FASB: Unrealized Option Benefits Must Go on Income Documents

November 20, 2003 (PLANSPONSOR.com) - US accounting rulemakers have decided that companies will have to include on their income statements any unrealized tax benefits they have previously gained by issuing stock-option based compensation.

According to a Dow Jones report, the Norwalk, Connecticut-based Financial Accounting Standards Board (FASB) reached the decision at its regular Wednesday meeting. The move is expected to whip up corporate protests because the change would pull down earnings. The International Accounting Standards Board (IASB), which sets European Union bookkeeping rules, has already decided to require companies to deduct from profits such tax shortfalls.

FASB’s Wednesday decision comes as part of a broader project on stock-based compensation on which FASB and the  IASB have been working together. US companies, FASB has said previously, will have to expense employee options starting in 2005, instead of disclosing the estimated costs in their financial footnotes as current rules allow (See  FASB: Option Expensing Begins in 2005 ).

As an example, the Dow Jones report said that a company recognizing $1 billion in stock option expenses and accruing a deferred tax asset of $350 million based on a tax rate of 35%, might realize only $150 million in tax benefits if some of the options become worthless and expire without being exercised. According to the new rule, the hypothetical company would have to slash its earnings total by $200 million, the amount associated with the unrealized tax benefits.

Currently, option payouts don’t have to count as expenses in income statements, but count as compensation on companies’ tax returns boosting cash flows as well as reducing taxes paid. According to Deutsche Bank analysts, between 2000 and 2002, companies in the NASDAQ 100 index got a combined $29-billion boost to cash flow from operations from the tax deduction. Companies that derived more than half of their operating cash flows from option tax benefits during the period included Amazon.com Inc., Idec Pharmaceuticals Corp., Broadcom Corp., and Ciena Corp, the analysts said.

FASB has already heard corporate grumbling about the tax shortfall issue. Financial Executives International, for instance, has said in a letter to the FASB that any tax shortfall associated with employee options – meaning that the actual tax benefits realized upon the exercise of options falls below the tax benefits initially expected by companies – should be deducted from shareholders’ equity in companies’ balance sheets without flowing through their profit-and- loss statements. That would represent a reasonable approach, the leading advocate for corporate financial chiefs has argued, given that any excess tax benefits get credited to shareholders’ equity, not to income.