Analysis of Income Taxes and Employee Stock Options

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

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 • 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 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 Chapter 14

6. Deferred Income Taxes 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. 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 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… • 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 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 known • Number of options • Exercise price • Vesting date • 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 Chapter 14