There is a pandora of misconception around ESOP accounting treatment, the requirement of valuation reports and disclosure etc. across the startup ecosystem.
Companies provide ESOPs to employees to buy the company’s share at a fixed or determinable price which is lower than the actual Fair market value. And, this ESOP component is offered over and above the cash compensation with an aim to retain the best employees.
This is definitely a cost for the company, not in cash but in kind. Since it’s a cost, the company has to properly record it in the books of account with the help of the methods prescribed by the Institute of Chartered Accountant (ICAI).
ICAI has prescribed rules and regulations to be followed by the companies for their accounting and bookkeeping. These rules are published in the form of Accounting Standards (AS) and Indian Accounting Standards (Ind AS). Every Indian company has to follow either of the two (i.e. AS or Ind AS) to complete their bookkeeping depending on its applicability. Surprisingly, as of now, there is no AS that specifically deals with ESOP accounting but for companies where Ind AS is applicable ICAI has issued ‘IndAS 102 – Share-Based Payments’ that govern ESOP accounting.
For companies following AS for their accounting, ICAI has issued an 80 pager guidance note that governs the accounting treatment for ESOPs. This is called ‘Guidance Note on Accounting for Employee Share-based Payments’.
We have summarized the Guidance Note in this article, and we will be discussing the IndAS 102 – Share-Based Payments in our next blog.
The Detailed Classification of Guidance Note
ESOP accounting based on the Guidance Note can be broadly classified into two categories, and it is the choice of the company to choose any of it:
- Intrinsic Value Approach
- Fair Value Approach
#1 Intrinsic Value Approach
Let’s start with the Intrinsic Value Approach: We have structured our discussion in an industry-accepted chronology and also explained the same with an example. The below example will explain an ESOP journey of a company from the beginning. Italics lines in between are the provision and the guiding principle which one needs to follow and take care of.
Here we go!
Founders of ABC limited were planning to introduce ESOPs in the compensation structure. With the help of mystartupequity.com and their channel partners, ABC Limited was able to draft an ESOP scheme that was best suited to them.
They went ahead and got it approved by their board (via board resolution) and shareholders (via special resolution) on 21st March 2019. On 1st April 2019 Mr. X, the Chief Brand Officer was granted with 5000 ESOPs, and each option was convertible into one equity share post completion of the vesting period of 4 years. Each year 25% of his options, i.e. 1250, will vest.
Now, to start off with the ESOP accounting entries, we primarily need three inputs:
- Exercise price: ICAI has provided no specific rule to determine the Exercise price. It is totally based on the best judgment of the company. ABC limited can fix the exercise price based on the discussion with their board.
- Intrinsic Value of the underlying share: Value of the shares determined by an Independent Valuer be it a Chartered Accountant or a Merchant Banker as on the Grant Date. Please note that one needs to obtain an Intrinsic Valuation report on every grant date.
- Value of the option issued: FMV of the underlined share as on the (Grant date* – Exercise price)
*Based on the industry standards, a 6 months old valuation report can be considered to determine the FMV of the underlined shares subject to the following conditions:
- No new funding round has happened in the past 6 months
- No abnormal or unusual event has taken place, which has significantly affected the business
Mystartuequity.com connected ABC Limited with its partner legal firm and valuers. With the help of the external consultants, ABC Limited arrived at the following numbers:
- Exercise price/ Strike Price was kept at INR 2500
- Intrinsic Value of the underlying share: INR 5500 (based on the share valuation report) and face value (FV) of the share was INR 10
- Value of the option issued: INR (5500 – 2500) = INR 3000
As per the Companies Act 2013, there should be at least a year between the date of grant and vesting of an option. So, in this case, the first vesting can only be on 31st March 2020.
No accounting entries are required to be passed on the grant date. We just need to have an option value in place, as discussed above. Accounting entries typically come into the picture on the completion of first vesting. On 31st March 2020, Mr. X’s 1250 options will vest having an option value of INR 3000 per option. We will be passing the below entry to record this expense:
Employee compensation of INR 37,50,000 will sit on the debit side of P&L, and Stock option outstanding will sit as a liability in the Balance sheet as a separate heading between Share Capital and Reserve and Surplus.
Assuming that Mr. X completed all the four vestings, the same accounting entry will be passed on the 31st March of Year 2, Year 3 and Year 4.
At the end of year 4, the total of the Employee compensation expenses booked in the P&L would be INR 150,00,000 (i.e. 5000 option vested of INR 3000 each), and also the Stock Options Outstanding A/c would show a total of INR 150,00,000 (i.e. 5000 option vested of INR 3000 each).
Based on the ESOP schemes Mr. X has a right to exercise the ESOP or to not to exercise the ESOP. Accounting for both the possibilities will be as follows:
1. Mr. X does not exercise the ESOP within the exercise period: The amount lying in the “Stock Options Outstanding A/c” i.e, INR 1,50,00,000 will be transferred to general reserves in the year in which the exercise period ends. In this case, to keep it easily understandable, we have assumed a 12 months exercise period. Therefore the reversal entry would be passed in Year 5.
At the end of Year 5, the Balance sheet will look like this:
2. If Mr. X exercises the ESOP within the exercise period (i.e. 12 months): We can infer that ABC Limited is liable to issue 5000 shares @ INR 2500 per share (exercise price) to Mr. X if he exercises his right to convert the options into shares. Over the period of four years, ABC Limited has booked expenses of INR 150,00,000 and liability of INR 150,00,000.
At the end of Year 5, all the options were exercised by Mr. X; therefore, Mr. X paid the exercise price, i.e. INR 1,25,00,000 (5000*2500) to ABC limited as 5000 shares are issued.
The following entry is passed for the exercise and share issue.
At the end of Year 5, the Balance sheet will look like this
- If the grant date is in between the financial year then one can book the proportionate expenses as on 31st March based on the number of months passed using the below formula:
- If Mr. X has left the organization (say after two years post completion of 50% of his vesting), then the following treatment can be done:
- If the has exercised 50% of his options:
- If he does not exercise the options: Expenses booked for two years will be reversed by passing the following entry.
#2 Fair Value Approach
Now comes the Fair value approach, all the entries that need to be passed are same as are there in Intrinsic Value Approach except the following:
- Option value will be based on the Option Valuation Report (OVR) obtained from an independent valuer be it a Merchant Banker or a practicing Chartered Accountant to determine the Value of option granted as on the date of grant. The option value in this method cannot be calculated based on the formula mentioned in the Intrinsic Value approach. OVR is different from a regular share valuation report, and the option value is arrived generally by using the Black-Scholes Model.
- On every grant date, ABC limited is liable to get an OVR. As per the market practice, an OVR not older than six months is considered valid given there is no change in the terms and conditions of the two grants and no unusual event has happened in the company that can substantially hit the options valuation. Therefore, it is advisable to plan your granting of options in a 6 months period because as per industry standards, the valuation report is valid for a maximum period of 6 months given.
Further ABC Limited also needs to do certain disclosures in the notes to accounts, and these disclosures are also prescribed by the ICAI in their Guidance note. The disclosures for the Intrinsic value approach and Fair value approach are generally the same except the below:
- Where an enterprise follows the intrinsic value approach, it should also disclose the impact on the net results and EPS – both basic and diluted – for the accounting period, had the fair value method been used.
Other than above all, the disclosures are similar for the intrinsic value and fair value approach. All the critical disclosures are listed below.
- Background of the ESO scheme is to be given in the manner given below:“Employees covered under the Stock Option Plan are granted an option to purchase shares of the company at the respective exercise prices, subject to the requirement of the vesting conditions. These options generally vest in tranches over a period of 4 years from the date of the grant. Upon vesting the employee can acquire one equity share for every option.”The stock compensation cost is computed under the fair value/ intrinsic value method and amortized as per the vesting schedule over a period of 4 years. For the year ended 31st March,….. ABC Limited has recorded the stock compensation expenses of INR …….. (previous year ……..).”
- Activity for the period needs to be summarized in the below manner:
- The exercise price, weighted average price, and a weighted average contractual life is to be given for the option outstanding at the year-end.
- Activity for the period needs to be summarized in the below manner:
Check out our blog on the tax implication of ESOPs on employees!