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related to income tax accounting under negatively affect the company’s income
ASC Topic 740 remain the same. tax expense and ETR at exercise, de-
To further reinforce pending on the stock’s share price when
Tax stock option treatment the importance the employee exercises the options.
For tax purposes, the appropriate treat- of detailed Topic
ment depends on whether the options Comprehensive illustrations
qualify as ISOs or NQOs. For simpli- 740 knowledge, The two examples that follow illustrate
fication, this column assumes options instructors should the computation and related disclosures
have no readily ascertainable fair market of stock options under Topic 740. The
value (FMV) at grant, which is most strongly consider accompanying downloadable Excel file
inviting a Topic 740
often the case. Note that the GAAP provides additional examples for fur-
treatment is the same regardless of the practitioner to class ther practice.
option’s tax classification.
to discuss its various Example 1: O Inc., a calendar
ISOs provisions. year-end public company, grants
Per Secs. 421(a)(2) and 422, ISOs do 60,000 options to its employees
not generate a tax deduction for the on Jan. 1, year 1. These options
granting company. Since the company have an exercise-date strike price
does have an expense for financial pur- unlike DTA items where book and tax of $19 per share, which equals the
poses each year over the vesting period, expense equal over time (e.g., deprecia- share price on the date of grant. At
it has a permanent book-tax difference tion or other cost recovery), the total grant, the company estimates the
each of those years. As such, it will ap- NQO tax expense will differ between options have a fair value of $10 per
pear as a reconciling item on the rate rec book and tax. This difference is the option. The options are subject to
in each of the vesting years. Because it is permanent component of the temporary a three-year cliff vesting provision,
an unfavorable difference (i.e., the com- book-tax difference. While companies and the company projects that 100%
pany will never enjoy a tax deduction for know there will be a permanent compo- of the options will vest. After three
it), the company’s current (and therefore nent to the difference, they are not able years have passed and all options are
total) income tax expense will be higher, to determine the magnitude or direc- fully vested, the employees exercise
resulting in an effective tax rate (ETR) tion of it until exercise. At that future the options. At exercise, the share
increase each year in the vesting period. point in time, the company will know price has risen to $23 per share. The
whether the tax expense is greater or currently enacted federal income
NQOs lesser than the total book expense, and tax rate for all years is 21%. O Inc.
Unlike the nondeductibility of ISOs, to what degree. has $1,000,000 pretax financial
Sec. 83(a) and Regs. Sec. 1.83-7(a) As initially set forth by FASB in Ac- income each year before considering
allow companies a tax deduction when counting Standards Update (ASU) No. options expense and has no other
an employee exercises an NQO. This 2016-09, Compensation — Stock Compen- book-tax differences.
deduction equals the bargain element sation (Topic 718): Improvements to Em-
enjoyed by the employee upon exercise ployee Share-Based Payment Accounting, Financial accounting expense
(equal to the stock’s FMV at exercise companies account for the permanent and tax expense assuming ISOs
minus the lower purchase price enjoyed component of the NQO temporary dif- Regardless of the tax classification as
by the employee by using the option to ference directly through income tax ex- an ISO or NQO, financial accounting
purchase shares). pense (versus additional paid in capital, compensation expense totals $600,000
Because NQOs generate a future which companies used prior to the ASU ($10 per option fair value × 60,000 op-
tax deduction, the issuing company will simplification). Once the options are tions). O Inc. will recognize this expense
originate a temporary book-tax differ- exercised, the company will remove the on its income statements evenly over the
ence at issuance. This difference will DTA from the books in full, whether three-year cliff vesting period, equaling
create a deferred tax asset (DTA) since it overestimated or underestimated the $200,000 of expense each in years 1, 2,
the financial expense (recognized over ultimate value of the tax deduction. The and 3. The company will not recognize
the vesting period) precedes the income permanent component of the tempo- financial expense in year 4 or beyond.
tax expense (recognized at exercise). But rary difference will either positively or Because the options are ISOs, O Inc. has

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