ASC 718 provides specific guidance on income tax accounting and clarifies how ASC 740 should be applied to stock-based compensation. ASC 718 requires that entities recognize the fair value of employee stock-based compensation awards as compensation cost in the financial statements beginning on the grant date. Compensation cost is based on the fair value of the awards the entity expects to vest and is recognized over the vesting period.

The related tax deduction generally occurs later than when the compensation cost is recognized for book purposes and is measured principally at the award’s intrinsic value (i.e., the amount by which the fair value of the underlying stock exceeds the exercise price of an option). For example, in the US, an entity’s income tax deduction generally is determined on the exercise date for stock options and on the vesting date for restricted stock. As a result, for awards that are expected to result in a tax deduction, a deferred tax asset is created as the entity recognizes compensation cost for book purposes.

For equity-classified awards under ASC 718, book compensation cost is determined at the grant date and compensation cost is recognized over the service period. As compensation cost is recognized, a corresponding deferred tax asset may need to be recognized to the extent there is a difference in timing for the deduction for tax purposes.

At the date of settlement (i.e., exercise date for stock options and vesting date for restricted stock), if the tax deduction exceeds the cumulative book compensation cost for the award, the tax benefit associated with any excess deduction is recognized as an income tax benefit in the income statement. If the tax deduction is less than the cumulative book compensation cost, the resulting difference is recognized as income tax expense in the income statement.

The income tax accounting for liability-classified awards (e.g., cash-settled stock appreciation rights) is similar to the income tax accounting for equity-classified awards. The difference is that the liability for book purposes is remeasured each reporting period and thus the related deferred tax asset is also remeasured to reflect the effects of remeasuring the book liability. Unlike an equity-classified award, a liability-classified award generally will not be expected to generate an excess tax benefit or tax deficiency upon settlement because the ultimate tax deduction will equal the cumulative book compensation cost as a result of the periodic remeasurements.