Employee Stock Option Plans (ESOPs) once unheard of in India are now a reality for the corporate world. Global competition makes it even more crucial to retain the best and the brightest resources and stock options serve as an effective HRD tool.
ESOPs are a part of compensation paid to an employee, though usually, they are granted over and above the fixed and variable salary components. The ‘accounting value’ of stock options is to be treated as a form of employee compensation in the financial statements of the issuing company. The accounting treatment is different as per the nature of schemes. For ESOPs, which are Equity-settled options, one-time valuation is required at grant date, whereas for cash-settled payments, valuation is required at each balance sheet date.
Different types of equity compensation may include:
1. Employee Stock Option Plans: these plans give employees the right to purchase company shares, usually at a discount.
2. Restricted Stock Grants: these give employees the right to shares only once certain criteria are achieved, for example meeting performance targets.
3. Stock Appreciation Rights (SARs): SARs give employees the right to the monetary equivalent of the appreciation in value of a specified number of shares over a specified period; such an increase in value is payable in cash.
4. Phantom Stock: is the right to a cash payment with respect to a designated event in the future, which is tied to the market value of specified number of shares; no legal transfer of share ownership usually takes place, although the phantom stock may be convertible to actual shares if defined trigger events occur.
Accounting of ESOPS
- The accounting value of the ESOP should be taken in the books of accounts as compensation cost.
- This cost should be measured as on the date of grant based on the available market prices of the instruments or estimate the value using an appropriate valuation technique.
- The cost so arrived at should be amortized over the vesting period or the estimated vesting period (beginning with the date of grant of the option and ending with the date after which the employee can exercise the option for acquiring shares of the company).
- The amortized portion shall be charged to the relevant profit and loss account while the unamortized portion is to be debited to a ‘Deferred Employee Compensation Expense’ account pending amortization.
Methods of Accounting
The relevant accounting standards relating to share-based payments are IND AS 102 and the guidance note issued by ICAI.
Both intrinsic or fair values are to be computed as on the date of grant and are not changed later, even if the assumptions used in the computation change later.
a) Intrinsic Value Method
In the case of a listed company, this is the amount by which the quoted market price of the underlying share exceeds the exercise price of an option. In the case of a non-listed company, since the shares are not quoted on a stock exchange, value of its shares is determined based on a valuation report from an independent valuer.
Fair value Method
Fair value method means the amount for which stock options granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction. The fair value of an ESOP follows the valuation techniques as used for standardized options.
Fair Values are generally calculated using an Option Pricing Model. This is a model that finds the value of a contract between two parties in which one party has the right but not the obligation to do something, usually to buy or sell some underlying asset. The following figure shows the inputs that go into these models.
Types of Option Pricing Models
This is a closed-form model, and it calculates the option price from an equation.
This method uses a pricing formula that included the stock price, the agreed sale or “strike” price of the option, the stock’s volatility, the time until the option expiration, and the risk-free interest rate offered on an alternative investment. Furthermore, this model assumes that an option can be exercised only at maturity, with no transaction costs or market imperfections, on a stock which pays no dividend and whose stock price follows a random pattern. Few variations can be made to this method to accommodate the dividend assumptions or early exercise option.
b) Binomial Lattice
The Binomial Lattice model is an open-form model, which creates a tree of possible future stock price movements for deducing the option’s price. The Black Scholes model works best for “European” options, which means the holder of the option can exercise the option only on its maturity date. However, most ESOPs are “American” options where the option holder can execute the vested option at any time up to and including the maturity date.
The binomial model breaks down the time to expiration into several time intervals, or steps. A tree of stock prices is produced and at each step it is assumed that the stock price will move up or down by an amount calculated using volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices.
The main advantage of the binomial model is that it can be used to accurately price American options. It is possible to check at every point in an option’s life (e.g., at every step of the binomial tree) for the possibility of early exercise. Where an exercise point is found it is assumed that the option holder would elect to exercise, and the option price can be adjusted to equal the intrinsic value at that point.
The Hull-White model (HW-model) is an extension of the Binomial Lattice model. It models the early exercise behavior of employees by assuming that exercise takes place whenever the stock price reaches a certain multiple M of the strike price X when the option has vested.
Fair value method Vs Intrinsic value method-
- When granted, a typical Employee Stock Option has time value but no intrinsic value. But the option is worth more than nothing and hence needs to be valued using FVM.
- The benefit offered might not be the same as the benefit realized by the employee. The benefit offered is the future value which needs to be captured today since the commitment is given today.
- In case the intrinsic value method is used for accounting, disclosure of the fair value by way of a note to accounts is mandatory.
The SEBI guidelines require the following disclosures in the Director’s report:
- Options granted during the year
- Options vested, exercised, and lapsed during the year
- Total number of options outstanding at the end of the year
- Total number of shares arising on exercise of options
- Fair value pricing model used for valuation
- Terms and conditions of ESOP
- Options granted to senior management
- Method of amortization of compensation cost
- Information regarding compensation committee / Trust
- Employee receiving more than 5% of the options granted in the particular year
- Employees who were granted more than 1% of the total issued capital of the company
- Diluted EPS
- The method of accounting used
- Impact of fair value method accounting on net profit and EPS
- Weighted average exercise prices and weighted average fair values
- A description of the assumptions