Question

Problem 5-36 (LO 5-2) Assume that on January 1 year 1, ABC Inc. issued 5,000 stock options with an estimated value of $10 per option. Each option entities the owner to purchase one share of ABC stock for $25 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 5,000 stock options were exercised in year 3 when the ABC stock was valued at $31 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: a. The stock options are incentive stock options. b. The stock options are nonqualified stock options. Complete the following table. (For all requirements, leave no answer blank. Enter zero if applicable and select "N/A" if no effect Year 1 Year 2 Book-Tax Diff Favorable Unfavorable Favorable Tamporary Temporary Permanent Book-Tax Diff Favorable Unfavorable Temporaryl Permanent Book Under ASC 718 Incentive Stock Options Nonqualified Stock Options Permanent Favorable N/A Unfavorable

Answer 1

		Year 1	Year 2	Year 3
		Book-tax diff	Fav/unfav	Temp/perm	Book-tax diff	Fav/unfav	Temp/perm	Book-tax diff	Fav/unfav	Temp/perm
	Under ASC 718
a.	Incentive stock options	$25000 (5000*50%*10)	Unfavourable	Permanent	$25000	Unfavourable	Permanent	0	N/A	N/A
b.	Nonqualified stock options	$25000 (5000*50%*10)	Unfavourable	Temporary	$25000	Unfavourable	Temporary	$50000 (5000*10)	Favorable	Temporary
								$20000 (50000-((31-25)*5000))	Unfavourable	Permanent

In case of incentive stock options, no book-tax difference in year 3 is reported.

In case of nonqualified stock options, when options are exercised in year 3, ABC deducts the bargain element which is calculated as follows:

FMV – exercise price

In year 3, unfavorable permanent difference is the difference between between the estimated value of the stock options exercised of $10 and the bargain element of $1 multiplied by 5000 i.e. the number of options.