US GAAP requires that, in certain cases, compensation cost be capitalized in the balance sheet, such as when employees devote significant time to a particular project (e.g., manufacturing inventory or constructing fixed assets). If the related stock-based compensation award will give rise to a tax deduction (e.g., when exercised, or over time as the asset is depreciated), ASC 718-740-25-2 states that compensation cost that is capitalized as part of the cost of an asset should be considered part of the tax basis of that asset for financial reporting purposes. As a result, at the time the compensation cost is capitalized, there would be no difference between the capitalized book basis and the deemed tax basis as it relates to the compensation cost. With respect to the determination of excess tax benefits and deficiencies and when those amounts should be recognized in the income statement, the same methodology (as when stock-based compensation is not capitalized) applies. That is, any adjustment for the excess benefit or deficiency is reflected in the same period the related tax deduction occurs.

Example TX 17-5 illustrates the journal entries that would be recorded to account for compensation expense related to a nonqualified option that is capitalized as part of an asset:

EXAMPLE TX 17-5
Capitalization of compensation cost related to an equity-classified nonqualified option

USA Corp grants nonqualified stock options to employees involved in the self-construction of a fixed asset, and $1,000 of that compensation cost is capitalized as part of the fixed asset. The asset has a 10-year life and the awards are fully vested on the grant date. USA Corp will receive a tax deduction for the amount of the intrinsic value when the option is exercised.

USA Corp has a 25% tax rate.

At the completion of construction of the asset, the book and tax basis of the compensation cost included in the cost of the asset are equal. During the first year after the asset is placed in service, the entity records $100 of depreciation expense for book purposes. Although the $1,000 is deemed to be part of the tax basis, because the expense has not yet been incurred for tax purposes, no tax deduction can be taken. As a result, Company USA has a $900 book basis in the portion of the carrying amount of the equipment that relates to the stock options compared to a $1,000 tax basis.

At the end of the second year, the employees exercise the options when the intrinsic value is $5,000 and an additional $100 of incremental book depreciation expense has been recorded. The entity receives a tax deduction for the intrinsic value of the options when they are exercised. Thus, at the end of the second year, the entity’s “tax basis” of $1,000 has been fully consumed by the tax deduction (i.e., it is now zero) and the book basis of the asset related to compensation cost is $800.

How should USA Corp account for this transaction and record the tax benefit?

The tax accounting related to the capitalization of compensation cost for an ISO is different because an ISO is not ordinarily expected to result in a tax deduction and therefore the tax effects are recorded only upon a disqualifying disposition. As an ISO is not expected to result in a tax benefit to the entity, no deferred tax benefit is established either at the outset or as the compensation cost is either capitalized or recognized in the income statement (through amortization or depreciation). Upon a disqualifying disposition, however, an entity will receive a tax deduction or may receive additional tax basis in the asset. If the entity receives a tax deduction, assuming the related capitalized asset is not yet fully amortized or depreciated, upon the disqualifying disposition, a current tax benefit is reflected in the income statement while a deferred tax liability is recognized for the related temporary difference.