Question

Assume that on January 1, year 1, XYZ Corp. issued 1,000 nonqualified stock options with an estimated value of $3.80 per option. Each option entitles the owner to purchase one share of XYZ stock for $14 a share (the per share price of XYZ stock on January 1, year 1 when the options were granted). The options vest 25 percent a year (on December 31) for four years (beginning with year 1). All 500 stock options that had vested to that point were exercised in year 3 when the XYZ stock was valued at $21 per share. No other options were exercised in year 3 or year 4. What is the book-tax difference associated with the stock options in Year Three? (enter a favorable difference as a positive and an unfavorable difference as a negative)

Answer 1

Answer:

	Year 3
	Book - tax difference	Fav/Unfav	Temp/Perm
ASC 718 doesn’t apply:
Non-qualified stock option	3,500	Favorable	Permanent
ASC 718 apply :
Non-qualified stock option	1,900	Favorable	Temporary
	1,600	Favorable	Permanent

Calculation :

Here we have to suppose two situations were ASC 718 does apply and doesnt apply. ASC 718 is the standard procedure through which companies expense employee stock based compensation.

Assume ASC 718 does not apply to the stock options:

No book expense is associated with stock options and no book tax difference associated with the stock options in year 1, 2, 4.

So could remove the bargain element which was exercised in year 3 due to tax.

Tax deduction :

Favorable permanent book-tax = (21- 14) * 500

Favorable permanent book-tax = 3,500 (Deducted for Tax purposes)

Hence, the book tax difference in year 3 is $3,500 tax deduction and $0 book deduction.

Assume ASC 718 does apply to the stock options.

For book purpose:

$950 per year in years 1, 2, 3, and 4 will be deducted.

3,800 * .25 = 950

For tax purpose:

3500 will be deducted in year 3 when the 500 shares are exercised.

Book tax-differences:

$950 will be reported as an unfavorable temporary book-tax difference in years 1, 2, 3, and 4.

In year 3, will report a $1,900 favorable temporary book-tax difference which is the reversal of the unfavorable book tax differences from years 1, 2 on the 500 options that vested in years 1,2 but was exercised in year 3.

And then will report a $1600 favorable permanent book tax difference in year 3 [($7 - $3.80) x 500 shares].

Note = [$21-$14 = 7]