Chapter 9. Expense Recognition:

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1 Chapter 9: xpense Recognition: Taxes and Options 1 Chapter 9 xpense Recognition: Income Taxes and Stock Options TABL OF CONTNTS Overview 3 Income Taxes 3 Assumptions Common to All Three xamples 5 xample 1 5 Tax Computations for xample 1 6 Record Keeping for xample 1 9 xample 2 9 Tax Computations for xample 2 10 Record Keeping for xample 2 12 xample 3 12 Tax Computations for xample 3 13 Record Keeping for xample 3 15 Key Take Aways From Tax xamples 15 xercise xercise xercise xercise xercise xercise

2 2 Navigating Accounting Stock Options 26 Tax Consequences of Stock Options 27 xample Assumptions 28 Tax Consequences xample 28 ntries During Vesting Period 29 ntries At xercise Date 30 ntries Associated with Options not xercised 32 Income-Statement ntry ffects 32 Balance-Sheet ntry ffects 33 Cash-Flow Statement ntry ffects 33 Additional Stock Option Disclosures 36 xercise xercise xercise

3 Chapter 9: xpense Recognition: Taxes and Options 3 OVRVIW This chapter provides an in-depth look at two topics often disclosed as critical accounting estimates by companies: income taxes and stockbased compensation, in particular stock options. By taking a closer look at these topics, you will gain an insight into the regulatory environment that influenced the related standards, the judgments behind these disclosures, and an appreciation for the complexity behind the reported numbers. This will enable you to better interpret disclosures and thus the company s overall performance. INCOM TAXS By now, you likely already know that companies generally report deferred tax assets and liabilities on their balance sheets and the tax expense reported on income statements has current and deferred components. What you may not know is tax footnotes present a good deal of information about these balance-sheet and income-statement items and the format of these footnotes is very consistent across companies. By the end of this section, you should know how to use information in these footnotes to reverse engineer tax entries, to identify places where the accounting rules for financial and tax reporting differ significantly, and, in some situations, to quantify these differences. One of the things you are going to learn is deferred tax assets reported on balance sheets aggregate information about several deferred tax assets reported in income tax footnote. Similarly, deferred tax liabilities reported on balance sheets aggregate information about several deferred tax liabilities in the income tax footnote. Companies compute each of these deferred tax assets and liabilities separately and once you understand how one deferred tax asset is computed and what it represents in terms of differences between financial and tax reporting, you will have a real good start at understanding how other deferred tax assets are derived and what they represent. Similarly, once you know how one deferred tax liability is derived and what it represents, you will find it relatively easy to interpret others. You are also going to learn the deferred provision of the tax expense is based on the changes in deferred tax assets and liabilities during the period. Actually, for smaller companies (not reporting other comprehensive income or foreign currencies), the deferred provision is the increase in the net deferred tax liabilities (deferred tax liabilities deferred tax assets). So, if you understand the computations behind deferred tax assets and liabilities and what they represent in terms of

4 4 Navigating Accounting differences between financial and tax reporting, you should find it relatively straightforward to understand deferred provisions. Current provisions are much more intuitive: they are similar to taxes you likely report on your own tax forms. The section presents three examples that will help you gradually learn the concepts you need to understand to analyze tax disclosures in footnotes and financial statements. The three examples are based on three merchandising companies: In the first example, Company 1 has a deferred tax liability because it depreciates a computer more quickly for tax reporting than for financial reporting. This is the only deferred tax liability it has and it has no deferred tax assets. This example will prepare you to analyze deferred tax liabilities reported in footnotes. It will also help you begin to understand the entries that record the current and deferred tax provisions and how the numbers behind them are computed. Finally, it will help you understand how tax payments generally differ from current provisions. In contrast to the other two companies we will study, Company 1 does not offer warranties to its customers (which are associated with a deferred tax asset) and its deferred tax provision is related to changes in the deferred tax liability associated with depreciation only. In the second example, Company 2 rents its computer and thus does not have depreciation for financial or tax reporting. However, Company 2 has a deferred tax asset because it recognizes a warranty expense for financial reporting before the government allows a related tax deduction. For financial reporting, companies typically recognize expenses for estimated future warranty claims related to current period sales. However, for tax reporting, companies can not deduct warranty costs until claims are satisfied. All of Company 2 s deferred tax provision is related to changes in this deferred tax asset. The computations associated with its current provision and tax payments are conceptually the same as Company 1 s entries but the numbers differ slightly. In the third example, Company 3 buys a computer and offers a warranty. As a result, (1) it has a deferred tax liability related to depreciation and a deferred tax asset related to warranties, and (2) the deferred provision is partly related to a change in the deferred tax asset and partly related to a change in a deferred tax liability. The deferred tax assets and liabilities are the same as those in the first two examples, so the central lesson in xample 3 is seeing how these assets and liabilities jointly affect the deferred provision. Thus,

5 Chapter 9: xpense Recognition: Taxes and Options 5 this example begins to approximate actual companies tax entries by including both deferred tax assets and liabilities. These three examples illustrate several important lessons about income taxes summarized in the Key Take-Aways section. Assumptions Common to All Three xamples The tax rate is 40% for all years 80% of the current provision is paid in the current year, and the remainder in the next year The table reports income items that are the same for financial and tax reporting: Common Assumptions: Buys and depreciates computer, but no warranty Financial Reporting Tax Reporting Financial less tax Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Revenues $2,000 $4,000 $2,000 $4,000 $0 $0 Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0 Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0 SG&A Other ($200) ($400) ($200) ($400) $0 $0 All of the tables in this chapter are in the following xcel file: Taxx.xls xample 1 Here are additional assumptions for Company 1: Company 1 buys a computer at the start of year 1 for $900. As indicated in the table on the top of the next page, the computer is completely depreciated for tax reporting in year 1. By contrast, for financial reporting the company uses the matching principle so that the depreciation expense matches the revenues over two years. For example, 1/3 of the cost is depreciated in year 1 because 1/3 of the total $6,000 revenues are generated in year 1. Company 1 does not offer a warranty to customers since the original manufacturer provides a warranty.

6 6 Navigating Accounting The following table summarizes income items for financial and tax reporting and their differences. Note, depreciation is the only item with a timing difference: Company 1: Buys and depreciates computer, but no warranty Financial Reporting Tax Reporting Financial less tax Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Revenues $2,000 $4,000 $2,000 $4,000 $0 $0 Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0 Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0 SG&A Depreciation ($300) ($600) ($900) $0 $600 ($600) No Warranty $0 $0 $0 $0 $0 $0 Other ($200) ($400) ($200) ($400) $0 $0 Total ($500) ($1,000) ($1,100) ($400) $600 ($600) Pretax Income $700 $1,400 $100 $2,000 $600 ($600) Tax Computations for xample 1 The following tables illustrate: (1) how the current provision is computed each year the current period s tax rate multiplied by income on the tax form, and (2) the tax payments, which are, by assumption, 80% of the current provision for the current year and 20% of the previous year s current provision. You can learn more about these computations by studying the formulas in the Taxx xcel file. Use the numbers to the left of the table to find the related cells in the TaxComp1 worksheet. Current provision computations Year 1 Year 2 4 Pretax income on tax form $100 $2,000 5 Current provision $40 $800 Tax payment computations Year 1 Year 2 6 Related to this year's current provision $32 $640 7 Related to last year's current provision $0 $8 8 Total paid $32 $648

7 Chapter 9: xpense Recognition: Taxes and Options 7 These tables illustrate that Company 1 will record $40 of taxes on its tax forms for year 1, and $800 for year 2. If Company 1 did not include a deferred provision in its tax expense, it s tax expense would not be matched with pretax income for financial reporting. As indicated in the earlier table, the $1,400 of pretax income recognized for financial reporting in the second year is twice the $700 recognized in the first year. Thus, the matching principle suggests the tax expense in the second year should be twice as large (since the tax rate is constant). The next table illustrates how the deferred provision is computed using the income-statement approach: Deferred provision computations using the income approach Year 1 Year 2 9 Financial reporting depreciation expense $300 $ Tax reporting depreciation deduction $900 $0 11 xcess of tax deduction over financial expense $600 ($600) 12 Deferred provision related to depreciation $240 ($240) Once the current and deferred provisions are computed, you can add them together to get the tax expense: Tax expense computations using the income approach Year 1 Year 2 13 Current provision $40 $ Deferred provision $240 ($240) 15 Tax expense $280 $560 Next, we will compute the deferred provision using the balancesheet approach. This approach is required under GAAP and generally yields the same answer as the income approach discussed above when statutory tax rates are not scheduled to change. Statutory rates are the ones set by the government before consideration for special credits and deductions. The income approach focuses on differences in income for financial and tax reporting. For example, differences in income caused by differences in depreciation for a reporting period. By contrast, the balance-sheet approach focuses on differences in the balance sheets for financial and tax reporting. For example, caused by differences between the book value of net PP& for financial and tax reporting. For tax reporting, the book value of an asset or liability is called its tax basis.

8 8 Navigating Accounting Here is how the two methods compute the deferred tax provision related to PP&: The income approach determines the deferred provision by multiplying the current year s statutory tax rate times the difference in depreciation for the year (financial versus tax). The balance-sheet approach determines the provision in three steps: 1. Determine the deferred tax liability related to net PP& at the end of the prior year by multiplying the prior year s statutory tax rate times the difference between the book value of the net PP& for financial reporting and the tax basis of PP&. 2. Determine the deferred tax liability related to net PP& at the end of the current year by multiplying the current year s statutory tax rate times the difference between the book value of the net PP& for financial reporting and the tax basis of PP&. 3. The deferred provision related to PP& is the increase in the deferred tax liability during the year (the number computed in step 2 less the one computed in step 1). The next table illustrates how to compute the deferred provision for Company 1 using the balance-sheet approach. Deferred provision computations using the balance sheet approach Year 1 Year 2 Financial reporting of net PP& 16 Beginning balance $0 $ New PP& $900 $0 18 Depreciation ($300) ($600) 19 nding balance (book value) $600 $0 Tax reporting of net PP& 20 Beginning balance $0 $0 21 New PP& $900 $0 22 Depreciation ($900) $0 23 nding balance (tax basis) $0 $0 Deferred taxes 24 Book value in excess of tax basis $600 $0 25 Deferred tax liability $240 $0 26 Def Provision: Increase (decrease) in Dtax liability $240 ($240)

9 Chapter 9: xpense Recognition: Taxes and Options 9 The deferred tax liability related to PP& at the end of year 1 represents additional taxes expected to be paid in year 2 (because depreciation deductions were used in year 1 for tax purposes). We have already seen how large the current provision is in year 2, relative to year 1, because depreciation was accelerated. Record Keeping for xample 1 The balance-sheet equation model shows the tax entries for years 1 and 2. Here are some key observations for both years 1 and 2: The tax expense equation holds: Tax expense = current provision + deferred provision Recording the current provision increases the tax expense and increases taxes payable (because it is owed to the government). Recording the deferred provision increases the tax expense when the deferred provision is positive and decreases the tax expense when the deferred provision is negative. There is an offsetting increase or decrease in the deferred tax liability to keep the balance-sheet equation balanced. Assets = Liabilities + Own q + C = + TaxPay + DefTaxL - Tax exp Beg bal year = Record tax expense + = Pay taxes = Other events + not relev = close to IS nd bal year 1 + not relev = = Beg bal year 2 + not rel = Record tax expense + = Pay taxes = Other events + not rel = close to IS nd bal year 2 + not rel = xample 2 Here are some additional assumptions for Company 2: Company 2 rents a computer and offers a warranty to customers for products purchased during year 1. The products sold during the second year are warranted by the original manufacturer. None of the products sold in year 1 will fail until year 2. The company expects that the cost to honor these warranty claims in year 2 will be 10% of the first-year revenues.

10 10 Navigating Accounting The following table summarizes the income items for financial and tax reporting. Notice that warranty is the only income item that differs. For tax purposes, the company does not get a deduction until year 2, when the costs are incurred. For financial reporting, Company 2 recognizes a warranty expense with an offsetting entry to an accrued warranty liability. This liability is not recognized in the tax records (and thus has zero tax basis). Company 2: Rents computer and offers warranty in year 1 Financial Tax Reporting Financial less tax Reporting Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Revenues $2,000 $4,000 $2,000 $4,000 $0 $0 Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0 Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0 SG&A Computer rent ($450) ($450) ($450) ($450) $0 $0 Warranty ($200) $0 $0 ($200) ($200) $200 Other ($200) ($400) ($200) ($400) $0 $0 Total ($850) ($850) ($650) ($1,050) ($200) $200 Pretax Income $350 $1,550 $550 $1,350 ($200) $200 Tax Computations for xample 2 The tables at the top of the next page are similar to those for xample 1 (and are located in the TaxComp2 sheet of Taxx.xls). xcept here, a deferred tax asset is recognized at the end of year 1, signifying the benefits the company will receive when it deducts the warranty claims in year 2.

11 Chapter 9: xpense Recognition: Taxes and Options 11 Current provision computations Year 1 Year 2 4 Pretax income on tax form $550 $1,350 5 Current provision $220 $540 Tax payment computations Year 1 Year 2 6 Related to this year's current provision $176 $432 7 Related to last year's current provision $0 $44 8 Total paid $176 $476 Deferred provision computations using the income approach Year 1 Year 2 9 Financial reporting warranty expense $200 $0 10 Tax reporting warranty deduction $0 $ xcess of financial expense over tax deduction $200 ($200) 12 Deferred provision related to warranty ($80) $80 Tax expense computations using the income approach Year 1 Year 2 13 Current provision $220 $ Deferred provision ($80) $80 15 Tax expense $140 $620 Note, the current provision is larger in year 1 than it would otherwise be if the government allowed Company 2 to deduct the warranty claims when they are anticipated. As we shall see, this increased current provision increases taxes payable, and this increase is offset by a deferred tax asset. These offsetting effects will be discussed more in the Take-Aways section. For now simply note they exist. The table at the top of the next page illustrates the balance-sheet approach followed by U.S. GAAP. Because Company 2 recognizes an accrued warranty for financial reporting, but not for tax reporting, it creates a deferred tax asset. This deferred tax asset represents the tax future benefit of the deductions the company will receive in year 2 when it reduces the accrued warranty liability (and honors the warranty claims).

12 12 Navigating Accounting Deferred provision computations using the balance sheet approach Year 1 Year 2 Financial reporting accrued warranty liability 16 Beginning balance $0 $ Update estimate of future claims $200 $0 18 Pay claims $0 ($200) 19 nding balance (book value) $200 $0 20 No related tax laibility Deferred taxes 21 Book value of warranty liability in excess of tax basis $200 $0 22 Deferred tax asset $80 $0 23 Def Provision: (Increase) decrease in Dtax asset ($80) $80 Record Keeping for xample 2 Here are the tax entries of years 1 and 2: Assets = Liabilities + Own q + C + DefTaxA = + TaxPay - Tax exp Beg bal year = Record tax expense = Pay taxes = Other events + not relev + = + - close to IS nd bal year 1 + not relev = = + - Beg bal year 2 + not rel = Record tax expense = Pay taxes = Other events + not rel + = + - close to IS nd bal year 2 + not rel = xample 3 Here are some additional assumptions for Company 3: Company 3 buys the same computer as Company 1 and depreciates it the same way as company 1 for tax and financial reporting. Similarly, it has the same warranty events as Company 2. The table at the top of the next page summarizes its pretax income for financial and tax reporting:

13 Chapter 9: xpense Recognition: Taxes and Options 13 Company 3: Buys computer and offers warranty in year 1 Financial Reporting Tax Reporting Financial less tax Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Revenues $2,000 $4,000 $2,000 $4,000 $0 $0 Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0 Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0 SG&A Depreciation ($300) ($600) ($900) $0 $600 ($600) Warranty ($200) $0 $0 ($200) ($200) $200 Other ($200) ($400) ($200) ($400) $0 $0 Total ($700) ($1,000) ($1,100) ($600) $400 ($400) Pretax Income $500 $1,400 $100 $1,800 $400 ($400) Tax Computations for xample 3 The tax computations in the tables below and on the next two pages are a combination of those for the two previous examples. The important observation is that the deferred provision is: (1) the decrease (increase) in the deferred tax asset associated with warranties plus (2) the increase (decrease) in the deferred tax liability associated with depreciation. Current provision computations Year 1 Year 2 4 Pretax income on tax form $100 $1,800 5 Current provision $40 $720 Tax payment computations Year 1 Year 2 6 Related to this year's current provision $32 $576 7 Related to last year's current provision $0 $8 8 Total paid $32 $584

14 14 Navigating Accounting Deferred provision computations using the income approach PP& Year 1 Year 2 9 Financial reporting depreciation expense $300 $ Tax reporting depreciation deduction $900 $0 11 xcess of tax deduction over financial expense $600 ($600) 12 Deferred provision related to depreciation $240 ($240) Warranties Year 1 Year 2 13 Financial reporting warranty expense $200 $0 14 Tax reporting warranty deduction $0 $ xcess of financial expense over tax deduction $200 ($200) 16 Deferred provision related to warranty ($80) $80 Total deferred provision 17 Deferred provision related to depreciation $240 ($240) 18 Deferred provision related to warranty ($80) $80 19 Total deferred provision $160 ($160) Deferred provision computations using the balance sheet approach Financial reporting of net PP& 23 Beginning balance $0 $ New PP& $900 $0 25 Depreciation ($300) ($600) 26 nding balance (book value) $600 $0 Tax reporting of net PP& 27 Beginning balance $0 $0 28 New PP& $900 $0 29 Depreciation ($900) $0 30 nding balance (tax basis) $0 $0 Deferred taxes related to PP& 31 Book value in excess of tax basis $600 $0 32 Deferred tax liability $240 $0 33 Def Provision: Increase (decrease) in Dtax liability $240 ($240) Year 1 Year 2 Financial reporting accrued warranty liability 34 Beginning balance $0 $ Update estimate of future claims $200 $0 36 Pay claims $0 ($200) 37 nding balance (book value) $200 $0 38 No related tax laibility Deferred taxes 39 Book value of warranty liability in excess of tax basis $200 $0 40 Deferred tax asset $80 $0 41 Def Provision: (Increase) decrease in Dtax asset ($80) $80

15 Chapter 9: xpense Recognition: Taxes and Options 15 Tax expense computations using the income approach Year 1 Year 2 20 Current provision $40 $ Deferred provision $160 ($160) 22 Tax expense $200 $560 Record Keeping for xample 3 Here are the entries for Company 3: Assets = Liabilities + Own q + C + DefTaxA = + TaxPay + DefTaxL - Tax exp Beg bal year = Record tax expense = Pay taxes = Other events + not relev + = close to IS nd bal year 1 + not relev = = Beg bal year 2 + not rel = Record tax expense = Pay taxes = Other events + not rel + = close to IS nd bal year 2 not rel + 0 = Key Take Aways From Tax xamples Here are some general points demonstrated by these examples reinforced by other examples and exercises throughout the chapter. When an asset or a liability has a different value for financial and tax reporting, the asset or liability will give rise to either a deferred tax asset or a deferred liability in the year the difference between financial and tax reporting originates. ach such asset or liability gives rise to a separate deferred tax asset or liability. This is illustrated in Intel s tax footnote, which reports separate deferred tax assets and liabilities for several items (see the table on page 74, Intel s 2006 Annual Report). If an asset (such as PP&) is smaller in the originating year for tax reporting, or a liability is larger, it generally means: (1) expense associated with the asset or liability in the originating year (such as depreciation expense associated with PP&) is less for financial reporting than for tax reporting, (2) a deferred tax liability is created for this asset or liability in the originating year, (3) this deferred tax liability is derived by multiplying the tax rate by the amount by which the

16 16 Navigating Accounting financial reporting asset exceeds the tax reporting asset, or by the amount that the tax reporting liability exceeds the financial reporting liability. This deferred tax liability represents additional taxes that will be paid in the future (if the company remains profitable) because deductions that would otherwise have reduced future taxable income were accelerated to the current period and thus will no longer be available in the future, resulting in higher future taxable income and corresponding higher taxes. This deferred tax liability will continue to increase in the future so long as the gap between the asset s or liability s financial and tax reporting values continues to widen. However, at some point this gap will begin to close and the deferred tax liability will begin to decrease. When the deferred tax liability is decreasing, we say it is reversing. Ignoring the effects of all other items, increases in this deferred tax liability in the originating year or subsequent years increase the deferred provisions in those years. Similarly, ignoring the effects of all other items, decreases in this deferred tax liability in future years (when it is reversing) decrease the deferred provisions in those years. By contrast, if an asset is larger in the originating year for tax reporting, or a liability (such as a warranty liability) is smaller, it generally means: (1) expense associated with the asset or liability in the originating year (such as accrued warranty expense) is larger for financial reporting than for tax reporting, (2) a deferred tax asset is created for this asset or liability in the originating year, (3) this deferred tax asset is derived by multiplying the tax rate by the amount by which the financial reporting asset is less than the tax reporting asset, or by the amount that the tax reporting liability is less than the financial reporting liability. This deferred tax asset represents taxes that will not be paid in the future (if the company remains profitable) because deductions that would otherwise have reduced current taxable income are postponed to the future and thus will be available in the future, resulting in lower future taxable income and corresponding lower taxes. This deferred tax asset will continue to increase after the originating year so long as the gap between the asset s or liability s financial and tax reporting values continues to widen. However, at some point the gap will begin to close and the deferred tax asset will begin to decrease (reverse).

17 Chapter 9: xpense Recognition: Taxes and Options 17 Ignoring the effects of all other items, increases in this deferred tax asset in the originating year or subsequent years decrease the deferred provision in those years. Similarly, ignoring the effects of all other items, decreases in this deferred tax asset in future years increase the deferred provision in those years. When do companies like to recognize liabilities? Companies like to recognize deferred tax liabilities. These are usually good news for tax departments. They typically occur when tax departments determine clever, but legal, ways to defer taxes or governments offer tax deferrals to promote economic development, spark the economy, or promote some other public interest. Consider the deferred tax liability associated with the depreciation in xample 1. The current provision is smaller in year 1 for Company 1 because the tax rules allow accelerated depreciation. In this case, the increase in the deferred tax liability is related to a smaller current provision in year 1, and thus in a decrease in taxes payable. Importantly, the amounts recorded to taxes payable and the deferred tax liability are the same, but the present values differ in Company 1 s favor. The tax savings from accelerated deduction (reflected in a smaller current provision) are realized in year 1, whereas additional taxes related to the deferred tax liability are not paid until year 2. Accounting fails to capture the economic benefits of tax deferral. One liability increases and the other decreases by the same amount. From an accounting perspective, there is no change in shareholders equity. The total tax expense is not affected by the tax break that gives rise to the deferred taxes, but the components of the tax expense are affected. The deferred provision increases because of the increase in the deferred tax liability and the current provision decreases because of the current-period s tax break. Thus, GAAP fails to recognize the economic benefit of tax deferral by not recognizing the difference in the present values of the decrease in taxes payable and increase in the deferred tax liability. If GAAP did recognize these present values, the present value of the increase in the deferred tax liability would be smaller than the present value of the decrease in taxes payable and the difference would be recognized as an increase in owners equity. This is reason that managers who can see through this GAAP imperfection like deferred tax liabilities. When do companies prefer not to recognize assets? Companies do not like to recognize deferred tax assets that are implicitly offset by increases in taxes payable. These situations are generally bad news

18 18 Navigating Accounting for tax departments. They usually occur when governments restrict tax departments from deducting economic costs or force them to recognize revenues when there is still too much uncertainty to recognize them for financial reporting. For example, companies are not permitted to deduct projected medical obligations for retired employees that are expensed for financial reporting when employees earn the right to claim these future benefits. Similarly, as we just saw, they are not permitted to deduct warrant costs until they are paid, even when they can be predicted reliably. Company 2 would prefer to deduct the warranty claims in year 1 for tax purposes. The current provision is larger in year 1 because Company 2 could not deduct the warranty claims in year 1. Thus, the tax rule prohibiting companies from deducting anticipated warranty costs gives rise to a deferred tax asset, which is offset by an increase in taxes payable (because the current provision is larger than it would be if companies could deduct the anticipated claims). However, similar to above, there is a significant economic difference between the increase in the deferred tax asset and the increase in taxes payable. They are both recorded at the same dollar value. However, a significant portion of taxes payable must be paid in year 1, whereas the tax savings associated with the asset will not be received until the future. Thus, while accountants record the same amount for the asset and liability, the present values of these items differs. This is the reason managers who can see through this GAAP imperfection would prefer not to have deferred tax assets.

19 Chapter 9: xpense Recognition: Taxes and Options 19 Search Icon This exercise requires you to search for information. xercise 9.01 Part 1 Use Intel s 2006 Annual Report. Complete the tax equations in the table below for Intel. Intel 2006 Tax expense = Current provision + Deferred provision Federal = + Computation Icon This exercise helps you learn how to compute financial measures. State = + Non-US = + Other = + Total = + Part 2 (a) Locate or estimate how much income taxes Intel paid during Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders. (b) Locate or estimate how much income taxes Gap paid during fiscal 2002 (Search Gap s 2002 Annual Report, Gap_AR_02.pdf) Hint: Companies are required to disclose income taxes payments if they are material. Typically, they do so at the bottom of the statement of cash flows, in a supplementary cash flow footnote, or in the tax footnote. Part 3 The following parts refer to the deferred taxes table on page 74 of Intel s 2006 Annual Report. Companies are required to report this table when their deferred tax assets and liabilities are material. (a) How do the entries in this tax table relate to specific line items in the financial statements? (b) Determine the 2006 changes in the following three accounts: (1) deferred tax assets; (2) deferred tax liabilities; and (3) net deferred tax assets (liability).

20 20 Navigating Accounting Part 1 asked you to determine Intel s 2006 deferred tax provision (related to net income reported on the income statement). The deferred provision is related to the change in net deferred tax assets and liabilities: The change in net deferred taxes during a year is the deferred provision for comprehensive income, which has two components: (1) the deferred provision associated with net income reported on the income statement (commonly abbreviated as the deferred provision when it is clear that it pertains to the income statement), and (2) the deferred provision associated with other comprehensive income. (c) How much of the 2006 change in the net deferred taxes is explained by the deferred tax provision associated with net income? (d) What events and circumstances related to other comprehensive income likely affected Intel s deferred tax accounts during 2006? (e) Do the deferred taxes associated with net income (part (c) above) and other comprehensive income (part (d) above) fully explain the change in net deferred taxes? If not, what are other material events or circumstances that likely explain the change? (f) What amount did Intel recognize at year-end 2006 for deferred tax liabilities related to depreciation? (g) True or False: The liability you identified in (f) represents the difference between the $17,602 of net PP& reported on the balance sheet and these assets tax basis. (h) Assuming a 35% tax rate, estimate the tax basis of Intel s net PP& at the end of 2006.

21 Cash change nt Assets cash +other assets = Owners' quity Operating Cash = Liabilities + Owners' quities liabilities + permanent O+ temporary O Zero Zero Gains & Losses Chapter 9: xpense Recognition: Taxes and Options 21 Search Icon This exercise requires you to search for information. xercise 9.02 This exercise pertains to tax-related questions on the 2007 final exam, which was based on a supplement from Motorola s fiscal 2006 annual report. Motorola s 2006 fiscal year ends December 31, Required Answer final exam 2007 questions 3a, 3f, 3j, 3l, and 4c. Be sure to read the directions for question 4 on the top of page 11, which specifies how account names should be chosen. Computation Icon This exercise helps you learn how to compute financial measures. R C O RD Beg Bal K P I N G r i e s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating R P Investing Financing O RT Assets Liabilities Revenue xpenses Net Income I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

22 Cash change nt Assets cash +other assets = Owners' quity Operating Cash = Liabilities + Owners' quities liabilities + permanent O+ temporary O Zero Zero Gains & Losses 22 Navigating Accounting Search Icon This exercise requires you to search for information. xercise 9.03 This exercise pertains to tax-related questions on the 2006 final exam, which was based on a supplement from Hewlett-Packard s (HP s) fiscal 2005 annual report. HP s fiscal 2005 year started on November 1, 2004 and ended on October 31, Required Answer final exam 2006 questions 2c, 3a, and 4d. Computation Icon This exercise helps you learn how to compute financial measures. R C O RD Beg Bal K P I N G r i e s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating R P Investing Financing O RT Assets Liabilities Revenue xpenses Net Income I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

23 Cash change nt Assets cash +other assets = Owners' quity Operating Cash = Liabilities + Owners' quities liabilities + permanent O+ temporary O Zero Zero Gains & Losses Chapter 9: xpense Recognition: Taxes and Options 23 Search Icon This exercise requires you to search for information. xercise 9.04 This exercise pertains to tax-related questions on the 2005 final exam, which was based on a supplement from Boston Scientific s fiscal 2004 annual report. Required Answer final exam 2005 questions 2a, 4a, 4f, and 5c. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen. Computation Icon This exercise helps you learn how to compute financial measures. R C O RD Beg Bal K P I N G r i e s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating R P Investing Financing O RT Assets Liabilities Revenue xpenses Net Income I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

24 24 Navigating Accounting xercise 9.05 This exercise pertains to tax-related questions on the 2004 final exam, which was based on a supplement from AMD s fiscal 2003 annual report. Search Icon This exercise requires you to search for information. Required Answer final exam 2004 questions 1g, 1h, 1j, and 2d. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

25 Cash change nt Assets cash +other assets = Owners' quity Operating Cash = Liabilities + Owners' quities liabilities + permanent O+ temporary O Zero Zero Gains & Losses Chapter 9: xpense Recognition: Taxes and Options 25 Search Icon This exercise requires you to search for information. xercise 9.06 This exercise pertains to tax-related questions on the 2003 final exam, which was based on a supplement from Gateway s fiscal 2002 annual report. Required Answer final exam 2003 questions 1e, 1j, 2j, 3c, 4g and 4h. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen. Computation Icon This exercise helps you learn how to compute financial measures. R C O RD Beg Bal K P I N G r i e s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating R P Investing Financing O RT Assets Liabilities Revenue xpenses Net Income I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

26 26 Navigating Accounting STOCK OPTIONS This section provides an in-depth look at stock options and related tax consequences. By taking a closer look, you will gain an appreciation for the complexity behind the reported numbers and thus enable you to better interpret disclosures and the company s overall performance. Options give employees the right to purchase their employer s stock at a price specified when the options are awarded the exercise price. Typically, the exercise price equals, or is very close to, the stock s fair value on the date the options are awarded the grant date and employees can not exercise the options until after a pre-specified period when employees earn the right to exercise the options, called the vesting period. Once vested, employees can exercise options at any time during the exercise period, which typically extends for ten or more years. Vesting Period xercise Period Grant Date Vested Date xpiration Date The key business decisions associated with stock-based awards are: whether to grant them, how many to grant, how to set parameters affecting their value to employees (e.g., the exercise price of options), and how long employees must work to earn them (the vesting period). These are challenging decisions potentially creating considerable value for current shareholders by aligning employees and shareholders interests and giving employees an incentive to work diligently to increase shareholder value. Simply put, options are effective when the marginal employee effort motivated by the option incentive increases the total value of owners equity (relative to what it would have been without the incentive) more than the value the employee receives from exercising the options. When this occurs, granting options is a good investment for current shareholders. Both the effectiveness of the incentive and the value the employee receives are determined by the option s exercise prices, vesting dates, the number of options granted, and other features of option plans. However, there is no formula for determining when these parameters are set appropriately and thus when the incentive effect on total owners equity more than compensates for the value employees receive. Moreover, options are fraught with conflicts of interest and employees, especially top management, have two ways to act on these conflicts and thus serve their own interests at the expense of current shareholders:

27 Chapter 9: xpense Recognition: Taxes and Options 27 Old Final xams You will only be responsible for the fair-value method. Most companies did not adopt this method until Thus, stock-option questions on final exams before 2007 were generally based on the intrinsic value method and will not help you prepare for this year s exam. You should also ignore option-related items reported for 2005 in 2007 annual reports. They are mostly based on the intrinsic method. Influence compensation committees unduly: A lack of independence between senior management and the board of directors can lead the board to adopt stock option plans that shift excessive value to employees (e.g., issuing too many options or specifying vesting periods that are too short). In principal, compensation committees work independently of management. However, the business media is full of stories about compensation committees apparently have not maintained this independence. Manipulate reported earnings and other financial statement information: Stock-based compensation gives management an incentive to manipulate accounting information in an effort to drive up stock prices. This incentive was arguably the root cause of the 2002 accounting scandals. The challenges associated with the business decisions related to stockbased compensation awards affect and are affected by the related accounting decisions. The most recent accounting standard, FAS 123 Revised (abbreviated as FAS 123R), Accounting for Stock-Based Compensation, was issued by the FASB after years of heated controversy. It specifies a fair-value method of accounting and reporting standards for all agreements where: (a) employees receive employers stock or other equity instruments with returns based on employers stock s prices (such as stock options), or (b) employers incur liabilities based on their stock prices. Tax Consequences of Stock Options For tax purposes, options are classified as incentive stock options (ISOs) or non-qualified stock options (NSOs). The critical distinction between ISOs and NSOs centers on the tax consequences for employers and employees. For NSOs, the company receives a tax deduction on the exercise date. The tax deduction is the amount by which the fair value of the common stock on the exercise date exceeds the option s exercise price. The tax benefit of this deduction is the company s tax savings: the deduction multiplied by the company s tax rate. When employees exercise NSOs, they are taxed at ordinary tax rates (rather than lower capital gains tax rates) for the same amount their employers deduct the excess of the fair value of the common stock on the exercise date over the option s exercise price. Thus, the government taxes NSOs the same as it taxes other compensation such as wages: the employer receives a deduction and the employee is taxed at ordinary rates.

28 28 Navigating Accounting By contrast, for ISOs, the company does not receive a tax deduction and thus pays higher taxes (if it has taxable income). mployees are generally not taxed when they exercise ISOs (unless they are subject to alternative minimum taxes). Rather, employees are taxed later when they sell the shares they received at the exercise date, but at lower capital-gains rates. verything else equal, employees would always prefer ISOs and employers would prefer NSOs. However, employers with net operating loss carryforwards not anticipating paying taxes in the near future often use ISOs. They do not need the tax benefits of NSOs and they can persuade employees to accept fewer ISOs: employees receive the same after-tax benefits with fewer ISOs. xample Assumptions The assumptions below will be used to demonstrate the tax consequences of options and their financial reporting using the fair value method. ABC grants 1,000 non-qualified stock options (NSOs) with a $60 exercise price on January 1, 2001 (grant date). The fair value of ABC s non-par stock is $60 on the grant date. The options have an estimated value of $6 per share on the grant date based on an accepted valuation model. The options are 100% vested after 3 years. All 1,000 options are exercised on January 1, 2004 (exercise date). The fair value of the common stock is $100 on the exercise date. The company s tax rate is 40%. Tax Consequences xample The company receives a $40,000 tax deduction when the options are exercised: 1,000 shares x ($100 - $60) The tax benefit from the exercised options is $16,000: 40% of the $40,000 tax deduction. Fair Value Method Under the fair value method, stock-option compensation cost is measured at the grant date based on the value of the options on that date and is subsequently recognized as service is rendered during the vesting period. Note: even though the compensation cost is measured on the grant date, no entry is recorded at this time. Instead, this cost is gradually expensed during the vesting period (or capitalized in situations where GAAP requires compensation costs be capitalized, such as compensation related to production employees, which is capitalized to inventory and subsequently expensed through cost of sales).

29 Chapter 9: xpense Recognition: Taxes and Options 29 ntries During Vesting Period Under the fair value method, ABC estimates the compensation cost at the grant date, January 1, 2001, using a widely accepted option pricing model: $6,000 (= $6 x 1,000). This cost is expensed evenly over the vesting period by recording the following pretax entry each of these three years: Paid In Compensation = + - Capital xpense = + + $2, $2,000 or Debit Credit Compensation expense $2,000 Paid in capital $2,000 In the ABC example, we are assuming ultimately all of the 1,000 granted options are fully vested and exercised. In practice, options are sometimes forfeited before they are fully vested because employees leave the company or for other reasons. At other times options are not exercised by the end of the exercise period they expire unused. So long as the forfeitures are not associated with market conditions such as declining stock prices, FAS 123R requires companies to adjust the compensation cost for expected forfeitures. For example, if, at the time ABC granted the options in 2001, it expected 3% of the 1,000 options to be forfeited, it would have amortized $5,820 (=$6 x 1,000 x (1-.03)) over rather than $6,000 (= $6 x 1,000). FAS 123R also requires companies to adjust the amount to be amortized each reporting period if it changes its forfeiture forecasts and to true-up for actual forfeitures at the end of the exercise period. In particular, the expense could be negative during the exercise period or at the end of the period if forfeiture forecasts were increased or actual forfeitures were greater than expected. By contrast, there are no adjustments to the compensation expense for options not exercised because of changing market conditions. For example, if ABC s stock price stayed below the option s $60 exercise price throughout the exercise period and, as a result, none of the 1,000 options were exercised, ABC would not reverse the $6,000 of compensation expense recognized during : option expenses are not trued-up for changes in market conditions. Under the fair value method, deferred taxes are also recognized during the vesting period. Recall, deferred taxes arise from timing differences between financial and tax reporting. There is a timing difference under the fair value method because compensation expense is recognized during the vesting period for financial reporting; but a tax deduction is not permitted until options are exercised.

30 30 Navigating Accounting Under the fair value method, there is generally both a timing difference (affecting deferred taxes) and a permanent difference (not affecting deferred taxes). This occurs because compensation cost is defined differently for financial and tax reporting: the financial reporting expense is based on an estimate of the options value on the grant date and the tax deduction on the excess of the fair value of the stock price on the exercise date over the exercise price (which is the option s value on that date). For example, ABC recognizes a total of $6,000 financial reporting expense during and records a $40,000 tax deduction in $6,000 of the $40,000 is a timing difference, giving rise to a deferred tax asset, and $34,000 is a permanent difference. We will show how the $34,000 permanent difference is accounted for later when we study the entries at the 2004 exercise date. An $800 deferred tax expense is recorded in (40% of the $2,000 excess of the financial reporting expense over the tax deduction). Actually, a tax benefit (negative expense) is recognized: Deferred Tax Deferred Tax + = - Asset xpense + + $800 = - - $800 or Debit Credit Deferred tax asset $800 Deferred tax expense $800 Another difference between the tax rules and financial reporting under the fair value method is expense is recognized for financial reporting when options are vesting (regardless of whether they are ultimately exercised) while tax deductions are only permitted for options exercised. ntries At xercise Date Before considering the pretax entry recognized at the exercise date, January 1, 2004, recall the pretax consequence for owners equity of the earlier entries is $0: a $6,000 increase in paid-in capital is offset by a $6,000 pretax decrease in retained earnings, representing 3 years of compensation expense. Thus, after the pretax entries, paid-in capital reflects the value of the consideration employees have contributed by rendering services. When they exercise options, employees give another form of consideration: $60,000 of cash associated with the exercise price. ABC recognizes this consideration as paid-in capital:

31 Chapter 9: xpense Recognition: Taxes and Options 31 + Cash = + Paid In Capital + + $60,000 = + + $60,000 or Debit Credit Cash $60,000 Paid in capital $60,000 Before considering the tax entry recognized at the exercise date, January 1, 2004, recall the balance sheet already reflects $2,400 of tax consequences associated with entries: A $2,400 deferred tax asset and a $2,400 increase in retained earnings (associated with the $800 per year tax benefit recognized during ). Thus, $2,400 of the $16,000 of consideration ABC receives from the government through tax deductions has been recognized in owners equity prior to the exercise date. The remaining $13,600 benefit is recognized in 2004 as additional paid-in capital. The 2004 tax entry also affects the deferred and current provisions of the tax expense. To facilitate the discussion, we will divide the 2004 tax entry into two parts. Assuming ABC can use the tax deduction in 2004, here is the entry to record the $13,600 increase to paid-in capital: = + Income Taxes + Paid In Capital Payable = + - $13, $13,600 or Debit Credit Income taxes payable $13,600 Paid in capital $13,600 After recording this entry, the entire $16,000 consideration received from the government is reported in owners equity and thus the second part of the 2004 tax entry, which we will record next, can have no net effect on owners equity. Before recording this second entry, there is still a $2,400 deferred tax asset on the balance sheet and income taxes payable only reflects $13,600 of the 2004 tax benefit. Thus, the second part of the entry: (a) removes the $2,400 deferred tax asset, (b) recognizes the remaining $2,400 benefit in income taxes payable, (c) recognizes a $2,400 tax benefit in the current provision of the tax expense, and (d) reverses the $2,400 benefit previously recognized in the deferred tax provision (expense). Deferred Tax Asset = + Income Taxes Payable - Deferred Tax xpense - Current Tax xpense - $2,400 = + - $2, $2, $2,400 or Debit Credit Deferred tax expense $2,400 Income taxes payable $2,400 Current tax expense $2,400 Deferred tax assets $2,400

32 32 Navigating Accounting ntries Associated with Options not xercised arlier we indicated expenses are not reversed when options expire unused or are otherwise not exercised because of market conditions. We also stated expenses can be reversed for options forfeited for reasons other than changes in market conditions (such as employee terminations). While it is true previously recognized option expense is not reversed when options are not exercised by the end of the exercise period because of market conditions, related deferred tax assets, which no longer have future benefits, must be removed from the balance sheet. Under FAS 123R, the entry to remove the deferred tax asset is: Decrease (credit) the deferred tax asset for the related balance, Decrease (debit) additional paid-in capital for any previous tax benefits recognized therein under FAS 123 or FAS 123R, and xpense any remainder to the income statement. Income-Statement ntry ffects Here are the income-statement effects of the example entries: Pretax income decreases by $2,000 each year for because compensation expense is recognized as the options vest. Tax expense is reduced by $800 each year for A negative deferred tax provision is recorded, reflecting the tax benefit associated with $2,000 of pretax compensation expense. A net tax expense of $0 is recognized in 2004 when the options are exercised: A $2,400 current provision, which represents the portion of the $16,000 tax benefit on the 2004 tax form associated with financial-reporting compensation expense. The other $13,600, which is associated with tax deductions in excess of financial reporting expense, is recorded as paid-in-capital and thus does not affect net income. A $2,400 deferred provision, which removes the deferred tax asset accumulated in : the benefit is no longer deferred because it is recognized on the 2004 tax form. As indicated earlier, the income statement can also be affected when deferred tax assets are written off if options are not exercised because of changes in market conditions.

33 Chapter 9: xpense Recognition: Taxes and Options 33 Balance-Sheet ntry ffects Here are the cumulative balance-sheets effects of the entries: Cash increases by the $60,000 exercise price received in Retained earnings decreases by $3,600: $6,000 of compensation expense recognized during $2,400 tax benefit recognized during Income taxes payable decreases by $16,000 in 2004 $13,600 recorded to paid-in capital $2,400 recorded to current tax provision recorded to income Paid-in capital increases by $79,600: $6,000 associated with the services rendered by employees during $13,600 associated with the $16,000 tax benefit received from the government in 2004 $60,000 associated with the cash contributed by employees Cash-Flow Statement ntry ffects Here are the cash-flow statement effects of the entries: The $800 deferred tax benefit recognized in net income each year from is part of the deferred tax provision and thus is reconciled to its $0 cash effect in these years through the deferred taxes adjustment. The cash associated with the $60,000 exercise price is classified as a financing cash flow in FAS 123R mandates the $13,600 portion of the $16,000 tax benefit received in 2004, recorded as an increase to paid-in capital, be reported in the financing section of the cash flow statement. Companies are generally reporting this portion of the tax benefit with captions such as xcess tax benefits from stock-based compensation. Here excess refers to the additional tax benefit received beyond that previously recognized in net income (beyond $2,400 for our example). The FASB broke from tradition by requiring this item to be reported in the financing section of the cash flow statement: with one other recent exception (related to derivatives), items in the financing or investing sections are associated with direct cash flows. Recall, cash is not directly affected when the tax benefit is recognized: increase (credit) paid-in capital for $13,600 and decrease (debit) income taxes payable for $13,600. Rather, $13,600 less cash is paid to the government than would have been paid without the tax benefit.

34 34 Navigating Accounting Having included a non-cash item in the financing section of the cash flow statement, the FASB was forced to include an offsetting non-cash item elsewhere to ensure the statement explains the change in the beginning and ending cash balances. To this end, FAS 123R mandates cash from operations must include the taxes that would have been paid if the company had not received the tax benefit from the options. In other words, this is the taxes actually paid (a real negative cash flow) after considering the full tax benefit of the options plus an additional amount (pseudo negative cash flow) for taxes that would have been paid if the excess tax benefits had not been received ($13,600 in our example). This is equivalent to mandating cash from operations reflect the taxes that would have been paid without the $16,000 tax benefit adjusted for the $2,400 portion of the benefit recognized in income during Having included a non-cash item in cash from operations, the FASB was forced to require companies reporting direct cash flow statements to include this non-cash item on their statements. As a result, direct cash flow statements are no longer purely direct. Before discussing alternative operating section adjustments companies use to ensure income is reconciled to cash from operations, we will extend the ABC example slightly by assuming: ABC reported $1,000 of income taxes payable at the start of ABC reported a current provision of $17,600 in 2004, but would have reported a current provision of $20,000 if it had not included $2,400 of the $16,000 tax benefit in the current provision (see the earlier entry). ABC paid $3,500 of income taxes during ABC s 2004 deferred tax provision was $2,400, all attributable to reversing the deferred tax asset in the earlier entry. Given these assumptions: Income taxes payable can be reconciled as follows for 2004: $1,000 beginning balance + $17,600 current provision - $3,500 payment - $13,600 excess tax benefit = $1,500 ending balance

35 Chapter 9: xpense Recognition: Taxes and Options 35 For the purpose of understanding the cash-flow statement adjustments later, notice the $500 increase in taxes payable can be divided into two parts: A $13,600 decrease associated with the excess tax benefit and A $14,100 net increase associated with the current provision and payment. The 2004 tax expense is $20,000 (the net-income effect): $20,000 current provision that would have been reported if ABC did not receive a tax benefit associated with the options - $2,400 current provision associated with the options tax benefit + $2,400 deferred benefit associated with options. FAS 123R mandates cash from operations reflect a $17,100 outflow for taxes (the cash-from-operations effect): $3,500 payment + $13,600 of excess tax credits (pseudo cash flow). A net adjustment of +$2,900 is needed to reconcile the negative $20,000 net income effect of the tax entries the tax expense to their negative $17,100 effect on cash from operations. FAS 123R does not mandate how this +$2,900 adjustment should be accomplished. Here are a few approaches companies use: Report: (1) -$13,600 of xcess tax benefit from stock-based compensation, which signals cash from operations includes the taxes ABC would have paid if it had not received the excess tax benefit, (2) $14,100 of Increase (decrease) in income taxes payable, which includes the net effects of recording the $17,600 current provision and $3,500 payment; but excludes the $13,600 decrease associated with the excess tax benefits (which is shown separately), and (3) $2,400 of Deferred taxes, which reverses the deferred provision. Dell, Cisco, and Microsoft seem to use this approach in their first quarter reports for fiscal (There is not enough tax information in quarterly reports to confirm this hypothesis.) Or report: (1) $500 of Increase (decrease) in income taxes payable, which includes the net effects of all of the events affecting this account, and (2) $2,400 of Deferred taxes, which reverses the deferred provision. Apple and Google seem to use this approach for their first quarter results in fiscal Or report: (1) $2,400 of Tax benefit from stock-based compensation, which reverses the portion of the deferred

36 36 Navigating Accounting Key lessons provision associated with options (all of the deferred provision in the example) and represents the portion of the $16,000 tax benefit recognized in income, and (2) $500 of Increase (decrease) in income taxes payable, which includes the net effects of all of the events affecting this account. Dell seems to use this approach in its first quarter report for fiscal Companies can and do use different formats to reconcile income effects of the tax benefits associated with options to their cash-from-operations effects. To interpret these disclosures, you need to understand the entries behind them and the alternative ways to reconcile their income and cash effects. Additional Stock Option Disclosures Companies typically present considerable details about their stock-based compensation plans in footnotes. As indicated on the next page, Johnson & Johnson s 2002 Common Stock, Stock Option Plans and Stock Compensation Agreements footnote discloses the following information, which is commonly found in companies footnotes: The number of options granted, exercised, and canceled or forfeited for the past three years. Options are cancelled when they expire and they are forfeited when employees leave the company before the options are vested. The note indicates J&J s options generally expire after 10 years. The estimated fair-value of the options J&J granted during the past three years based on the Black-Scholes model and the assumptions behind these estimates (needed for the model). The outstanding and exerciseable (vested) options at the end of 2002 grouped by exercise price ranges. Among other things, this information can be used to estimate the cash J&J received in 2002 when employees exercised options: $413 million = $21,012 x $19.64 (see the third row from the bottom of the table at the bottom of the first column below). This estimate is close to the $390 recognized in the financing section of the statement of cash flows as Proceeds from the exercise of stock options. The difference may be due to transaction costs expensed and included in cash from operations.

37 Chapter 9: xpense Recognition: Taxes and Options Common Stock, Stock Option Plans and Stock Compensation Agreements At December 29, 2002 the Company had 24 stock-based compensation plans. Under the 2000 Stock Option Plan, the Company may grant options to its employees for up to 1.6% of the issued shares of the Company s Common Stock, plus the number of shares available from the previous year that were not issued, as well as shares issued under the Plan that expired or terminated without being exercised. The shares outstanding are for contracts under the Company s 1991, 1995 and 2000 mployee Stock Option Plans, the 1997 Non-mployee Director s Plan and the Mitek, Cordis, Biosense, Gynecare, Centocor, Innovasive Devices, ALZA and Inverness Stock Option Plans. Stock options generally expire 10 years from the date they are granted and vest over service periods that range from one to six years. All options are granted at current market price on the date of grant. Shares available, under the 2000 Stock Option Plan, for future grants are based on 1.6% of the issued shares each year, and 49.9 million shares could be granted each year during the years 2002 through 2005, in addition to any other available shares as described above. Shares available for future grants under the 2000 plan were 62.1 million at the end of A summary of the status of the Company s stock option plans as of December 29, 2002, December 30, 2001 and December 31, 2000 and changes during the years ending on those dates, is presented below: Weighted Options Average (Shares in Thousands) Outstanding xercise Price Balance at January 2, ,486 $25.65 Options granted 46, Options exercised (27,130) Options canceled/forfeited (6,824) Balance at December 31, , Options granted 8,975 (1) Options exercised (30,622) Options canceled/forfeited (5,117) Balance at December 30, , Options granted 48, Options exercised (21,012) Options canceled/forfeited (4,543) Balance at December 29, ,741 $41.42 For the year ended December 30, 2001, there was a change in the timing of granting stock compensation and options to employees from December 2001 to February This change was enacted to have 2001 results finalized in order to align compensation with performance. The same timing of grants will be followed for fiscal The average fair value of options granted was $15.49 in 2002, $13.72 in 2001 and $14.79 in The fair value was estimated using the Black-Scholes option pricing model based on the weighted average assumptions of: Risk-free rate 4.39% 4.87% 5.45% Volatility 26.0% 27.0% 27.0% xpected life 5.0 yrs 5.0 yrs 5.0 yrs Dividend yield 1.33% 1.33% 1.40% The following table summarizes stock options outstanding and exercisable at December 29, 2002: (Shares in Thousands) Outstanding xercisable Average Average xercise Average xercise xercise Price Range Options Life (a) Price Options Price $.79-$ , $ ,572 $10.29 $11.16-$ , , $21.57-$ , , $40.08-$ , , $50.69-$ , $57.30-$ , $63.30-$ , $ ,702 $30.47 (a) Average contractual life remaining in years. Stock options exercisable at December 30, 2001 and December 31, 2000 were 99,176 options at an average exercise price of $24.34 and 90,384 options at an average exercise price of $19.46, respectively. (1) Includes 3,108 options issued to replace Inverness options outstanding at or granted prior to the acquisition. Pages 47-48, Johnson and Johnson s 2002 Annual Report

38 Cash change Assets cash +other assets = Owners' quity Operating Cash liabilities + permanent O+ temporary O Zero Zero Gains & Losses 38 Navigating Accounting R P O RT I N G R C O RD K P I N G Operating Investing Financing Beg Bal nt r i e s Tr Bal Cls IS Cls R nd Bal Assets Liabilities = Liabilities + Owners' quities Direct Cash Flows Balance Sheets Income Statements Reconciliations Net Income Adjustments Revenue xpenses Net Income Record Keeping and Reporting Icon This exercise helps you meet the insiders record keeping and reporting challenge. xercise 9.07 The goal of this exercise is to give you an opportunity to practice the entries discussed in the text from the perspective of an insider. You will need to open the following xcel file to complete this exercise: x_09.07.xls. Required Given the assumptions below and assuming the company uses the fair value method, complete the entries and year-end balances in the Insiders_ Tax_ Template worksheet of x_09.07.xls. Year-1 Income tax expense and payment $120 current provision recorded on year 1 tax forms -$240 deferred provision related to warranties $720 deferred provision related to depreciation $96 tax payment Options $20 option value, as determined on the grant date, is expensed (all options vest in year 1, no option costs capitalized to inventory) No options exercised in year 1 $7 deferred tax Year-2 Income tax expense and payment $2,160 current provision recorded on year 2 tax forms $180 deferred provision related to warranties $600 deferred provision related to depreciation $1,752 tax payment Options exercised No option expense in year 2 $100 exercise price

39 Chapter 9: xpense Recognition: Taxes and Options 39 $300 fair value when exercised $200 tax deduction for company when exercised (= $300-$100) $70 tax benefit for company (= 35% tax rate * $200) $3 of tax benefit previously recorded to deferred tax asset when option expensed

40 Cash change Assets cash +other assets = liabilities + permanent O+ temporary O Zero Owners' quity Operating Cash Zero Gains & Losses 40 Navigating Accounting Search Icon This exercise requires you to search for information. Computation Icon This exercise helps you learn how to compute financial measures. R P O RT I N G Liabilities Owners' quities i s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating Assets Revenue Investing Liabilities xpenses Financing Net Income R C = + O RD Beg Bal nt r e K P I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. xercise 9.08 Part 1 This exercise centers on the balance-sheet-equation (BS) matrix, which pertains to Intel accounts affected by tax entries and stock options during (a) Fill in the beginning and ending balances for income taxes payable and net deferred tax assets (liabilities). Note, the net deferred tax assets (liabilities) balance will be negative in this matrix when the deferred tax liabilities exceed the deferred tax assets. (b) Record the tax expense, tax payment, and issuance of shares to employees through stock plans. (c) Determine the remaining unexplained amounts (if any) in income taxes payable and the net deferred tax assets (liabilities), meaning the amounts explained by other events. + Cash + Net deferred tax = + assets (liabilities) Income taxes payable + Common stock and APIC Year-end $7,324 + = + + $6,245 - Tax expense + + = Tax payment + + = Sell of shares to employees through stock plan + + = Tax expense Other (unexplained) + ignore + = + + ignore - ignore Year-end $6,598 + = + + $7,825 - Part 2 This connects your part 1 answers to Intel s statement of cash flows. (a) Complete the following table using Intel s 2006 SCF. For the first three blank columns, indicate the effects of the events on the SCF items. Combine the results of these three columns in the fourth blank column. Do these events largely explain the SCF adjustments? Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.

41 Chapter 9: xpense Recognition: Taxes and Options 41 Reported in Intel's 2006 SCF Net income $5,044 Deferred taxes ($325) xcess tax benefit of stock plan ($123) Income taxes payable ($60) Cash from operations $10,620 Tax expense ffects of ntries on SCF mployee Tax stock payment issue Comb Part 2 continued (b) Intel received $1,046 million from its employees for the shares it issued to them. Where is this cash inflow reported in the SCF? (c) Why is there a ($123) adjustment included in the SCF reconciliation related to employee stock? (d) Is the ($60) income taxes payable adjustment the amount you would expect to see given the entries you recorded in part a? (e) Does the deferred tax adjustment equal: (1) the deferred provision; or (2) the change in the net deferred tax assets (liabilities)? (f) Which SCF line items might reflect the unexplained entries in part a? Part 3 Come to class prepared to answer the following: (a) What amount did Intel recognize at year-ends 2006 and 2005 for deferred tax assets related to accrued compensation and benefits? (b) Why would an expert state that the tax concepts related to accrued compensation and benefits are essentially the same as those for warranties? (c) Is the accrued compensation and benefits liability for tax reporting at the end of 2006 smaller (or larger) than the one reported for financial reporting? (d) Assuming that Intel uses a 35% tax rate for deferred tax computations, estimate the tax basis of the accrued compensation and benefits liability at the end of (e) Would Intel s 2006 pretax income for financial reporting have been smaller (or larger) if Intel had recognized the same compensation

42 42 Navigating Accounting and benefits expense for financial reporting as it did for tax reporting during 2006? How much smaller or larger? Hint: The tax effect of such difference in financial and tax reporting pretax income increases or decreases the deferred tax asset.

43 Cash change nt Assets cash +other assets = Owners' quity Operating Cash = Liabilities + Owners' quities liabilities + permanent O+ temporary O Zero Zero Gains & Losses Chapter 9: xpense Recognition: Taxes and Options 43 Search Icon This exercise requires you to search for information. xercise 9.09 This exercise pertains to options-related questions on the 2007 final exam, which was based on a supplement from Motorola s fiscal 2006 annual report. Required Answer final exam 2007 questions 1j, 3m, 3n, and 4f. Be sure to read the directions at the start of question 4 (on page 11). R C O RD Beg Bal K P I N G r i e s Tr Bal Cls IS Cls R nd Bal Direct Cash Flows Balance Sheets Income Statements Operating R P Investing Financing O RT Assets Liabilities Revenue xpenses Net Income I N G Reconciliations Net Income Adjustments Record Keeping and Reporting Icon This exercise helps you meet the outsiders record keeping and reporting challenge reverse engineering entries. Usage Icon This exercise helps you learn how accounting reports are interpreted and used by outsiders.