Assume that on January 1, year 1, XYZ Corp. issued 1,000 nonqualified stock options with an estimated value of $4 per option. Each option entitles the owner to purchase one share of XYZ stock for $14 a share (the per share price of XYZ stock on January 1, year 1, when the options were granted). The options vest 25 percent a year (on December 31) for four years (beginning with year 1). All 500 stock options that had vested to that point were exercised in year 3 when the XYZ stock was valued at $20 per share. No other options were exercised in year 3 or year 4.

Identify XYZ’s year 1, 2, 3, and 4 tax deductions and book-tax difference (identify as permanent and/or temporary) associated with the stock options under the following alternative scenarios: (Do not round any division. Round other intermediate computations to the nearest whole dollar amount. Input all amounts as positive values. Leave no answer blank. Enter zero if applicable.)

ASC 718 does not apply to the stock options.

ASC 718 applies to the stock options.

a.

There's no book expenses associated with the stock options and there is no book-tax difference associated with the stock options in year 1, 2, or 4.

.

It is permissible to remove the bargain element that are exercised in year 3 because of tax.

In year 3, XYZ will report a $3,000 tax deduction for the stock options in year 3.

The tax deduction is calculated by [(20 – 14) x $500];

= 6 * $500

= $3,000

So, the book tax difference in year 3 is $3000 tax deduction and $0 book deduction.

b.

For book purposes,:

$1,000 a year in years 1, 2, 3, and 4 will be deducted.

This will amount to $4,000 value of options * 25% for each year of the vesting period

For tax purposes:

3,000 will be deducted in year 3 when the 500 shares are exercised.

Book tax-differences:

$1,000 will be reported as an unfavorable temporary book-tax difference in years 1, 2, 3, and 4.

In year 3,

The reversal of unfavorable book tax difference will be reported as $2000 favorable temporary book tax from year 1 and 2 on the 500 options that vested in years 1 and 2 but were exercised in year 3).

Finally, XYZ will report a $1,000 favorable permanent book tax difference in year 3 that represents the excess of the bargain element of the options of $6 per option over the $4 estimated value of the options multiplied by the 500 options that were exercised [($6 - $4) x 500 shares].

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