Here are the cash-flow statement effects of the 2001-2004 entries:
• The $800 deferred tax benefit recognized in net income each year from 2001-2003 is part of the deferred tax provision and thus is reconciled to its $0 cash effect in these years through the “deferred taxes” adjustment.
• The cash associated with the $60,000 exercise price is classified as a financing cash flow in 2004.
• FAS 123R mandates the $13,600 portion of the $16,000 tax benefit received in 2004, recorded as an increase to paid-in capital, be reported in the financing section of the cash flow statement.
Companies are generally reporting this portion of the tax benefit with captions such as “Excess tax benefits from stock-based compensation.” Here excess refers to the additional tax benefit received beyond that previously recognized in net income (beyond
$2,400 for our example). The FASB broke from tradition by requiring this item to be reported in the financing section of the cash flow statement: with one other recent exception (related to derivatives), items in the financing or investing sections are associated with direct cash flows. Recall, cash is not directly affected when the tax benefit is recognized: increase (credit) paid-in capital for $13,600 and decrease (debit) income taxes payable for $13,600. Rather,
$13,600 less cash is paid to the government than would have been paid without the tax benefit.
• Having included a non-cash item in the financing section of the cash flow statement, the FASB was forced to include an offsetting non-cash item elsewhere to ensure the statement explains the change in the beginning and ending cash balances. To this end, FAS 123R mandates cash from operations must include the taxes that would have been paid if the company had not received the tax benefit from the options. In other words, this is the taxes actually paid (a real negative cash flow) after considering the full tax benefit of the options plus an additional amount (pseudo negative cash flow) for taxes that would have been paid if the excess tax benefits had not been received ($13,600 in our example). This is equivalent to mandating cash from operations reflect the taxes that would have been paid without the $16,000 tax benefit adjusted for the $2,400 portion of the benefit recognized in income during 2001-2003.
• Having included a non-cash item in cash from operations, the FASB was forced to require companies reporting direct cash flow statements to include this non-cash item on their statements. As a result, direct cash flow statements are no longer purely direct.
Before discussing alternative operating section adjustments companies use to ensure income is reconciled to cash from operations, we will extend the ABC example slightly by assuming:
• ABC reported $1,000 of income taxes payable at the start of 2004.
• ABC reported a current provision of $17,600 in 2004, but would have reported a current provision of $20,000 if it had not included
$2,400 of the $16,000 tax benefit in the current provision (see the earlier entry).
• ABC paid $3,500 of income taxes during 2004.
• ABC’s 2004 deferred tax provision was $2,400, all attributable to reversing the deferred tax asset in the earlier entry.
Given these assumptions:
• Income taxes payable can be reconciled as follows for 2004:
$1,000 beginning balance + $17,600 current provision - $3,500 payment
- $13,600 excess tax benefit
= $1,500 ending balance
• For the purpose of understanding the cash-flow statement
adjustments later, notice the $500 increase in taxes payable can be divided into two parts:
A $13,600 decrease associated with the excess tax benefit and
A $14,100 net increase associated with the current provision and payment.
• The 2004 tax expense is $20,000 (the net-income effect):
$20,000 current provision that would have been reported if ABC did not receive a tax benefit associated with the options
- $2,400 current provision associated with the options tax benefit + $2,400 deferred benefit associated with options.
• FAS 123R mandates cash from operations reflect a $17,100 outflow for taxes (the cash-from-operations effect):
$3,500 payment
+ $13,600 of excess tax credits (pseudo cash flow).
• A net adjustment of +$2,900 is needed to reconcile the negative
$20,000 net income effect of the tax entries — the tax expense
— to their negative $17,100 effect on cash from operations. FAS 123R does not mandate how this +$2,900 adjustment should be accomplished. Here are a few approaches companies use:
Report: (1) -$13,600 of “Excess tax benefit from stock-based compensation,” which signals cash from operations includes the taxes ABC would have paid if it had not received the excess tax benefit, (2) $14,100 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of recording the $17,600 current provision and $3,500 payment; but excludes the $13,600 decrease associated with the excess tax benefits (which is shown separately), and (3) $2,400 of “Deferred taxes,” which reverses the deferred provision. Dell, Cisco, and Microsoft seem to use this approach in their first quarter reports for fiscal 2006. (There is not enough tax information in quarterly reports to confirm this hypothesis.)
Or report: (1) $500 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of all of the events affecting this account, and (2) $2,400 of “Deferred taxes,” which reverses the deferred provision. Apple and Google seem to use this approach for their first quarter results in fiscal 2006.
Or report: (1) $2,400 of “Tax benefit from stock-based compensation,” which reverses the portion of the deferred
provision associated with options (all of the deferred provision in the example) and represents the portion of the $16,000 tax benefit recognized in income, and (2) $500 of ‘Increase (decrease) in income taxes payable,” which includes the net effects of all of the events affecting this account. Dell seems to use this approach in its first quarter report for fiscal 2006.
Key lessons
• Companies can and do use different formats to reconcile income effects of the tax benefits associated with options to their cash-from-operations effects.
• To interpret these disclosures, you need to understand the entries behind them and the alternative ways to reconcile their income and cash effects.