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For most stock-based compensation awards, a reporting entity will recognize a related deferred tax asset. Just like any other deferred tax assets, a valuation allowance may be needed if, based on the weight of the available positive and negative evidence, it is more-likely-than-not that the deferred tax asset will not be realized. See TX 5 for guidance on assessing the need for a valuation allowance.
When an entity measures its deferred tax asset related to stock-based compensation awards or determines whether a valuation allowance is necessary, its current share price (and how far the award may be out of the money) is not a relevant datapoint. Rather, an entity should establish a valuation allowance only if it is more-likely-than-not that it will not have sufficient future taxable income to realize an economic benefit from the deferred tax asset. In particular, an entity should not consider whether a decline in the company’s share price makes it likely an option would expire unexercised or if an exercise would not result in a tax deduction sufficient to recover the entire deferred tax asset. This is the case even where expiration of an unexercised award is imminent. For example, on December 31, 20X1, an entity would not record a valuation allowance on a deferred tax asset expected to reverse when an out-of-the-money award expires on January 15, 20X2. The entity should wait until the award’s expiration date to adjust the related deferred tax asset. If an entity expects that pending deferred tax write-offs will be material, it should disclose this expectation. Refer to TX 5.7.3 for guidance on the interplay of anticipated future excess tax deductions (so-called “windfall tax benefits”) when forecasting taxable income for purposes of assessing realizability of deferred tax assets. Additionally, refer to TX 16.3.1 for interim accounting considerations of excess tax deductions.
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