1. Analysis of Income Taxes and Employee Stock Options
Chapter 14
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2. 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
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3. 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
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4. 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
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5. Deferred Income Taxes Depreciation Example
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6. Deferred tax liability
Deferred Income Taxes
Recognize
Tax before books
Books before tax
Revenues
Deferred tax asset
Deferred tax liability
Expenses
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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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
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15. 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
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16. Employee Stock Options
Incentive stock options (ISOs)
Nonqualified (nonstatutory) stock options (NQSOs)
Employee stock purchase plans
Restricted stock
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17. 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
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18. 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
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19. 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
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20. 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
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21. 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
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22. 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
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23. 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
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24. 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
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25. 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
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26. 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
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27. 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
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28. 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
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29. Implications for Analysis
Cash inflow related to stock-based compensation
From exercise
Income tax benefit
Treasury shares are generally used to satisfy option exercises
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30. Summary Deferred income taxes Stock-based compensation Assets
Liabilities
Stock-based compensation
Options (ISO, NQSO)
Restricted shares
Stock purchase plans
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