Analysis of Income Taxes and Employee Stock Options Chapter 14 Robinson, Munter and Grant

Learning Objectives Deferred taxes Stock-based compensation Assets and liabilities Book vs. taxable income Stock-based compensation Financial accounting rules Tax regulations Impact on profitability and cash flow Robinson, Munter & Grant Chapter 14

Deferred Income Taxes Income tax payable is based on the firm’s income tax return Based on applicable tax laws Deferred income taxes are based on cumulative temporary differences between book and taxable income Income tax expense (the provision) is the combination of 1 + 2 Robinson, Munter & Grant Chapter 14

Deferred Income Taxes Depreciation example A five-year asset is purchased for $500,000 Book depreciation is calculated using the straight-line method Tax depreciation is calculated using MACRS (rates taken from IRS tables) MACRS is an accelerated form of depreciation resulting in a greater expense for tax purposes in the early years of the asset’s life Total MACRS = Total Straight-line depreciation Robinson, Munter & Grant Chapter 14

Deferred Income Taxes Depreciation Example Robinson, Munter & Grant Chapter 14

Deferred tax liability Deferred Income Taxes Recognize Tax before books Books before tax Revenues Deferred tax asset Deferred tax liability Expenses Robinson, Munter & Grant Chapter 14

Deferred Tax Liabilities Timing Differences Revenues recognized for book purposes before they are taxable Installment receivables are taxable when payment is received Expenses that are deductible before they are recognized for books purposes MACRS depreciation for tax, straight-line for books Robinson, Munter & Grant Chapter 14

Deferred Tax Assets Timing Differences Revenues are taxable before they are recognized for book purposes Subscriptions collected in advance are taxable when payment is received Expenses recognized for books purposes before they are deductible Cannot estimate product warranty costs for income tax purposes; deduct actual expenditure Robinson, Munter & Grant Chapter 14

Deferred Income Taxes Basis Differences Deferred tax assets Tax credits reduce asset basis and depreciation deductions Deferred tax liabilities Currency indexing (in some jurisdictions) allow greater deductions Also, business combinations accounted for using the purchase method Robinson, Munter & Grant Chapter 14

Deferred Income Taxes Permanent differences between book and taxable income do not give rise to deferred income taxes Tax-free interest Non-deductible fines and penalties Permanent differences will cause the effective tax rate to differ from the statutory rate This is reconciled in the notes to the financial statements Robinson, Munter & Grant Chapter 14

Calculating Deferred Income Taxes In general… Identify cumulative temporary differences Consider operating loss and tax credit carryforward Determine applicable tax rate Generally rate currently enacted Temporary difference * tax rate = deferred tax Adjust the balance sheet account(s) Change in deferred tax balance is an element of deferred tax expense Robinson, Munter & Grant Chapter 14

Calculating Deferred Income Taxes More specifically… Identify cumulative temporary differences, and operating loss and tax credit carryforward Measure total deferred tax liabilities using appropriate tax rate Recognize change in deferred tax liabilities for the period Measure total deferred tax assets using appropriate tax rate Robinson, Munter & Grant Chapter 14

Calculating Deferred Income Taxes More specifically… 5. Measure deferred tax assets for tax credit carryforward 6. Apply more likely than not test 7. Recognize remaining portion of the change in deferred tax assets 8. Sum items 3 and 7 to determine total deferred tax expense Robinson, Munter & Grant Chapter 14

Calculating Deferred Income Taxes More likely than not test US GAAP allows the recognition of the tax effect associated with deferred tax assets when it is more likely than not that the benefits will be realized in the future Future income must be available to offset the expenses International standards apply a more stringent “probable” standard If test is not met, the adjustment is deferred via a valuation account Robinson, Munter & Grant Chapter 14

Calculating Deferred Income Taxes Other items Net operating losses May be carried back (tax refund or reduction in current liability) or forward (deferred tax asset or valuation account) Consider changes in tax rates Determine current and noncurrent deferred taxes Robinson, Munter & Grant Chapter 14

Employee Stock Options Incentive stock options (ISOs) Nonqualified (nonstatutory) stock options (NQSOs) Employee stock purchase plans Restricted stock Robinson, Munter & Grant Chapter 14

Incentive Stock Options Employee is not taxed until shares are sold Option grant and exercise are tax-free events Must hold the option for two years Employee is taxed at lower capital gains rates Must hold the shares for one year Grants are subject to several restrictions Tenure, transferability, term, price and maximum grant amount No tax deduction for granting/employing firm Robinson, Munter & Grant Chapter 14

Nonqualified Stock Options Do not meet ISO criteria Employee generally recognizes taxable income upon exercise Difference between exercise price and share price is ordinary income Company recognizes same amount as compensation deduction Robinson, Munter & Grant Chapter 14

Employee Stock Purchase Plan Employees can purchase shares of the employing firm at a discount of up to 15% Participation is limited to 5 years Amount cannot exceed $25,000 per year Upon sale, the gain attributable to the discount is ordinary income, the remainder is capital gain Not deductible by employer Robinson, Munter & Grant Chapter 14

Employee Stock Purchase Plan An interesting twist when employee does not hold shares for two years after grant or one year after exercise Employee will recognize ordinary compensation income for the difference between the value at exercise and the purchase price If share price declines, employee may record a capital loss, along with ordinary income, upon sale Robinson, Munter & Grant Chapter 14

Restricted Stock Awards Taxable to employee when substantially vested When transferable or When no long subject to substantial risk of forfeiture Income = Cost to employee – stock’s value Dividends received during restriction period are compensation to employee Robinson, Munter & Grant Chapter 14

Stock-based Compensation Employment taxes Currently, compensation associated with employee stock purchase plans is the only form of stock-based remunerations subject to employment taxes This includes social security, Medicare, unemployment taxes as well as income tax withholding Robinson, Munter & Grant Chapter 14

Stock-based Compensation Cash flow consequences Generally when the employee recognizes ordinary/compensation income, the employer gets a concurrent deduction for the same amount Deduction does not result from cash outflow Actually, a cash inflow from the benefit of the deduction (reduced corporate income taxes) Additional cash inflow from employee upon exercise of option Robinson, Munter & Grant Chapter 14

Accounting for Stock-based Compensation Awards Award is fixed when the following are known Number of options Exercise price Vesting date Expiration date Award is variable when one or more of the above conditions is not met Robinson, Munter & Grant Chapter 14

APB 25, Accounting for Stock Issued to Employees No compensation expense as long as option exercise price is not less than share fair market value at grant date Compensation expense only when intrinsic value exists Calculated as of grant date for fixed awards Generally no earnings charge because option exercise price = market value of share Robinson, Munter & Grant Chapter 14

SFAS 123, Accounting for Stock-Based Compensation Currently optional but used by many firms Options are valued using mathematical models Fixed/variable distinction is not important Calculated values represent compensation expense Robinson, Munter & Grant Chapter 14

International Standards Currently more lax than GAAP Essentially state that because there is no cost to the entity, no expense should be recognized for stock-based compensation Issue is currently under investigation by IASB Robinson, Munter & Grant Chapter 14

Implications for Analysis Options have a dilutive effect on EPS Earnings/number of shares Assume option exercise No income statement impact Except denominator of EPS (above) But, consider APB 25 vs. SFAS 123 Robinson, Munter & Grant Chapter 14

Implications for Analysis Cash inflow related to stock-based compensation From exercise Income tax benefit Treasury shares are generally used to satisfy option exercises Robinson, Munter & Grant Chapter 14

Summary Deferred income taxes Stock-based compensation Assets Liabilities Stock-based compensation Options (ISO, NQSO) Restricted shares Stock purchase plans Robinson, Munter & Grant Chapter 14