Academic journal article Journal of Accountancy

Avoiding FASB 123(R) Pitfalls: NOL Companies' Choice of When to Recognize Tax Benefits under FASB 123(R) Can Affect Their Bottom Line

Academic journal article Journal of Accountancy

Avoiding FASB 123(R) Pitfalls: NOL Companies' Choice of When to Recognize Tax Benefits under FASB 123(R) Can Affect Their Bottom Line

Article excerpt

EXECUTIVE SUMMARY

* FASB Statement no. 123(R), Share-Based Payment, poses a potential dilemma for companies with net operating losses (NOLs) that award nonqualified stock options (NQSOs) as compensation. If a company's allowable tax deduction for stock option compensation exceeds the related book expense, it can realize an excess tax benefit.

* But because with an NOL the company may have no current tax liability to reduce, the tax benefit may be deferred. The company then must determine when the benefit should be recognized for financial reporting purposes.

* Two methods for making that determination have been identified by the FASB 123(R) Resource Group, an advisory group to the FASB staff: the "tax-law-ordering" and "with-and-without" methods. The tax-law-ordering method recognizes an excess tax benefit when the stock option deduction is used on the company's tax return, before an NOL or another tax attribute. The with-and-without method recognizes the excess tax benefit only when the stock option deduction provides an incremental benefit after considering all other tax benefits (including NOLs) available to the company.

* Companies may be more likely to avoid a charge against income if they elect the tax-law-ordering approach. This is because it results in recording windfall tax benefits to APIC sooner than the with-and-without approach and thus provides a larger pool to offset future shortfalls.

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CPAs who assist clients or employers with implementing FASB Statement no. 123(R), Share-Based Payment, face myriad accounting issues, including income tax accounting implications. In their article "Options and the Deferred Tax Bite" (JofA, March 06, page 71), Nancy Nichols and Luis Betancourt summarized the statements tax accounting implications and suggested that companies with net operating losses (NOLs) be wary of possible implementation pitfalls.

This article elaborates on how CPAs can help NOL companies avoid those pitfalls by examining the methods companies may use to determine when excess tax benefits are realized. It also illustrates how the choice of method will affect a company's record-keeping and the resulting pool of excess tax benefits--that is, the additional paid-in capital (APIC) pool--and thus the likelihood that an NOL company will incur a charge against income. This article is not relevant to companies that have NOLs with a full valuation allowance and are in a loss position prior to the consideration of NOLs and excess stock option deductions. Such companies generally do not need to consider the discussion in this article until they have pretax book income prior to the consideration of NOLs and excess stock option deductions.

DEFERRED TAX ACCOUNTING

When a company grants an employee equity-based nonqualified stock options (NQSOs) under Statement no. 123(R), it records compensation expense over the requisite service period in an amount equal to the estimated grant date fair value of the options and credits APIC. The accounting for the income tax consequence is principally addressed by FASB Statement no. 109, with specific guidance in Statement no. 123(R). As the company will not receive a tax deduction for the stock option until it is exercised, the recognition of compensation expense generally occurs prior to the related tax deduction being recognized. Statement no. 123(R)'s general principle is that a deferred tax asset (DTA) needs to be established as the company recognizes compensation cost for book purposes. Thus, as the company recognizes compensation expense related to the equity award, the company will contemporaneously record a DTA and a credit to deferred tax benefit in the profit and loss statement in an amount equal to the compensation expense multiplied by the company's applicable income tax rate.

When the NQSOs are exercised, the company compares the allowable tax deduction to the related compensation expense recorded earlier for financial statement purposes. …

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