Tax Accounting & Diluted EPS: To Boldly Go Where
Private Companies Have Not Gone
Elizabeth Dodge, CEP, Stock & Option Solutions, Inc.
Ellie Kehmeier, CPA, Steele Consulting, LLC
Kevin Hassan, CPA, PricewaterhouseCoopers, LLP
July 25th, 2012
Agenda
Tax Accounting
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General Concepts of Tax Accounting Under ASC 718
(formerly FAS 123R)
Complications
Diluted EPS
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Earnings Per Share – ASC Topic 260 (formerly FAS 128)
Common Stock / Potential Common Stock
Treasury Stock Method – Explained
Treasury Stock Method – An Example
Other Considerations & Complications
TAX ACCOUNTING
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Common Acronyms and Terms
ISO = Incentive Stock Option (IRC sec. 421)
NQSO or NSO or NQO = Nonqualified Stock Option, Nonstatutory option or “nonqual” (sec. 83)
RS or RSA = Restricted Stock or Restricted Stock Award
(sec. 83)
RSU = Restricted Stock Unit
FMV = Fair Market Value (stock price)
Bargain Element or Spread = Difference between
purchase price and FMV, usually computed as of date
of exercise. Also known as intrinsic value
Fair Value = Expense per Share
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Common Tax Accounting Lingo under ASC 718
ASC = Accounting Standards Codification (ASC 718 = FAS 123R)
APIC = Additional Paid-in-Capital; part of equity
Tranche = portion of award that vests at any given time
Cliff vesting = typically means entire grant vests at same time
Graded vesting = tranches within grant vest over time.
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Typical option = 25% “cliff vesting” at end of one year, with 36
monthly tranches thereafter
Tax Deficiency = “Shortfall”: amount by which expense
exceeds tax deduction
Excess tax benefit = “Windfall”: amount by which tax
deduction exceeds expense
APIC Pool = sum of excess benefits that have been realized by
reducing taxes payable
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Background
ASC 718 requires that companies record compensation
expense for fair value of equity awards issued;
generally over the vesting period
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e.g., Stock options, RSAs, RSUs, etc.
Tax rules only allow a tax deduction on company’s tax
return when and if there is a tax event
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Exercise of NSOs
Disqualifying disposition of ISOs and qualified ESPPs
Release of RSAs
Delivery of RSU shares
Thus, in most cases, timing AND amount of book expense
and tax deductions differs
And therein lies the complexity!!
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General Concepts
ASC 718/FAS 123R
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Requires that:
• Record expected tax benefit (i.e., deferred tax asset or
DTA) as expense is booked, based on cumulative book
expense
• Reverse and reconcile DTA at time of tax deduction (or
lack thereof)
• Excess tax benefits (aka windfalls) be recognized as an
addition to paid-in capital (APIC Pool) when they reduce
taxes payable, NOT as a reduction in income tax expense
• Tax deficiencies (aka shortfalls) be recognized as income
tax expense
– Unless there are excess tax benefits in the APIC Pool
General Concepts
Translation
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Deferred Tax Asset (that you booked as expense was
recognized) does not equal Actual Tax Deduction
If excess = increase to APIC (but only when tax benefit
reduces taxes payable)
If shortfall/deficiency =
• Reduction to APIC Pool (if sufficient) or
• Potential tax expense (if APIC Pool not available to
offset)
• But not for ISOs
General Concepts – Deferred Tax Asset (cont’d)
Example of journal entries for expense and DTA (both
booked over “requisite service period”):
- Book expense for NQO = $10,000
- Vests annually over 4 years, straight-line accrual
($10,000 / 4 years = $2,500 expense per year)
- 40% statutory tax rate for country
Debits/credits for each year of service period:
Debit: Compensation Expense
2,500
Credit: Additional Paid-in Capital
Debit: Deferred Tax Asset
1,000
Credit: Deferred Tax Benefit
(reduces Income Tax Expense on I/S)
Notes:
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2,500
1,000
- Book expense reduced by estimated forfeiture rate until shares vest
- APIC in this entry is NOT the APIC Pool
Non-Qualified Option - Excess Example
NQO granted for 1,000 shares, exercise price = $30
ASC 718 book Expense = $10 per share (total = $10,000)
Deferred tax asset = 40% x $10,000 = $4,000 once vested
Shares exercised when market value = $42
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Tax Deduction = 1,000 shares x $12 gain per share =
$12,000
Actual Tax Benefit = $12,000 x 40% = $4,800
Actual
Deferred
Tax Benefit Tax Asset
$4,800
$4,000
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Result
Excess = $800
(Increase to APIC Pool)
Non-Qualified Option - Deficiency Example
NQ granted for 1,000 shares, exercise price = $30
Expense = $10 per share (total = $10,000)
Deferred tax asset = 40% x $10,000 = $4,000 once vested
Shares exercised when market value = $36
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Tax Deduction = 1,000 shares x $6 gain per share = $6,000
Actual Tax Benefit = $6,000 x 40% = $2,400
Actual
Deferred
Tax Benefit Tax Asset
$2,400
$4,000
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Result
Deficiency = $1,600
(Either Reduce APIC Pool,
or Increase Tax Expense)
Non-Qualified Option – Cancel/Expiration Example
Same facts as deficiency example
Larger deficiency because NO tax benefit
Vested shares expire unexercised
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Tax Deduction = $0
Actual Tax Benefit = $0
Actual
Deferred
Tax Benefit Tax Asset
$0
$4,000
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Result
Deficiency = $4,000
(Either Reduce APIC Pool or
Increase Tax Expense)
Statutory Option (ISO/ESPP) Treatment
Under ASC 718, companies not allowed to anticipate
a future tax deduction for ISOs, qualified ESPPs
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i.e., cannot record a DTA for ISOs, qualified ESPPs
Tax benefit can only be recorded in income statement
if / when there is a tax deduction
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i.e., only if there is a disqualifying disposition (DD)
Tax benefit recorded in income statement limited to
LESSER of actual tax benefit or expected amount based
on book expense
• i.e., tax benefit in P&L limited to same amount as
for NQs, but may be less if actual tax deduction is
less than book expense
ISO Disqualifying Disposition - Excess Example
If actual tax benefit > estimated tax benefit (i.e., benefit based
on book expense), excess increases APIC Pool &
estimated tax benefit reduces tax expense, but only if DD
– If actual > estimated
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Excess tax benefit to APIC (when realized)
Estimated tax benefit reduces tax expense at DD
Example
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Actual: $4,800 > estimated $4,000
$800 = APIC AND $4,000 reduction to income tax
expense
Actual
Estimated
Tax Benefit Tax Benefit
Result
$4,800
$4,000
Excess = $800
(Increase to APIC AND $4,000
reduction to Tax Expense)
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ISO Disqualifying Disposition – “Deficiency” Example
No DTA booked, so no “real” deficiency
If actual tax benefit <= “estimated tax benefit”, no additional
paid-in capital and actual tax benefit reduces tax expense
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If actual < estimated
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APIC = $0
Actual tax benefit reduces tax expense
Example
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Actual $3,000 < estimated $4,000 (but estimate not recorded
as a DTA)
• $0 = APIC AND $3,000 reduction to tax expense
Actual
“Estimated”
Tax Benefit Tax Benefit
Result
$3,000
$4,000
“Deficiency” = $1,000
($0 APIC AND $3,000 Reduction to Tax
Expense)
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ISO – Cancel/Expiration Example
Same initial facts as deficiency example
Vested shares expire unexercised; NO tax benefit
No tax accounting impact, since no DTA would have
been recorded for ISOs
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Tax Deduction = $0
Actual Tax Benefit = $0
Actual
Tax Benefit
$0
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Deferred
Tax Asset
$0
Result
No entry
Tax Accounting for Restricted Stock and RSUs
Book expense based on FMV of the stock on grant date
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Same under ASC 718/FAS 123R, and old APB 25
Tax accounting similar to NQs:
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Recognize tax benefit and record DTA for book expense
Reverse DTA as award becomes deductible for tax
Excess benefit to APIC pool; shortfall to APIC or tax
expense (if no APIC pool)
Note: Since tax event is typically vest date, windfalls and
shortfalls arise sooner with RSA/RSUs than with options
– DTAs for underwater options don’t get written off
until options expire
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Forfeitures v. Cancellation of Vested Awards
Forfeitures
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When award forfeited, book expense previously recorded
reversed, along with DTA previously recorded
Typically, Co records net book expense (i.e., current period
expense netted with any forfeiture adjustments), so current
period DTA set up takes into account forfeiture adjustment
Cancellations/Expirations of vested options
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When vested option cancelled or expires (eg. If an
underwater option expires) book expense not reversed
However, DTA must be reversed (no actual tax benefit) and
shortfall will increase tax expense, unless:
• APIC pool is sufficient to absorb shortfall, or..
• Valuation allowance offsetting DTA (i.e., no net
deficiency), or..
• ISO (remember – no DTA booked for ISOs)
Loss Companies with Valuation Allowances
Valuation allowance recorded as offset to DTA if future tax benefit
is too uncertain
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Very common for companies with a history of losses
Eliminates recognition of tax benefit on income statement
If full valuation allowance, then there is no net DTA
• And no net deficiency!
Need for valuation allowance based solely on expectation
of sufficient future taxable income
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For example, don’t record valuation allowance just because
stock price declines, even if options are deeply under water
APIC Pool Basics
APIC Pool represents excess tax benefits that can offset
future tax benefit deficiencies
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Excess benefits must be “realized”, meaning that
deductions have to actually reduce taxes payable
Companies must track APIC pool separately from G/L APIC
account
• Some companies use sub-account in G/L for APIC Pool
• APIC Pool can sometimes exceed APIC balance recorded
in G/L
Exclude awards outside ASC 718’s scope (e.g., ESOPs)
APIC pool includes employee and non-employee awards &
all jurisdictions included in consolidated financial
statements
APIC pool can never be negative
Realization of Excess Tax Benefits
A source of incredible complexity – tax geeks only
Credit to APIC for excess tax benefits postponed until
“realized”
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E.g., if excess benefits merely increase a net operating loss
(NOL), APIC Pool not increased until NOL used to offset
taxable income
– ASC 718-740-25-10 (formerly SFAS 123R, Footnote 82)
Tracked off balance sheet – aka “footnote 82 memo account”
Two policy choices for how & when excess benefits are
realized:
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Tax law ordering (Follow the tax law)
Excess benefits last (a.k.a. with and without approach)
Accounting policy decision; should be applied consistently and
should be disclosed if has significant impact
Realization of Excess Tax Benefits (cont.)
Know your policy and make sure you follow it!
Especially important if you have a valuation allowance (VA)
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Under “excess benefits last” approach, you use current
and prior year attributes (NOL, credit carryforwards) that
are not from excess benefits prior to current and prior
year excess benefits
– This minimizes tax expense while company has a VA
– However, it delays “realization” of excess benefits, meaning
company isn’t building up an APIC pool such that shortfalls
increase tax expense once VA is gone
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Other Deferred Tax Accounting Complexities
Not a complete list!
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Reclassification of gross excess benefits to financing
cash flow
Complexities with multinationals & grants to overseas
employees
Awards assumed in M&A transactions
Modification accounting: option repricings, exchanges
Impact of Section 162(m)
Pre-adoption grants (prior to 2006)
Expense under APB 25
DILUTED EPS
Earnings Per Share
Calculating earnings per share
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Basic EPS
• Does not include potential common shares
• Net Earnings divided by Common Stock
Diluted EPS
• Includes common shares & other potential common
shares (warrants, convertible debt, employee equity
awards, etc.)
• Net Earnings divided by Common Stock and potential
common shares
• Treasury Stock Method
• If-Converted method
• Contingently issuable shares
Earnings Per Share
Basic Earnings Per Share (“EPS”) =
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Net Earnings1 / Common Stock
Measurement of company’s success
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Higher Earnings = Higher EPS
Higher EPS = greater return on investment
Example:
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Net Earnings: $100,000,000
Common Stock: 50,000,000
EPS: $100,000,000 / 50,000,000 shares = $2.00
1 Earnings
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attributable to common shareholders
Earnings Per Share
Shareholder Shares
Company Shares
Plan
Reserve
Grant
Outstanding
Awards
Potential Common
Shares
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Option/SAR
RSU
RSA
ESPP
Exercise
Release
Vest
Purchase
Common
Stock
Earnings Per Share
To calculate basic & diluted EPS, determine:
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Net earnings
Common stock issued and outstanding
Potential common shares
Diluted EPS =
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Net Earnings / (Common Stock + Potential Common Shares)
Unissued Stock
Employee Equity Grants
Warrants
Convertible Debt, etc.
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Common Stock
Common Stock
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Weighted for length of time during reporting period
stock was issued and outstanding
Common stock issued and outstanding for entire
period is weighted at 100%
Common stock issued during period is weighted at
proportionately smaller percentage
Common Stock – Weighting
>
Weighted for length of time stock was issued and outstanding
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Common stock issued and outstanding for entire period weighted at 100%
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Common stock issued during period weighted at proportionately smaller percentage
July 1
Aug 4
Exercise
> Example:
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Reporting period is 92 days (July 1 to Sept 30)
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1,000 shares exercised on August 4
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Shares issued for 58 days (Aug 4 to Sept 30)
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Shares not issued for entire period so are weighted at less than 100%
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Shares are weighted at 63% (58 days / 92 days)
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1,000 shares exercised = 630 shares included as common stock
Sept 30
Potential Common Shares – Weighting
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Potential common shares / Potential Equivalents
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Weight equity for length of time grants are outstanding
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Determine shares that would be issued and outstanding after exercise / release/ vest /
purchase of the weighted grants
July 1
Aug 4
Sept 30
Grant1
Grant 2
> Example: Grant 1
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Reporting period is 92 days (July 1 to Sept 30)
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Grant 1 outstanding for entire period and is included at 100%
> Example: Grant 2
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Grant 2 is exercised on Aug 4
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Grant 2 is outstanding for 34 days (July 1 to Aug 3)
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Grant 2 weighted at 37% (34 days / 92 days)
Treasury Stock Method – Explained
ASC 260-10-45-28A and 28B
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All options and nonvested shares assumed issued or
exercised at beginning of period (or time of grant if later)
All “underwater” options excluded from Treasury Stock
Method (ASC 260-10-45-25)
All proceeds from hypothetical “exercise” assumed to
repurchase stock on open market at Average Market Value
during period
• “Buyback Shares”
• Three components of “exercise proceeds” (more later)
Shares “issued” minus “buyback shares” = incremental
shares for diluted EPS calculation
Treasury Stock Method – Assumed Proceeds
ASC 260-10-45-29
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Exercise price of options (restricted stock is $0), plus
Weighted average unrecognized compensation cost
during the period, plus
Excess tax benefits or minus certain tax benefit
deficiencies
• But ignore this for ISOs/ Qualified ESPPs since you
can’t anticipate any tax deduction
• Also, probably ignore both excess tax benefits and
deficiencies if company has valuation allowance
(more later)
Treasury Stock Method Steps in 5 Easy (?) Steps – An
Example
1. Exclude underwater options
2. Weight shares for time outstanding during period (WSO)
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Can be complex if transactions occurred during period
3. Calculate exercise proceeds & “buyback shares”
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A. Exercise price: (Exercise Price * WSO)
B. Tax benefit: ((((MV-Price) – Fair Value) * Tax Rate) * WSO)
C. Avg unamortized expense: (((Beg. Unamortized Expense +
Ending Unamortized Expense) / 2) * (WSO / Total Shares))
D. Sum 3 components/Avg Market Value = total “buyback shares”
4. If buyback shares > WSO (anti-dilutive), exclude grant
5. Weighted shares minus buyback shares = dilutive shares to
include in diluted EPS calc in addition to common stock
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Treasury Stock Method
Effect of forfeitures on diluted EPS
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Options forfeited during reporting period weighted for
portion of period they were outstanding
Based on actual forfeitures not estimated forfeitures
ASC 260-10-45-1:
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“Diluted EPS shall be based on the actual number of
options or shares granted and not yet forfeited, unless
doing so would be anti-dilutive.”
Treasury Stock Method - Summary
Calculation of Potential Common Shares Calculation:
Weighted Shares Outstanding
Less:
- Exercise Price Buyback Shares
- Tax Benefit Buyback Shares
(only for grants with expected tax deduction – i.e.,
ignore ISOs/ qualified ESPPs)
- Avg Unamortized Expense Buyback Shares
-----------------------------------------------------------------------------= Total Buyback Shares
= Dilutive Shares
(if negative, exclude grant from calculation)
Calculation should be performed grant-by-grant
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Treasury Stock Method – Underwater Options
Calculation of Buyback Shares
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Could be “dilutive” even if not “in-the-money”
because of impact of tax benefit deficiency; however,
Resource Group concluded options not “in-themoney” should be excluded from EPS.
Example
• Proceeds = $20 x 200,000 shares = $4,000,000
• Buyback shares = Proceeds / Avg MV
– $4,000,000 / $15 = 266,667 shares
• Buyback shares (266,667) exceed weighted option
shares outstanding (200,000)
• Anti-dilutive and excluded from the calculation
Other Grant Types
Restricted Stock/Units
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Same calculation as options, but with $0 exercise price
ESPP
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Calculations similar as for options
For qualified ESPP - No tax benefit calculation (no DTA
booked)
Practice/guidance for ESPP varies
ISOs
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No tax benefit calculation (no DTA booked)
Same as other options otherwise
Other Considerations
In-the-money Grants can be Anti-dilutive
Valuation Allowance and Tax Benefit Calculation
Reduction of Assumed Proceeds for Tax Benefit
Deficiency
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If sufficient APIC pool, include deficiency
If insufficient APIC pool, do not consider
Performance shares
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Performance/market conditions
Two Class Method for Participating Securities
Potential Changes to EPS
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Other Considerations: In-the-Money Grants can be
Anti-Dilutive
When buyback shares exceed weighted shares outstanding,
transaction would increase (rather than decrease) EPS –
must be excluded
Comparison of buyback shares to weighted shares outstanding
must be done on grant-by-grant basis
More common early in life of grant
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Higher unamortized expense
Shares only outstanding for a portion of reporting period
Example:
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NQ for 1,000 shares granted 9/15/11, Vesting over 4 years
Grant Date Market Value = $10, Price = $10
Expense per Share = $7, Avg Market Value during period = $12
Reporting Period from 7/1/12 to 9/30/12
Other Considerations: Valuation Allowance and Tax
Benefit Calculation
Excess Tax Benefits increase assumed proceeds, but
only if expected to be realized
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Company with Valuation Allowance (VA) offsetting
DTAs does not expect to realize future tax
deductions
Thus, companies with a VA should probably exclude
excess benefits from assumed proceeds
Shortfalls reduce assumed proceeds, but if company
has a VA, then no net shortfall
•
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Thus, companies with VA should probably exclude
shortfalls as well as excess benefits
Other Considerations: Reduction of Assumed
Proceeds for Tax Benefit Deficiency
When expense per share exceeds “hypothetical gain” at
exercise
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Tax Benefit Buyback Shares can be negative
A “reduction to assumed proceeds” if sufficient APIC Pool to
offset
Text from Topic 260:
• “Paragraph 718-740-35-5 states that the amount deductible
on an employer’s tax return may be less than the cumulative
compensation cost recognized for financial reporting
purposes. If the deferred tax asset related to that resulting
difference would be deducted from additional paid-in capital
(or its equivalent) pursuant to that paragraph assuming
exercise of the options, that amount shall be treated as a
reduction of assumed proceeds.” [emphasis added]
Performance/Market Awards
When performance shares would be issuable, if end
of EPS reporting were the end of contingency
period, then those performance shares are
included as outstanding for diluted EPS
Prior to the goal being met, these shares will be
excluded from diluted EPS
The percentage of shares to be included in EPS will
not necessarily line up with the number of shares
expensed
Can create significant volatility in diluted EPS
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Performance/Market Awards
Two Steps:
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1. Performance condition already met at end of
reporting period?
• No = exclude all shares
2. Yes = include # of shares “vesting” based on
performance target met as of end of the period
– Impact all amounts by “expected to payout”
ratio
Contact Information
Elizabeth Dodge, CEP
Vice President, Product Management
Bus: (408) 754-4609
Mobile: (650) 773-2142
E-mail: edodge@sos-team.com
www.sos-team.com
Kevin Hassan, CPA
Managing Director
Bus: (203) 539-4049
Email: kevin.hassan@us.pwc.com
www.pwc.com
Ellie Kehmeier, CPA
Bus: (408) 221-2002
Email:
ellie.kehmeier@steeleconsultingllc.com
www.steeleconsultingllc.com
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