excess/general tax benefits from stock based compensation
anyone familiar with how the accounting goes for excess/general tax benefits for stock based compensation? from my understanding:
1. general tax benefits from SBC added back to cash flow from operations, also add to additional paid in capital
2. excess tax benefits from SBC subtract from cash flow from operations, add to cash flow from financing
do people agree with this? i guess i didn't have a problem with this until i was looking at a company that had an adjustment on CFF for excess tax benefits from SBC, though didn't have an entry included for CFO. i wanted to assume that the excess portion was embedded in the general tax benefit from SBC (which was an entry that was included), though i wasn't sure if this was the correct approach
When SBC is initially awarded, the company expenses the FMV of the comp on the IS. When the options/warrants are exercised by the employee, the value of the proceeds is deducted for tax purposes.
If the SBC increases in value from the time it was given to the time it was exercised, the tax deduction will be greater than the initial GAAP deduction on the books. This results in lower taxes, and thus an excess tax benefit (also because the actual number will likely be greater than the initial deferred tax asset).
From here on out, I'm not positive but here is what I'm thinking:
Since this is essentially an equity transaction, it is removed from the OCF section and added to the CFF section. "But it's non-cash" you say? Good question - I think it's atypical in terms of CF line items because it represents taxes you didn't have to pay, in effect providing cash to you (similar to an increase in an account payable in the operating section).
This treatment seems strange to me and I wonder if this warrants an adjustment to OCF (i.e. add back the excess tax benefit to OCF and remove it from CFF).
Any thoughts from others? Should we adjust OCF for this? How do others think about / treat this issue?
As far as I understand it the outstanding options basically function as a sort of deffered tax account like bmcrhino described. Since the cash provided to you occurs through your payment of taxes which is a result of your operations the cash benefit is listed under cash from operations along with other deferred tax assets/liabilities.
I don't think this is correct. Accounting standards dictate that the excess tax benefit associated with SBC be removed from Ops and added to Financing. So, it's not in operations.
I'm still not sure whether or not this warrants an add-back to operating cash flow measures. For example. If you look at the most recent 10-Q for Chipotle, it seems the OCF was negatively affected by this - would it be more accurate to add the excess tax benefit back into ops?
In the period that the SBC is awarded, GAAP requires you to run an estimate of their value through the IS but the IRS won't allow you to expense them as a tax benefit. As a result, you pay more cash taxes that GAAP taxes during the period and build a deferred tax asset on your balance sheet. Consequently, your GAAP income will be overstated and will need to be reconciled in the OCF statement since there is no actual cash impact on your cash flow from operations - similar to other deferred tax assets.
My bad on the poorly worded initial explanation attempt, I hope the above is more clear. I wouldn't think of it as negatively impacting OCF but rather positively impacting your net income.
Got it. Agreed.
But unlike other deferred tax assets, this one is added to the financing section. My understanding is that the DTA are removed from OCF because they are non-cash. In the case of excess benefits, they are also removed (lowering OCF) but added to the financing section, which is atypical I think.
Do you have any idea why this happens? If it truly is non-cash, why show it as a cash inflow in the financing section? Am I missing something?
If the SBC is eventually exercised at a higher value than it was originally granted at you receive a higher tax benefit than you originally wrote off. That causes the excess benefit recognition, which provides you with cash. The excess tax benefit recognition is however not caused by operational activity but rather through financing activity and should thus be included under CFF.
The cause of the excess is the time difference between the IRS and GAAP recognition of the tax benefit. The original issuance of the SBC is entirely non-cash since it doesn't affect IRS taxes in the least, but once they're actually exercised they cause a decrease in the cash tax rate. Some of this was already written into a DTA in the period of issuance under GAAP, but if the tax asset ends up being worth more than it was originally entered at it provides you with an excess cash benefit. The taxation on SBC is definitely non "non-cash" even if their issuance is. Problem here is that the excess benefit received isn't originally incurred through operational activities but through financial ones and thus needs to be moved over into CFF.
example timeline:
issue SBC => GAAP taxes down, IRS taxes flat, build a DTA (say it's worth a) stock goes up => DTA becomes worth more (now worth a+b), since on exercise you will be able to deduct more from IRS taxes exercise SBC => DTA is recognized. This recognition has two parts: one from the original amount you built, which was incurred in regular operational activity with worth (a). The other part of the benefit you incurred over the period of time between issuance and exercise with value (b).
On the cash flow statement this means that the DTA decreases by amount (a+b) which flows into CFO. However, since only (a) should be recognized as originating from operations, the excess benefit (b) is removed from CFO and inserted under CFF where it belongs.
Hope that helps, if someone who's first language is English could jump in it might help a little...
That does help. I don't know whose english your talking about, but you have perfectly good english.
So, basically the add back to financing cash flows isn't an actual cash inflow, but rather a tax savings. Correct if I'm wrong, otherwise I think I got it.
It seems that the excess tax benefit would warrant an add-back to operating cash flow in order to assess a company's true cash-generating ability.
I realize this is an old post, but still trying to understand this. I think I have most of it except how the excess tax benefits DON'T hit the income statement but still need to be subtracted from CFO and added to CFF. It's just a wash then right? No change in cash if it's not reflected in Net income to begin with (doesn't hit the income statement), and it's subtracted from CFO but then added back to CFF....feels like nothing happens.
You're Net Income was $100 w/o excess, is still $100 w/ excess, that $100 goes into Net Inc. line on CFS, you subtract whatever excess tax benefit (ETB) from the CFO and you add back the excess tax benefit in CFF....and you still have NO change in cash, NO change in Net income.
But that can't be it because we actually do realize ADDITIONAL cash tax savings....how does cash end up increasing though in the CFS?
I realize on the BS we've got APIC increasing by the ETB, but what increases on the other side to balance the BS? I'm assuming cash, but how? And if it is cash, then that means DTA doesn't change, right?
Moreover, does the APIC only increase by the ETB or the entire difference in SBC and actual value of the SBC? Because when we first issue SBC (let's say for $100), we get a $40 tax benefit ($40 tax rate), but APIC goes up by $100, not $40. So if that Stock-Based Compensation ends up being valued at $150, shouldn't APIC increase by $50? But if that's the case, then how does the rest of the BS balance?
I wouldn't add it back to the operating cash flow since it's not cash that the day to day operations of the business creates. There's also a funny bit of logic involved if you were to add it back, since you could arrive at a higher stock price than others based on an add-back that assumes that the stock price will increase.
Since the excess only exists if the stock goes up and depends on how much the stock goes up, it's not exactly a dependable source of cash. Since you would generally try to asses the cash generating ability of the business itself you wouldn't include it when you're trying to look at the past performance of the business. If you're comparing companies by their past performance you don't include debt raises either, do you? (unless you're checking how management has dealt with capital structure in the past, but that's outside of the scope of assessing the business itself)
I'm not saying you can't throw them in when you're building a model looking forward. Definitely take capital structure choices into account when you make predictions. Still, if a company uses SBC enough to create a substantial excess benefit it's most likely already overvalued (at least from what I've seen) since that requires either the stock rallying a lot or there being a crap-ton of SBC which dilutes your share in the company
Thanks. Those are good points. Also, I read that excess tax benefit doesn't flow through the income statement, but hits APIC. Is this your understanding? If so, and it's not reflected in the income tax expense line of the IS, why is it subtracted from operating cash flows?
Honestly I haven't considered the effect it would have on APIC, although it'd make sense for it to affect it.
It gets subtracted out of OCF because it's reflected in the DTA line but doesn't stem from operations.
I would imagine that it is a part of income tax expense but I read this fas 123r write up from Deloitte that said it doesn't hit the income statement. In that case it didn't make sense how it would not be in net income but taken out of OCF.
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