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Tax Accounting

Option [Deferred] Tax Benefits



Option tax benefits leave tracks in numerous locations within the shareholders’ equity section, the statement of cash flows, income tax notes, and various sections of the MD&A. A review of these disclosures is required in order to identify option tax benefits and to determine whether they have reduced tax payments and, therefore, increased overall cash flow.

Beyond any nonrecurring character, the inclusion of the option tax benefits in operating cash flows can be challenged. These benefits are associated with the use of options to compensate employees, and this would argue for their classification within operating cash flows. However, both the cash received from the exercise of options as well as associated tax savings are accounted for as additions to shareholders’ equity. This would argue for a financing classification in the statement of cash flows. On balance, in cases where option tax benefits are very material and irregular in amount, we believe that removing the benefits from operating cash flow is appropriate.



Option Tax Benefits and the Profitable Firm

The exercise of nonqualified stock options provides the issuing firm with a tax return deduction equal to the excess of the market value of the shares over the option exercise price. For the profitable firm, or a firm with loss carryback potential, the deduction produces either a tax refund or a reduction in tax payments. The realization of the tax savings takes place within the same period that the options are exercised. In most current cases there will have been no corresponding compensation deduction in the book income statement. The absence of a deduction in the book income statement normally would be seen as giving rise to a permanent difference. Although this is technically the case, the option expense is not treated as a permanent difference when it comes to computing and recording the current tax provision.

Consider a case where nonqualified options are exercised for a total of $100,000 and the associated market value of the acquired shares is $300,000. Assume that the firm has taxable book and tax-return income of $1,000,000 in the absence of the stock option transaction.

Although there is some variability in disclosure practices, the options-related information usually would appear in four areas:

  • There will be an addition to net income in the operating activities section of the statement of cash flows. A common label for this line item is stock option income tax benefits or something comparable. It is essentially a noncash component of the current tax provision, much like a deferred tax provision. This adjustment also ensures that the cash tax benefit from the reduction of taxes payable is part of cash flow from operating activities.
  • The common stock accounts, and in some cases additional paid-in capital, will be increased by the receipt upon exercise of the options. This disclosure will appear in the schedule of changes in shareholders’ equity.
  • Cash inflow from exercise of the options is classified in the financing activities section of the statement of cash flows
  • It is common for the income tax notes to disclose the amount of option tax benefits in text discussion. Disclosure within the MD&A is also provided on occasion.


The addition of the tax benefits to net income, adjusts for the overstatement of the current tax provision that keeps the option tax benefit out of reported earnings. Generally accepted accounting principles require that the recognized tax benefits of exercised options be included in stockholders’ equity. The impact of the option benefits on stockholders’ equity is presented in a disclosure.


Potential Option Reporting Changes on the Horizon

It is important to note that the FASB has an exposure draft of a new standard that, if approved, will have a significant effect on the accounting for stock options. The comment deadline is June 30, 2004. If approved, the standard would become effective for fiscal years beginning after June 15, 2005.

In its current form, the standard will require that compensation expense be recognized in the income statement for stock options. In terms of the statement of cash flows, the principal change will be to alter the classification, in a specific circumstance, of some of the tax cash savings realized by compensation deductions taken in the tax return.

All realized tax benefits derived from compensation expense associated with the exercise of stock options are classified in operating activities. For the most part, the classification of cash tax savings will continue to be in operating activities under the terms of the proposed new standard. However, in the case of excess tax benefits, some of the cash tax savings will be included in financing activities. Excess tax benefits are realized tax savings produced when there is an excess of compensation cost deducted in the employer’s tax return over that recognized in the employer’s book income statement.

If the proposed standard is approved, our position will continue to be that realized tax benefits from stock options used for purposes of compensation are nonrecurring cash benefits. Benefits included in operating activities will be removed in developing adjusted measures of operating cash flow. Excess tax benefits included in financing activities will require no adjustment.


Disclosure of Delayed or Deferred Tax Payments or Receipts [Benefits]

Although they may appear to be the same, the sources of delayed versus deferred tax payments or receipts are quite different. Delayed tax payments or receipts are the simple product of differences between the timing of the recognition and realization of certain tax provisions or benefits. However, deferred tax payments and receipts are the product of temporary differences between book and tax return earnings.


Delayed Tax Payments or Receipts

The most common form of delayed tax payment results from differences between the accrual of current tax provisions or benefits and their payment or receipt. The lag between recording and the subsequent tax payment or receipt often pushes some of the cash movement into a subsequent period. This delay may be more pronounced when firms have taxable units in other countries. Moreover, the typical disclosure of these payments and receipts often makes it difficult to detect the actual cash movement. However, for most large U.S. firms, without significant foreign operations, installment payments of expected taxes during the year should result in only a limited delay of payments or receipts.

The concern about material delayed tax payments or receipts is that they might create a significant spread between reported and sustainable cash flow produced in a given period. American Greetings Company presents just such a possibility. American Greetings disclosed a $144 million tax charge in fiscal 2001. The charge was related to a contested income tax issue. This charge to the income statement was offset by an increase in taxes payable. However, substantial payment on this obligation was not made until fiscal 2003. American Greetings noted that a $106 million decrease in accounts payable and other liabilities, including income taxes payable, in fiscal 2003 was “primarily to settle the disputed income tax liability associated with the Corporation’s company owned life insurance (COLI) program”.


Deferred Tax Payments or Receipts: Short-term Deferrals

Nonrecurring deferred tax payments or receipts can result from reversals of temporary differences over relatively short periods of time. For example: a firm might have a deferred tax liability for the deferral of tax payments from a gain that was recognized fully on the books but accounted for as an installment sale in the tax return. All payments could be received as soon as the next year, resulting in a full reversal of the original deferred tax liability. For example: Gilman & Ciocia, Inc. recorded a $140,000 deferred tax liability on an installment sale in 2001 that was fully reversed by the end of 2002. Both the gain and the associated tax payment should be considered nonrecurring.

Detection of these and other potentially nonrecurring deferred tax transactions requires a careful review of the schedule of deferred tax assets and liabilities. In the current case, the focus should be on identifying line items for deferred tax liabilities associated with gains on installment sales. The installment gains are recognized in their entirety on the books in the year of the sale. Moreover, a deferred tax provision and offsetting deferred tax liability are recognized. Subsequently, in a reversal of the temporary difference, the deferred tax liability is drawn down as the installments are collected and the gains are now included in the tax return. In the absence of offsetting deductions in the tax return or loss carryforwards, these reversals of taxable temporary differences increase tax cash payments.

Both the gains on property sold as well as the associated tax payments are nonrecurring. The cash collected on the sale is properly classified in cash flows from investing activities. Under GAAP, the tax payments must be classified in operations. However, these cash payments should be removed from operating cash flows for the purpose of assessing sustainable cash flows from operations.


Deferred Tax Payments or Receipts: Longer-term Deferrals

Longer-term deferrals of tax cash payments or receipts also have the potential to affect the sustainability of operating cash flows. The deferral of tax payments associated with depreciation temporary differences has received considerable attention for almost half a century. For capital- intensive firms that are both growing and profitable, a cumulative excess of tax over book depreciation can create very large deferred tax liabilities that may grow for decades.

Banks and other financial firms that provide substantial lease financing also accumulate very large deferred tax liabilities. For example: General Electric disclosed net deferred tax liabilities of about $13 billion dollars at December 31, 2003. Leasing transactions were the largest contributor to its net deferred-tax-liability position. Verizon Communications, Inc., reported about $20 billion of net deferred tax liabilities at December 31, 2003. Depreciation and leasing temporary differences contributed about $13 billion to the net deferred-tax-liability balance of Verizon Communications.


Repayment of Deferred Tax Liabilities

Although the deferral of tax payments is a clear benefit to operating cash flow, analysts should be conscious of the deferred prefix to these liabilities. A decline in capital expenditures or a reduction in lease-financing activities would eventually result in a reversal of both depreciation and leasing temporary differences. This results in turn in a rise in tax return income in relationship to book income. The deferred tax liability will be paid down as total tax payments exceed the book tax provision for the year.

The underlying transactions in these cases had terms of less than five years. However, the transaction terms underlying the depreciation and lease-related temporary differences of General Electric and Verizon Communications are no doubt longer. This means that the reversal of the temporary differences and payment of the deferred tax liabilities would be spread out over a longer period of time. The payment of depreciation-related deferred tax liabilities will generally have the least effect on the sustainability of operating cash flow because the reversals of the temporary differences and payment of the deferred tax liabilities will normally extend over many years.

The useful lives of the depreciable assets of heavy industrial firms are usually quite long. However, the depreciable lives of assets used by various technology-related firms often are relatively short. The dynamic and volatile nature of technology firms also may cause greater fluctuations in their capital expenditures. Both of these factors mean that special attention should be paid to analyzing the sources of deferred tax liabilities in the case of technology or related firms. The short useful lives of their depreciable assets plus the sometimes-volatile nature of their capital expenditures increase the likelihood of sharp reversals of temporary differences and a rapid repayment of deferred tax liabilities.


Tax Law Initiatives and the Repayment of Deferred Tax Liabilities

Financial analysts have shown a growing interest in the potential for substantial reductions in the capacity of some firms to maintain or grow their depreciation-related deferred tax liabilities. Special attention has been focused on the effects of tax law changes that provided for further acceleration of tax-return depreciation.

Important depreciation-related changes are found in two tax acts: the Job Creation and Worker Assistance Act of 2002 (2002 Tax Act) and the Jobs Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act). The 2002 Tax Act allows firms to take 30 percent bonus depreciation for certain assets acquired after September 10, 2001, but before September 11, 2004. That is, 30 percent of the cost of eligible assets could be written off as depreciation in the year of acquisition. In addition, depreciation also can be recorded in the year of acquisition on the remaining cost, that is, the 70 percent of the original cost.

Property that qualifies must be Modified Accelerated Cost Recovery System property with a class life of 20 years or less. Real estate generally does not qualify for bonus depreciation.

The 2003 Tax Act added a further depreciation bonus on top of the 30 percent provided by the 2002 Tax Act. The 2003 Tax Act increases the bonus to 50 percent of the asset’s cost. The 50 percent bonus applies to qualifying assets purchased after May 2003 but before June 1, 2005.

The dramatic acceleration of depreciation made possible by the two acts will either expand the current depreciation temporary differences of a firm or create new depreciation temporary differences. In some cases net operating losses may be created. The limited extension of the NOL carryback to five years, which is also a feature of the 2002 Tax Act, may make it possible to receive tax refunds from such depreciation-produced losses.

A corollary of the accelerated depreciation of the cost of acquired assets is reduced depreciation in future periods. In the absence of growth in qualified asset additions, tax return depreciation may fall below book levels after 2005 when the bonus depreciation expires. This temporary-difference reversal will result in a decline of the depreciation-related deferred tax liability and an increase in tax cash outflows. The tax mix will move from reduced current and increased deferred provisions to increased current and reduced deferred tax provisions.

Some recent attention has focused on the telecommunications services industry. It has been noted that “the Bells have been fortunate that tax law changes have allowed deferred taxes to increase despite declining capex (capital expenditures)”. However, going forward, especially beyond 2005, declining capital expenditures will no doubt result in the reversal of some of the multibillion-dollar deferred tax liabilities of these companies.

Even if capital spending were maintained and did not decline, the phase-out of bonus depreciation probably would cause some reversals of the depreciation temporary differences and a paydown of deferred tax liabilities.

The point to be made is that current levels of operating cash flow may not be sustainable because of a heavy reliance in some cases on the bonus depreciation of the Tax Acts of 2002 and 2003. The detection of these possibilities would call for the examination of a firm’s schedule of deferred tax assets and liabilities. Special attention should be given to schedules of deferred tax assets and liabilities that are dominated by depreciation-related deferred tax liabilities. Then attention should be given to recent and prospective spending on depreciable assets. Operating cash flow may be under threat in the case of firms that currently have flat capital expenditures and prospects for future declines in capital spending.


Deferred Tax Assets and Future Cash Flows

Attention historically has centered on deferred tax liabilities and the associated deferral of cash tax payments. However, many firms now have overall deferred tax asset positions because of other tax law changes, changes in GAAP, and the economic conditions of the past decade. The Tax Reform Act of 1986 introduced a number of changes that created new deferred tax assets. Some of the key changes introduced:

  • Dramatically reduced the deferral of profits by substantially reducing the availability of the installment method of accounting
  • Reduced the availability of the completed-contract method of reporting earnings
  • Increased the range of costs that had to be capitalized for tax purposes
  • Substantially reduced the ability to use the reserve method of accounting for bad debts


Each of these changes initially reduces book income in relationship to tax return income. This is because either revenues or gains are recognized sooner or expenses and losses are deducted later in the tax return versus the books.

In addition to these tax law changes, difficult times created substantial NOL carryforwards. Generally accepted accounting principles require that deferred tax assets be recorded for all NOL and tax credit carryforwards. Other FASB statements also accelerated expense recognition on the books versus the tax return, for example, SFAS No. 106, “Employers’Accounting for Postretirement Benefits other than Pensions,” and SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.”

Unlike a firm with a net deferred tax liability position, operating cash flow is bolstered by the reversal of temporary differences that produced deferred tax assets. For example: the reversal of temporary differences underlying the “reserves not currently deductible” in the exhibit will increase expenses that are deductible in the tax return. These increased expenses will in turn reduce taxable income and cash tax payments. If a loss is created by the increased expenses, then a tax benefit can be derived by either a carryback or carryforward of the loss.

In summary, a firm that is in a net deferred tax liability position has a potential future threat to operating cash flows if the underlying temporary differences reverse. Alternatively, the reversal of the temporary differences underlying deferred tax assets produces cash tax savings. These conditions are both a further source of nonrecurring tax cash flows.

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