Options and the deferred tax bite: just when you thought it couldn't get any more complicated.

EXECUTIVE SUMMARY

* Implementation of FASB Statement no. 123(R) goes beyond selecting a method to value employee stock options. CPAs also must help companies make the necessary tax accounting adjustments to properly track the tax benefits from stock-based compensation.

* Statement no. 123(R) requires companies to use deferred tax accounting for employee stock options. An option's tax attributes determine whether a deductible temporary difference arises when the company recognizes the option-related compensation expense on its financial statements. Companies will treat nonqualified and incentive options differently.

* Companies that did not follow the fair value approach of Statement no. 123 must establish an opening pool of excess tax benefits for all awards granted after December 15, 1994, "as if" the company had been accounting for stock options under this statement all along. To do this CPAs must do a grant-by-grant analysis of the tax effects of options granted, modified, settled, forfeited or exercised after the effective date of Statement no. 123.

* Certain unusual situations may require special handling. These include cases in which employees forfeit an option before it is vested, the company cancels an option after vesting or an option expires unexercised, typically because it is underwater. CPAs also need to be cautious of possible pitfalls when options are underwater, when the company operates in other countries with different tax laws or has a net operating loss.

* Calculating the beginning APIC pool and the ongoing tax computations required by Statement no. 123(R) is a complex process requiring careful record-keeping. The newly approved simplified method adds yet another set of computations companies need to perform. CPAs should encourage companies to begin making these calculations as soon as possible as some require tracking down historical information.

You've made the necessary valuation methodology decision and helped the company select an adoption method. Now its time to sit back and relax while other companies struggle to finish implementing FASB Statement no. 123 (revised), Share-Based Payment. But wait.... Before you get too comfortable, there are other concerns companies that issue stock-based compensation must deal with. While valuation issues have received the lion's share of the attention, CPAs also must help unwary companies cope with Statement no. 123(R)'s tax implications.

The tax rules under Statement no. 123(R) are complex. They require tracking tax benefits from stock-based compensation on a grant-by-grant and country-by-country basis. Plus, to reduce the income statement impact of future transactions, companies need to prepare a 10-year history of stock option activity to determine the amount of the additional-paid-in-capital (APIC) pool. This article describes the relevant tax and accounting so CPAs can help employers and clients comply with the new requirements more easily.

THE BACKGROUND

FASB issued Statement no. 123(R) in December 2004. Under the earlier Statement no. 123, companies had the choice of accounting for share-based payments using the intrinsic value method of APB Opinion no. 25, Accounting for Stock Issued to Employees, or a fair value method. Most used the intrinsic value method. Statement no. 123(R) eliminated that choice and requires companies to use the fair value method. To estimate the fair value of employee options, companies must use an option-pricing model such as Black-Scholes-Merton or lattice.

In addition to selecting a pricing model, companies need to consider the deferred tax accounting impact of expensing options based on fair value. With FASB Staff Position no. 123(R)-3 allowing most companies until at least November 11, 2006, to determine a method for computing the pool of excess tax benefits, there is still time for CPAs to help companies prepare for the deferred tax issues Statement no. 123(R) creates.

DEFERRED TAX ACCOUNTING

Statement no. 123(R) requires companies to use deferred tax accounting for employee stock options. An option's tax attributes will determine whether a deductible temporary difference will arise when a company recognizes the option-related compensation expense on its financial statements.

Nonqualified stock options (NQSOs). When a company grants an employee an NQSO, it recognizes the related compensation expense and records a tax benefit equal to the compensation expense multiplied by the company's income tax rate. This creates a deferred tax asset because the company is taking a financial statement deduction that is not currently deductible for income tax purposes.

When an employee exercises an NQSO, the company compares the allowable tax deduction with the related financial statement compensation expense computed earlier and credits the tax benefit associated with any excess tax deduction to APIC. In other words, CPAs should compare the actual tax benefit with the deferred tax asset and credit any excess to stockholders' equity instead of to the income statement.

If the tax deduction is less than the financial statement compensation expense, the write-off of the remaining deferred tax asset is charged against the APIC pool. If the amount exceeds the pool, the excess is charged against income.

A company's deferred tax asset usually differs from its realized tax benefit. Think of the deferred tax asset as an estimate based on the compensation cost recorded for book purposes. Companies should not expect the deferred tax asset to equal the tax benefit they ultimately receive. Exhibit 1, page 73, illustrates the accounting for NQSOs and deferred taxes.</p> <pre> Exhibit 1 Deferred Tax Accounting for NQSOs On January 1, 2006, XYZ Corp. grants Jane Smith options or 100 shares. The options have an exercise price of $10 (stock price on date of grant), vest at the end of three years and have a fair value of $3. All the options are expected to vest. Thus, the compensation cost to be recognized over the three year period is $300 (100 options x $3). Assuming a tax rate of 35%, the same journal entries would be made each year in 2006, 2007 and 2008 to record compensation cost and the related deferred tax: Dr. Compensation Cost $100 Cr. Additional paid-in capital  $100 (To recognize compensation cost) Dr. Deferred tax asset $35 Cr. Tax expense

$35 (To recognize a deferred tax asset for the temporary difference related to compensation cost) At the end of 2008 the balance in the deferred tax asset is $105 and $300 in additional paid-in capital. Assume Smith exercises her options in 2009 when the stock price is $30 per share. If XYZ's common stock is no-par stock it would record the exercise as follows: Dr. Cash ($10 exercise price x 100)

$1,000 Dr. Additional paid-in capital (balance from above)

300 Cr. Common Stock

$1,300 (To record issuance of stock upon exercise of options) For tax purposes, XYZ Corp. has a deduction of $2,000 (($30 share price--$10 exercise price) x 100). Assuming XYZ has sufficient income to realize the deduction, the deduction yields a tax benefit of $700 ($2,000 x .35), which exceeds the $105 benefit recorded in the deferred tax asset by $595. This $595 is the tax benefit of the excess of the deductible amount over the recognized compensation cost. XYZ would make the following entries: Dr. Tax expense $105 Cr. Deferred tax asset $105 (To write off the deferred tax asset upon exercise of options) Dr. Current taxes payable

$700 Cr. Tax expense $105 Cr. Additional paid-in capital 595 (To adjust current tax expense and taxes payable to recognize the current accounting tax benefit upon exercise of options) If all the same facts as above hold true except the options expire unexercised, there would be no deduction on the company's tax return. Under Statement no. 123(R) any write-off of the deferred tax asset would first offset, to the extent remaining, any additional paid-in capital from excess tax benefits from previous awards accounted for in accordance with Statement no. 123(R) or Statement no. 123. The remaining balance, if any, would be recognized in the income statement. Thus, assuming no additional paid-in capital from excess tax benefits from previous awards, XYZ would make the following entry: Dr. Tax expense $105 Cr. Deferred tax asset

$105 (To write off the deferred tax asset upon expiration of options) </pre> <p>Incentive stock options (ISOs). ISOs do not ordinarily result in a tax deduction. Accordingly, companies recognize no tax benefit when they record the compensation expense under Statement no. 123(R). When a disqualifying disposition of an ISO occurs when an employee disposes of the stock within two years of the option grant date or within one year of the option exercise date--the company gets a tax deduction equal to the difference between the option's fair value and the exercise price on the date the disqualifying disposition took place.

The tax effect of a disqualifying disposition results in a financial statement deduction in the year it occurs. The recognized tax benefit may not exceed the total compensation expense under Statement no. 123(R) for that option grant. Any excess is credited to APIC. Exhibit 2, page 74, illustrates the accounting for an ISO with a disqualifying disposition.</p>

<pre> Exhibit 2 Deferred Tax Accounting for ISOs With Disqualifying Disposition Assume XYZ Corp. grants 1,000 ISOs on January 1, 2006. The exercise price of $25 equals the fair value of a share on the grant date. All the options are expected to vest under one-year cliff vesting. The fair value of an option is $15, resulting in a compensation deduction of $15,000 ($15 x 1,000 options). On April 1,2007, all the options are exercised and immediately sold when the stock price is $45. The immediate sale results in a disqualified disposition. The company's tax deduction is $20,000 (($45 fair market value (FMV)--$25 exercise price) x 1,000 options). The tax benefit recognized in the income statement equals $5,250 ($15 fair value x 1,000 options x 35% tax rate). The excess tax benefit of $1,750 [($20,00 tax deduction--$15,000 compensation expense recorded) x 35% tax rate] is credited to APIC. </pre> <p>THE APIC POOL

Statement no. 123(R) provides two transition alternatives: the modified prospective method and the modified retrospective method with restatement. In addition, Staff Position no. 123(R)-3, which FASB posted on its Web site on November 11, 2005, offers a third simplified option. In all cases CPAs must help companies calculate the amount of eligible excess tax benefits (the APIC pool) on the adoption date. This is important because is helps avoid an additional income statement hit to earnings for future option exercises or cancellations.

Companies that did not follow the fair value approach of the original Statement no. 123 must establish an opening pool of excess tax benefits included in APIC related to all awards granted and settled in periods beginning after December 15, 1994, "as if" the company had been accounting for stock awards under the Statement no. 123 approach all along. These companies also should determine what their deferred tax assets would have been had they followed Statement no. 123's recognition provisions.

If, after adopting Statement no. 123(R), a company's book expense on an option exercise is greater than the tax deduction, the difference, adjusted for taxes, is applied against the existing APIC pool. It does not have an impact on the current-year financials. Without the APIC pool, the tax-adjusted difference would be an additional income statement expense.

Obviously, calculating the beginning APIC pool and the deferred tax asset will take some time. CPAs must do a grant-by-grant analysis of the tax effects of all options granted, modified, settled, forfeited or exercised after the effective date of the original Statement no. 123. (That statement was effective for fiscal years beginning after December 15, 1995. For entities that continued to use the Opinion no. 25 approach, pro forma disclosures needed to include the effects of all awards granted in fiscal years beginning after December 15, 1994.)

For companies that were using the recognition provisions of Opinion no. 25, a good starting point will be the information used previously for Statement no. 123 disclosure purposes. The tax return preparation files should include information on NQSOs exercised and ISO disqualified dispositions. Human resource department files may be another good source of information.

Although recordkeeping must be done on a grant-by-grant basis, ultimately the excess tax benefits and the tax-benefit deficiencies for each grant are netted to determine the APIC pool. Awards granted before the effective date of Statement no. 123 are excluded from the computation.

SEC Staff Accounting Bulletin no. 107 says a company needs to calculate the APIC pool only when it has a current-period shortfall. Given the difficulty of obtaining 10-year-old information, companies should start this calculation as soon as possible in case it is needed.

THE SIMPLIFIED APPROACH

A recent FASB staff position allows companies to elect a simpler approach to calculating the beginning balance of the APIC pool. Under this method the beginning balance equals the difference between

* All increases in additional paid-in capital recognized in the company's financial statements related to tax benefits from stock-based compensation during the periods following adoption of Statement no. 123 but before the adoption of Statement no. 123(R).

* The "cumulative incremental" compensation expense disclosed during the same period, multiplied by the company's current blended statutory tax rate when it adopts Statement no. 123(R).

The blended tax rate includes federal, state, local and foreign taxes. Cumulative incremental compensation is the expense calculated using Statement no. 123 minus the expense using Opinion no. 25. The expense should include compensation costs associated with awards that are partially vested at the date of adoption.

Companies have one year from the later of the date they adopt Statement no. 123(R) or November 10, 2005, to select a method for computing the APIC pool.

THE IMPACT OF GRANT-BY-GRANT TRACKING

Companies determine whether an employee's exercise of an NQSO creates an excess tax benefit or deficiency on a grant-by-grant basis by looking at the compensation expense and related deferred tax asset they recorded for each specific grant to see the amount of deferred tax asset "relieved" from the balance sheet. The deferred tax assets related to all unexercised awards are not considered. If the employee exercises only a portion of an option award, then only the deferred tax asset related to the exercised portion is relieved from the balance sheet.

STRADDLING THE EFFECTIVE DATE

Many companies using the modified prospective application method will have NQSOs that were granted and at least partially vested prior to adopting Statement no. 123(R). When employees exercise these options, the company should record the reduction in current taxes payable as a credit to APIC to the extent it exceeds the deferred tax asset, if any Exhibit 3, below, illustrates the impact of NQSOs that straddle the effective date.</p> <pre> Exhibit 3 NQSOs Straddling the Effective Date Assume ABC Co. had a partially vested award when it adopted Statement no. 123(R) on January 1, 2006. The total book compensation cost is $1,500 ($500 in Statement no. 123 pro forma disclosure and $1,000 recorded in the income statement under Statement no. 123(R)). Assuming a 35% tax rate, the company has a $175 pro forma deferred tax asset and a $350 recognized deferred tax asset. Assume that all the options are exercised, resulting in a tax deduction of $2,000. The first calculation results in a $350 credit to APIC [($2,000 tax deduction x 35%) less ($1,000 recognized compensation expense x 35%)]. The second calculation determines the addition to the APIC pool. This amount equals $175 [($2,000 tax deduction - $1,500 total compensation expense) x 35% tax rate)]. </pre> <p>UNUSUAL SITUATIONS

CPAs implementing the tax aspects of Statement no. 123(R) may encounter some unique circumstances.

Forfeiture before vesting. Employees who leave a company frequently forfeit their options before the vesting term is complete. When this happens, the company reverses the compensation expense, including any tax benefit it previously recognized.

Cancellation after vesting. If an employee leaves the company after options vest but does not exercise them, the company cancels the options. When NQSOs are canceled after vesting, the compensation expense is not reversed but the deferred tax asset is. The write-off is first charged to APIC to the extent there are cumulative credits in the APIC pool from the prior recognition of tax benefits. Any remainder is expensed through the company's income statement.

Expiration. Many nonqualified options expire unexercised, usually because the options are "underwater" (meaning the option price is higher than the stock's current market price). The same rules apply as with cancellation after vesting; the compensation expense is not reversed but the deferred tax asset is. The write-off is first charged to APIC to the extent there are cumulative excess tax benefits. Any remaining amount is expensed through the company's income statement.

POSSIBLE PITFALLS

When implementing Statement no. 123(R) CPAs need to exercise some caution in certain areas.

Deferred tax rates. Companies that operate in more than one country need to be especially careful computing the deferred tax asset. Such computations should be performed on a country-by-country basis, taking into account the tax laws and rates in each jurisdiction. Tax laws about stock option deductions vary around the world. Some countries do not allow deductions while others permit them at the grant or vesting date.

Underwater options. When an option is underwater, Statement no. 123(R) does not permit the company to record a valuation allowance against the deferred tax asset. Valuation allowances are recorded only when a company's overall tax position shows future taxable income will not be sufficient to realize all of the benefits of its deferred tax assets. The deferred tax asset related to underwater options can be reversed only when the options are canceled, exercised or expire unexercised.

Net operating losses. A company may receive a tax deduction from an option exercise before actually realizing the related tax benefit because it has a net operating loss carryforward. When that occurs, the company does not recognize the tax benefit and credit to APIC for the additional deduction until the deduction actually reduces taxes payable.

CASH FLOW IMPACT

The method a company selects to compute the APIC pool also has an impact on how it represents realized tax benefits in its cash flow statement. Under Statement no. 123(R) companies must use a "gross" approach to reporting excess tax benefits in the cash flow statement. The excess tax benefit from exercised options should be shown as a cash inflow from financing activities and as an additional cash outflow from operations. Excess tax benefits cannot be netted against tax-benefit deficiencies. The amount shown as a cash inflow from financing will differ from the increase in APIC due to excess tax benefits when the company also records tax-benefit deficiencies against APIC during the period.

Companies that elect the simplified approach will report the entire amount of the tax benefit that is credited to APIC from options that were fully vested before they adopted Statement no. 123(R) as a cash inflow from financing activities and a cash outflow from operations. For partially vested options or those granted after adopting Statement no. 123(R), the company will report only the excess tax benefits in the cash flow statement.

FINAL THOUGHTS

Many companies are still considering modifications to their existing stock option plans before they adopt Statement no. 123(R). Those with underwater stock options are deciding whether to accelerate the vesting to avoid recognizing compensation expense. Although the compensation expense deduction can be avoided under the modified prospective method, the impact on the APIC pool cannot be avoided. When the options eventually expire unexercised, the company must write off the "as-if" deferred tax asset against the APIC pool to the extent of net excess tax benefits. Depending on the size of the option grant, this may reduce the APIC pool to zero.

The income tax accounting requirements of Statement no. 123(R) are very complex. Both the computation of the beginning APIC pool and the ongoing calculations require companies to develop a process for tracking individual Stock option grants. The newer simplified method only adds another set of computations companies will have to perform. Public companies also must focus on designing the proper internal controls to meet the requirements of section 404 of the Sarbanes-Oxley Act. Combined with the potential difficulty of tracking down 10-year-old information, the obvious conclusion is to start now.

Change Is Inevitable

In anticipation of mandatory expensing of stock options, 71% of companies were revising or planning to revise their long-term employee incentive programs.

Source: Hewitt associates, Lincolnshire, Ill., www.hewitt.com.

Practical Tips

* A good starting point for calculating the beginning APIC pool and deferred tax asset is the information the company used for Statement no. 123 disclosure purposes. Tax return preparation files and human resource records also may include information on exercised NQSOs and any ISO disqualified dispositions.

* Companies need to calculate the APIC pool only when they have a current-period shortfall. However, given the difficulty of obtaining 10-year-old information, it's a good idea to start this calculation as soon as possible in case it is needed.

* If a company operates in more than one country, be careful when computing the deferred tax asset. Perform the computations on a country-by-country basis, taking into account the tax laws and rates in each jurisdiction.

Nancy Nichols, CPA, PhD, is associate professor of accounting at James Madison University in Harrisonburg, Va. Her e-mail address is [e-mail]. Luis Betancourt, CPA, PhD, is assistant professor of accounting at James Madison University. His email address is [e-mail].