Permanent component of a temporary difference: ASC Topic 740 analysis.

• Author: Nellen, Annette
• Position: Accounting Standards Codification

In its November 2021 20-year review of financial restatements, Audit Analytics reports that accounting for income taxes has been among the top five issues causing restatements for the last decade (ranking fourth in 2020). It continues to be an important area of knowledge for practicing accountants and for students entering the field. An earlier Campus to Clients column provides a comprehensive discussion of FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, for classic temporary and permanent differences including construction of the effective tax rate reconciliation (the rate rec) (Evans, "Constructing the Effective Tax Rate Reconciliation and Income Tax Provision Disclosure," 50 The Tax Adviser 600 (August 2019)).

Stock options, as well as other types of stock-based equity compensation, arc unique within the category of book-tax differences. While companies treat incentive stock options (ISOs) in the same manner as other permanent differences, nonqualified options (NQOs) present a more complex case. Not only is the timing of book and tax expense different for NQOs, so is the ultimate expense amount. Further, the tax deduction is unknowable until the future point in time when the employee exercises the options. NQOs are therefore a unique case of a temporary difference that will also have a permanent component. This column presents the process of accounting for stock options, a mainstay in the equity compensation portfolio, in detail.

GAAP stock option treatment

For financial reporting purposes, FASB Accounting Standards Codification (ASC) Paragraph 718-10-35-2 requires companies to expense the fair value of the stock options granted over the requisite service period the employee must provide to be entitled to the stock award, typically the vesting period. Entities can recognize the expense straight line over the entire vesting period, or straight line for each separately vesting portion ot the award if the company has a graded vesting schedule (see ASC Paragraph 718-10-35-8).

While there are other aspects of granting options that will affect the ultimate options compensation expense for book purposes (e.g., projected number ot options that will vest), to retain focus on the income tax accounting analysis this column makes some simplifying assumptions throughout. Specifically, it will assume the corporation correctly estimates 100% of the options granted will be exercised after they vest. It also assumes a cliff vesting plan, where all options vest in full after a certain number of years of employment. While expanding these simplifying assumptions would change the mathematical computation of compensation expense each year, the conceptual underpinnings related to income tax accounting under ASC Topic 740 remain the same.

Tax stock option treatment

For tax purposes, the appropriate treatment depends on whether the options qualify as ISOs or NQOs. For simplification, this column assumes options have no readily ascertainable fair market value (FMV) at grant, which is most often the case. Note that the GAAP treatment is the same regardless of the option's tax classification.

ISOs

Per Secs. 421(a)(2) and 422, ISOs do not generate a tax deduction for the granting company. Since the company does have an expense for financial purposes each year over the vesting period, it has a permanent book-tax difference each of those years. As such, it will appear as a reconciling item on the rate rec in each of the vesting years. Because it is an unfavorable difference (i.e., the company will never enjoy a tax deduction for it), the company's current (and therefore total) income tax expense will be higher, resulting in an effective tax rate (ETR) increase each year in the vesting period.

NQOs

Unlike the nondeductibility of ISOs, Sec. 83(a) and Regs. Sec. 1.83-7(a) allow companies a tax deduction when an employee exercises an NQO. This deduction equals the bargain element enjoyed by the employee upon exercise (equal to the stock's FMV at exercise minus the lower purchase price enjoyed by the employee by using the option to purchase shares).

Because NQOs generate a future tax deduction, the issuing company will originate a temporary book-tax difference at issuance. This difference will create a deferred tax asset (DTA) since the financial expense (recognized over the vesting period) precedes the income tax expense (recognized at exercise). But unlike DTA items where book and tax expense equal over time (e.g., depreciation or other cost recovery), the total NQO txx expense will differ between book and tax. This difference is the permanent component of the temporary book-tax difference. While companies know there will be a permanent component to the difference, they are not able to determine the magnitude or direction of it until exercise. At that future point in time, the company will know whether the tax expense is greater or lesser than the total book expense, and to what degree.

As initially set forth by FASB in Accounting Standards Update (ASU) No. 2016-09, Compensation--Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, companies account for the permanent component of the NQO temporary difference directly through income tax expense (versus additional paid in capital, which...