How are income tax benefits accounted for?

Statement 123(R), taken together with FASB Statement No. 109, Accounting for Income Taxes and FASB Statement No. 95, Statement of Cash Flows, contains requirements and guidance to account for differences in timing and amounts between the income tax return deductions for share-based payment awards and the compensation expense recognized for financial statement reporting purposes.

Accounting for Three Types of Awards

As a reminder, the ultimate goal of Statement 123(R) is that the final measure of compensation cost for an equity award should be based on the amount estimated at the grant date for the condition or outcome that is actually satisfied.

In terms of income tax benefits associated with share-based payment awards, generally there are three types of awards: (1) equity awards under Statement 123(R) that ordinarily trigger an income tax deduction (e.g., restricted stock or nonqualified options); (2) equity awards under Statement 123(R) that ordinarily do not trigger an income tax deduction but through a future event, such as an employee's disqualifying disposition of shares, can give rise to a tax deduction (e.g., incentive stock options (ISOs) and Internal Revenue Code Section 423 qualified Employee Stock Purchase Plans (ESPPs)); and (3) liability awards under Statement 123(R). Of the three, type (1) is the most prevalent and most difficult to account for.

1. Accounting for equity awards that ordinarily trigger an income tax benefit

   Currently, income tax deductions are measured at vesting date (for shares) or exercise date (for options), based on the intrinsic value at that date¹⁰. Both the measurement date and the measurement method used for income tax purposes differ from Statement 123(R), so the tax deduction (to be treated as a temporary difference for purposes of applying Statement 109)¹¹. inevitably will differ from the compensation expense recorded for accounting purposes. An employer accrues an income tax benefit and a deferred tax asset as it accrues compensation expense and assesses the deferred tax asset for realizability, as is done for other deferred tax assets under Statement 109. If the actual tax deduction exceeds the compensation expense accrued for accounting purposes under Statement 123(R), the excess tax benefit ("windfall") is credited to additional paid-in capital (APIC) when it is realized. If the actual tax deduction is less than the compensation expense accrued for accounting purposes, then the unrealized portion of the deferred tax asset ("shortfall") is offset against prior excess credits to APIC; the remainder is charged-off to income tax expense. An employer needs to track tax benefits for each individual award, but the computation of a windfall or shortfall is made on an aggregate basis for all options exercised (or restricted shares that vest) in a year.

   To summarize, Statement 123(R) carries forward from prior standards (both Opinion 25 and Statement 123) the principle that the income tax benefit from an income tax deduction in excess of compensation expense for financial reporting purposes should be credited to APIC, not to the provision for income taxes. When the reverse situation occurs, (e.g., an income tax deduction that is less than compensation expense for financial reporting purposes), the shortfall is charged against APIC to the extent of prior credits, and the remainder of the shortfall, if any, is charged to income. The key point is that the income tax benefit recorded in earnings is equal to the lesser of (a) the actual tax benefit realized on the tax return or (b) the cumulative compensation expense for financial reporting purposes multiplied by the statutory income tax rate.

   While the principle is the same, the application is more complex than under Opinion 25 for two reasons. First, for an option with zero compensation expense under Opinion 25, a shortfall was impossible, and the entire tax benefit was a windfall. Under Statements 123 and 123(R), shortfalls can occur whenever the stock price languishes during an option's life, and a windfall will be only part of the tax benefit. Second, Statement 123(R) allows windfalls to be recognized only when they are realized. While Opinion 25 and Statement 123 had similar language, the FASB staff informally advised accountants that windfalls should be recognized based on the normal recognition threshold (more likely than not) in Statement 109. Statement 123(R) imposes a different, higher threshold (realized) on excess tax deductions from share-based payment transactions, which requires substantially more recordkeeping.

2. Accounting for equity awards that ordinarily do not generate an income tax benefit

   If the award is of a type that ordinarily would not generate an income tax benefit, such as an incentive stock option (ISO) as defined in Section 422 of the Internal Revenue Code, the compensation accrued for financial reporting purposes is not a temporary difference, and the employer records no deferred tax asset as it accrues compensation for financial reporting. If the employee makes a disqualifying disposition and the employer receives a tax deduction, the amount of tax benefit reported in earnings is limited to the lesser of (a) the actual tax benefit received or (b) the cumulative compensation expense for financial reporting purposes multiplied by the statutory income tax rate, similar to the limitation for awards that ordinarily generate an income tax benefit.

   Note: The FASB Resource Group discussed the situation when the amount of the deduction that results from a disqualifying disposition is less then the compensation cost recorded and concluded that the reduction in income taxes payable as a result of a disqualifying disposition should be limited to the actual deduction received, with no drawdown of prior credits to APIC¹².

3. Accounting for liability awards

   For awards classified as liabilities under Statement 123(R), the tax deduction generally will equal the cumulative compensation expense for financial reporting purposes, but the timing will differ. The compensation deduction will be taken upon exercise or settlement, whereas the compensation expense for financial reporting will be recorded ratably over the requisite service period and then adjusted each period from the end of the requisite service period until exercise or settlement. Therefore, the employer treats the accrued liability as a temporary difference and records a tax benefit and deferred tax asset as it accrues compensation for financial reporting purposes. The deferred tax asset is assessed for realizability like other deferred tax assets under Statement 109.

For the remainder of this section, we will focus primarily on equity awards that ordinarily trigger an income tax benefit. Statement 123(R) permits a pooling of amounts that are reflected in APIC (the APIC pool). However, to many companies' surprise, the beginning balance of the APIC pool under Statement 123(R) is not the actual amount the company credited to APIC in prior years. Rather, it is the hypothetical amount that the company would have credited since 1995 if it had followed the fair value method of Statement 123. Many companies do not know that hypothetical amount. In some cases, they lack that information because of corporate transactions like poolings of interest or spin-offs since 1995. In other cases, it appears that companies that continued to apply Opinion 25 and disclosed fair value information in the notes to financial statements were not as thorough as they could have been in accumulating the fair value information from year to year. Recognizing this lack of information, the FASB offered a practical transition election in FSP FAS 123(R) - 3 - "Transition Election Related to Accounting for the Tax Effects of Share-Based Awards," which allows a company to choose one of the following methods for calculating the pool of excess income tax benefits available to absorb shortfalls recognized subsequent to adoption of Statement 123(R):

1. Include net excess benefits that would have qualified had the company adopted Statement 123 for recognition purposes starting in 1995 (Refer to Paragraph 81 of Statement 123(R)) (the regular method);

OR

2. At adoption of Statement 123(R), calculate the beginning APIC pool as:

   • All increases to APIC related to stock compensation tax benefits recognized in a company's financial statements for periods subsequent to adoption of Statement123 but prior to adoption of Statement 123(R), less

   • For awards that vested before adoption of Statement 123(R), cumulative incremental gross compensation cost that would have been recognized under the fair value method of Statement 123 multiplied by the company's current blended statutory tax rate (the short-cut method).

The guidance in this FSP is to be applied as of initial adoption of Statement 123(R), but companies have a one-year "grace period" to choose their method.

Awards that are partially vested upon adoption should be excluded from the short-cut computation above. For partially vested awards, a company will compare the tax deduction to the sum of compensation cost recognized for that award under Statement 123(R) plus the compensation cost disclosed for that award under Statement 123. For both fully vested and partially vested awards, the tax effect of any resulting excess deduction for tax purposes should increase the APIC pool; the tax effect of any resulting deficient deduction for tax purposes should be deducted from the APIC pool.

Private companies

As discussed later, private companies generally will apply Statement 123(R) prospectively to new awards. In this situation, they start a new APIC pool for awards accounted for under Statement 123(R) that is separate from the APIC pool created under Opinion 25.

Accounting for tax loss carryforwards

As noted previously, Statement 123(R) specifically prohibits recognition of windfall tax benefits that have not been realized. That is, no deferred tax assets may be recorded for the portion of a net operating loss (NOL) carryforward created by windfall tax benefits¹³. In this situation, a tax benefit and accompanying credit to APIC for the excess deduction would not be recognized until the deduction reduces taxes payable.

Upon adoption of Statement 123(R), any existing deferred tax assets related to NOL carryforwards created by windfall tax benefits and the related credits to APIC continue to be recorded, but those credits to APIC are not included in the pool of available benefits to absorb deficiencies. Those credits may only be included in the APIC pool when the NOL carryforward is subsequently realized as a reduction of taxes payable.

If a company has NOL carryforwards from operating losses and NOL carryforwards from windfall tax benefits from stock compensation awards, which NOLs are used first? The FASB Resource Group discussed how Statement 123(R) interacts with the intraperiod allocation rules under Statement 109¹⁴. The Resource Group reached a consensus that a company may make a policy election to either follow the "with-and-without" approach described in EITF Topic D-32, "Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations" or the tax return approach in determining the order in which NOL carryforwards are used to reduce taxes payable. Under the with-and-without approach, the NOL carryforwards from windfall tax benefits are considered realized only if they provide an incremental benefit after considering all other tax attributes presently available to the company (i.e., windfall tax benefits are considered last). Under the tax return approach, NOL carryforwards are considered realized based on the ordering of NOLs under tax law. The policy election should be consistently applied and disclosed.

The Resource Group intends to consider whether and how the direct impacts of the deductions related to share-based payments should be considered in applying the with-and-without method at a future meeting.

Accounting for income taxes in interim periods

The FASB Resource Group also addressed how deficiencies should be accounted for and reported in interim financial statements¹⁵. The Resource Group reached a consensus that the comparison of tax deductions to compensation expense for financial reporting purposes is an annual computation based on options exercised and shares vested that year. Therefore, shortfalls should be recognized as part of the tax provision in the interim periods in which they are incurred but reversed to the extent windfalls occur in subsequent interim periods within the same year. The Resource Group reached a consensus that it would be inappropriate for companies to anticipate the effects of vesting or exercises later in the year. Shortfalls would be treated as "discrete" events and would not be included in estimating the annual effective tax rate. Likewise, estimations of future deficiencies (e.g., resulting from existing out-of-the money options that will expire later in the current year) should not be considered in estimating the effective tax rate.

Practical note: Companies should be assessing current processes and physical tracking mechanisms in preparation for the significant income tax accounting changes posed by adoption of Statement 123(R).

How Statement 123(R) differs from Opinion 25

Because most stock options have zero compensation expense under Opinion 25, there is no need to record deferred tax assets, and there is no possibility that the tax deduction could be smaller than the cumulative compensation expense for financial reporting purposes. The tax benefit for the compensation deduction claimed on the tax return is recorded as APIC, similar to Statement 123(R). For the minority of plans that create compensation expense for financial reporting purposes that is measured differently from the tax deduction (for example, a stock option granted with an exercise price below market price on date of grant), the benefit of a tax deduction in excess of cumulative compensation for financial reporting is credited to APIC. If the tax deduction is less than cumulative compensation for financial reporting, the shortfall is charged to APIC to the extent of prior credits to APIC. Any shortfall in excess of prior credits to APIC is charged to income tax expense.

How Statement 123(R) differs from Statement 123

The limitation that windfall tax benefits may be recorded only when realized, rather than following the recognition guidance of Statement 109, is new. In other respects the accounting for income taxes in Statement 123(R) is similar to Statement 123.

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