Question

One reason companies use stock options to compensate employees is to conserve cash. Under current tax law, companies get to deduct compensation when the employees actually exercise options. Explain how the cash flow savings from stock option exercises affect the statement of cash flows.

Answer 1

Answer:

This is a very complex topic, as it relates to an intersection of two very complex topics-tax accounting and option accounting. The effects of such compensation plans on the statement of cash flows are highlighted in the chapter. First, there are no cash flow effects of stock option compensation until employees exercise options. At this time, the company receives a tax deduction for the amount the employee must report as taxable income. Second, this cash inflow, in the form of cash taxes avoided, needs to show within operating cash flows. This is effectively accomplished when the deferred tax asset associated with stock options declines. Third, a special exception requires that excess tax benefits (i.e., the amount of the deduction minus the amount of compensation expense, in aggregate across vesting periods) be reclassified to financing cash flows. This is accomplished by a subtraction of the excess tax benefits from operating cash flows, and a simultaneous addition to financing cash flows.