospective or modified prospective application method. Additionally, an entity could have elected to use the short-cut method regardless of whether it had the information available to calculate its pool of windfall tax benefits under the long-form method.
Short-Cut Calculation
Under the short-cut method, the pool of windfall tax benefits as of the date of adoption of ASC 718 was calculated using the following two steps:
Step 1: Determine the sum of all net increases of APIC recognized in an entity’s annual financial statements related to tax benefits from stock-based employee compensation during fiscal periods subsequent to the adoption of the prior standard but before the adoption of ASC 718, regardless of whether the entity had previously adopted the recognition provisions or disclosed the pro forma effects of applying the prior standard. If the entity continued to use the intrinsic-value method, the amounts recorded to APIC under that method should be used in this step because those amounts would be the amounts recognized in the annual financial statements.
Step 2: Subtract from the amount determined in step one the cumulative incremental pretax employee compensation cost that would have been recognized if the prior standard had been used to account for stock-based employee compensation, multiplied by the entity’s blended statutory tax rate upon adoption of ASC 718, inclusive of federal, state, local, and foreign taxes.
The cumulative incremental compensation cost used in step two of the short-cut calculation was the total stock-based employee compensation cost included in an entity’s pro forma footnotes less the stock-based compensation cost included in its financial statements. If an entity recorded stock-based compensation cost in its financial statements, those amounts were excluded from cumulative incremental compensation cost. In addition, cumulative incremental compensation cost should also have excluded:
Compensation cost associated with awards that were partially vested upon the adoption of ASC 718, and
Compensation cost associated with an award that ordinarily does not result in a tax deduction under existing tax law. An entity did not need to exclude this compensation cost if (1) a tax deduction has been obtained prior to the adoption of ASC 718 or (2) an entity was unable to obtain the information necessary to determine the amount of such cost. For example, compensation cost for ISOs and ESPPs would have been excluded unless there was a disqualifying disposition prior to the adoption of ASC 718. Other awards that may have qualified for exclusion in step two include awards issued in jurisdictions in which the entity is not entitled to a local tax deduction.
18.11.4.1 Transition Considerations under the Short-Cut Method
The transition considerations for the income tax effects of awards granted before the adoption of ASC 718 were not applicable to entities that used the modified retrospective application method for all prior periods because these entities would have adjusted their financial statements for prior periods to give effect to the fair-value-based method of accounting for awards granted, modified, or settled in cash in fiscal years beginning after December 15, 1994.
In the related guidance, the term “partially vested” was used to describe awards for which compensation cost is not fully recognized because only a portion of the requisite service period has been completed. “Fully vested” awards are awards for which the compensation cost is fully recognized (generally, because the award is legally vested).
Entities that grant nonqualified options or restricted stock awards using the modified prospective application method (or the modified retrospective application method for interim periods in the year of adoption only) should calculate windfall tax benefits or shortfalls for purposes of determining the impact on the pool of windfall tax benefits for awards that are settled following the adoption of ASC 718 as follows:
Partially vested awards: The windfall tax benefit (or shortfall) that increases (or decreases) the pool of windfall tax benefits should be determined by comparing the tax deduction for a partially vested award with the sum of the compensation cost recognized and disclosed for that award under the prior standard and ASC 718 (i.e., the “as if” windfall or shortfall).
Fully vested awards: The windfall tax benefit (or shortfall) that increases (or decreases) the pool of windfall tax benefits is equal to the tax effects recognized in APIC as a result of the settlement of the award subsequent to the adoption of ASC 718 (i.e., the windfall recognized under the prior guidance).
The ongoing income tax accounting for partially vested awards as of the adoption date of ASC 718, as described above, is the same under the short-cut and long-form methods. However, an election to use the short-cut method affects the ongoing income tax accounting for awards that were fully vested as of the adoption date of ASC 718. The windfall tax benefits related to fully vested awards calculated for purposes of the roll-forward of the pool of windfall tax benefits will be calculated on an “as if” basis under the long-form method, while under the short-cut method these windfalls will be equal to the amounts recognized in APIC under the prior guidance.
Example 18-12 illustrates the tax implications of an ISO award granted and vested before the adoption of ASC 718, when a disqualifying disposition occurs after the adoption of ASC 718 under the modified prospective application method. This entity elected the short-cut method for calculating the historical pool of windfall tax benefits.
Example 18-12: Disqualifying Dispositions and the Pool of Windfall Tax Benefits
A calendar-year public entity adopts ASC 718 on January 1, 2006, using the modified prospective application method. On January 1, 2001, the entity granted 100,000 equity-classified, incentive stock options with an exercise price of $25 (equal to the grant-date stock price) with a four-year cliff-vesting period; therefore, these options were fully vested upon the adoption of ASC 718. Because the options were at-the-money on the grant date, no compensation cost was recognized. Upon adopting ASC 718, the entity determines it has a pool of windfall tax benefits of $60,000. The entity’s applicable tax rate for all periods is 40 percent. The entity has sufficient taxable income for the stock option tax deductions to reduce income taxes payable in all periods.
At the end of 2007, the entity has the following balances:
On January 1, 2008, all of the options are exercised when the market price of the entity’s common stock is $32. The employees immediately sell the stock in the open market, which causes a disqualifying disposition. The calculations of the tax implications resulting from the disqualifying disposition are similar to those in Example 18-11 and are summarized in the schedule below.
Note that, for entities that elected the short-cut method, the recognized windfall in APIC for fully vested awards at the date of adoption of ASC 718 upon exercise of the award equals the “as if” windfall being added to the pool of windfall tax benefits.
In this example, the entity’s pool of windfall tax benefits would be as follows:
In this example, the entity would record the following journal entries:
18.11.5 Determining the Pool of Windfall Tax Benefits for Entities That Became Public Entities After the Effective Date of the Prior Standard but Before Adopting ASC 718
Entities that were not public entities as of the adoption date of the prior standard but that became public entities before adopting ASC 718 had two alternatives in calculating the historical pool of windfall tax benefits. An entity’s decision to apply one of these two methods would have been an accounting policy decision. The key difference between these two alternatives was how an entity treated awards that were granted prior to its becoming a public entity that were valued using the minimum-value method.
Alternative 1: Under the first approach, an entity would only have included in the historical pool of windfall tax benefits those awards measured using the fair value method (i.e., awards granted as a public entity). Entities could have elected either the short-cut or long-form method to calculate their ASC 718 pool of windfall tax benefits, but would have applied this method only to awards granted as a public entity. These entities would maintain a separate pool of windfall tax benefits for awards granted prior to becoming a public entity, for which they would continue to apply prior standards to calculate the windfall. Any windfalls generated from such awards would be tracked separately and would not impact the ASC 718 pool of windfall tax benefits. Similarly, if a shortfall was incurred upon exercise of an award accounted for under prior standards (after ASC 718’s adoption), entities should determine the accounting for the shortfall (i.e., whether to record it in equity or the income statement) based on this separate pool of windfall tax benefits. The shortfall from this award would not impact the ASC 718 pool of windfall tax benefits.
Alternative 2: Under this approach, an entity would have combined the windfall tax benefits from awards measured using the minimum-value method and fair value method when determining its historical pool of windfall tax benefits. Additionally, entities could have elected either the short-cut or long-form method and applied this method to their awards regardless of whether the awards were measured using the minimum value method or the fair value method. This alternative permits entities that were public entities on the date they adopted ASC 718, using either the modified prospective or modified retrospective transition method, to include all settlements of awards, measured previously using the minimum value or fair value method, in the pool of windfall tax benefits. Entities that elected this alternative would have maintained a separate pool of windfall tax benefits for awards granted prior to becoming a public entity, for which they will continue to apply for the prior recognition provisions.
If a shortfall is incurred upon exercise of an award accounted for under prior standards (after ASC 718’s adoption), an entity would account for the shortfall based on a two-step process: (1) the recognition of the shortfall (i.e., the determination of the amount and whether the shortfall is recorded in equity or the income statement) should be determined based on the prior pool of windfall tax benefits and (2) the shortfall calculated based on the award’s minimum value also should be included in the ASC 718 pool of windfall tax benefits. If a windfall is incurred upon exercise of an award, the amount of the windfall to be recorded in APIC would be based on a comparison of the tax benefit with the amount of compensation cost recognized in the financial statements. The windfall would be calculated based on the award’s minimum value and would be included in the ASC 718 pool of windfall tax benefits. Entities that elected this alternative are effectively required to calculate and track two pools for the exercises of minimum value awards—the prior pool and the ASC 718 pool.
18.11.6 Determining the Pool of Windfall Tax Benefits for Prospective Adopters
The short-cut method was available only to entities adopting under the modified prospective or modified retrospective methods and, therefore, should not have been used by a nonpublic entity adopting ASC 718 under the prospective transition method. We believe that the historical pool of ASC 718 windfall tax benefits would have been zero as of the adoption date of ASC 718 for nonpublic entities adopting under the prospective transition method, because ASC 718 is applied only to awards granted or modified after the adoption date. Nonpublic entities that adopted ASC 718 under the prospective transition method should track two separate pools of windfall tax benefits: (1) windfall tax benefits generated from awards accounted for under prior standards and (2) windfall tax benefits generated from awards accounted for under ASC 718. Shortfalls incurred under ASC 718 should not be offset against windfall tax benefits generated by awards accounted for under prior standards.
18.11.7 Determining the Tax Benefit from Awards with Graded Vesting and Separate Fair Values
In some cases, an entity may grant awards with graded vesting (e.g., 25 percent of the award vests each year for four years) and separately estimate the fair value for each vesting tranche, which could make it difficult to determine how to calculate the windfall or shortfall. If an entity is unable to determine which tranche of options was exercised, the entity should assume that the first exercises were from the first tranche to vest and that subsequently exercised options were from any remaining options in the first tranche, followed by options in later tranches, in order of vesting.
18.12 Business Combinations, Equity Restructurings, and Separately
Reporting Subsidiaries
18.12.1 Impact of Business Combinations, Equity Restructurings, Spin-offs, Equity-Method Investments, Majority-Owned Subsidiaries, and Bankruptcy on the Pool of Windfall Tax Benefits
When applying the long-form method of calculating the pool of windfall tax benefits, entities that completed business combinations or equity restructurings after the effective date of the prior standard and before adopting ASC 718 need to determine the impact of these transactions when calculating their pool of windfall tax benefits. Additionally, after the adoption of ASC 718, all entities need to consider the impact of business combinations or equity restructurings on the pool of windfall tax benefits.
ASC 718 does not provide specific guidance on the impact of these transactions on the pool of windfall tax benefits. We believe the following approaches are acceptable:
Business combination: The windfall pool of an acquired entity is set to zero at the acquisition date (i.e., the acquired entity’s historic windfall pool does not carry over).
Pooling of interests (for business combinations accounted for under this method prior to June 30, 2001): Because a pooling of interests represents a transaction that combines the ownership interests, on a predecessor basis, via the exchange of equity securities, the pool of windfall tax benefits will include both entities’ windfall tax benefits, determined on an annual basis.
Sale of a subsidiary: If the windfall tax benefit resulted from the parent entity’s equity, the pool of windfall tax benefits will remain with the parent entity. Alternatively, if the pool relates to the subsidiary’s equity (e.g., the subsidiary had its own option program), the pool of windfall tax benefits should follow the subsidiary.
Spin-off of a subsidiary: One view is that the pool of windfall tax benefits should follow the employees. For example, if the pool of windfall tax benefits generated by awards settled prior to the spin-off resulted from awards that were issued to the spinnee’s employees, such amounts should be carved out of the parent entity’s (the spinnor’s) pool of windfall tax benefits and be allocated to the spinnee. An alternative view is that if the pool of windfall tax benefits was generated as a result of parent entity equity, it should remain with the parent entity. If, on the other hand, the pool of windfall tax benefit relates to the spun-off subsidiary’s equity, then it should remain with the subsidiary after the spin-off. We believe either alternative, applied consistently, is acceptable.
Equity-method investee: Windfall tax benefits that the investee generates should not be included in the investor’s pool of windfall tax benefits.
Majority-owned subsidiary: An entity’s majority-owned subsidiary may issue awards in the subsidiary’s separate equity. The consolidated pool of windfall tax benefits should include the pools for both the parent and the majority-owned subsidiary. However, the portion of windfall tax benefits that relates to the noncontrolling interest should not be presented in the consolidated entity’s APIC. Instead, it should be included in the noncontrolling interest line item within the equity section of the consolidated enterprise’s balance sheet. In addition, if the majority-owned subsidiary issues separate financial statements, the pool of windfall tax benefits for purposes of the subsidiary’s separate financial statements likely will differ from the pool included in the parent entity’s consolidated pool of windfall tax benefits.
Bankruptcy: For entities that adopt fresh-start reporting upon emergence from a formal reorganization under ASC 852 Reorganizations, the pool of windfall tax benefit would be zero as of the date of emergence from bankruptcy.
18.12.2 Pool of Windfall Tax Benefits for Separately Reporting Subsidiaries
For separately reporting subsidiaries, the determination of the pool of windfall tax benefits will depend on the method used to allocate income taxes to the entities within the consolidated tax group. Under a separate-return method, the subsidiary determines its income tax provision as if it were a separate taxpayer. Although the separate-return method is preferable, other methods or a modification of the separate-return method may be used by some entities.
18.12.3 Tax Effects of Awards Exchanged in a Business Combination
18.12.3.1 Awards That Ordinarily Result in a Tax Deduction
For awards that ordinarily result in a tax deduction, a deferred tax asset should be recorded at the acquisition date related to the fair value of a replacement award. If the acquirer is obligated to grant the replacement award, the fair value of the award and the deferred tax asset related to pre-combination services should be included in the consideration transferred for the acquiree. This deferred tax asset represents a future tax benefit that the acquirer has obtained the right to receive as a result of the acquisition. If the acquirer is not obligated to grant the replacement award, the entire fair value of the award and the related deferred tax asset should be recognized as expense in the post-combination financial statements. For the fair value of a replacement award that is attributed to post-combination services, a deferred tax asset is recorded in the post-combination financial statements as the service period is completed.
18.12.3.1.1 Equity-Classified Awards That Ordinarily Result in a Tax Deduction
As noted above, a deferred tax asset should be recorded at the acquisition date for replacement awards that ordinarily result in a tax deduction and are included in the consideration transferred for the acquiree. The resulting income tax effects of equity-classified awards (e.g., stock options or restricted shares) exchanged in a business combination should be accounted for in accordance with ASC 718. If the tax deduction received by the acquirer upon the exercise of stock options or vesting of restricted shares is greater than the sum of the fair value of the award added to the purchase price plus the cumulative U.S. GAAP compensation cost recorded by the acquirer, the tax benefit related to the excess tax deduction (i.e., windfall) should be recorded as an adjustment to additional paid-in capital. If the tax deduction received by the acquirer upon the exercise of stock options or vesting of restricted shares is less than the sum of the fair value of the award included in the purchase price plus the cumulative U.S. GAAP compensation cost recorded by the acquirer, the resulting difference (i.e., shortfall) should be charged first to additional paid-in capital, to the extent of the acquirer’s pool of windfall tax benefits. Any remaining shortfall would be recognized in income tax expense. Windfalls and shortfalls generated from replacement awards are included in the acquirer’s pool of windfall tax benefits, similar to other awards granted by the acquirer. Example 18-13 illustrates this guidance. Please note that the following example does not consider the par value of the common stock issued or cash received for the option’s exercise price.
Example 18-13: Income Tax Accounting for a Vested Equity-Classified Nonqualified Option
Background/Facts:
Company K (the acquirer) exchanges replacement awards with a fair value of $50 at the acquisition date for Company L’s (the acquiree) awards with a fair value of $50. Company K was obligated to issue replacement awards under the terms of the acquisition agreement. When granted, Company L’s awards had a service period of four years. As of the acquisition date, all four years of service have been rendered. The awards are nonqualified options and, therefore, result in a tax deduction upon exercise of the awards. The exercise price of the awards is $30. Company K’s applicable tax rate is 40 percent. All of the awards are exercised six months after the acquisition date when the market price of Company K’s shares is $90.
Analysis/Conclusion:
As the replacement awards do not have any excess fair value at the acquisition date and 100 percent (4 years pre-combination service / 4 years total service) of the fair value of the awards is attributable to pre-combination services, the entire $50 should be included in the consideration transferred for the acquiree:1
Company K should also record a deferred tax asset equal to $20 ($50 x 40%) because, at the time of the acquisition, the awards are expected to result in a tax deduction (assuming that it is more-likely-than-not that the deferred tax asset will be realized):
Upon exercise of the awards, Company K will be entitled to a tax deduction of $60 ($90 market price of Company K’s shares – $30 exercise price). The tax benefit of the tax deduction (i.e., the reduction in taxes payable) is $24 ($60 x 40%). The excess tax benefit of $4 (tax benefit of $24 – deferred tax asset of $20) is recorded to additional paid-in capital (i.e., windfall tax benefit). Assuming that Company K has sufficient taxable income such that the tax deduction results in a reduction in taxes payable (in accordance with ASC 718-740-25-10), the journal entries to record the income tax effects of the option exercise would be to (i) reverse the deferred tax asset against deferred tax expense and (ii) reduce taxes payable:
1 All computations have been provided on an individual award basis.
The income tax effects of equity-classified awards that were transferred as part of a business combination and are attributable to post-combination services should be recorded in the post-combination financial statements in the period those effects arise, as if the awards were issued absent a business combination. No adjustment should be made to the accounting for the business combination for the related tax effects.
For example, if a partially vested replacement award is granted on the acquisition date, a deferred tax asset would only be recorded for the portion of the award’s fair value that was attributed to pre-combination services. A deferred tax asset related to the portion of the awards’ fair value attributed to post-combination services would be recorded in the post-combination financial statements as the service period is completed. For the portion of the awards’ fair value attributed to post-combination services, no deferred tax asset would be recorded as part of the consideration transferred for the acquiree (i.e., there are no adjustments to goodwill for the deferred tax asset related to awards attributed to post-combination services).
Example 18-14 illustrates this guidance. Please note that the following example does not consider the par value of the common stock issued or cash received for the option’s exercise price.
Example 18-14: Income Tax Accounting for a Partially Vested Equity-Classified Nonqualified Option
Background/Facts:
Company K (the acquirer) exchanges replacement awards with a fair value of $50 at the acquisition date for Company L’s (the acquiree) awards with a fair value of $50. Company K was obligated to issue replacement awards under the terms of the acquisition agreement. When granted, Company L’s awards had a service period of four years. As of the acquisition date, three years of service required by the original terms of Company L’s awards have been rendered. The replacement awards have the same terms as the original awards. The awards are nonqualified options and, therefore, are expected to result in a tax deduction upon exercise of the awards. The exercise price of the awards is $30. Company K’s applicable tax rate is 40 percent. All of the awards are exercised two years after the acquisition date when the market price of Company K’s shares is $90.
Analysis/Conclusion:
As of the acquisition date, 75 percent (3 years pre-combination service / 4 years total service) of the fair value of the awards is attributable to pre-combination services. The replacement awards had no excess fair value over the acquiree awards; therefore, $37.5 ($50 x 75%) should be included in the consideration transferred for the acquiree:1
Company K should also record a deferred tax asset for the portion of the awards attributed to pre-combination services equal to $15 ($37.5 x 40% tax rate) because, at the time of the acquisition, 75 percent of the awards are expected to result in a tax deduction (assuming that it is more-likely-than-not that the deferred tax asset will be realized):
One year after the acquisition date, the remaining year of service is completed, resulting in the vesting of the replacement awards. Company K should record compensation cost of $12.5 ($50 x 25%) in the post-combination financial statements for the remaining 25 percent of the fair value of the awards. A deferred tax asset should also be recorded for the portion of the awards attributed to post-combination services equal to $5 ($12.5 x 40% tax rate), since the awards are
expected to result in a tax deduction (assuming that it is more-likely-than-not that the deferred tax asset will be realized):
Upon exercise of the awards, Company K will be entitled to a tax deduction of $60 ($90 market price of Company K’s shares – $30 exercise price). The tax benefit of the tax deduction (the reduction in taxes payable) is $24 ($60 x 40%). The excess tax benefit of $4 (tax benefit of $24 – deferred tax asset of $20) is recorded to additional paid-in capital (i.e., windfall tax benefit). Assuming that Company K has sufficient taxable income such that the tax deduction results in a reduction in taxes payable (in accordance with ASC 718-740-25-10), the journal entries to record the income tax effects of the option exercise would be to (i) reverse the deferred tax asset against deferred tax expense and (ii) reduce taxes payable:
The income tax effects of replacement awards (i.e., windfalls and shortfalls) are accounted for through adjustments to the total pool of windfall tax benefits of the consolidated company, reflecting the windfall tax benefits of all awards granted by the company (not only the replacement awards). In other words, the income tax effects of awards for pre-combination services or post-combination services are considered against a single pool of windfall tax benefits which includes the tax effects of all awards, including those unrelated to the business combination, granted by the acquirer to its employees or any of its consolidated subsidiaries as of the exercise or settlement date.
18.12.3.1.2 Liability-Classified Awards That Ordinarily Result in a Tax Deduction
For liability-classified awards, the income tax accounting for awards exchanged in a business combination is similar to that for equity-classified awards. If the acquirer is obligated to grant the replacement award, the fair value of the award and the deferred tax asset related to pre-combination services should be included in the consideration transferred for the acquiree. However, for liability-classified awards, book compensation cost and the related deferred tax asset should be remeasured every reporting period. Therefore, liability-classified awards will generally not generate a windfall or a shortfall, because the tax deduction will equal book compensation cost upon settlement. For purposes of ASC 805, all changes in the fair value of liability-classified awards after the acquisition date and the related income tax effects are recognized in the post-combination financial statements of the acquirer in the period(s) in which the change occurs (ASC 805-30-55-13).
18.12.3.2 Awards That Do Not Ordinarily Result in a Tax Deduction
For awards that do not ordinarily result in a tax deduction (e.g., an incentive stock option) where the award’s fair value was attributed to pre-combination services, the acquirer should not recognize a deferred tax asset at the acquisition date, because the awards are not expected to result in a tax benefit. In some situations, the acquirer may receive a tax deduction due to events that occur after the acquisition date (e.g., the disqualifying disposition of an incentive stock option because the employee did not hold the underlying shares for the minimum holding period required by the Internal Revenue Code). The tax effect of a disqualifying disposition should be recognized when it occurs (ASC 805-740-25-11). However, ASC 805 does not address where in the financial statements the tax benefit of such an event should be recorded. We believe there are two acceptable approaches: (i) the entire tax benefit of the disqualifying disposition is recorded to equity (i.e., additional paid-in capital), or (ii) the tax benefit is recorded in the income tax provision up to the amount of the tax benefit related to the fair value of the award that was included in the consideration transferred, with the remaining portion of the tax benefit recorded as an adjustment to additional paid-in capital.
Incentive stock options that do not ordinarily result in a tax deduction and for which the award’s fair value was attributed to post-combination services should be accounted for in the same manner as awards that were granted absent a business combination. That is, the tax effects, if any, should be reported in the post-combination financial statements in the period they arise, and no adjustment should be made to the accounting for the business combination (ASC 805-740-25-11).
When determining the deferred tax asset that should be recognized, companies should also consider whether the IRC Section 162(m) limitation applies. Refer to Section TX 3.2.8 for further discussion.
18.13 Ongoing Accounting for Share-Based Awards Granted Prior to the Effective Date of ASC 805
Prior to the adoption of ASC 805, entities were not permitted to recognize deferred tax assets at the acquisition date for replacement share-based payment awards. Instead, any tax deduction resulting from the exercise of the award was recognized as an adjustment to the cost of the acquisition (usually as a reduction of goodwill) to the extent of the fair value of the award recognized at the acquisition date.
However, if any incremental compensation cost was recorded in the acquirer’s financial statements as a result of applying modification accounting (see Chapter SC 1 of PwC’s Guide to Accounting for Stock-Based Compensation, for further guidance on accounting for modifications of awards), a corresponding deferred tax asset was recorded. Additionally, unvested awards that generate post-acquisition compensation cost result in the recognition of a deferred tax asset as compensation cost is recorded.
For those replacement awards granted as part of a business combination that was consummated prior to the effective date of ASC 805 (i.e., where no deferred tax asset was recorded at the acquisition date), the acquirer should continue to adjust goodwill for the tax benefits realized upon the settlement of the awards.
Upon settlement of equity-classified, nonqualified awards exchanged in a business combination prior to the effective date of ASC 805, entities would do the following:
For nonqualified awards that were vested as of the acquisition closing date and for the vested portion of a partially vested award: An adjustment to the purchase price would be recorded equal to the tax benefit for the deduction that corresponds to the fair value of the awards recognized as part of the purchase price. Any excess tax deduction over the fair value of the awards recognized as part of the purchase price is a windfall tax benefit and would be recorded to APIC.
For nonqualified awards that were unvested as of the acquisition closing date and for the unvested portion of a partially vested award: Because compensation cost and a related deferred tax asset are recorded post-combination, the accounting treatment upon settlement is the same as the accounting for an award granted after the acquisition. Any excess tax deduction over the recognized compensation cost is a windfall tax benefit and would be recorded to APIC.
We believe that the tax effects of (1) liability-classified awards and (2) ISOs should be accounted for as follows:
For Liability-classified awards exchanged in a business combination: We believe that the guidance in ASC 805-740-25-3 would require the recognition of a deferred tax asset for the difference between the fair value and the tax basis of a liability-classified award. As the liability-classified award continues to be remeasured at fair value each reporting period, the deferred tax asset also would be adjusted each reporting period until settlement. Therefore, there would be no windfall tax benefit or shortfall upon settlement of the award.
For ISOs exchanged in a business combination: For ISOs that were vested as of the acquisition date and for the vested portion of partially vested ISOs, the entity should not record deferred tax assets as of the acquisition date. Rather, the entity should recognize any tax benefit as a result of a disqualifying disposition in APIC on the date of the disqualifying disposition and should not adjust the purchase price, because the ISO was not expected to result in a tax deduction at the date of acquisition. For awards that were unvested as of the acquisition date and for the unvested portion of partially vested awards, compensation cost should be recognized after the acquisition without recording deferred tax assets. The tax benefit of a disqualifying disposition will be recognized on the date of the disqualifying disposition following the same accounting treatment as for any other disqualifying disposition.
18.13.1 Example: Options Exchanged in a Business Combination Prior to the Effective Date of ASC 805
This example illustrates the accounting treatment of options exchanged in a business combination prior to the effective date of ASC 805.
On September 1, 2007, Entity A announces its intention to acquire Entity B and the signing of a definitive purchase agreement. As part of the purchase agreement, Entity A will issue nonqualified stock options to purchase 100,000 shares of Entity A’s common stock to Entity B’s employees in exchange for their existing nonqualified stock options to purchase 100,000 shares of Entity B’s common stock, which is the same exchange ratio (1 to 1) offered to all other shareholders. No other terms of the options granted to Entity B’s employees will be modified in connection with the acquisition. The options originally issued by Entity B contain only a service condition and were equity-classified. No modifications are made to the purchase agreement or Entity B’s employee stock options between September 1, 2007, and the acquisition closing date of December 31, 2007. Additionally, there are no forfeitures of Entity B’s stock options in the period from the announcement date to the closing date.
Example 18-15: Options Exchanged in a Business Combination Prior to the Effective Date of ASC 805
Background/Facts:
Entity A is a calendar-year-end entity that adopted the guidance in ASC 805 using the modified prospective application method.
Entity A’s common stock has a par value of $0.01 per share.
Entity A has an applicable tax rate of 40 percent. In each period, there is sufficient taxable income so that Entity A realizes any windfall tax benefits generated from the exercise of the options. Entity A also has determined that it is more-likely-than-not that all deferred tax assets will be realized (i.e., there is no valuation allowance). Entity A has elected to consider only the direct effects of stock-based compensation tax deductions when calculating windfall tax benefits and shortfalls.
At the closing date of the acquisition, 50,000 of Entity B’s options are vested. The remaining 50,000 options were granted originally by Entity B on December 31, 2006, and cliff-vest on December 31, 2008 (i.e., one year of the vesting period remains as of the closing date of the acquisition). The vesting terms are not modified as a result of the exchange.
The comparison of the fair value of the exchanged options immediately before and immediately after the closing date does not result in incremental compensation cost.
18.13.1.1 Fair Value of Options Exchanged
Entity A estimates that the fair value of the stock options exchanged in the acquisition is $25 per option, using the Black-Scholes model. The fair value of $25 is based on Entity A’s assumptions as of the announcement date (September 1, 2007) and the market price of Entity A’s stock a few days before and a few days after the announcement date. As of December 31, 2007, Entity A estimates a 5 percent forfeiture rate for the 50,000 unvested options. Therefore, total options expected to vest are 97,500 (50,000 vested options + 47,500 partially vested options). The total fair value of the exchanged options is estimated to be $2,437,500 (97,500 x $25). Entity A includes the fair value of the options exchanged in the acquisition as part of the purchase price paid for Entity B.
Entity A does not record a deferred tax asset for the exchanged options on the closing date because no compensation expense has been recorded. Additionally, Entity A does not record a liability for the employer’s portion of the payroll taxes associated with the exchanged options until the event occurs that triggers the measurement and payment of the tax (generally, the exercise date for nonqualified stock options). If the triggering event occurs after the closing date of the acquisition, no adjustment should be made to the purchase price of the business combination for the payroll taxes.
18.13.1.2 Entry to Record Fair Value Allocated to Future Service
When employee service is required subsequent to the closing of the acquisition in order for the employees to vest in the options, a portion of the option’s fair value should be allocated to the future service and recognized over the future service period. The value attributed to the unvested options is based on the fair value of the options as of the closing date of the acquisition. Entity A estimates a fair value of $23 per option on December 31, 2007, which differs from the fair value estimated as of September 1, 2007 (i.e., $25), because of the different measurement date. The fair value of the unvested options that relates to the future service period is $546,250 (47,500 options expected to vest x $23 x 50% of requisite service period remaining). This amount is deducted from the purchase price paid for Entity B. However, deferred compensation should not be recorded because this deferred compensation is now considered unrecognized compensation cost under ASC 718. Therefore, the value of the unvested options reduces additional paid-in capital.
18.13.1.3 Requisite-Service-Period Entries
During the period from December 31, 2007, through December 31, 2008, Entity A records compensation cost for the exchanged options and the related deferred tax assets.
If Entity A revises its forfeiture-rate assumption during the requisite service period, it would adjust compensation cost in the period of the change in estimate and no adjustment would be recorded to the previously measured purchase price for the business combination.
None of the employees forfeit their options during the one-year requisite service period as compared with Entity A’s estimated pre-vesting forfeiture rate of 5 percent. Therefore, Entity A records the remaining $57,500 (2,500 options x $23) of compensation cost, along with the related deferred tax assets.
18.13.1.4 Exercised Options—Options Vested at Closing Date
On April 30, 2008, when the market price of Entity A’s common stock is $70 per share, all 50,000 of the options that were vested as of the closing date of the acquisition are exercised. Because a deferred tax asset was not recorded at the closing date of the acquisition, the tax deduction resulting from the exercise of the stock options is recognized as an adjustment to the purchase price of Entity B to the extent that the tax deduction does not exceed the fair value of the exchanged options recognized as part of the purchase price. To the extent that the tax deduction exceeds the fair value of the exchanged options recognized as purchase price, that windfall would be recognized in APIC and would be included in the pool of windfall tax benefits. The calculations of the tax implications resulting from the exercise are summarized in the schedule below and followed by the corresponding journal entries.
As a result of the exercise of these options, Entity A’s pool of windfall tax benefits increased by $100,000.
18.13.1.5 Exercised Options—Options Unvested at Closing Date
On February 15, 2009, when the market price of Entity A’s common stock is $75 per share, the remaining 50,000 options, which vested on December 31, 2008, are exercised. Because 50 percent of the requisite service period for these options was completed prior to the closing date of the business combination (i.e., the options were 50 percent vested), the tax benefit should be prorated between the vested and unvested portion of the award. The accounting for the income tax effects of the vested portion is recorded as an adjustment to the purchase price. The accounting for the unvested portion is the same as the accounting for options granted absent a business combination. The calculations of the tax implications resulting from the exercise are summarized in the schedule below and followed by the corresponding journal entries.
As a result of the exercise of these options, Entity A’s pool of windfall tax benefits increased by $221,000 ($112,500 + $108,500).
18.14 Net Operating Losses
Under ASC 740, a deferred tax asset is recorded for an NOL carryforward and is offset by a valuation allowance if it is more-likely-than-not that the entity will not have sufficient future taxable income to realize the economic benefit from the NOL carryforward.
When the settlement of an award results in an NOL carryforward, or increases an NOL carryforward, that settlement will generate a tax deduction before the realization of the tax benefit from that tax deduction. In that case, ASC 718-740-25-10 provides that the excess tax benefit and the credit to APIC for the windfall should not be recorded until the deduction reduces income taxes payable, on the basis that cash tax savings have not occurred. When an entity cannot recognize the tax benefit of an excess deduction because it did not reduce income taxes payable, the NOL carryforwards for which a deferred tax asset is recorded will differ from the amount of NOL carryforwards available to the entity (as disclosed in the entity’s tax return). The NOL carryforwards related to windfall tax benefits will need to be tracked separately but will be included with the other available NOL carryforwards that are disclosed in the footnotes. An entity also should disclose in its footnotes the amount of NOL carryforwards for which a benefit would be recorded in APIC when realized. This accounting should be applied only to the windfall portion of the deduction. The portion of the NOL that corresponds to the book compensation cost will be recorded as a deferred tax asset under ASC 740 and will be subject to normal valuation allowance considerations.
In instances where a company will claim a refund for prior taxes paid (i.e., a company will record a debit to taxes receivable) as a result of an NOL carryback that includes a windfall deduction, the company may have realized a tax benefit for the excess deduction in accordance with ASC 718-20-55-20. Although the company will not reduce income taxes payable in the current period, the windfall deduction may reduce the amount of taxes paid related to prior years. If the company were able to carry back only a portion of the losses generated in the current year (e.g., because the income in the carryback period was less than the losses generated in the current period), ASC 718-20-55-20 would prohibit the recognition of a tax benefit for the portion of the windfall deduction that has not yet reduced cash taxes paid or payable. While authoritative literature does not directly address this situation, we believe it would be appropriate to follow an approach similar to an allocation of the IRC 162(m) limitation as discussed in TX 3.2.8.
The implications of ASC 718-740-25-10 also may impact the accounting for NOL carryforwards acquired in a business combination. For example, if a business combination results in a new book basis, and if the acquiree had NOL carryforwards that resulted partly from windfall tax benefits that were not recognized on its books because of ASC 718-740-25-10, the NOL carryforwards would lose their “taint” after the acquisition and therefore would be considered in determining the amount of the deferred tax asset that the acquirer would recognize in acquisition accounting, subject to any valuation allowance that might be necessary. This would not be the case, however, in a carryover-basis transaction such as a spin-off. In these cases, the NOL carryforwards resulting from windfall tax benefits of the spinnee that were not recognized because of ASC 718-740-25-10 would have to be realized before being recognized in the spinnee’s financial statements.
18.15 Valuation Allowances
For most stock-based compensation awards, an entity will recognize a related deferred tax asset. An entity should provide a valuation allowance for a deferred tax asset if, based on the weight of the available positive and negative evidence, it is more-likely-than-not that the deferred tax asset will not be realized. See Chapter TX 5 for guidance on assessing the need for a valuation allowance.
When an entity measures its deferred tax asset related to stock-based compensation awards or determines whether a valuation allowance is necessary, the current fair value of its stock should not be considered. An entity should establish a valuation allowance only if it expects that it will not have sufficient future taxable income to realize economic benefit from the deferred tax asset.
In practice, prior to the adoption of ASC 718, deferred tax assets generally were recorded for windfall tax benefits even if such amounts increased or created an NOL carryforward for which a valuation allowance was required. As discussed previously, ASC 718-740-25-10 provides that the tax benefit and the credit to APIC for the windfall tax benefit should not be recorded until the tax deduction reduces current taxes payable. Entities need to consider how ASC 718-740-25-10 impacts the reversal of any valuation allowance established for deferred tax assets related to windfall tax benefits prior to the adoption of ASC 718.
The Resource Group reached a consensus on the treatment of a valuation allowance that existed as of the adoption date of ASC 718 and was reversed after adoption. If the windfall tax benefit gave rise to an increase in the net deferred tax asset and a concurrent increase in the valuation allowance, no net tax benefit was recorded in APIC because no initial recognition had occurred. If, after the adoption of ASC 718, an entity concludes that it should release some or all of its valuation allowance, it should not recognize the net deferred tax asset and corresponding credit to APIC for windfall tax benefits until such amounts are realized in accordance with ASC 718-740-25-10 (i.e., until these amounts reduce taxes payable). The Resource Group agreed that, for purposes of disclosure upon adoption of ASC 718, the entity could either (1) net its NOL deferred tax asset and the related valuation allowance for the windfall tax benefit determined previously or (2) continue to reflect a deferred tax asset and valuation allowance for such NOL carryforwards.
Alternatively, if the windfall tax benefit initially was recognized in APIC and then a valuation allowance was established in a subsequent period, the valuation allowance would have been recorded as a charge to continuing operations. In this case, it would be appropriate to reverse the entire valuation allowance through continuing operations in a period after the adoption of ASC 718, including the portion that originally resulted from the windfall tax benefits. See Chapters TX 5 and TX 6 for further guidance on accounting for releases of valuation allowances.
18.15.1 Accounting for Settlements When There Is a Valuation Allowance
For an entity with a valuation allowance recorded against its deferred tax assets, the entity will not recognize any shortfalls upon settlement of an award. ASC 718-740-35-5 provides that the write-off of a deferred tax asset is net of any related valuation allowance. Thus, when an award is settled and the award’s related deferred tax asset has a valuation allowance recorded against it, the shortfall, if any, results in no net effect on the income statement or the balance sheet because any effect from reversing the deferred tax asset is offset by reversing the corresponding valuation allowance.
18.16 Uncertain Tax Positions
Because tax laws, related regulations, and corresponding legal interpretations are voluminous and complex, it is sometimes unclear whether a particular position taken in a tax return will ultimately be sustained if the tax authorities challenge it. Such filing positions commonly are referred to as uncertain tax positions. Uncertainty as to whether deductions related to stock-based compensation will be sustained should be assessed in accordance with ASC 740’s recognition and measurement criteria described in Chapter TX 16. Favorable or unfavorable adjustments that either increase or decrease the pool of windfall tax benefits should be recorded based on the source of the item that resulted in the uncertain tax position. Thus, the favorable or unfavorable adjustments related to windfalls for stock-based compensation should be traced backwards to APIC in accordance with ASC 740-20-45-11.
See Chapter TX 16 for further guidance on the accounting and disclosure requirements related to uncertain tax positions. Entities should consider whether tax benefits not yet recorded should be presented as an unrecognized tax benefit in the tabular reconciliation that will be disclosed in the footnotes to the financial statements. We believe that this footnote reconciliation should include all unrecognized tax benefits, whether or not they are reflected in a tax reserve liability account or are not recognized in the financial statements pursuant to other GAAP, such as the ASC 718-740-25-10 criteria for recording a tax benefit only when it reduces taxes payable.
18.17 Intraperiod Tax Allocation
Intraperiod tax allocation is the allocation of income tax expense or benefit among continuing operations, discontinued operations, extraordinary items, other comprehensive income, and items charged or credited directly to equity. Intraperiod tax allocation is discussed in Chapter TX 12. For issues regarding the ordering of when tax benefits reduce taxes payable, see Section TX 12.2.2.2.3.3. For other intraperiod allocation issues relating to stock-based compensation, including accounting for the indirect effects of stock-based compensation deductions and the effects of windfall tax benefits under the alternative minimum tax, see Section TX 12.2.3.2.5.
18.18 Interim Reporting
Entities should bear in mind certain interim-period considerations when estimating their annual effective tax rate and recognizing windfalls and shortfalls. For instance, an entity might issue incentive stock options, thereby causing a permanent difference in the tax rate. For a discussion on accounting for the effects of windfalls and shortfalls in the annual effective tax rate, see Section TX 17.4.6.
18.19 Capitalized Compensation Cost
U.S. generally accepted accounting principles require that, in certain cases, compensation cost be capitalized in the balance sheet, such as when employees devote significant time to a particular project (e.g., manufacturing inventory or constructing fixed assets). If the related stock-based compensation award will give rise to a tax deduction (e.g., when exercised, or over time as the asset is depreciated), ASC 718-740-25-2 specifies that compensation cost that is capitalized as part of the cost of an asset will be considered part of the tax basis of that asset for financial reporting purposes. With respect to the determination of windfalls and shortfalls and the corresponding income statement and APIC presentation, and with respect to the impact on the pool of windfall tax benefits, upon realizing a tax deduction for awards for which the underlying compensation cost was capitalized, an entity would apply the same income tax accounting methodology as for awards whose compensation costs were expensed.
Example 18-16 illustrates the journal entries that will be recorded to account for compensation expense related to a nonqualified option that is capitalized as part of an asset:
Example 18-16: Capitalization of Compensation Cost Related to an Equity-Classified Nonqualified Option
Background/Facts:
An entity grants nonqualified stock options to employees involved in the self-construction of a fixed asset, and $1,000 of compensation cost is capitalized as part of the fixed asset. The asset has a 10-year life and the awards are fully vested on the grant date. The entity will receive a tax deduction for the amount of the intrinsic value when the option is exercised.
The entity has a 40 percent tax rate and has sufficient taxable income to realize the deduction.
At the end of the first year, the entity records $100 of incremental depreciation expense and has a $900 book basis in the portion of the carrying amount of the equipment that relates to the stock options. Pursuant to ASC 718-740-25-2, the entity’s corresponding tax basis is presumed to be $1,000, which is not depreciated for tax-return purposes; therefore, a $40 deferred tax asset is recorded [($1,000 tax basis – $900 book basis) x the 40 percent tax rate].
At the end of the second year, the employees exercise the options when the intrinsic value is $5,000 and an additional $100 of incremental book depreciation expense has been recorded. The entity receives a tax deduction for the intrinsic value of the options when they are exercised. Thus at the end of the second year, the entity’s tax basis is zero and book basis is $800, resulting in a $320 deferred tax liability. This deferred tax liability would be reversed as book depreciation is recognized.
The following journal entries illustrate how an entity would account for this transaction and record the tax benefit.
The deferred tax asset that has already been established is removed from the books.
A deferred tax liability is recorded for the taxable temporary difference of $800, which will be expensed for book purposes over the remaining eight years.
APIC, and the pool of windfall tax benefits, increased by $1,600 (related to the excess deduction of $4,000 [$5,000 deduction for the intrinsic value at exercise less $1,000 of compensation cost]).
The tax accounting related to the capitalization of compensation cost for an ISO is different because an ISO is not ordinarily expected to result in a tax deduction and therefore the tax effects are recorded only upon a disqualifying disposition. As an ISO is not expected to result in a tax benefit to the entity, no deferred tax benefit is established either at the outset or as the compensation cost is either capitalized or recognized in the income statement (through amortization or depreciation). Upon a disqualifying disposition, an entity will receive a tax deduction. Assuming the related capitalized asset is not fully amortized or depreciated and the book compensation expense will be recognized over a future period, upon the disqualifying disposition an entity will have to establish a deferred tax liability that will be recognized as deferred tax expense as the amortization or depreciation expense is recognized.
Example 18-17 illustrates the journal entries that will be recorded to account for the compensation cost from an ISO that is capitalized as part of an asset that results in a disqualifying disposition when the asset has not been fully amortized or depreciated when the disqualifying disposition occurs.
Example 18-17: Capitalization of Compensation Cost Related to an Equity-Classified ISO That Later Has a Disqualifying Disposition
Background/Facts:
An entity issues an ISO award to an employee where the compensation cost is capitalized because the employee provides services on the self-construction of one of the entity’s fixed assets. Compensation cost of $1,000 will be capitalized as part of the fixed asset. The asset has a 10-year life, the entity uses straight-line depreciation, and the awards are vested on the grant date.
The entity has a 40 percent tax rate and has sufficient taxable income to absorb a tax deduction in the event that there is a disqualifying disposition.
At the end of the first year, the employee exercises the options when the intrinsic value is $5,000 and enters into a same-day sale, resulting in a disqualifying disposition.
The following journal entries illustrate how an entity would account for this transaction and record the tax benefit from the disqualifying disposition.
The recognized income tax benefit is limited to the amount of compensation cost that has been expensed for book purposes ($100) (i.e., depreciation expense). Accordingly, a $40 tax benefit has been recognized (i.e., $400 current tax benefit partially offset by $360 deferred tax expense). The remaining tax benefit will be recognized as depreciation expense is recorded for book purposes.
A deferred tax liability is recorded for the difference between the tax deduction of $900 and the book basis, which will be reversed for book purposes over the remaining nine years.
The pool of windfall tax benefits increased by $1,600.
18.20 Multinational Entities
U.S. multinational entities face several income tax issues involving stock-based compensation for non-U.S.-based employees. Income tax laws in each country are unique and may provide for tax deductions that differ from those permitted under U.S. tax law. This may result in a different income tax accounting treatment than for a stock-based compensation award issued to U.S. employees.
A non-U.S. subsidiary generally must bear the cost of a stock-based compensation award in order to be eligible for a local corporate income tax deduction. If the costs of a stock-based compensation award are recharged to the non-U.S. subsidiary in return for cash, the recharge should be treated as the parent entity’s issuance of capital stock in exchange for cash or property, and generally should not result in a taxable transaction in the U.S.
When a U.S. multinational entity issues stock-based compensation to its employees in non-U.S. subsidiaries and it expects to receive a tax deduction in the local jurisdiction, the non-U.S. subsidiary should record a deferred tax asset, based on the local tax rate, as it recognizes book compensation cost over the requisite service period. At the time of settlement, the non-U.S. subsidiary would determine its windfall or shortfall based on the local jurisdiction tax deduction and account for such amount in accordance with ASC 718.
Stock-based compensation deductions incurred by non-U.S. subsidiaries also may have an indirect effect on the ultimate U.S. taxes paid by the U.S. parent entity. For example, such deductions may reduce the non-U.S. subsidiary’s earnings and profits for U.S. tax purposes and thereby reduce the amount of U.S. taxes paid when cash is distributed from non-U.S. subsidiaries (i.e., the deduction will affect the portion of a cash distribution from the non-U.S. subsidiary that would be considered a dividend versus a return of capital for tax purposes). In other cases, amounts that are charged back to the U.S. parent under transfer pricing arrangements that are determined on a “cost plus” basis might include a deduction for stock-based compensation, thereby providing the U.S. parent with a greater tax deduction than would have been the case absent the award. The Resource Group agreed that such indirect tax effects of awards should not be considered for purposes of either (1) establishing the deferred tax asset over the requisite service period or (2) measuring the windfall or shortfall at settlement of the award (i.e., the tax benefit is limited to the tax benefit of the deduction taken on the local tax return).
18.21 Cost-Sharing Pool
Affiliated entities that plan to share the cost of developing intangible property may choose to enter into a cost-sharing agreement whereby one entity bears certain expenses on behalf of another entity and is reimbursed for those expenses. U.S. tax regulations specify the expenses that should be included in a pool of shared costs; such expenses include costs related to stock-based compensation awards granted in tax years beginning after August 26, 2003.
U.S. tax regulations provide two methods for determining the amount and timing of stock-based compensation that is to be included in the pool of shared costs: the exercise method and the grant method.
Under the exercise method, the timing and amount of the allocated expense are based on the intrinsic value that the award has on the exercise date. Under this method, the tax deduction and initial deferred tax asset recorded are directly affected by the cost-sharing arrangement and, accordingly, the amounts are recorded net of any impact of the arrangement.
Entities that elect to follow the grant method use grant-date fair values that are determined based on the amount of book compensation cost to be included in a pool of shared costs. Effectively, all shared costs related to stock options will be included in U.S. taxable income, in the same amount (and at the same time) as the expenses that an entity concurrently records for book purposes. Entities should include such costs in U.S. taxable income regardless of whether the options ultimately are exercised by the holder and result in a U.S. tax deduction.
The following example illustrates the income tax accounting for cost-sharing payments for Entity A (the parent entity) and Entity B (an affiliate of the parent entity).
Entity A, which is located in the U.S., enters into a cost-sharing arrangement with Entity B, which is located in Switzerland. Under the arrangement, the two entities share costs associated with the research and development of certain technology. Entity B reimburses Entity A for 30 percent of the research and development costs incurred by Entity A. The U.S. tax rate is 40 percent. Cumulative book compensation for a vested option is $100 for the year-ended December 31, 2006. The award is exercised during 2007, when the intrinsic value of the option is $150.
The tax accounting impact is as follows:
Exercise method: On December 31, 2006, Entity A has recorded a $28 deferred tax asset related to the option [$100 book compensation cost x 70 percent (percentage not reimbursed) x 40 percent]. In 2007, when the option is exercised, any tax benefit associated with the excess tax deduction is a windfall. The entity is entitled to a U.S. tax benefit (net of the inclusion) of $42 [$150 intrinsic value when the option is exercised x 70 percent (percentage not reimbursed) x 40 percent]. Accordingly, the windfall tax benefit is $14 [$42 U.S. tax benefit (net of the inclusion) – $28 deferred tax asset].
Grant method: On December 31, 2006, Entity A has recorded a $40 deferred tax asset related to the option ($100 book compensation cost x 40 percent). The cost-sharing impact is an increase of currently payable U.S. taxes each period; however, in contrast to the exercise method, the cost sharing should have no direct impact on the carrying amount of the U.S. deferred tax asset related to stock-based compensation. If there was $100 of stock-based compensation during 2006, the impact on the December 31, 2006, current tax provision would be $12 [$100 book compensation cost x 30 percent (percentage reimbursed) x 40 percent]. The net impact on the 2006 income statement is a tax benefit of $28
($40 – $12). At settlement, the windfall tax benefit is $20 [$60 ($150 intrinsic value when the option is exercised x 40 percent) – $40 deferred tax asset]. In this example, the cost-sharing reimbursement under the grant method is smaller and provides a $6 greater tax benefit.
This example considers only the U.S. tax implications. Entity B’s accounting is not considered. In measuring deferred tax assets and potential windfalls, entities also need to consider any possible tax benefit in the foreign jurisdiction where the compensation charge has been allocated.
18.22 Income Tax Disclosures, Assumed Proceeds under the Treasury Stock Method, and Cash Flow Statement Presentation
The following should be disclosed related to the tax effects of stock-based compensation awards:
The amount of cash resulting from the settlement of the awards, and the corresponding tax benefit that the entity realized for the current year.
The total compensation cost that the entity recognized in income, as well as the total recognized tax benefit for all income statements that the entity presented.
18.22.1 Assumed Proceeds in the Computation of Dilutive EPS under the Treasury Stock Method
In applying the treasury stock method of ASC 260-10-45, the assumed proceeds of stock-based compensation arrangements are the sum of (1) the amount, if any, the employee must pay on exercise, (2) the amount of compensation cost that will be recognized in the future, and (3) the amount of tax benefits (either windfalls or shortfalls), if any, that would be debited or credited to additional paid-in capital for awards that ordinarily result in a tax deduction. The tax benefit is calculated using the average share price for the period and the tax rate in effect at the beginning of the period. Tax benefits that would be available only upon further action by the employee (such as a disqualifying disposition of stock received upon exercise of an incentive stock option) should not be assumed. The entity also should consider whether windfall tax benefits would be “realized” pursuant to ASC 718-740-25-10. Windfall tax benefits that would not be realized should be excluded from the assumed proceeds.
In calculating diluted EPS in an interim period early in the year, an entity should consider the annual estimate of taxable income when determining whether the windfall tax benefits would be “realized,” consistent with the methodology described in ASC 740-270-30 for determining the effective tax rate. An entity could have a loss in the first quarter but expect that for the year it will have taxable income. The entity would be able to consider the windfall tax benefits as realized in this situation. In addition, we believe that entities should determine whether a windfall has been “realized” using the same method (i.e., “with-and-without” or tax law ordering) used to determine whether windfall tax benefits are “realized” for financial statement purposes.
If an award would result in a shortfall, the amount of the shortfall is a reduction of the assumed proceeds from recording the shortfall as a charge to APIC (because there is a sufficient pool of windfall tax benefits). If the shortfall would be charged to income tax expense (because there is not a sufficient pool of windfall tax benefits), the shortfall should be excluded from the assumed proceeds. Thus, the amount of the shortfall that reduces assumed proceeds is limited to the amount of the entity’s pool of windfall tax benefits.
18.22.2 Cash Flow Statement Presentation
Windfall tax benefits from stock-based compensation cost should be classified, under both the direct and indirect methods of reporting cash flows, as cash inflows from financing activities. The amount shown in the financing section of the statement of cash flows should equal the sum of the gross windfall tax benefits that the entity realized from awards, even though the shortfalls are netted against the pool of windfall tax benefits in the statement of stockholders’ equity.
A non-public entity that previously used the minimum value method to measure its share-based awards and adopted ASC 718 using the prospective method should report windfall tax benefits from those exercised awards as operating cash flows. Prior to the effective date of ASC 718, prior guidance2 stipulated that the reduction of income taxes paid as a result of the deduction triggered by employee exercise of stock options (i.e., windfall tax benefit) should be classified as an operating cash flow. While ASC 718 changed this guidance, the prior accounting treatment should continue to be applied to awards accounted for under the prospective method.
2 EITF Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.
In certain cases where the tax benefit from a stock option relates to awards that were exchanged in a business combination consummated prior to the effective date of ASC 805, the tax benefit may be recorded as a reduction of goodwill. The tax benefit in this situation would be shown as an operating activity, because ASC 230 requires that all income tax-related matters be shown as operating activities, with the only exception being for the excess tax benefit received from stock-based compensation, which is required to be shown as a financing activity.
If an entity elects to use the long-form method to calculate its historical pool of windfall tax benefits, the windfall amounts disclosed as cash inflows from financing activities should be based on the “as if” windfall tax benefits calculated by comparing the tax deduction with the sum of the compensation recognized and disclosed under the prior standard and ASC 718. The “as if” windfall is the windfall that increases the pool of windfall tax benefits, as discussed in Section TX 18.11.
Entities that elected to use the short-cut method to calculate their historical pool of windfall tax benefits should have calculated the windfall amounts disclosed as cash inflows from financing activities, as follows:
Partially vested awards as of ASC 718 adoption: The windfall tax benefit or shortfall should be determined by comparing the tax deduction for a partially vested award with the sum of the compensation cost recognized and disclosed for that award under the prior standard and ASC 718 (i.e., the “as if” windfall or shortfall).
Fully vested awards as of ASC 718 adoption: The windfall tax benefit is equal to the tax effects recognized in APIC as a result of the settlement of the award subsequent to the adoption of ASC 718 (i.e., the recognized windfall).
Example 18-18 illustrates how a windfall and a shortfall should be shown in the statement of cash flows.
Example 18-18: Windfall and Shortfall Presentation in the Statement of Cash Flows
Background/Facts:
The pool of windfall tax benefits is zero at December 31, 2006. Individual employees at a calendar-year entity exercised the following four nonqualified stock options during 2007 (i.e., one employee award was exercised during each quarter). All awards were granted post-adoption and no other awards were exercised during the period. The following table depicts the results of the awards exercised: