As always, this is a high-level, basic understanding. In accounting, there are always exceptions. Learn the basics, then learn the exceptions later.
Stock-based compensation is recognized for GAAP as either a liability (for awards which are or can be settled in cash) or equity (for awards settled with stock). Here, we are only discussing equity-classified awards. Yearly GAAP expense entry looks like this:
Stock comp expense xx
APIC – stock comp xx
GAAP determines the fair value (FV, not to be confused with fair market value, or FMV) of the award based on quite a few factors including risk free interest rate, option expiration, current stock price, etc. We don’t have to worry about this, just know that FV is different than FMV. GAAP then recognizes the FV of the award over the service period (employee) or vesting period (non-employee). Obviously if you are an employee, there’s little chance you get a vesting period shorter than the service period. So for simplicity we will say GAAP records expense over the vesting period. GAAP expense is recorded over time.
The tax deduction, however, does not occur until an award is settled; for an option this is the exercise date, for other awards this is the end of the vesting period (baring a section 83(b) election). This means that the DTA for stock-based compensation will be comprised of the inception to date GAAP expense recorded on all outstanding options and awards (ie, those not yet settled). This is your check figure, your expectation for ending DTA balance. If you are not checking the ending DTA balance back to a schedule detailing this, or at least a reasonable expectation calculation of this balance, you are not auditing the figure!!
The tax deduction is the amount of the fair market value (FMV, market price of stock) on the date of settlement, less any amount of money paid (ie, excercise price). This is the same as the amount that is taxable to the individual as compensation on their W-2. So if FMV is $100, and exercise price is $10, then the individual gets taxed on $90 and the corporation gets a $90 tax deduction.
Where do you see this tax deduction? It’s both in the perm and the temp section of the current provision. GAAP’s estimate of fair value (FV) is not going to be equal to the FMV on settlement, which means that the tax deduction will be either greater or less than the GAAP expense recognized on the award, and the difference between GAAP expense and tax deduction is a permanent item. Say the award just settled above had total GAAP expense recognized over the vesting period of $120. That means that $30 ($120 GAAP expense less $90 tax deduction) is a permanent item.
Let’s break it down.
Perm NSO – exercises $30
Temp NSO – exercises -$120
Total TD – exercises -$90
Let’s say this wasn’t an option, but was an RSU. Restricted Stock Units* are given to recipient. They do not have an exercise price. Same exact treatment, just assume a zero for the amount paid. So $100 FMV – $0 EP = $100 TD. Breaks down as follows:
Perm RSU settlement $20
Temp RSU settlement -$120
Total RSU tax deductions -$100
Now let’s talk about the effects of the GAAP expense recorded for current year vesting. This is going to be included in the trial balance account containing the stock-based compensation expense. So it’s in pre-tax GAAP income for the year, but needs to be removed to get to our taxable income figure. There are two main types of equity recorded awards: incentive stock options (ISO) and nonqualified stock options (NSO).
Note: NSO includes Restricted Stock Units and Performance Stock Units (RSU and PSU). I like to call options “NSO” on my provisions, and just know that RSU/RSA/PSU/PSAs** are all NSO as well, but label them RSU/PSU within my provision. Just my preference.
ISO and NSO can come from the same awards. The IRS says that if you meet certain requirements (essentially giving awards to more than just those high earning execs), then you can count $100k per year per employee of the compensation as non-taxed to the employee. Remember that the corporation’s tax deduction equals the individual’s amount taxed, so if the individual is not taxed, the corporation gets no deduction. The ISO amount is a permanent expense.
Let’s say you had an award that was $100k ISO and $400k NSO for the year. That expense addback would look something like this:
Perm ISO CY GAAP exp $100
Temp NSO CY GAAP exp $400
So taken all together, all the activity for the year between settlements and current expense would look something like this on the current provision:
Perms
Perm NSO – exercises $30
Perm RSU settlement $20
Perm ISO CY GAAP exp $100
Temps
Temp NSO – exercises -$120
Temp RSU settlement -$120
Temp NSO CY GAAP exp $400
This gives you a total addback of $500 that ties back to the GAAP trial balance account for current year stock comp expense, a $100 tax deduction for the RSU and $90 tax deduction for NSO that settled. There is an increase to the DTA of $400 for CY vesting/service period expense, and $240 decrease to DTA to remove the settlements during the year of NSO and RSUs.
This is the basics of equity recorded stock-based compensation.
*Watch out for 83(b) elections. Once you learn stock comp basics, learn 83(b) next.
** What’s the difference between a Stock Award and a Stock Unit? Go look it up, its not part of the basics, but does have an impact on 83(b) elections.
Tax Sophomore 