Feature Article

Underwater Stock Options and Deferred Tax Assets
By Mitchell Kopelman, CPA and Rob Casey, CPA

What do you do when your company has "underwater" stock options and you have deferred tax assets related to the compensation expense that was recognized for book purposes?

Under Financial Accounting Standards Board Statement No. 123(R), Share-Based Payment (FASB 123R), companies are required to recognize compensation expense for stock options, which can be calculated using various valuation techniques such as the Black- Scholes method. Incentive stock options (ISOs) generally do not result in a future tax deduction when exercised unless certain rules, including minimum holding period, are not met and, as a result, do not create deferred tax assets. Non-qualified stock options (NQOs) may result in a future tax deduction when exercised and companies can record a deferred tax asset based on the compensation recognized for book purposes and their tax rates.

When the employee exercises an NQO, the actual tax deduction may be higher or lower than the deferred tax asset recognized at the time the compensation was recorded, due to several factors:

The deferred tax asset is not adjusted for changes in the underlying stock price but is reduced if the company determines it will more than likely not have the taxable income sufficient to utilize the deferred tax asset.
When the tax deduction is higher than the compensation expense recognized for book purposes, the excess of the tax deduction over the previously recognized deferred tax asset is recorded as additional paid in capital (APIC).
When the tax deduction is lower than the compensation expense recognized for book purposes, the difference is adjusted through APIC to the extent of any previously recognized excess tax benefits.
If the APIC previously recognized for excess tax benefits is insufficient to absorb the tax deficiencies, the remaining deficiencies are charged to income tax expense in the income statement unless there was a valuation allowance on the deferred tax asset.

Many companies have recorded compensation expense and related deferred tax assets related to NQOs over the last few years. If those options issued are now underwater, the company has two issues to deal with.

First, the company's employees have options that may never provide a benefit because they will expire before the stock price exceeds the option price. A significant benefit of NQOs is to help retain good employees and motivate them to increase the value of the company. If the options are underwater, the motivation for the employee diminishes.

Second, the company may have a deferred tax asset on its books that it may never be able to benefit from in the future. If the options begin to expire, and the company has not previously recognized any excess tax benefit for stock options, the expiration of the options will result in a charge to income tax expense that will directly reduce a companyfs earnings. Although the result of the expense is a noncash item, the expense will still reduce earnings.

This may not affect every company with significant excess tax benefits (Cisco Systems, Inc. has recorded excess tax benefits of over $1.7 billion in the last three years), but it may affect some companies that have not had the luxury of excess tax benefits. This is just another consideration for companies struggling to hit earnings.

Many companies are considering repricing their existing NQOs in light of the depression of the stock market. Another consideration is how to treat the deferred tax asset currently recorded on a companyfs balance sheet if its NQOs are re-priced.

As your company considers layoffs of employees with NQOs and/or re-pricing NQOs, be sure to consider the financial statement impact. Your company may have a material deferred tax asset related to the options held by exiting employees or by retained employees whose options may be re-priced. Be sure that your SEC reporting group as well as your auditors are in agreement on how to handle these matters to avoid financial reporting surprises.

If you have questions about these or similar matters please contact Mitchell Kopelman or Rob Casey.

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