Accounting of stock options

Employee Stock Option Plans/Equity Incentive Plans (commonly referred to as ESOPs) have

been in practice for a long time, and are being increasingly used as a compensation tool by both multi-national and Indian companies

WHY ESOPSWHY ESOPS

WHY ESOPS

• ESOPs were the brainchild of a visionary economist named Louis Kelso, who said that “for capitalism to survive, there needed to be more capitalists”.

• Wealth creation for employees

• Retention tool• Retention tool

• Motivation through feeling of ownership

• According to a recent survey, Global Equity Incentives, by PwC and the National Association of Stock Plan Professionals, the need to attract and retain talent made India Inc give 35% more equity grants in 2012 compared with 2011.

Legal provisions relating to ESOPs

• The companies Act, 1956

• Foreign exchange management act 1999

• SEBI guidelines, 1999

• Income tax act, 1961• Income tax act, 1961

• SEBI guidelines are mandatory for listed

companies, however, non listed companies

also follow them voluntarily

Important issues

• Impact on company’s financials – shareholding

dilution, tax implication on employer or

employee, accounting implications

• Regulatory issues – company law, SEBI, foreign

exchange

TYPES OF STOCK OPTIONS

• Employee Stock Option Scheme (ESOS)

� An ESOS is a right to buy shares at a pre-determined price.

� The option granted under the plan confers a right but not an obligation on

the employee.

� Stock options are subject to vesting, requiring continued service over a

specified period of time. Upon vesting of options, employees can exercise specified period of time. Upon vesting of options, employees can exercise

the options to get shares, by paying the pre-determined exercise price

• Employee Stock Purchase Plan (ESPP)

� An ESPP allows employees to purchase company shares, often at a discount from FMV at grant or exercise. The plan term determines the date and price at which the employee is entitled to purchase company stock

� In an ESPP plan, an employee has to contribute a part of his salary in ESPP plan each month. An employee can choose how much of his salary he wants to contribute by himself. It can range from 1% to 15% of his salary. All the money how much of his salary he wants to contribute by himself. It can range from 1% to 15% of his salary. All the money which he contributes gets accumulated for few months and then in one go, stocks are purchased for him at some discounted price

� On what price the discount will be given depends on your company ESPP plan. However in general its the minimum of the prices in the start of the EPSS plan and at the end of the ESPP plan. The discount usually ranges upto 15%.

• Stock Appreciation Right (SAR) / Phantom Equity Plan (PEP)

� Under SAR/PEP, the employees are allotted notional shares/ units at a pre-

determined price. On completion of vesting conditions, the employee is

paid cash equivalent of the net gain i.e. appreciation in the price of

underlying shares without any cash investment. These plans generally

result in cash outflow for the company

• Restricted Stock Award (RSA)

�Under RSA, an employee receives an award of stock subject to certain underlying conditions. If the underlying conditions are not met, the shares are forfeited. The employee is considered to be the owner of the shares from the date of award with entitlement to receive dividends and voting rights. rights.

�The forfeiture conditions may be based on continued service over a specified period of time. The employee may be required to pay for RSA at grant which may be at a discount or more usually is awarded the stock at no cost.

• • Restricted Stock Unit (RSU)

� RSU or Restricted Stocks units are very simple to understand. The

Company gives company Stock to an employee without any conditions,

however there is a vesting period involved. Vesting Period is the tenure for

which you will have to wait, before you can claim those shares. So if a

company gives you 100 RSU vesting in 2 yrs. That simply means that after company gives you 100 RSU vesting in 2 yrs. That simply means that after

2 yrs, you will get 100 stocks of the company. It will be all yours and you

are free to keep them or sell them after that. RSU’s are also a great way to

reward the employees

� Until shares are actually delivered, the employee is not a shareholder and

does not have voting rights or rights to receive dividends. It is important to

note that RSU is not an immediate transfer of shares subject to forfeiture,

but a promise to give shares in the future. RSUs are generally entitled to

quasi-dividends

Key terms• Grant date: the date at which the enterprise and its employees agree to the

terms of an employee share based payment plan. If that agreement is subject to an approval process grant date is date on which this approval is obtained

• Exercise price: price payable by the employee for exercising the option granted

• Vesting date: it’s the date when an employee becomes entitled to receive cash or shares on satisfaction of any specified vesting conditions

• Vesting period: it is the period between the grant date and the date on which all the specified vesting conditions of the stock option plan are to be satisfied

• Vesting period: it is the period between the grant date and the date on which all the specified vesting conditions of the stock option plan are to be satisfied

• Vesting conditions: these are the conditions that must be satisfied for the employee to become entitled to receive cash or shares of the entreprisepursuant to the plan. They can include service conditions, which require the employee to complete a specified period of service and performance conditions which require specified performance targets to be met.

• Exercise date: date on which empolyee exercises the stock option

• Exercise period: it’s the time period after vesting within which the employee should exercise his right to apply for shares against the option vested in him in pursuance of the stock option plan

• Intrinsic value: The amount by which the

quoted market price of the underlying share in

case of listed enterprise or value of underlying

share determined by an independent valuer in share determined by an independent valuer in

case of unlisted enterprise exceeds the

exercise price of the option on the grant date

Tax implication in india• Taxation of ESOPs in India has witnessed continuous change. Till FY ending

March 1999, there were no specific provisions for taxing the benefits

arising from ESOPs. They were generally taxed as a perquisite in the hands

of the employees on the difference between the FMV of the stock on the

date of vesting of the options and the exercise price.

• Subsequently, there was a concessional tax treatment for ESOPs, which

were designed in accordance with prescribed ESOP Guidelines. The were designed in accordance with prescribed ESOP Guidelines. The

taxation triggered only at the time of sale of the shares for such qualified

ESOPs.

• Unqualified ESOPs were taxable as a perquisite on the difference between

the FMV on the date of vesting/exercise and the exercise price. During the

period April 2007 to March 2009, employer was required to pay Fringe

Benefit Tax (FBT) on benefit derived by employee from ESOPs. The

employer was allowed to recover such FBT from the employees

• Currently, ESOP benefits are taxable as perquisite and form part of

employees salary income. The employer is required to withhold tax at

source in respect of such Perquisite. The perquisite value is computed as

the difference between the FMV of the share on the date of exercise and

the exercise price.

• There are specific valuation rules prescribed for listed and unlisted

companies.

• Where shares in the company are listed on a single recognised stock

exchange then FMV shall be the average of opening and closing price of exchange then FMV shall be the average of opening and closing price of

shares on the date of exercise of option. However, if on the date of

exercise of option there is no trading in shares, the FMV shall be the

closing price of the share on any recognised stock exchange on a date

closest to the date of exercise of option and immediately preceding such

date of exercise of option.

• Unlisted companies need to determine the FMV by a Category I Merchant

Banker registered with SEBI. Specified date means the date of exercise of

option or any date earlier than the date of exercise of option, not being a

date which is more than 180 days earlier than the date of exercise of

option.

• The incremental gain (i.e. difference between sale consideration and the

FMV on the date of exercise), on sale of shares is considered a capital gain

for the employee.

• For computing capital gains, the FMV on the date of exercise becomes the

cost base. The capital gains tax treatment further depends on the holding

period and whether the shares are sold on a recognised stock exchange in period and whether the shares are sold on a recognised stock exchange in

India.

• The deductor can claim deduction for the compensation (as well as other

expenses) is from firm’s gross income to arrive at its taxable income.

Hence the deduction is allowable in the year in which the option is

exercised by the employees i.e. when the liability became certain and not

proportionately over the vesting period as claimed by the employee.

• Let's see how an employee can gain from ESOPs. On April 1 2010, suppose the company grants him 100 shares, at an exercise price of Rs 100 per share, which is also the market price that day. Let's assume that the vesting period is two years. At any point after 1 April 2012, he can pay Rs 100 a share and get the shares. If the market price on 1 August 2012 is Rs 200, he can sell the shares and make a neat profit. However, if the market price is Rs 50, he need not exercise the option. He can instead wait for the price is Rs 50, he need not exercise the option. He can instead wait for the stock price to rise.

Listed/ Gain Type Short term capital gain

(less than 1 year)

Long term capital gain

(more than 1 year)

Stocks listed on indian

stock exchage

15% tax on profits No tax

Stock listed on foregin

stock exchanbe

Profit will be treated as

your tax slab

20% with indexation

stock exchanbe your tax slab

• Employers use share-based payments as a part of remuneration package

for their employees. Hence the employers engaged in such arrangements

with employees recognize the cost of services received over the requisite

service period.

• The accounting value is determined by finding either fair value of the

option or intrinsic value of the option. Intrinsic value means the excess of option or intrinsic value of the option. Intrinsic value means the excess of

the fair value of the share at the date of grant of the option over the

exercise price of the option. Fair value of an option means the market

price of the option, had it been traded in the market.

• When we account for employee stock options, following new accounts come into existence:

• Employee compensation expense account – It forms part of the compensation expense account and is taken in the profit and loss account.

• Deferred employee compensation expense – This account is created at the time of grant of options for the total amount of at the time of grant of options for the total amount of compensation expense to be accounted. This account is a part of the Balance sheet and forms a negative balance in the Shareholders equity or Net worth.

• Employee Stock Options Outstanding account – It is a part of the Shareholders equity and is transferred to Share Capital, Share Premium or General Reserves. Amortized employee stock compensation expenses are taken in the Profit and loss account.

• Calculation of Compensation Expense / Cost: The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest.

• This cost is recognized over the requisite service period with a corresponding credit to Employee Stock Options Outstanding account. The number of instruments expected to vest is estimated at the service inception date, and is revised during the requisite service period to reflect subsequent information.

• Total compensation cost is also revised accordingly. Employees earn the right to • Total compensation cost is also revised accordingly. Employees earn the right to exercise the option after the completion of the vesting period, which is generally the service condition. The requirement that an individual remain an employee for that period is a service condition. An explicit service condition is explicitly stated in the terms of share-based arrangements (e.g., three years of continuous employee service from January 3, 2012).

• The objective of accounting for transactions under share-based arrangements with employees is to recognize compensation costs related to employee services received in exchange for equity instruments issued.

ESPP accounting

• The details of the shares issued under the ESPP and the terms and conditions thereof shall be disclosed in the Directors’ report or in an annexure thereto.

• In respect of shares issued under an ESPP during any accounting period, the accounting value of the shares accounting period, the accounting value of the shares so issued shall be treated as another form of employee compensation in the financial statements of the company. The accounting value of shares issued under ESPP shall be the excess of the fmv over the purchase price granted to the employee

Illustration

• Suppose a company issues 500 shares on 1/4/1999 under an ESPP at Rs 40 when the market price is Rs 160 and the total employee compensation for the year 1999-2000 is Rs 900,000. Also supposed that 150 unvested options lapse on 1/5/2001, 300 options are 900,000. Also supposed that 150 unvested options lapse on 1/5/2001, 300 options are exercized on 30/6/2002 and 50 vested options lapse at the end of exercise period.

• accounting value of the shares being the maximum of:

• A)500 x [(160-40) = 60,000

Esop

• 1/4/1999 Deferred empl compensation dr 60000

• to employee stock options outstanding 60000

• (Grant of options)

• 31/3/2000 Employee compensation expense Dr 24000

• deferred employee compensation expense 24000

• (amortization of def empl compensation exp over 2.5 yrs)

• 31/3/2001 Employee compensation expense Dr 24000

• deferred employee compensation expense 24000

• (amortization of def empl compensation exp over 2.5 yrs)

• 1/5/2001 employee stock option outstadning acct dr 18000

• to empl compensation expense 14400

• To deffered employee compensation exp 3600

• (reversal of compensation accounting on lapse of 150 unvested options)

• 31/3/2002 employee compensation exp 8400• 31/3/2002 employee compensation exp 8400

• to deferred empl compensation exp 8400

• 30/6/2002 cash 12000

• Empl stock option outstanding 36000

• to paid up equity capital 3000

• To share premium 45000

• (exercise of 300 options at rs 40 each, accoutning value rs 80 each)

• 1/10/2002 employee stock option outstanding

6000

• To employee compensation expense 6000

Employee stock options outstanding

account

Deferred employee compensation

expense

• Employee Stock Options Outstanding will

appear in the Balance Sheet as part of Net

Worth or Shareholders' Equity . Deferred

Employee Compensation will appear in the Employee Compensation will appear in the

Balance Sheet as a negative item as part of

Net Worth or Shareholders' Equity