Digital River 2006 Annual Report Download - page 42

amount of acquired foreign operating tax loss carryforwards. The benefit of the loss carryforwards from
exercise of stock options was recognized as additional paid in capital when the deferred tax asset
valuation allowance was reversed in the fourth quarter of 2005. The benefit of the acquired tax loss
carryforwards has been reserved by a valuation allowance pursuant to United States generally accepted
accounting principles. These valuation reserves of the deferred tax asset will be reversed if and when it is
more likely than not that the deferred tax asset will be realized. We evaluate the need for a valuation
allowance of the deferred tax asset on a quarterly basis. If the benefit of these acquired tax loss
carryforwards is recognized, we will not recognize the benefit in the statement of income. Rather, the
benefit will be recognized as a reduction to goodwill.
We may face challenges from domestic and foreign tax authorities regarding the amount of tax due.
These challenges may include questions regarding the timing and amount of deductions and the allocation
of income among various tax jurisdictions. In evaluating the exposure associated with various tax filing
positions, we record reserves for probable exposures. Based on our evaluation of our tax position, we
believe the amounts related to these tax exposures are appropriately accrued. To the extent we were to
favorably resolve matters for which accruals have been established or be required to pay amounts in
excess of the aforementioned reserves, our effective tax rate in a given financial statement period may be
impacted.
No provision has been made for federal income taxes on approximately $25.8 million of our foreign
subsidiaries undistributed earnings since we plan to indefinitely reinvest all such earnings. If these
earnings were distributed to the U.S. in the form of dividends or otherwise, we would be subject to
U.S. income taxes on such earnings. The amount of U.S. income taxes would be subject to adjustment for
foreign tax credits and for the impact of the step-up in the basis of assets resulting from a Section 338
election made at the time of acquisition. If these earnings were to be distributed, the income tax liability
would be approximately $4.9 million.
Stock-Based Compensation Expense. On January 1, 2006, we adopted Statement of Financial
Accounting Standards No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires
the measurement and recognition of compensation expense for all share-based payments made to
employees and directors including stock options, restricted stock grants and employee stock purchases
made through our Employee Stock Purchase Plan based on estimated fair values. SFAS 123(R) supersedes
our previous accounting under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for
Stock Issued to Employees,” for periods beginning in 2006.
Prior to the adoption of SFAS 123(R), we had elected to apply the disclosure-only provision of
SFAS No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148. Accordingly, we
accounted for stock-based compensation using the intrinsic value method prescribed in APB 25 and related
interpretations. Compensation expense for stock options was measured as the excess, if any, of the fair value
of our common stock at the date of grant over the stock option exercise price.
We have adopted SFAS 123(R) using the modified prospective transition method under which prior
periods are not revised. Stock-based compensation expense recognized during the period is based on the value
of the portion of share-based awards that are ultimately expected to vest during the period. Stock-based
compensation expense recognized in our Consolidated Statement of Operations for 2006 includes compensa-
tion expense for share-based awards granted prior to, but not yet vested, as of December 31, 2005 as well as
compensation expense for the share-based payment awards granted subsequent to December 31, 2005. The fair
value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing
model. The fair value of restricted stock is determined based on the number of shares granted and the closing
price of our common stock on the date of grant. Compensation expense for all share-based payment awards
are recognized using the straight-line amortization method over the vesting period. Stock-based compensation
expense of $13.9 million was charged to operating expenses during 2006. The related tax benefit of
$4.9 million resulted in a net after-tax stock-based compensation expense of $9.0 million for 2006.
As stock-based compensation expense recognized in our Consolidated Statement of Operations for 2006
is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R)
38