GAAP/Tax Differences In Accounting For Nonqualified Employee Stock Options: The Gathering Storm

Abstract

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">The escalating size of compensation packages to senior managers and investor disillusionment resulted in the issuance of FAS 123(R). Under the current rules, the grant date fair value of employee stock options (ESO) are expensed over the vesting period. The two primary methods used to value ESO are the Black-Scholes closed form equation and the lattice model. Several studies suggested an alternative Simple model for valuing ESO that marks the option expense to market in succeeding financial statement dates and allows for the staggered exercise dates of option holders. This approach is easy to understand, would have a low cost of implementation, and offers a superior estimate of the true cash flow effects and economic injury associated with the opportunity cost to shareholders of ESO exercise. Moreover, the Simple model would head off another threat to the legitimacy of the FASB that is unfolding in the U.S. Congress as Senator Carl Levin holds hearings on ESO in the Senate Permanent Subcommittee on Investigations to decide what to do about the multi-billion dollar gap between what companies report to stockholders as ESO expense and what they deduct on their tax returns. In addition, this gap results in highly controversial rules of accounting and reporting for the favorable impact of the deductions in the financial statements.</span></span></p>

Continuing Case Against Inter-Period Tax Allocation

“…(2) FASB's failure to allow for discounting of the deferred tax liability (Rayburn, 1987); (3) complexity of the accounting methods and their potential lack of usefulness (Colley, Rue, and Volkan, 2006;Bierman. 1990;Burton and Sack, 1989; Gregory, Petree, and Vitray, 1992); (4) failure of the FASB to deal with temporary differences that are permanently deferred (Jeter and Chancy, 1988); (5) potential negative impact of the requirements on stock options (Placid, Rue, and Volkan, 2008;Nichols and Betancourt, 2006); and (6) lack of relevance of deferred tax amounts under full recognition approach (both discounted and undiscounted) in predicting stock returns (Lev and Nissim, 2004), market value of firms (Guenther and Sansing, 2004), discounted value of asset-level reversals of deferred tax balances (Guenther and Sansing, 2004), and future profitability of firms in U.K. where partial recognition method was recently replaced with the S109 approach (Gordon and Joos, 2004). Many of these concerns have not been fully addressed by S109.…”