analysis of income taxes and employee stock options

Analysis of Income Taxes and Employee Stock Options

Chapter 14

Robinson, Munter and Grant

Robinson, Munter & Grant

Chapter 14 2

Learning Objectives

• Deferred taxes– Assets and liabilities– Book vs. taxable income

• Stock-based compensation– Financial accounting rules– Tax regulations– Impact on profitability and cash flow


Chapter 14 3

Deferred Income Taxes

1. Income tax payable is based on the firm’s income tax return

– Based on applicable tax laws

2. Deferred income taxes are based on cumulative temporary differences between book and taxable income

3. Income tax expense (the provision) is the combination of 1 + 2


Chapter 14 4

Deferred Income TaxesDepreciation 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


Chapter 14 5

Deferred Income TaxesDepreciation Example

-

50,000

100,000

150,000

200,000

1 2 3 4 5 6

Year

Dep

reci

atio

n

exp

ense Book

Tax

Deferred Tax Liabilty Deferred Tax Asset


Chapter 14 6


Recognize

Tax before books Books before tax

Revenues Deferred tax asset Deferred tax liability

Expenses Deferred tax liability

Deferred tax asset


Chapter 14 7

Deferred Tax LiabilitiesTiming 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


Chapter 14 8

Deferred Tax AssetsTiming 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


Chapter 14 9

Deferred Income TaxesBasis 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


Chapter 14 10


• 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


Chapter 14 11

Calculating Deferred Income TaxesIn 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


Chapter 14 12

Calculating Deferred Income TaxesMore specifically…

1. Identify cumulative temporary differences, and operating loss and tax credit carryforward

2. Measure total deferred tax liabilities using appropriate tax rate

3. Recognize change in deferred tax liabilities for the period

4. Measure total deferred tax assets using appropriate tax rate


Chapter 14 13

Calculating Deferred Income TaxesMore 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


Chapter 14 14

Calculating Deferred Income TaxesMore 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


Chapter 14 15

Calculating Deferred Income TaxesOther 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


Chapter 14 16

Employee Stock Options

• Incentive stock options (ISOs)

• Nonqualified (nonstatutory) stock options (NQSOs)

• Employee stock purchase plans

• Restricted stock


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 24

Accounting for Stock-based Compensation Awards

• Award is fixed when the following are known1. Number of options

2. Exercise price

3. Vesting date

4. Expiration date

• Award is variable when one or more of the above conditions is not met


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 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


Chapter 14 30

Summary

• Deferred income taxes– Assets– Liabilities

• Stock-based compensation– Options (ISO, NQSO)– Restricted shares– Stock purchase plans

analysis of income taxes and employee stock options

Documents

income tax purposes

deferred tax balance

firms income tax returnbased

effective tax rate

deferred taxadjust

analysis of income taxes

book depreciation

book purposessubscriptions