Question

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 blonk. Enter zero if applicable and select "N/A" If no effect.) Book-Tax Diff Year 1 Favorable! Unfavorable Temporaryl Permanent Book-Tax Diff Year 2 Favorable! Unfavorable Temporary Permanen Under ASC 718 Incentive Stock Options Nonqualified Stock Options

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.