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I am taking the liberty of starting a new thread for this discussion, hoping to get some insight for myself as well

Original question

I've been looking at some companies that have posted very large increases in Deferred Tax Assets that have resulted from newly created NOLs, themselves the product of new practices of expensing stock options in the past couple of years. While I understand the mechanics and the GAAP involved, I'm concerned that the very large increase in Investment in DTA is biasing the income tax charges way upward for both Defensive Earnings and Enterprising Earnings relative to the Accrual Earnings. Ultimately showing much lower Def. and Ent. relative to Accr. and perhaps making a seemingly "good" company look worse than it is. Thoughts?

And his follow up

Folks, I've been out for over a week and haven't kept track but having read through the threads I'm glad to see the DTA question sparked so much discussion. After reviewing the threads I have to say good job in carving this issue up. So it's with much added clarity on some of your approaches that I pose the original question once again...and we can use the 06 figures for specifics.

Given that the Accrual Inc Taxes are $54.1MM and the Investment in DTA is $74.2 (as noted above), the overall impact on Defensive Earnings is quite material even though it appears to me to be driven by the new treatment on the stock options and not real cash flows. My basic understanding of the new ruling is the company is taking a charge to income for the stock options and creating a DTA based on that value but I don't believe the ruling on its own now triggers a new, and actual cash payment for the taxes. Unless I'm wrong, these types of charges and the subsequent impact on our Defensive Earnings calcs, will put a negative bias on those calculations which aren't really reflecting reality (i.e. impacts to cashflows)...and ultimately biasing our investment decisions? Final thoughts?


Defensive earnings are calculated using working capital and the higher the assets the higher the working capital charge leading to lowered cash flow. I am not sure this is part of the original question but it has an effect. As we discussed in the previous thread(Matthew) suggested backing all tax effects out of such calculations

FASB 123

Requires that options be expensed at the market value of the options on the grant date.However, options are not predictably exercised and the expense is recognized ove rthe vesting period. Because options are exercised when the price of the stock is higher than the strike, this creates a "loss" and a tax deduction. It has always been this way and the tax benefit is part of the cash flow statement.

The financial expense and the tax deduction may be recognized in different periods and create a deferred tax asset. The deferred tax asset is the expense multiplied by the statutory tax rate(this was FASB 109)The tax benefit recognized also requires the amount to be recognized as additional paid in capital

The only change that FASB 123 brought in that I could find was the following:

Tax Benefit Situations. If the tax deduction realized exceeds the amount recognized for financial reporting purposes (that is, if intrinsic value at exercise exceeds grant-date fair value), the excess is recognized as additional paid-in capital (APIC) at the time the tax benefit is realized.

Example: In year 1, employee is granted 100 options that cliff vest after five years with an exercise price and fair market value of $10/share. Assume that the fair value is $5/share, with a total fair-value expense of $500. In year 6, the stock price has increased to $16 and the employee exercises the options, the company is entitled to a deduction of $6 per share, or a total deduction of $600. Because the deduction exceeds the fair-value expense ($5/share), the excess amount of $35 ($1 ($6 less $5) x 100 options x the tax rate (assume 35 percent) is a credit to APIC.

Footnote 82 of FAS 123R specifies that if a company will not benefit from the tax deduction (that is, if the company has a net operating loss carryforward that is increased by the tax deduction), the credit to APIC would not be recognized until the deduction reduces current taxes payable. The outcome under the FAS 123R footnote is a significant change from past practice, when the excess tax benefits were recognized when the taxable event occurred (that is, the excess tax benefits were recognized when the tax deduction was taken and then were evaluated to determine if a valuation allowance was necessary). However, FAS 123R provides for the prospective application of that change in accounting for excess tax benefits. Therefore, companies should not adjust APIC or deferred tax assets recognized before a company's adoption of FAS 123R, but should apply the new guidance to options exercised or shares vested after they adopt FAS 123R.

This would not have an effect on defensive earnigs that would have been much different than in past years except if you use the net income after options expense.They will be lower but have little to do with deferred taxes.

The paid in capital account should also not have much to do with defensive ernings. The only way i saw the deferred tax asset to impact defensive earnings was through increased working capital. Have I missed the boat? And if so I hope someone can help out

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