Chapter 9 · Chapter 9: Expense Recognition ... accounting rules for financial and tax reporting...

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© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson

Chapter 9: Expense Recognition: Taxes and Options

Chapter 9expense reCognition:

inCome taxes and stoCk options

TABLE OF CONTENTS

Overview 3

Income Taxes 3

Assumptions Common to All Three Examples 5

Example 1 5

Tax Computations for Example 1 6

Record Keeping for Example 1 9

Example 2 9



Example 3 12



Key Take Aways From Tax Examples 15

Exercise 9.01 19

Exercise 9.02 21

Exercise 9.03 22

Exercise 9.04 23

Exercise 9.05 24

Exercise 9.06 25

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Navigating Accounting ®

Stock Options 26

Tax Consequences of Stock Options 27

Example Assumptions 28

Tax Consequences Example 28

Entries During Vesting Period 29

Entries At Exercise Date 30

Entries Associated with Options not Exercised 32

Income-Statement Entry Effects 32

Balance-Sheet Entry Effects 33

Cash-Flow Statement Entry Effects 33

Additional Stock Option Disclosures 36

Exercise 9.07 38

Exercise 9.08 40

Exercise 9.09 43

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OVERVIEWThis chapter provides an in-depth look at two topics often disclosed as critical accounting estimates by companies: income taxes and stock-based compensation, in particular stock options. By taking a closer look at these topics, you will gain an insight into the regulatory environment that influenced the related standards, the judgments behind these disclosures, and an appreciation for the complexity behind the reported numbers. This will enable you to better interpret disclosures and thus the company’s overall performance.

INCOME TAXESBy now, you likely already know that companies generally report deferred tax assets and liabilities on their balance sheets and the tax expense reported on income statements has current and deferred components. What you may not know is tax footnotes present a good deal of information about these balance-sheet and income-statement items and the format of these footnotes is very consistent across companies. By the end of this section, you should know how to use information in these footnotes to reverse engineer tax entries, to identify places where the accounting rules for financial and tax reporting differ significantly, and, in some situations, to quantify these differences.

One of the things you are going to learn is deferred tax assets reported on balance sheets aggregate information about several deferred tax assets reported in income tax footnote. Similarly, deferred tax liabilities reported on balance sheets aggregate information about several deferred tax liabilities in the income tax footnote. Companies compute each of these deferred tax assets and liabilities separately and once you understand how one deferred tax asset is computed and what it represents in terms of differences between financial and tax reporting, you will have a real good start at understanding how other deferred tax assets are derived and what they represent. Similarly, once you know how one deferred tax liability is derived and what it represents, you will find it relatively easy to interpret others.

You are also going to learn the deferred provision of the tax expense is based on the changes in deferred tax assets and liabilities during the period. Actually, for smaller companies (not reporting other comprehensive income or foreign currencies), the deferred provision is the increase in the net deferred tax liabilities (deferred tax liabilities – deferred tax assets). So, if you understand the computations behind deferred tax assets and liabilities and what they represent in terms of

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differences between financial and tax reporting, you should find it relatively straightforward to understand deferred provisions. Current provisions are much more intuitive: they are similar to taxes you likely report on your own tax forms.

The section presents three examples that will help you gradually learn the concepts you need to understand to analyze tax disclosures in footnotes and financial statements. The three examples are based on three merchandising companies:

• In the first example, Company 1 has a deferred tax liability because it depreciates a computer more quickly for tax reporting than for financial reporting. This is the only deferred tax liability it has and it has no deferred tax assets. This example will prepare you to analyze deferred tax liabilities reported in footnotes. It will also help you begin to understand the entries that record the current and deferred tax provisions and how the numbers behind them are computed. Finally, it will help you understand how tax payments generally differ from current provisions. In contrast to the other two companies we will study, Company 1 does not offer warranties to its customers (which are associated with a deferred tax asset) and its deferred tax provision is related to changes in the deferred tax liability associated with depreciation only.

• In the second example, Company 2 rents its computer and thus does not have depreciation for financial or tax reporting. However, Company 2 has a deferred tax asset because it recognizes a warranty expense for financial reporting before the government allows a related tax deduction. For financial reporting, companies typically recognize expenses for estimated future warranty claims related to current period sales. However, for tax reporting, companies can not deduct warranty costs until claims are satisfied. All of Company 2’s deferred tax provision is related to changes in this deferred tax asset. The computations associated with its current provision and tax payments are conceptually the same as Company 1’s entries but the numbers differ slightly.

• In the third example, Company 3 buys a computer and offers a warranty. As a result, (1) it has a deferred tax liability related to depreciation and a deferred tax asset related to warranties, and (2) the deferred provision is partly related to a change in the deferred tax asset and partly related to a change in a deferred tax liability. The deferred tax assets and liabilities are the same as those in the first two examples, so the central lesson in Example 3 is seeing how these assets and liabilities jointly affect the deferred provision. Thus,

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Year 1 Year 2 Year 1 Year 2 Year 1 Year 2

Revenues $2,000 $4,000 $2,000 $4,000 $0 $0

Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0

Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0

SG&A

Other ($200) ($400) ($200) ($400) $0 $0

Financial Reporting Tax Reporting Financial less tax

Common Assumptions: Buys and depreciates computer, but no warranty

this example begins to approximate actual companies’ tax entries by including both deferred tax assets and liabilities.

These three examples illustrate several important lessons about income taxes summarized in the Key Take-Aways section.

assumptions Common to all three examples• The tax rate is 40% for all years

• 80% of the current provision is paid in the current year, and the remainder in the next year

• The table reports income items that are the same for financial and tax reporting:

All of the tables in this chapter are in the following Excel file:

TaxEx.xls

example 1Here are additional assumptions for Company 1:

• Company 1 buys a computer at the start of year 1 for $900. As indicated in the table on the top of the next page, the computer is completely depreciated for tax reporting in year 1. By contrast, for financial reporting the company uses the matching principle so that the depreciation expense matches the revenues over two years. For example, 1/3 of the cost is depreciated in year 1 because 1/3 of the total $6,000 revenues are generated in year 1.

• Company 1 does not offer a warranty to customers since the original manufacturer provides a warranty.

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Year 1 Year 2 Year 1 Year 2 Year 1 Year 2

Revenues $2,000 $4,000 $2,000 $4,000 $0 $0

Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0

Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0

SG&A

Depreciation ($300) ($600) ($900) $0 $600 ($600)

No Warranty $0 $0 $0 $0 $0 $0

Other ($200) ($400) ($200) ($400) $0 $0

Total ($500) ($1,000) ($1,100) ($400) $600 ($600)

Pretax Income $700 $1,400 $100 $2,000 $600 ($600)


Company 1: Buys and depreciates computer, but no warranty

Year 1 Year 24 Pretax income on tax form $100 $2,000

5 Current provision $40 $800

Year 1 Year 26 Related to this year's current provision $32 $640

7 Related to last year's current provision $0 $8

8 Total paid $32 $648

Current provision computations

Tax payment computations

• The following table summarizes income items for financial and tax reporting and their differences. Note, depreciation is the only item with a timing difference:

Tax Computations for Example 1The following tables illustrate: (1) how the current provision is computed each year — the current period’s tax rate multiplied by income on the tax form, and (2) the tax payments, which are, by assumption, 80% of the current provision for the current year and 20% of the previous year’s current provision. You can learn more about these computations by studying the formulas in the TaxEx Excel file. Use the numbers to the left of the table to find the related cells in the TaxComp1 worksheet.

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These tables illustrate that Company 1 will record $40 of taxes on its tax forms for year 1, and $800 for year 2. If Company 1 did not include a deferred provision in its tax expense, it’s tax expense would not be matched with pretax income for financial reporting.

As indicated in the earlier table, the $1,400 of pretax income recognized for financial reporting in the second year is twice the $700 recognized in the first year. Thus, the matching principle suggests the tax expense in the second year should be twice as large (since the tax rate is constant). The next table illustrates how the deferred provision is computed using the income-statement approach:

Year 1 Year 29 Financial reporting depreciation expense $300 $600

10 Tax reporting depreciation deduction $900 $0

11 Excess of tax deduction over financial expense $600 ($600)

12 Deferred provision related to depreciation $240 ($240)

Deferred provision computations using the income approach

Year 1 Year 213 Current provision $40 $800

14 Deferred provision $240 ($240)

15 Tax expense $280 $560

Tax expense computations using the income approach

Once the current and deferred provisions are computed, you can add them together to get the tax expense:

Next, we will compute the deferred provision using the balance-sheet approach. This approach is required under GAAP and generally yields the same answer as the income approach discussed above when statutory tax rates are not scheduled to change. Statutory rates are the ones set by the government before consideration for special credits and deductions.

The income approach focuses on differences in income for financial and tax reporting. For example, differences in income caused by differences in depreciation for a reporting period. By contrast, the balance-sheet approach focuses on differences in the balance sheets for financial and tax reporting. For example, caused by differences between the book value of net PP&E for financial and tax reporting. For tax reporting, the book value of an asset or liability is called its tax basis.

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Year 1 Year 2 Financial reporting of net PP&E

16 Beginning balance $0 $60017 New PP&E $900 $018 Depreciation ($300) ($600)19 Ending balance (book value) $600 $0

Tax reporting of net PP&E20 Beginning balance $0 $021 New PP&E $900 $022 Depreciation ($900) $023 Ending balance (tax basis) $0 $0

Deferred taxes24 Book value in excess of tax basis $600 $025 Deferred tax liability $240 $026 Def Provision: Increase (decrease) in Dtax liability $240 ($240)

Deferred provision computations using the balance sheet approach

Here is how the two methods compute the deferred tax provision related to PP&E:

• The income approach determines the deferred provision by multiplying the current year’s statutory tax rate times the difference in depreciation for the year (financial versus tax).

• The balance-sheet approach determines the provision in three steps:

1. Determine the deferred tax liability related to net PP&E at the end of the prior year by multiplying the prior year’s statutory tax rate times the difference between the book value of the net PP&E for financial reporting and the tax basis of PP&E.

2. Determine the deferred tax liability related to net PP&E at the end of the current year by multiplying the current year’s statutory tax rate times the difference between the book value of the net PP&E for financial reporting and the tax basis of PP&E.

3. The deferred provision related to PP&E is the increase in the deferred tax liability during the year (the number computed in step 2 less the one computed in step 1).

The next table illustrates how to compute the deferred provision for Company 1 using the balance-sheet approach.

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The deferred tax liability related to PP&E at the end of year 1 represents additional taxes expected to be paid in year 2 (because depreciation deductions were used in year 1 for tax purposes). We have already seen how large the current provision is in year 2, relative to year 1, because depreciation was accelerated.

Record Keeping for Example 1The balance-sheet equation model shows the tax entries for years 1 and 2. Here are some key observations for both years 1 and 2:

• The tax expense equation holds: Tax expense = current provision + deferred provision

• Recording the current provision increases the tax expense and increases taxes payable (because it is owed to the government).

• Recording the deferred provision increases the tax expense when the deferred provision is positive and decreases the tax expense when the deferred provision is negative. There is an offsetting increase or decrease in the deferred tax liability to keep the balance-sheet equation balanced.

= + Own Eq+ C = + TaxPay + DefTaxL - Tax exp

Beg bal year 1 + + 0 = + + 0 + + 0 - + 0Record tax expense + = + + 40 + + 240 - + 280Pay taxes + - 32 = + - 32 + -Other events + not relev = + + - close to ISEnd bal year 1 + not relev = + + 8 + + 240 - + 0

+ = + + -Beg bal year 2 + not rel = + + 8 + + 240 - + 0Record tax expense + = + + 800 + - 240 - + 560Pay taxes + - 648 = + - 648 + -Other events + not rel = + + - close to ISEnd bal year 2 + not rel = + + 160 + + 0 - + 0

LiabilitiesAssets

example 2Here are some additional assumptions for Company 2:

• Company 2 rents a computer and offers a warranty to customers for products purchased during year 1. The products sold during the second year are warranted by the original manufacturer.

• None of the products sold in year 1 will fail until year 2. The company expects that the cost to honor these warranty claims in year 2 will be 10% of the first-year revenues.

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Year 1 Year 2 Year 1 Year 2 Year 1 Year 2Revenues $2,000 $4,000 $2,000 $4,000 $0 $0Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0SG&A

Computer rent ($450) ($450) ($450) ($450) $0 $0Warranty ($200) $0 $0 ($200) ($200) $200Other ($200) ($400) ($200) ($400) $0 $0Total ($850) ($850) ($650) ($1,050) ($200) $200

Pretax Income $350 $1,550 $550 $1,350 ($200) $200


Company 2: Rents computer and offers warranty in year 1

• The following table summarizes the income items for financial and tax reporting. Notice that warranty is the only income item that differs. For tax purposes, the company does not get a deduction until year 2, when the costs are incurred. For financial reporting, Company 2 recognizes a warranty expense with an offsetting entry to an accrued warranty liability. This liability is not recognized in the tax records (and thus has zero tax basis).

Tax Computations for Example 2The tables at the top of the next page are similar to those for Example 1 (and are located in the TaxComp2 sheet of TaxEx.xls). Except here, a deferred tax asset is recognized at the end of year 1, signifying the benefits the company will receive when it deducts the warranty claims in year 2.

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Year 1 Year 29 Financial reporting warranty expense $200 $0

10 Tax reporting warranty deduction $0 $200

11 Excess of financial expense over tax deduction $200 ($200)

12 Deferred provision related to warranty ($80) $80


14 Deferred provision ($80) $80






Note, the current provision is larger in year 1 than it would otherwise be if the government allowed Company 2 to deduct the warranty claims when they are anticipated.

As we shall see, this increased current provision increases taxes payable, and this increase is offset by a deferred tax asset. These offsetting effects will be discussed more in the “Take-Aways” section. For now simply note they exist.

The table at the top of the next page illustrates the balance-sheet approach followed by U.S. GAAP. Because Company 2 recognizes an accrued warranty for financial reporting, but not for tax reporting, it creates a deferred tax asset.

This deferred tax asset represents the tax future benefit of the deductions the company will receive in year 2 when it reduces the accrued warranty liability (and honors the warranty claims).

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Year 1 Year 2 Financial reporting accrued warranty liability

16 Beginning balance $0 $200

17 Update estimate of future claims $200 $0

18 Pay claims $0 ($200)

19 Ending balance (book value) $200 $0

20 No related tax laibility

Deferred taxes21 Book value of warranty liability in excess of tax basis $200 $0

22 Deferred tax asset $80 $0

23 Def Provision: (Increase) decrease in Dtax asset ($80) $80


= + Own Eq

+ C + DefTaxA = + TaxPay - Tax expBeg bal year 1 + + 0 + + 0 = + + 0 - + 0Record tax expense + + + 80 = + + 220 - + 140Pay taxes + - 176 + = + - 176 -Other events + not relev + = + - close to ISEnd bal year 1 + not relev + + 80 = + + 44 - + 0

+ + = + -Beg bal year 2 + not rel + + 80 = + + 44 - + 0Record tax expense + + - 80 = + + 540 - + 620Pay taxes + - 476 + = + - 476 -Other events + not rel + = + - close to ISEnd bal year 2 + not rel + + 0 = + + 108 - + 0

LiabilitiesAssets

Record Keeping for Example 2Here are the tax entries of years 1 and 2:

example 3Here are some additional assumptions for Company 3:

• Company 3 buys the same computer as Company 1 and depreciates it the same way as company 1 for tax and financial reporting. Similarly, it has the same warranty events as Company 2.

• The table at the top of the next page summarizes its pretax income for financial and tax reporting:

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Year 1 Year 2 Year 1 Year 2 Year 1 Year 2Revenues $2,000 $4,000 $2,000 $4,000 $0 $0

Cost of good sold ($800) ($1,600) ($800) ($1,600) $0 $0

Gross margin $1,200 $2,400 $1,200 $2,400 $0 $0

SG&A

Depreciation ($300) ($600) ($900) $0 $600 ($600)

Warranty ($200) $0 $0 ($200) ($200) $200

Other ($200) ($400) ($200) ($400) $0 $0

Total ($700) ($1,000) ($1,100) ($600) $400 ($400)

Pretax Income $500 $1,400 $100 $1,800 $400 ($400)


Company 3: Buys computer and offers warranty in year 1








Tax Computations for Example 3The tax computations in the tables below and on the next two pages are a combination of those for the two previous examples.

The important observation is that the deferred provision is:

(1) the decrease (increase) in the deferred tax asset associated with warranties plus

(2) the increase (decrease) in the deferred tax liability associated with depreciation.

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PP&E Year 1 Year 29 Financial reporting depreciation expense $300 $600

10 Tax reporting depreciation deduction $900 $0

11 Excess of tax deduction over financial expense $600 ($600)


Warranties Year 1 Year 213 Financial reporting warranty expense $200 $0

14 Tax reporting warranty deduction $0 $200

15 Excess of financial expense over tax deduction $200 ($200)


Total deferred provision



19 Total deferred provision $160 ($160)


Financial reporting of net PP&E23 Beginning balance $0 $60024 New PP&E $900 $025 Depreciation ($300) ($600)26 Ending balance (book value) $600 $0

Tax reporting of net PP&E27 Beginning balance $0 $028 New PP&E $900 $029 Depreciation ($900) $030 Ending balance (tax basis) $0 $0

Deferred taxes related to PP&E31 Book value in excess of tax basis $600 $032 Deferred tax liability $240 $0

33 Def Provision: Increase (decrease) in Dtax liability $240 ($240)

Year 1 Year 2 Financial reporting accrued warranty liability

34 Beginning balance $0 $20035 Update estimate of future claims $200 $036 Pay claims $0 ($200)37 Ending balance (book value) $200 $0

38 No related tax laibility

Deferred taxes

39 Book value of warranty liability in excess of tax basis $200 $0

40 Deferred tax asset $80 $041 Def Provision: (Increase) decrease in Dtax asset ($80) $80


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21 Deferred provision $160 ($160)



= + Own Eq

+ C + DefTaxA = + TaxPay + DefTaxL - Tax exp

Beg bal year 1 + + 0 + + 0 = + + 0 + + 0 - + 0Record tax expense + + + 80 = + + 40 + + 240 - + 200Pay taxes + - 32 + = + - 32 + -

Other events + not relev + = + + - close to ISEnd bal year 1 + not relev + + 80 = + + 8 + + 240 - + 0

+ + = + + -

Beg bal year 2 + not rel + + 80 = + + 8 + + 240 - + 0Record tax expense + + - 80 = + + 720 + - 240 - + 560Pay taxes + - 584 + = + - 584 + -

Other events + not rel + = + + - close to ISEnd bal year 2 not rel + 0 = + 144 + + 0 - + 0

LiabilitiesAssets

Record Keeping for Example 3Here are the entries for Company 3:

key take aways From tax examplesHere are some general points demonstrated by these examples reinforced by other examples and exercises throughout the chapter.

• When an asset or a liability has a different value for financial and tax reporting, the asset or liability will give rise to either a deferred tax asset or a deferred liability in the year the difference between financial and tax reporting originates. Each such asset or liability gives rise to a separate deferred tax asset or liability. This is illustrated in Intel’s tax footnote, which reports separate deferred tax assets and liabilities for several items (see the table on page 74, Intel’s 2006 Annual Report).

• If an asset (such as PP&E) is smaller in the originating year for tax re-porting, or a liability is larger, it generally means: (1) expense associ-ated with the asset or liability in the originating year (such as depre-ciation expense associated with PP&E) is less for financial reporting than for tax reporting, (2) a deferred tax liability is created for this asset or liability in the originating year, (3) this deferred tax liability is derived by multiplying the tax rate by the amount by which the

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financial reporting asset exceeds the tax reporting asset, or by the amount that the tax reporting liability exceeds the financial reporting liability.

This deferred tax liability represents additional taxes that will be paid in the future (if the company remains profitable) because deductions that would otherwise have reduced future taxable income were accel-erated to the current period and thus will no longer be available in the future, resulting in higher future taxable income and corresponding higher taxes.

This deferred tax liability will continue to increase in the future so long as the gap between the asset’s or liability’s financial and tax reporting values continues to widen. However, at some point this gap will begin to close and the deferred tax liability will begin to decrease. When the deferred tax liability is decreasing, we say it is reversing.

Ignoring the effects of all other items, increases in this deferred tax liability in the originating year or subsequent years increase the deferred provisions in those years. Similarly, ignoring the effects of all other items, decreases in this deferred tax liability in future years (when it is reversing) decrease the deferred provisions in those years.

• By contrast, if an asset is larger in the originating year for tax reporting, or a liability (such as a warranty liability) is smaller, it generally means: (1) expense associated with the asset or liability in the originating year (such as accrued warranty expense) is larger for financial reporting than for tax reporting, (2) a deferred tax asset is created for this asset or liability in the originating year, (3) this deferred tax asset is derived by multiplying the tax rate by the amount by which the financial reporting asset is less than the tax reporting asset, or by the amount that the tax reporting liability is less than the financial reporting liability.

This deferred tax asset represents taxes that will not be paid in the future (if the company remains profitable) because deductions that would otherwise have reduced current taxable income are postponed to the future and thus will be available in the future, resulting in lower future taxable income and corresponding lower taxes.

This deferred tax asset will continue to increase after the originating year so long as the gap between the asset’s or liability’s financial and tax reporting values continues to widen. However, at some point the gap will begin to close and the deferred tax asset will begin to decrease (reverse).

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Ignoring the effects of all other items, increases in this deferred tax asset in the originating year or subsequent years decrease the deferred provision in those years. Similarly, ignoring the effects of all other items, decreases in this deferred tax asset in future years increase the deferred provision in those years.

• Whendocompaniesliketorecognizeliabilities? Companies like to recognize deferred tax liabilities. These are usually good news for tax departments. They typically occur when tax departments determine clever, but legal, ways to defer taxes or governments offer tax deferrals to promote economic development, spark the economy, or promote some other public interest.

Consider the deferred tax liability associated with the depreciation in Example 1. The current provision is smaller in year 1 for Company 1 because the tax rules allow accelerated depreciation. In this case, the increase in the deferred tax liability is related to a smaller current provision in year 1, and thus in a decrease in taxes payable. Importantly, the amounts recorded to taxes payable and the deferred tax liability are the same, but the present values differ in Company 1’s favor. The tax savings from accelerated deduction (reflected in a smaller current provision) are realized in year 1, whereas additional taxes related to the deferred tax liability are not paid until year 2.

Accounting fails to capture the economic benefits of tax deferral. One liability increases and the other decreases by the same amount. From an accounting perspective, there is no change in shareholders’ equity. The total tax expense is not affected by the tax break that gives rise to the deferred taxes, but the components of the tax expense are affected. The deferred provision increases because of the increase in the deferred tax liability and the current provision decreases because of the current-period’s tax break.

Thus, GAAP fails to recognize the economic benefit of tax deferral by not recognizing the difference in the present values of the decrease in taxes payable and increase in the deferred tax liability. If GAAP did recognize these present values, the present value of the increase in the deferred tax liability would be smaller than the present value of the decrease in taxes payable and the difference would be recognized as an increase in owners’ equity. This is reason that managers who can see through this GAAP imperfection like deferred tax liabilities.

• Whendocompaniesprefernottorecognizeassets? Companies do not like to recognize deferred tax assets that are implicitly offset by increases in taxes payable. These situations are generally bad news

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for tax departments. They usually occur when governments restrict tax departments from deducting economic costs or force them to recognize revenues when there is still too much uncertainty to recognize them for financial reporting. For example, companies are not permitted to deduct projected medical obligations for retired employees that are expensed for financial reporting when employees earn the right to claim these future benefits. Similarly, as we just saw, they are not permitted to deduct warrant costs until they are paid, even when they can be predicted reliably.

Company 2 would prefer to deduct the warranty claims in year 1 for tax purposes. The current provision is larger in year 1 because Company 2 could not deduct the warranty claims in year 1. Thus, the tax rule prohibiting companies from deducting anticipated warranty costs gives rise to a deferred tax asset, which is offset by an increase in taxes payable (because the current provision is larger than it would be if companies could deduct the anticipated claims).

However, similar to above, there is a significant economic difference between the increase in the deferred tax asset and the increase in taxes payable. They are both recorded at the same dollar value. However, a significant portion of taxes payable must be paid in year 1, whereas the tax savings associated with the asset will not be received until the future. Thus, while accountants record the same amount for the asset and liability, the present values of these items differs. This is the reason managers who can see through this GAAP imperfection would prefer not to have deferred tax assets.

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Tax expense = Currentprovision + Deferred

provision

Federal = +

State = +

Non-US = +

Other = +Total = +

Intel 2006

Search IconThis exercise requires you to search for information.

Computation IconThis exercise helps you learn how to compute financial measures.

Exercise 9.01Part 1Use Intel’s 2006 Annual Report.

Complete the tax equations in the table below for Intel.

Part 2

(a) Locate or estimate how much income taxes Intel paid during 2006.

(b) Locate or estimate how much income taxes Gap paid during fiscal 2002 (Search Gap’s 2002 Annual Report, Gap_AR_02.pdf )

Hint: Companies are required to disclose income taxes payments if they are material. Typically, they do so at the bottom of the statement of cash flows, in a supplementary cash flow footnote, or in the tax footnote.

Part 3The following parts refer to the deferred taxes table on page 74 of Intel’s 2006 Annual Report. Companies are required to report this table when their deferred tax assets and liabilities are material.

(a) How do the entries in this tax table relate to specific line items in the financial statements?

(b) Determine the 2006 changes in the following three accounts: (1) deferred tax assets; (2) deferred tax liabilities; and (3) net deferred tax assets (liability).

Usage IconThis exercise helps you learn how accounting reports are interpreted and used by outsiders.

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Part 1 asked you to determine Intel’s 2006 deferred tax provision (related to net income reported on the income statement). The deferred provision is related to the change in net deferred tax assets and liabilities:

The change in net deferred taxes during a year is the deferred provision for comprehensive income, which has two components: (1) the deferred provision associated with net income reported on the income statement (commonly abbreviated as the “deferred provision” when it is clear that it pertains to the income statement), and (2) the deferred provision associated with other comprehensive income.

(c) How much of the 2006 change in the net deferred taxes is explained by the deferred tax provision associated with net income?

(d) What events and circumstances related to other comprehensive income likely affected Intel’s deferred tax accounts during 2006?

(e) Do the deferred taxes associated with net income (part (c) above) and other comprehensive income (part (d) above) fully explain the change in net deferred taxes? If not, what are other material events or circumstances that likely explain the change?

(f ) What amount did Intel recognize at year-end 2006 for deferred tax liabilities related to depreciation?

(g) True or False: The liability you identified in (f ) represents the difference between the $17,602 of net PP&E reported on the balance sheet and these assets’ tax basis.

(h) Assuming a 35% tax rate, estimate the tax basis of Intel’s net PP&E at the end of 2006.

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Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity

Net IncomeCash change

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' EquitiesRECORDKEEPING

REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income

Direct Cash Flows Balance Sheets Income Statements

Record Keeping and Reporting IconThis exercise helps you meet the outsiders’ record keeping and reporting challenge — reverse engineering entries.

Exercise 9.02This exercise pertains to tax-related questions on the 2007 final exam, which was based on a supplement from Motorola’s fiscal 2006 annual report. Motorola’s 2006 fiscal year ends December 31, 2006.

RequiredAnswer final exam 2007 questions 3a, 3f, 3j, 3l, and 4c. Be sure to read the directions for question 4 on the top of page 11, which specifies how account names should be chosen.


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Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income



Exercise 9.03This exercise pertains to tax-related questions on the 2006 final exam, which was based on a supplement from Hewlett-Packard’s (HP’s) fiscal 2005 annual report. HP’s fiscal 2005 year started on November 1, 2004 and ended on October 31, 2005.

RequiredAnswer final exam 2006 questions 2c, 3a, and 4d.


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Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income



Exercise 9.04This exercise pertains to tax-related questions on the 2005 final exam, which was based on a supplement from Boston Scientific’s fiscal 2004 annual report.

RequiredAnswer final exam 2005 questions 2a, 4a, 4f, and 5c. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen.


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Exercise 9.05This exercise pertains to tax-related questions on the 2004 final exam, which was based on a supplement from AMD’s fiscal 2003 annual report.

RequiredAnswer final exam 2004 questions 1g, 1h, 1j, and 2d. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen.


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Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income



Exercise 9.06This exercise pertains to tax-related questions on the 2003 final exam, which was based on a supplement from Gateway’s fiscal 2002 annual report.

RequiredAnswer final exam 2003 questions 1e, 1j, 2j, 3c, 4g and 4h. Be sure to read the directions for question 4 on the top of page 8, which specifies how account names should be chosen.


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STOCK OPTIONSThis section provides an in-depth look at stock options and related tax consequences. By taking a closer look, you will gain an appreciation for the complexity behind the reported numbers and thus enable you to better interpret disclosures and the company’s overall performance.

Options give employees the right to purchase their employer’s stock at a price specified when the options are awarded — the exercise price. Typically, the exercise price equals, or is very close to, the stock’s fair value on the date the options are awarded — the grant date — and employees can not exercise the options until after a pre-specified period when employees earn the right to exercise the options, called the vesting period. Once vested, employees can exercise options at any time during the exercise period, which typically extends for ten or more years.

Grant Date

Vested Date

Vesting Period Exercise Period

Expiration Date

The key business decisions associated with stock-based awards are: whether to grant them, how many to grant, how to set parameters affecting their value to employees (e.g., the exercise price of options), and how long employees must work to earn them (the vesting period).

These are challenging decisions potentially creating considerable value for current shareholders by aligning employees’ and shareholders’ interests and giving employees an incentive to work diligently to increase shareholder value. Simply put, options are effective when the marginal employee effort motivated by the option incentive increases the total value of owners’ equity (relative to what it would have been without the incentive) more than the value the employee receives from exercising the options. When this occurs, granting options is a good investment for current shareholders.

Both the effectiveness of the incentive and the value the employee receives are determined by the option’s exercise prices, vesting dates, the number of options granted, and other features of option plans. However, there is no formula for determining when these parameters are set appropriately and thus when the incentive effect on total owners’ equity more than compensates for the value employees receive.

Moreover, options are fraught with conflicts of interest and employees, especially top management, have two ways to act on these conflicts and thus serve their own interests at the expense of current shareholders:

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• Influence compensation committees unduly: A lack of independence between senior management and the board of directors can lead the board to adopt stock option plans that shift excessive value to employees (e.g., issuing too many options or specifying vesting periods that are too short). In principal, compensation committees work independently of management. However, the business media is full of stories about compensation committees apparently have not maintained this independence.

• Manipulate reported earnings and other financial statement information: Stock-based compensation gives management an incentive to manipulate accounting information in an effort to drive up stock prices. This incentive was arguably the root cause of the 2002 accounting scandals.

The challenges associated with the business decisions related to stock-based compensation awards affect and are affected by the related accounting decisions. The most recent accounting standard, FAS 123 Revised (abbreviated as FAS 123R), Accounting for Stock-Based Compensation, was issued by the FASB after years of heated controversy. It specifies a fair-value method of accounting and reporting standards for all agreements where: (a) employees receive employers’ stock or other equity instruments with returns based on employers’ stock’s prices (such as stock options), or (b) employers incur liabilities based on their stock prices.

tax ConsequenCes oF stoCk optionsFor tax purposes, options are classified as incentive stock options (ISOs) or non-qualified stock options (NSOs). The critical distinction between ISOs and NSOs centers on the tax consequences for employers and employees.

For NSOs, the company receives a tax deduction on the exercise date. The tax deduction is the amount by which the fair value of the common stock on the exercise date exceeds the option’s exercise price. The tax benefit of this deduction is the company’s tax savings: the deduction multiplied by the company’s tax rate.

When employees exercise NSOs, they are taxed at ordinary tax rates (rather than lower capital gains tax rates) for the same amount their employers deduct — the excess of the fair value of the common stock on the exercise date over the option’s exercise price. Thus, the government taxes NSOs the same as it taxes other compensation such as wages: the employer receives a deduction and the employee is taxed at ordinary rates.

Old Final ExamsYou will only be responsible for the fair-value method. Most companies did not adopt this method until 2006.

Thus, stock-option questions on final exams before 2007 were generally based on the intrinsic value method and will not help you prepare for this year’s exam.

You should also ignore option-related items reported for 2005 in 2007 annual reports. They are mostly based on the intrinsic method.

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By contrast, for ISOs, the company does not receive a tax deduction and thus pays higher taxes (if it has taxable income). Employees are generally not taxed when they exercise ISOs (unless they are subject to alternative minimum taxes). Rather, employees are taxed later when they sell the shares they received at the exercise date, but at lower capital-gains rates.

Everything else equal, employees would always prefer ISOs and employers would prefer NSOs. However, employers with net operating loss carryforwards not anticipating paying taxes in the near future often use ISOs. They do not need the tax benefits of NSOs and they can persuade employees to accept fewer ISOs: employees receive the same after-tax benefits with fewer ISOs.

Example AssumptionsThe assumptions below will be used to demonstrate the tax consequences of options and their financial reporting using the fair value method. • ABC grants 1,000 non-qualified stock options (NSOs) with a $60

exercise price on January 1, 2001 (grant date). • The fair value of ABC’s non-par stock is $60 on the grant date.• The options have an estimated value of $6 per share on the grant date

based on an accepted valuation model. • The options are 100% vested after 3 years. • All 1,000 options are exercised on January 1, 2004 (exercise date).• The fair value of the common stock is $100 on the exercise date.• The company’s tax rate is 40%.

Tax Consequences Example • The company receives a $40,000 tax deduction when the options are

exercised: 1,000 shares x ($100 - $60)• The tax benefit from the exercised options is $16,000: 40% of the

$40,000 tax deduction.

Fair Value methodUnder the fair value method, stock-option compensation cost is measured at the grant date based on the value of the options on that date and is subsequently recognized as service is rendered during the vesting period. Note: even though the compensation cost is measured on the grant date, no entry is recorded at this time. Instead, this cost is gradually expensed during the vesting period (or capitalized in situations where GAAP requires compensation costs be capitalized, such as compensation related to production employees, which is capitalized to inventory and subsequently expensed through cost of sales).

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= + Paid In Capital - Compensation

Expense= + + $2,000 - + $2,000

Debit CreditCompensation expense $2,000

Paid in capital $2,000or

In the ABC example, we are assuming ultimately all of the 1,000 granted options are fully vested and exercised. In practice, options are sometimes forfeited before they are fully vested because employees leave the company or for other reasons. At other times options are not exercised by the end of the exercise period — they expire unused.

So long as the forfeitures are not associated with market conditions such as declining stock prices, FAS 123R requires companies to adjust the compensation cost for expected forfeitures. For example, if, at the time ABC granted the options in 2001, it expected 3% of the 1,000 options to be forfeited, it would have amortized $5,820 (=$6 x 1,000 x (1-.03)) over 2001-2003 rather than $6,000 (= $6 x 1,000). FAS 123R also requires companies to adjust the amount to be amortized each reporting period if it changes its forfeiture forecasts and to “true-up” for actual forfeitures at the end of the exercise period. In particular, the expense could be negative during the exercise period or at the end of the period if forfeiture forecasts were increased or actual forfeitures were greater than expected.

By contrast, there are no adjustments to the compensation expense for options not exercised because of changing market conditions. For example, if ABC’s stock price stayed below the option’s $60 exercise price throughout the exercise period and, as a result, none of the 1,000 options were exercised, ABC would not reverse the $6,000 of compensation expense recognized during 2001-2003: option expenses are not trued-up for changes in market conditions.

Under the fair value method, deferred taxes are also recognized during the vesting period. Recall, deferred taxes arise from timing differences between financial and tax reporting. There is a timing difference under the fair value method because compensation expense is recognized during the vesting period for financial reporting; but a tax deduction is not permitted until options are exercised.

Entries During Vesting PeriodUnder the fair value method, ABC estimates the compensation cost at the grant date, January 1, 2001, using a widely accepted option pricing model: $6,000 (= $6 x 1,000). This cost is expensed evenly over the 2001-2003 vesting period by recording the following pretax entry each of these three years:

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Under the fair value method, there is generally both a timing difference (affecting deferred taxes) and a permanent difference (not affecting deferred taxes). This occurs because compensation cost is defined differently for financial and tax reporting: the financial reporting expense is based on an estimate of the options’ value on the grant date and the tax deduction on the excess of the fair value of the stock price on the exercise date over the exercise price (which is the option’s value on that date).

For example, ABC recognizes a total of $6,000 financial reporting expense during 2001-2003 and records a $40,000 tax deduction in 2004. $6,000 of the $40,000 is a timing difference, giving rise to a deferred tax asset, and $34,000 is a permanent difference. We will show how the $34,000 permanent difference is accounted for later when we study the entries at the 2004 exercise date.

An $800 deferred tax expense is recorded in 2001-2003 (40% of the $2,000 excess of the financial reporting expense over the tax deduction). Actually, a tax benefit (negative expense) is recognized:

+ Deferred Tax Asset = - Deferred Tax

Expense+ + $800 = - - $800

Debit CreditDeferred tax asset $800

Deferred tax expense $800or

Another difference between the tax rules and financial reporting under the fair value method is expense is recognized for financial reporting when options are vesting (regardless of whether they are ultimately exercised) while tax deductions are only permitted for options exercised.

Entries At Exercise DateBefore considering the pretax entry recognized at the exercise date, January 1, 2004, recall the pretax consequence for owners’ equity of the earlier entries is $0: a $6,000 increase in paid-in capital is offset by a $6,000 pretax decrease in retained earnings, representing 3 years of compensation expense. Thus, after the 2001-2003 pretax entries, paid-in capital reflects the value of the consideration employees have contributed by rendering services.

When they exercise options, employees give another form of consideration: $60,000 of cash associated with the exercise price. ABC recognizes this consideration as paid-in capital:

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Debit CreditCash $60,000


Before considering the tax entry recognized at the exercise date, January 1, 2004, recall the balance sheet already reflects $2,400 of tax consequences associated with 2001-2003 entries: A $2,400 deferred tax asset and a $2,400 increase in retained earnings (associated with the $800 per year tax benefit recognized during 2001-2003).

Thus, $2,400 of the $16,000 of consideration ABC receives from the government through tax deductions has been recognized in owners’ equity prior to the exercise date. The remaining $13,600 benefit is recognized in 2004 as additional paid-in capital. The 2004 tax entry also affects the deferred and current provisions of the tax expense.

To facilitate the discussion, we will divide the 2004 tax entry into two parts. Assuming ABC can use the tax deduction in 2004, here is the entry to record the $13,600 increase to paid-in capital:

= +IncomeTaxes

Payable+ Paid In Capital

= + - $13,600 + + $13,600

Debit CreditIncome taxes payable $13,600


After recording this entry, the entire $16,000 consideration received from the government is reported in owners’ equity and thus the second part of the 2004 tax entry, which we will record next, can have no net effect on owners’ equity.

Before recording this second entry, there is still a $2,400 deferred tax asset on the balance sheet and income taxes payable only reflects $13,600 of the 2004 tax benefit. Thus, the second part of the entry: (a) removes the $2,400 deferred tax asset, (b) recognizes the remaining $2,400 benefit in income taxes payable, (c) recognizes a $2,400 tax benefit in the current provision of the tax expense, and (d) reverses the $2,400 benefit previously recognized in the deferred tax provision (expense).

Deferred Tax Asset = +

IncomeTaxes

Payable- Deferred Tax

Expense - Current Tax Expense

- $2,400 = + - $2,400 - + $2,400 - - $2,400

Debit CreditDeferred tax expense $2,400Income taxes payable $2,400

Current tax expense $2,400Deferred tax assets $2,400

or

+ Cash = + Paid In Capital

+ + $60,000 = + + $60,000

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Entries Associated with Options not ExercisedEarlier we indicated expenses are not reversed when options expire unused or are otherwise not exercised because of market conditions. We also stated expenses can be reversed for options forfeited for reasons other than changes in market conditions (such as employee terminations).

While it is true previously recognized option expense is not reversed when options are not exercised by the end of the exercise period because of market conditions, related deferred tax assets, which no longer have future benefits, must be removed from the balance sheet. Under FAS 123R, the entry to remove the deferred tax asset is:

• Decrease (credit) the deferred tax asset for the related balance,

• Decrease (debit) additional paid-in capital for any previous tax benefits recognized therein under FAS 123 or FAS 123R, and

• Expense any remainder to the income statement.

Income-Statement Entry Effects Here are the income-statement effects of the 2001-2004 example entries:

• Pretax income decreases by $2,000 each year for 2001-2003 because compensation expense is recognized as the options vest.

• Tax expense is reduced by $800 each year for 2001-2003. A negative deferred tax provision is recorded, reflecting the tax benefit associated with $2,000 of pretax compensation expense.

• A net tax expense of $0 is recognized in 2004 when the options are exercised: A $2,400 current provision, which represents the portion of

the $16,000 tax benefit on the 2004 tax form associated with financial-reporting compensation expense. The other $13,600, which is associated with tax deductions in excess of financial reporting expense, is recorded as paid-in-capital and thus does not affect net income.

A $2,400 deferred provision, which removes the deferred tax asset accumulated in 2001-2003: the benefit is no longer deferred because it is recognized on the 2004 tax form.

As indicated earlier, the income statement can also be affected when deferred tax assets are written off if options are not exercised because of changes in market conditions.

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Balance-Sheet Entry Effects Here are the cumulative balance-sheets effects of the 2001-2004 entries:

• Cash increases by the $60,000 exercise price received in 2004.

• Retained earnings decreases by $3,600: $6,000 of compensation expense recognized during 2001-2003 $2,400 tax benefit recognized during 2001-2003

• Income taxes payable decreases by $16,000 in 2004 $13,600 recorded to paid-in capital $2,400 recorded to current tax provision recorded to income

• Paid-in capital increases by $79,600: $6,000 associated with the services rendered by employees during

2001-2003 $13,600 associated with the $16,000 tax benefit received from

the government in 2004 $60,000 associated with the cash contributed by employees

Cash-Flow Statement Entry EffectsHere are the cash-flow statement effects of the 2001-2004 entries:

• The $800 deferred tax benefit recognized in net income each year from 2001-2003 is part of the deferred tax provision and thus is reconciled to its $0 cash effect in these years through the “deferred taxes” adjustment.

• The cash associated with the $60,000 exercise price is classified as a financing cash flow in 2004.

• FAS 123R mandates the $13,600 portion of the $16,000 tax benefit received in 2004, recorded as an increase to paid-in capital, be reported in the financing section of the cash flow statement. Companies are generally reporting this portion of the tax benefit with captions such as “Excess tax benefits from stock-based compensation.” Here excess refers to the additional tax benefit received beyond that previously recognized in net income (beyond $2,400 for our example). The FASB broke from tradition by requiring this item to be reported in the financing section of the cash flow statement: with one other recent exception (related to derivatives), items in the financing or investing sections are associated with direct cash flows. Recall, cash is not directly affected when the tax benefit is recognized: increase (credit) paid-in capital for $13,600 and decrease (debit) income taxes payable for $13,600. Rather, $13,600 less cash is paid to the government than would have been paid without the tax benefit.

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• Having included a non-cash item in the financing section of the cash flow statement, the FASB was forced to include an offsetting non-cash item elsewhere to ensure the statement explains the change in the beginning and ending cash balances. To this end, FAS 123R mandates cash from operations must include the taxes that would have been paid if the company had not received the tax benefit from the options. In other words, this is the taxes actually paid (a real negative cash flow) after considering the full tax benefit of the options plus an additional amount (pseudo negative cash flow) for taxes that would have been paid if the excess tax benefits had not been received ($13,600 in our example). This is equivalent to mandating cash from operations reflect the taxes that would have been paid without the $16,000 tax benefit adjusted for the $2,400 portion of the benefit recognized in income during 2001-2003.

• Having included a non-cash item in cash from operations, the FASB was forced to require companies reporting direct cash flow statements to include this non-cash item on their statements. As a result, direct cash flow statements are no longer purely direct.

Before discussing alternative operating section adjustments companies use to ensure income is reconciled to cash from operations, we will extend the ABC example slightly by assuming:

• ABC reported $1,000 of income taxes payable at the start of 2004.

• ABC reported a current provision of $17,600 in 2004, but would have reported a current provision of $20,000 if it had not included $2,400 of the $16,000 tax benefit in the current provision (see the earlier entry).

• ABC paid $3,500 of income taxes during 2004.

• ABC’s 2004 deferred tax provision was $2,400, all attributable to reversing the deferred tax asset in the earlier entry.

Given these assumptions:

• Income taxes payable can be reconciled as follows for 2004: $1,000 beginning balance+ $17,600 current provision- $3,500 payment- $13,600 excess tax benefit = $1,500 ending balance

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• For the purpose of understanding the cash-flow statement adjustments later, notice the $500 increase in taxes payable can be divided into two parts: A $13,600 decrease associated with the excess tax benefit and A $14,100 net increase associated with the current provision and

payment.

• The 2004 tax expense is $20,000 (the net-income effect): $20,000 current provision that would have been reported if ABC

did not receive a tax benefit associated with the options- $2,400 current provision associated with the options tax benefit+ $2,400 deferred benefit associated with options.

• FAS 123R mandates cash from operations reflect a $17,100 outflow for taxes (the cash-from-operations effect): $3,500 payment+ $13,600 of excess tax credits (pseudo cash flow).

• A net adjustment of +$2,900 is needed to reconcile the negative $20,000 net income effect of the tax entries — the tax expense — to their negative $17,100 effect on cash from operations. FAS 123R does not mandate how this +$2,900 adjustment should be accomplished. Here are a few approaches companies use: Report: (1) -$13,600 of “Excess tax benefit from stock-based

compensation,” which signals cash from operations includes the taxes ABC would have paid if it had not received the excess tax benefit, (2) $14,100 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of recording the $17,600 current provision and $3,500 payment; but excludes the $13,600 decrease associated with the excess tax benefits (which is shown separately), and (3) $2,400 of “Deferred taxes,” which reverses the deferred provision. Dell, Cisco, and Microsoft seem to use this approach in their first quarter reports for fiscal 2006. (There is not enough tax information in quarterly reports to confirm this hypothesis.)

Or report: (1) $500 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of all of the events affecting this account, and (2) $2,400 of “Deferred taxes,” which reverses the deferred provision. Apple and Google seem to use this approach for their first quarter results in fiscal 2006.

Or report: (1) $2,400 of “Tax benefit from stock-based compensation,” which reverses the portion of the deferred

36



provision associated with options (all of the deferred provision in the example) and represents the portion of the $16,000 tax benefit recognized in income, and (2) $500 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of all of the events affecting this account. Dell seems to use this approach in its first quarter report for fiscal 2006.

Keylessons

• Companies can and do use different formats to reconcile income effects of the tax benefits associated with options to their cash-from-operations effects.

• To interpret these disclosures, you need to understand the entries behind them and the alternative ways to reconcile their income and cash effects.

additional stoCk option disClosuresCompanies typically present considerable details about their stock-based compensation plans in footnotes. As indicated on the next page, Johnson & Johnson’s 2002 Common Stock, Stock Option Plans and Stock Compensation Agreements footnote discloses the following information, which is commonly found in companies’ footnotes:• The number of options granted, exercised, and canceled or forfeited

for the past three years. Options are cancelled when they expire and they are forfeited when employees leave the company before the options are vested. The note indicates J&J’s options generally expire after 10 years.

• The estimated fair-value of the options J&J granted during the past three years based on the Black-Scholes model and the assumptions behind these estimates (needed for the model).

• The outstanding and exerciseable (vested) options at the end of 2002 grouped by exercise price ranges.

Among other things, this information can be used to estimate the cash J&J received in 2002 when employees exercised options: $413 million = $21,012 x $19.64 (see the third row from the bottom of the table at the bottom of the first column below). This estimate is close to the $390 recognized in the financing section of the statement of cash flows as Proceeds from the exercise of stock options. The difference may be due to transaction costs expensed and included in cash from operations.

37



10 Common Stock, Stock Option Plans and StockCompensation AgreementsAt December 29, 2002 the Company had 24 stock-based com-pensation plans. Under the 2000 Stock Option Plan, the Com-pany may grant options to its employees for up to 1.6% of theissued shares of the Company’s Common Stock, plus the num-ber of shares available from the previous year that were notissued, as well as shares issued under the Plan that expiredor terminated without being exercised. The shares outstandingare for contracts under the Company’s 1991, 1995 and 2000Employee Stock Option Plans, the 1997 Non-Employee Direc-tor’s Plan and the Mitek, Cordis, Biosense, Gynecare, Centocor,Innovasive Devices, ALZA and Inverness Stock Option Plans.

Stock options generally expire 10 years from the date theyare granted and vest over service periods that range from oneto six years. All options are granted at current market priceon the date of grant. Shares available, under the 2000 StockOption Plan, for future grants are based on 1.6% of the issuedshares each year, and 49.9 million shares could be grantedeach year during the years 2002 through 2005, in addition toany other available shares as described above. Shares avail-able for future grants under the 2000 plan were 62.1 millionat the end of 2002.

A summary of the status of the Company’s stock optionplans as of December 29, 2002, December 30, 2001 andDecember 31, 2000 and changes during the years ending onthose dates, is presented below:

Weighted Options Average

(Shares in Thousands) Outstanding Exercise Price

Balance at January 2, 2000 181,486 $25.65Options granted 46,456 48.29Options exercised (27,130) 15.22Options canceled/forfeited (6,824) 33.03

Balance at December 31, 2000 193,988 32.27Options granted 8,975(1) 36.31Options exercised (30,622) 19.00Options canceled/forfeited (5,117) 49.38

Balance at December 30, 2001 167,224 34.37Options granted 48,072 57.30Options exercised (21,012) 19.64Options canceled/forfeited (4,543) 50.86

Balance at December 29, 2002 189,741 $41.42

(1) Includes 3,108 options issued to replace Inverness options outstanding at orgranted prior to the acquisition.

For the year ended December 30, 2001, there was a changein the timing of granting stock compensation and options toemployees from December 2001 to February 2002. Thischange was enacted to have 2001 results finalized in order toalign compensation with performance. The same timing ofgrants will be followed for fiscal 2002.

The average fair value of options granted was $15.49 in2002, $13.72 in 2001 and $14.79 in 2000. The fair value wasestimated using the Black-Scholes option pricing model basedon the weighted average assumptions of:

2002 2001 2000

Risk-free rate 4.39% 4.87% 5.45%Volatility 26.0% 27.0% 27.0%Expected life 5.0 yrs 5.0 yrs 5.0 yrsDividend yield 1.33% 1.33% 1.40%

The following table summarizes stock options outstanding andexercisable at December 29, 2002:

(Shares in Thousands) Outstanding Exercisable

Average AverageExercise Average Exercise ExercisePrice Range Options Life(a) Price Options Price

$.79-$11.15 5,572 1.2 $10.29 5,572 $10.29$11.16-$21.24 16,550 1.8 12.93 16,550 12.93$21.57-$39.86 43,541 4.0 27.05 42,403 26.85$40.08-$50.66 40,916 6.7 45.94 35,829 45.76$50.69-$55.91 36,337 7.8 50.74 306 51.82$57.30-$61.68 46,655 9.1 57.34 1 57.36$63.30-$66.50 170 8.0 64.37 41 64.74

189,741 6.3 $41.42 100,702 $30.47

(a) Average contractual life remaining in years.

Stock options exercisable at December 30, 2001 andDecember 31, 2000 were 99,176 options at an average exerciseprice of $24.34 and 90,384 options at an average exercise priceof $19.46, respectively.

Pages 47 - 48, Johnson and Johnson’s 2002 Annual Report

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Exercise 9.07The goal of this exercise is to give you an opportunity to practice the entries discussed in the text from the perspective of an insider.

You will need to open the following Excel file to complete this exercise: Ex_09.07.xls.

RequiredGiven the assumptions below and assuming the company uses the fair value method, complete the entries and year-end balances in the Insiders_Tax_ Template worksheet of Ex_09.07.xls.

Year-1

Income tax expense and payment

• $120 current provision recorded on year 1 tax forms

• -$240 deferred provision related to warranties

• $720 deferred provision related to depreciation

• $96 tax payment

Options

• $20 option value, as determined on the grant date, is expensed (all options vest in year 1, no option costs capitalized to inventory)

• No options exercised in year 1

• $7 deferred tax

Year-2

Income tax expense and payment

• $2,160 current provision recorded on year 2 tax forms

• $180 deferred provision related to warranties

• $600 deferred provision related to depreciation

• $1,752 tax payment

Options exercised

• No option expense in year 2

• $100 exercise price

Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income


Record Keeping and Reporting IconThis exercise helps you meet the insiders’ record keeping and reporting challenge.

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• $300 fair value when exercised

• $200 tax deduction for company when exercised (= $300-$100)

• $70 tax benefit for company (= 35% tax rate * $200)

• $3 of tax benefit previously recorded to deferred tax asset when option expensed

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+ Cash +Net

deferred tax assets

(liabilities)

= +Incometaxes

payable+

Commonstock and

APIC- Tax

expense

Year-end 2005 + $7,324 + = + + $6,245 -Tax expense + + = + + -Tax payment + + = + + -

Sell of shares to employees through stock plan

+ + = + + -

Other (unexplained) + ignore + = + + ignore - ignoreYear-end 2006 + $6,598 + = + + $7,825 -

Part 2This connects your part 1 answers to Intel’s statement of cash flows.

(a) Complete the following table using Intel’s 2006 SCF. For the first three blank columns, indicate the effects of the events on the SCF items. Combine the results of these three columns in the fourth blank column. Do these events largely explain the SCF adjustments?



Exercise 9.08Part 1This exercise centers on the balance-sheet-equation (BSE) matrix, which pertains to Intel accounts affected by tax entries and stock options during 2006.

(a) Fill in the beginning and ending balances for income taxes payable and net deferred tax assets (liabilities). Note, the net deferred tax assets (liabilities) balance will be negative in this matrix when the deferred tax liabilities exceed the deferred tax assets.

(b) Record the tax expense, tax payment, and issuance of shares to employees through stock plans.

(c) Determine the remaining unexplained amounts (if any) in income taxes payable and the net deferred tax assets (liabilities), meaning the amounts explained by other events.

Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income




41



Part 2 continued

(b) Intel received $1,046 million from its employees for the shares it issued to them. Where is this cash inflow reported in the SCF?

(c) Why is there a ($123) adjustment included in the SCF reconciliation related to employee stock?

(d) Is the ($60) income taxes payable adjustment the amount you would expect to see given the entries you recorded in part a?

(e) Does the deferred tax adjustment equal: (1) the deferred provision; or (2) the change in the net deferred tax assets (liabilities)?

(f ) Which SCF line items might reflect the unexplained entries in part a?

Part 3

Come to class prepared to answer the following:

(a) What amount did Intel recognize at year-ends 2006 and 2005 for deferred tax assets related to accrued compensation and benefits?

(b) Why would an expert state that the tax concepts related to accrued compensation and benefits are essentially the same as those for warranties?

(c) Is the accrued compensation and benefits liability for tax reporting at the end of 2006 smaller (or larger) than the one reported for financial reporting?

(d) Assuming that Intel uses a 35% tax rate for deferred tax computations, estimate the tax basis of the accrued compensation and benefits liability at the end of 2006.

(e) Would Intel’s 2006 pretax income for financial reporting have been smaller (or larger) if Intel had recognized the same “compensation

Taxexpense

Taxpayment

Employeestockissue

Comb

Net income $5,044Deferred taxes ($325)Excess tax benefit of stock plan ($123)Income taxes payable ($60)Cash from operations $10,620

Reported in Intel's 2006 SCF

Effects of Entries on SCF

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and benefits” expense for financial reporting as it did for tax reporting during 2006? How much smaller or larger? Hint: The tax effect of such difference in financial and tax reporting pretax income increases or decreases the deferred tax asset.

43




Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity




REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income



Exercise 9.09This exercise pertains to options-related questions on the 2007 final exam, which was based on a supplement from Motorola’s fiscal 2006 annual report.

RequiredAnswer final exam 2007 questions 1j, 3m, 3n, and 4f. Be sure to read the directions at the start of question 4 (on page 11).


Chapter 9 · Chapter 9: Expense Recognition ... accounting rules for financial and tax reporting...

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Transcript of Chapter 9 · Chapter 9: Expense Recognition ... accounting rules for financial and tax reporting...