Question

Assume that on January 1, year 1, ABC Inc. issued 8,800 stock options with an estimated value of $15 per option. Each option entitles the owner to purchase one share of ABC stock for $27 a share (the per share price of ABC stock on January 1, year 1, when the options were granted). The options vest at the end of the day on December 31, year 2. All 8,800 stock options were exercised in year 3 when the ABC stock was valued at $33 per share. Identify ABC’s year 1, 2, and 3 tax deductions and book–tax differences (indicate whether permanent and/or temporary) associated with the stock options under the following alternative scenarios:

Required:

1. The stock options are incentive stock options and ASC 718 applies to the options.
2. The stock options are nonqualified stock options and ASC 718 applies to the options.

Answer 1

Solution:

a.

Unless ASC 718 applies, ABC will not deduct any compensation expense for the options for book purpose. Further for tax purposes, ABC is not allowed any deductions related to incentives stock options. Consequently, there are no book-tax differences associated with the stock options in years 1, 2 or 3.

b.

Without the application of ASC 718 thee is no book deduction for nonqualified stock options. However, for tax purposes, ABC can deduct the bargain element (FMV exercise price) of the options when they are exercised in year 3. Thus there are no book-tax differences for years 1 and 2 But a $52.800 [($33 - $27)* 8800] Favourable, permanent book-ax difference in year 3.