Accounting Treatment and Accounting Valuation of ESOP

Accounting Treatment and Accounting Valuation of ESOP

I. What is ESOP

ESOPs, 'Employees Stock Ownership Plans' or "Employees Stock Options Plans" is the generic term for a basket of instruments and incentive schemes provided to the employees of the company.

Over the years, the ESOP has taken various forms. ESOP when spelled as 'Employees Stock Ownership Plans' , relates to the broad and generic meaning which covers most types of share based payments made to employees. Share based payments can take form of

• Employee Stock Option Plan(ESOP),
• Employee Stock Purchase Plan(ESPPs) and
• Stock appreciation right

However, ESOP as 'Employees Stock Options Plans' is one of the mode of share based payment

A stock option is 'a right but not an obligation granted to an employee in pursuance of the employee stock option scheme to apply for shares of the company at a pre-determined price'.

II. ESOP's Cycle

An option is first granted to an employee and after a specific period (when exercised) vests with the employee. This period is referred to as the vesting period.

Vesting Period=Period between vesting and granting

III. How much cost to be recognized in profit and Loss statement?

Through there is no accounting standard on share based payment however Institute of Chartered accountant has issued a guidance note to establish uniform principle and practice for accounting.

In accordance to the guidance note the cost of services received in a share based payment is required to be recognised over vesting period with a corresponding credit to an appropriate equity account say,'stock option outstanding account'

IV. How Cost of service is determined?

Fair value of shares determined on grant date should be used as a cost of service received.

V. Accounting Treatment at various stages of cycle

• At the time of Grant

The Company should recognise an amount for the service received during the vesting period based upon the best available estimate of number of shares expected to vest and should revise estimate if necessary.

Example:

At the beginning of year 1, an enterprise grants 300 options to each of its 1,000 employees. The contractual life (comprising the vesting period and the exercise period) of options granted is 6 years. The other relevant terms of the grant are as below:

Vesting Period: 3 years
Exercise Period: 3 years
Expected Life: 5 years
Exercise Price: 50
Market Price: 50
Expected forfeitures per year 3%

The fair value of options, calculated using an option pricing model, is 15 per option. Actual forfeitures, during the year 1, are 5 per cent and at the end of year 1, the enterprise still expects that actual forfeitures would average 3 per cent per year over the 3-year vesting period. During the year 2, however, the management decides that the rate of forfeitures is likely to continue to increase, and the expected forfeiture rate for the entire award is changed to 6 per cent per year. It is also assumed that 840 employees have completed 3 years vesting period.

Suggested Accounting Treatment

Year 1

1. At the grant date, the enterprise estimates the fair value of the options expected to vest at the end of the vesting period as below:

No. of options expected to vest = 300 x 1,000 x 0.97 x 0.97 x 0.97 = 2,73,802 options
Fair value of options expected to vest = 2,73,802 options x 15 = 41,07,030

2. At the balance sheet date, since the enterprise still expects actual forfeitures to average 3 per cent per year over the 3-year vesting period, no change is required in the estimates made at the grant date. The enterprise, therefore, recognises one-third of the amount estimated at (1) above (i.e., ` 41,07,030/3) towards the employee services received by passing the following entry:

Employee compensation expense A/c Dr. 13,69,010
To Stock Options Outstanding A/c 13,69,010

• Between Grant and Vesting

Year 2

1. At the end of the financial year, management has changed its estimate of expected forfeiture rate from 3 per cent to 6 per cent per year. The revised number of options expected to vest is 2,49,175 (3,00,000 x .94 x .94 x .94). Accordingly, the fair value of revised options expected to vest is 37,37,625 (2,49,175 x ` 15). Consequent to the change in the expected forfeitures, the expense to be recognised during the year are determined as below:

Revised total fair value =37,37,625
Revised cumulative expense at the end of year 2= (`37,37,625 x 2/3) = 24,91,750

Expense already recognized in year 1 = 13,69,010
Expense to be recognized in year 2 = 11,22,740

2. The enterprise recognizes the amount determined at (1) above (i.e., 11,22,740) towards the employee services received by passing the following entry:

Employee compensation expense A/c Dr. 11,22,740
To Stock Options Outstanding A/c 11,22,740

• Upon Vesting

Year 3

1. At the end of the financial year, the enterprise would examine its actual forfeitures and make necessary adjustments, if any, to reflect expense for the number of options that vested. Considering that 840 employees have completed three years vesting period, the expense to be recognized during the year is determined as below:
No. of options vested = 840 x 300 = 2,52,000
Fair value of options actually vested (Rs. 2,52,000 x Rs. 15) = Rs. 37,80,000
Expense already recognized Rs. 24,91,750
Expense to be recognized in year 3 Rs. 12,88,250

2. The enterprise recognises the amount determined at (1) above towards the employee services received by passing the following entry:

Employee compensation expense A/c Dr. Rs. 12,88,250
To Stock Options Outstanding A/c Rs. 12,88,250

VI. Method of Accounting Valuation of ESOP under IGAAP

There are two methods of doing ESOP valuation Intrinsic value method and. fair value method.

• Intrinsic value method

'Intrinsic value' is the excess of the market price of the share under ESOP over the exercise price of the option. Example: A company grants an ESOP to its employees whose current market price(CMP) is INR 110 which can be exercised after 2 years for INR 80. In this case intrinsic value shall be INR 30.

However, if CMP is INR 50 instead, there would be no intrinsic value of the option since the exercise price is more than CMP and in this case options could not be exercised and instead stand lapsed.

• Fair value method

The fair value of an ESOP is estimated using an option pricing model like the Black Scholes Merton or a Binomial Model.

Factors considered in option pricing model

• Exercise price-Price at which option will be exercised
• Life of the option- When estimating the expected life of stock options granted to a group of employees, the enterprise could base that estimate on an appropriately weighted average expected life for the entire employee group or on appropriately weighted average lives for subgroups of employees within the group, based on more detailed data about employees’ exercise behaviour
• Current price of shares-Current Share Price
• Expected volatility-Listed Companies should consider historical volatility of its own shares whereas unlisted companies are recommended to consider volatility as zero. As an alternative unlisted company can consider volatility of other similar listed company
• Dividend yield- The Companies are required to estimate the future dividend yield rate. The historical dividend yield can be used to estimate its expected future dividend yield.
• Risk free interest rate for the life of the option- The risk-free interest rate is the implied yield currently available on zero coupon government securities or bonds.

VII. Which method is more appropriate?

Fair value method is considered more appropriate as it takes into various factors like time value, interest rate, volatility etc. These factors are not considered under Intrinsic value method.

VIII. Comparison of Black Scholes and Binomial Model

The longer the term of the option and the higher the dividend yield, the larger the amount by which the binomial lattice model value may differ from the Black-Scholes-Merton value.

IX. Comparison IGAAP and IND AS -ESOP Valuation

X. Conclusion

ESOP valuation plays crucial role in the success of the ESOP Scheme. ESOP valuation effects EPS of the Company and higher valuation may result into higher tax pay-out by employees as a perquisite and may turn ESOP scheme unattractive thus appropriate planning is required.

Courtesy: Mrs. Shuchi Maitra - Director at International Business Advisors

To know about the ESOP's taxation and accounting in detail, click here