Valuation of ESOPs and Accounting of ESOPs

 

Important Definitions:

Employee Stock Option is a contract that gives the employees of the enterprise the right, but not the obligation, for a specified period of time to purchase or subscribe to the shares of the enterprise at a fixed or determinable price.

 

Exercise means making an application by the employee to the enterprise for the issue of shares against the option vested in him in pursuance of the Employee Stock Option Plan.

 

Exercise Period is 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 Employee Stock Option Plan.

 

Expected Life of an Option is the period of time from the grant date to the date on which an option is expected to be exercised.

 

Exercise Price is the price payable by the employee for exercising the option granted to him in pursuance of the Employee Stock Option Plan.

 

Fair Value is the amount for which stock option granted or a share offered for purchase could be exchanged between knowledgeable, willing parties in an arm’s length transaction.

 

Grant Date is the date at which the enterprise and its employees agree to the terms of an employee share-based payment plan. At the grant date, the enterprise confers on the employees the right to cash or shares of the enterprise, provided the specified vesting conditions, if any, are met. If that agreement is subject to an approval process, (for example, by shareholders), the grant date is the date when that approval is obtained.

 

Intrinsic Value is the amount by which the quoted market price of the underlying share in case of a listed enterprise or the value of the underlying share determined by an independent valuer in case of an unlisted enterprise, exceeds the exercise price of an option.

 

The vest is to become entitled to receive cash or shares on the satisfaction of any specified vesting conditions under an employee share-based payment plan.

 

Vesting Period is the period between the grant date and the date on which all the specified vesting conditions of an employee share-based payment plan are to be satisfied.

 

Volatility is a measure of the amount by which a price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period.

For accounting purposes, employee share-based payment plans are classified into the following categories:

 

(a) Equity-settled: Under these plans, the employees receive shares.

(b) Cash-settled: Under these plans, the employees receive cash based on the price (or value) of the enterprise’s shares.

(c) Employee share-based payment plans with cash alternatives: Under these plans, either the enterprise or the employee has a choice of whether the enterprise settles the payment in cash or by the issue of shares.

 

ESOP Cycle – 

Grant                     Vest                  Exercise               Issue/Settlement

 

Equity-settled Employee Share-based Payment Plans

An enterprise should recognise as an expense (except where service received qualifies to be included as a part of the cost of an asset) the services received in an equity-settled employee share-based payment plan when it receives the services, with a corresponding credit to an appropriate equity account, say, ‘Stock Options Outstanding Account’. This account is transitional in nature as it gets ultimately transferred to another equity account such as share capital, securities premium account and/or general reserve.

 

Determination of vesting period:

A grant of shares or stock options to an employee is typically conditional on the employee remaining in the employment of the enterprise for a specified period of time. Thus, if an employee is granted stock options conditional upon completing three years’ service, then the enterprise should presume that the services to be rendered by the employee as consideration

for the stock options will be received in the future, over that three-year vesting period.

 

How Cost of service is determined

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

Accounting Treatment at various stages of the cycle

Measurement

Typically, shares (under ESPPs) or stock options (under ESOPs) are granted to employees as part of their remuneration package, in addition to a cash salary and other employment benefits. Usually, it is not possible to measure directly the services received for particular components of the employee’s remuneration package. Estimating the fair value of those additional benefits is likely to be difficult. Because of the difficulty of measuring directly the fair value of the services received, the enterprise should measure the fair value of the employee

services received by reference to the fair value of the shares or stock options granted.

 

Determining the fair value of shares or stock options granted

 

An enterprise should measure the fair value of shares or stock options granted at the grant date, based on market prices if available.

 

If market prices are not available, the enterprise should estimate the fair value of the instruments granted using a valuation technique to estimate what the price of those instruments would have been on the grant date in an arm’s length transaction between knowledgeable, willing parties. The valuation technique should be consistent with generally accepted valuation methodologies for pricing financial instruments (e.g., use of an option pricing model for valuing stock options) and should incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price.

 

Valuation:

 

Intrinsic Value Method

Intrinsic value, in the case of a company, is the amount by which the fair value of the underlying share exceeds the exercise price of an option.

 

For example, an option with an exercise price of Rs 200 on an equity share whose current quoted market price is Rs  125, has an intrinsic value of Rs 75 per share on the date of its valuation.

 

Fair Value of Options: 

 

the Black-Scholes-Merton formula may produce a value that is substantially the same as a more flexible options pricing model such as the Binomial Valuation Model.

 

All option pricing models take into account, at a minimum, the following factors:

(a) the exercise price of the option;

(b) the life of the option;

(c) the current price of the underlying shares;

(d) the expected volatility of the share price;

(e) the dividends expected on the shares (if appropriate); and

(f) the risk-free interest rate for the life of the option.

 

Accounting of Options:

 

No of Employees 50
No of Grants to Each Employee 500
Contractual Life of Options 5
Vesting Period: 3 Years
Exercise Period: 3 Years
Expected Life: 5 Years
Exercise Price: 50
Market Price: 100
Expected forfeitures per year % 3%
FV as per Option Pricing Model 25
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 = 500 x50 x 0.97 x 0.97 x 0.97 = 22817
Fair value of options expected to vest = 22817 options x 25 = 342252
Per Year Cost allocation  (for three Years)
Employee compensation expense A/c Dr.        1,90,140
To Stock Options Outstanding A/c        1,90,140

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By |2019-10-04T12:05:16+00:00September 17th, 2019|Blogs, News|