Recoverability of Equity-Based Compensation Deferred Tax Assets

As the stock market slides, more stock options and related deferred compensation instruments are underwater, and the related deferred tax assets may no longer be recoverable, according to an article in the Journal of Accountancy.

In addition to recognizing an expense for equity compensation awards, companies also recognize the tax benefit they reap from awards. They receive tax deductions for amounts that employees must recognize as ordinary income. For equity compensation awards that are not tax-qualified-meaning for everything except ISOs and Section 423 ESPPs-companies estimate ultimate tax deduction based on the accounting expense recognized for the arrangement under FAS 123(R) and, as the arrangement vests, record tax savings based on this estimate, reducing their reported tax expense during that period.

If, at the time of exercise, the company's actual deduction is bigger than the original estimated amount, the company records the difference (called a "windfall") on its balance sheet as additional paid-in capital. Any windfall amounts are used as credits to cushion any subsequent shortfalls by forming a "pool." However, this pool can never fall below zero.

If the company's actual tax deduction is less than the amount it originally estimated, as it most likely is for many companies whose options are now underwater, it will incur a shortfall for the difference. If the company does not have sufficient amounts in the pool to offset the shortfall, then the difference between the estimate and the actual tax deduction is recorded as additional tax expense on the company's income statement.

The journal article points out that the balance sheets and tax footnotes of many entities highlight the magnitude of these equity-based compensation deferred tax assets and encourages companies to monitor their plans quarterly for events that trigger the fixing of the corporate tax deduction and affect the recoverability of the related tax asset. When and how they are written off, the article says, could have a significant impact on the income statement. The article is available at this link.