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How ASC 740 Affects Stock-Based Compensation

June 8, 2022

ASC 740 governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP. ASC 718 provides specific guidance on accounting for the various types of equity-based awards that companies use to compensate their employees. It also clarifies how ASC 740 should be applied to stock-based compensation.

See how Bloomberg Tax Provision untangles ASC 740’s complexity.

What is stock-based compensation?

ASC 718 governs the accounting for share-based compensation. The standard requires companies to recognize compensation expense related to their equity awards on an award-by-award basis. The expense is recorded over the vesting period in which the award is earned and offset by a credit to additional paid-in-capital (APIC).

Stock compensation glossary

  • Grant Date. The date on which the company grants the award to the employee and typically the day the vesting period begins.
  • Vest Date. The date the award is available for exercise (in the case of options) or the restrictions lapse (in the case of restricted stock units). Options typically vest in tranches over three or four years with a multiple-year exercise period. Restricted stock units typically all vest on the same date after a three or four-year period. This is often referred to as a “cliff vest.”
  • Exercise/Strike Price. The price, established at the grant date, at which the option is exercisable.
  • Exercise Date. The date an option is exercised.
  • Vesting/Service Period. The period over which the award is earned and becomes available for exercise by the employee.

Watch on demand: Stock-based compensation webinar

Learn about the basic concepts of accounting for stock compensation under ASC 740 including the following: accounting for different types of awards, NQSOs, RSUs, ISOs, Excess Benefits, and Sec. 162(m) disallowance of compensation deductions.

How does stock-based compensation affect the ASC 740 provision for tax?

An excess benefit, or windfall benefit, is the amount by which the realized tax benefit associated with an award exceeds the tax benefit associated with the GAAP compensation expense. Excess benefits are recorded as permanent items.

Accounting by award type

The tax accounting for share-based payments differs depending on the ultimate tax consequence of the reward to the company. Awards such as non-qualified stock options (NQSOs) and restricted stock units (RSUs) that ordinarily result in deductions to the company are accounted for as temporary items. Conversely, incentive stock options (ISOs), which provide favorable tax treatment to employees and no deduction to the employer, are treated as permanent items.

Regardless of the award type, excess deductions are recorded as discrete items.

Nonqualified stock options (NQSOs)

In a nonqualified stock option, the company grants an employee the opportunity to purchase a certain number of shares of stock, at the exercise price, after a vesting date. NQSOs are typically subject to a condition of continued employment.

The company calculates the intrinsic value of the options on the grant date using an option-pricing model and records the value as compensation expense over the vesting period with an offsetting credit to APIC.

In anticipation of future deduction, the company recognizes a deferred tax asset related to the compensation expense.

Upon exercise, the company receives a tax deduction equal to the difference between the fair value of the exercised awards and the exercised price of the awards of the exercise date.

The deferred tax asset associated with the exercised option is reversed. Any excess benefit or shortfall is recorded as a discrete benefit or cost in the period in which the NQSO is exercised.

Restricted stock units (RSUs)

In an RSU, the company awards shares of stock to the employee at a future date if the employee satisfies specific vesting requirements, such as continued employment or achievement of performance goals.

For GAAP, the company records the value of the award as of the grant date as compensation expense over the vesting period with an offsetting credit to APIC. The company also recognizes a deferred tax asset related to the compensation expense in anticipation of the future deduction.

Upon vest, the company receives a tax deduction equal to the fair value of the awards.

The company reverses the deferred tax asset associated with the restricted shares upon vest. It records any excess benefit or shortfall as a discrete benefit or cost in the period in which the RSU is exercised.

Incentive stock options (ISOs)

In an ISO, the company grants an employee the option to purchase a certain number of shares of stock, at the exercise price, after a vesting date. ISOs are typically subject to a condition of continued employment. An option must meet certain statutory requirements to be considered an ISO and qualify for preferential treatment.

For GAAP, the company calculates the intrinsic value of the options on the grant date using an option pricing model. It records the value as compensation expense over the vesting period with an offsetting credit to APIC.

Since ISOs do not result in deductions, the company does not record a deferred tax asset. In other words, it treats the compensation expense as a permanent item.

If the employee complies with the requisite holding periods, the company receives no deduction upon exercise.

If the employee does not meet the requisite holding period for preferential treatment (a disqualifying disposition), the company receives a tax deduction equal to the difference between the fair value of the exercised awards and the exercise price of the awards on the exercise date.

The company records any excess benefit or shortfall as a discrete benefit or cost in the period in which the employee exercises the ISO.

Calculate accurate provisions

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How does the section 162(m) deduction limitation interact with ASC 740?

Sec. 162(m) sets a $1 million deduction limitation on compensation paid to the top five employees in a publicly traded company. As a result, the company only records a deferred tax asset if it expects the compensation expense to be deductible.

Since GAAP compensation expense associated with stock awards is expensed over the vesting period in periods prior to exercise (in the case of NQSOs) or restriction lapse (in the case of RSUs), companies must estimate the amount of GAAP compensation that will be subject to Sec. 162(m) each year. They treat the estimated non-deductible amount as a permanent item.

When compensation is expected to be limited by Sec. 162(m), there are three approaches for determining the portion of the non-deductible compensation that relates to stock-based compensation:

  1. Deductible compensation is allocated to cash compensation first. If cash compensation is expected to exceed the limit, the company does not record a deferred tax asset for stock-based compensation.
  2. Deductible compensation is allocated to the earliest compensation recognized for financial statement purposes. Because stock-based compensation is typically expensed over a multiple-year vesting period but deductible when fully vested or exercised, and cash-based compensation is generally deductible when expensed for financial statement purposes, stock-based compensation is generally considered the earliest compensation recognized for financial statement purposes. The company records a deferred tax asset for stock-based compensation up to the deduction limit.
  3. Limitation is allocated pro-rata between stock-based compensation and cash compensation. A partial deferred tax asset may result based on the expected ratio of stock-based compensation to cash compensation.

Learn more: How to calculate the ASC 740 tax provision

Learn the fundamentals of ASC 740, how to calculate the tax provision, and how to make the process easier.

What other tax provision considerations relate to stock-based compensation?

If awards expire un-exercised, the accounting depends on whether the expired awards have been vested. If an unvested award expires, the company reverses the associated compensation cost and writes off the related deferred tax asset as a permanent item to income tax expense. The compensation cost is not reversed for vested awards, but the deferred tax asset is written off to income tax expense.

Valuation allowances

Regardless of subsequent fluctuations in the value of the underlying stock, no subsequent adjustments are made to the total compensation expense associated with a particular award. Furthermore, the existence of underwater options (i.e., options where the exercise price exceeds the fair value) is not negative evidence in considering the need for a valuation allowance. However, if the deferred tax asset is material to the financial statements, it should be disclosed.

Interim reporting

Though the excess benefits are reported as permanent items, they will not be included in calculating the annual effective tax rate. Since excess benefits will be treated as discrete items, as a general rule, this differentiates the treatment of excess benefits from virtually all other permanent items that would typically be reflected in a company’s return for the year. As such, the company should segregate them from the other permanent items as a process matter.

Examples showing how to treat stock-based compensation under ASC 740

Example 1: NQSO Vesting

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with NQSOs in a vesting year and calculates the deferred tax asset associated with the NQSO awards. [10:11]

Example 2: NQSOs Exercised

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with NQSOs in a vesting year and the exercise of a portion of the NQSOs. It also includes the calculation of the deferred tax asset associated with the NQSO awards. [8:32]

Example 3: RSUs Vesting

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with RSUs in a vesting year and calculates the deferred tax asset associated with the RSU awards. [4:24]


Example 4: RSUs Exercised

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with RSUs in a vesting year and the lapse of the restriction/vest of a portion of the RSUs. The example includes the calculation of the deferred tax asset associated with the RSU awards. [8:06]

Example 5: ISOs Vesting

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with ISOs in a vesting year and calculates the permanent item associated with the ISO awards. [4:39]

Example 6: ISOs Exercised

This ASC 740 example includes a single entity with pretax income and temporary items. The example includes an entity with ISOs in a vesting year and the exercise portion of the ISOs. It also shows how to calculate the permanent items associated with the ISO awards. [7:25]

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