ESOP- A Brief Review

Conceptual Framework• Plan under which company provides options to the employees the benefit or the right to purchase at a future date the securities offered by the company at a pre determined price.

• ESOP provides a compensation packages to attract, reward , motivate ,retain employees till the maturity of the exercise period to achieve financial goal.

• ESOP is a sensitive & controversial issue regarding recognition or non recognition of compensation expenses.

• In developed countries the Employee Stock Option Plan (ESOP) is seen an important HRD (Human Resource Development) tool.

• There are 5 types of ESOP such as Employees stock purchase plan, Option, Restricted stock, Stock appreciation rights, Phantom share.

EVOLUTION OF ESOP• In 1956, Louis Kelso, invented the first ESOP, which allowed the employees of Peninsula

Newspapers to buy out the company founders.

• ESOPs became widespread for a short period in the UK under the government of Margaret Thatcher, and particularly following the Transport Act 1985.

• The leaders of those 19th century companies of United States decided to set aside stock in the company that would be given to the employee when she or he retired.

• The ESOPs are governed by federal pension laws, called the Employee Retirement Income Security Act, or “ERISA”.

Contd.

• In 2001, the United States Congress enacted Internal Revenue Code section 409(p), which is based on equitable distribution of ESOP.

• In November 1997, the SEBI constituted a Group to review the existing regulations relating to ESOP & recommend changes thereto.

• ESOP in India should rely on the twin principles of complete disclosure and shareholders’ approval.

• SEBI issued the ESOP Guidelines in 1999 to regulate the implementation of stock option schemes and stock purchase schemes by Indian listed companies.

• State-run National Aluminum Company Limited (Nalco) has become the first public sector undertaking (PSU) in India to offer Employee Stock Option (ESOPs).

Objective of the Study

• Find out the reasons for adopting ESOP in a company.

• Find out the accounting issues regarding ESOP.

Research Methodology

• This study regarding ESOP basically conducted through secondary source of data and information & all of these aspects have been acquired from relevant books and

internet site.

Benefits of ESOP• Lock in period.

• A ‘Sense of Ownership’ for the employees.

• Kind instead of Cash

• There’s no cost.

• It’s an incentive, not an entitlement.

Regulatory Framework• The Companies Act, 1956(Companies Bill 2009 included private companies under

section 56)

• SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme), Guidelines, 1999 & SEBI provides guideline regarding disclosure of stock option compensation expenses.

• SEBI Guidelines are applicable only in case of Listed Companies. However, generally unlisted companies also voluntarily comply with these guidelines.

• New clause 22B provides restriction in acquisition of own securities from secondary

market.

• ESOP covered under section 17(2)(iii) of Income Tax Act, 1961.

Accounting Regulation on ESOP• It is the fact that US GAAP contains most comprehensive treatment regarding

accounting ESOPs.

• Accordingly, we discuss the issue under three heads: US GAAP, IASB position and Indian GAAP.

•

• The International Accounting standard Board (IASB) issued a new accounting standard, IFRS 2, on stock based compensation in 2004.

• IFRS2 requires the use of a fair value based accounting to measure and expense all share based payment transaction (IASB, 2004).

Contd.• US GAAP: -- US GAAP provides a brief guideline regarding stock option compensation

expenses. There are four pronouncement under US GAAP, such as-

APB Opinion 25 issued in 1972(Intrinsic Value Method):- APB measures compensation associated with issuance of stock options by the intrinsic value method.

SFAS 123 issued in 1993 (Fair value method):-. SFAS 123 introduced in 1993 when standard setters & financial statement users was uncomfortable with APB25 & it provides the guideline on calculation of compensation cost based on its fair value on the grant date.

SFAS 148 issued in 2002 (Transition & Disclosure):-SFAS 148 issued by FASB in December 2002, provides alternative method of transaction for a voluntary changes in fair value based method of stock option compensation expenses accounting & amends the disclosure requirement of SFAS123.

SFAS (R) issued in 2004[Fair Value Method (Mandatory)]:- SFAS 123 (Revised) is based on the underlying accounting principles that compensation costs resulting from share based payment transactions should be reflected in the financial statements at fair value.

Table 1 below gives illustration of accounting procedure under different US pronouncements.

Table 1

Illustration of accounting Procedures

Example: On April 1, 2007 a company grants an option to its Managing

Director to purchase one share of Rs. 10 face value at Rs.100(which is

the market price of the stock at that time) anytime during April 1 2008 to

March 31 2011. The recipient can exercise the option anytime after

March 31 2008; The Black-Scholes value of the option is determined to

be Rs. 16. The market price of share at the end of financial year 2007-08,

2008-09 and 2009-10 is Rs.110,Rs.115, & Rs.121 respectively. On

March 31, 2011 when the price is Rs.121 the recipient exercise the

option.

Accounting under APB 25

No accounting entry is necessary as intrinsic value is nil, exercise

price being set at market price on the grant date. On exercise of

option following accounting entry will be made.

31.032011 Bank Dr. Rs. 100 Common stock Cr. Rs. 10 Paid-in capital Cr. Rs. 90

Accounting under SFAS 123 & SFAS 123 (R )

Accounting entries are necessary to recognize fair value of option. Following

accounting entries will be necessary.

1.04.2007 Differed Option Exp Dr. Rs. 16 Paid-in Capital: Option Cr. Rs. 1631.03.2008 Personnel Exp. Dr. Rs. 8 Deferred Option Exp. Cr. Rs. 831.03.2011 Bank Dr. Rs. 100 Common Stock Cr. Rs. 10 Paid-in Capital: Option Dr. Rs. 16 Paid-in Capital Cr. Rs. 106

Note: Under SFAS, fair value accounting is optional but under SFAS123 ( R ) fair value accounting is mandatory. Further, one may debit personnel expenses directly against paid-in capital option instead of routing the expenses through differed compensation

account.

Contd.

• IASB position: -IASB issued IFRS 2, Share-based payment on 19th February 2004 ,which ensures that all the compensation provided to the employees should be recognized at fair value as an expenses on equity's in financial statement.

• Indian GAAP:- Regulatory framework of accounting of accounting of ESOP in India is at its fantasy. There is no standard on the issue by the Chartered Accountants Of India (ICAI). At present, ESOP accounting in India is governed by the SEBI Guidelines issued in 1999 and the Guidance Note issued by the ICAI in 2003.

Review of A Survey

• Out of 350 firms (including listed & unlisted) 64% Indian company & 36% foreign companies have implemented ESOP.

• .In India at least 68% of listed companies and 29% of unlisted companies give ESOPs.

• One third of listed & one fourth of unlisted companies issued more than 5% of their equity as equity compensation & has diluted more than 10% of equity to employees respectively.

• listed companies primarily use ESOPs as a reward tool, unlisted companies use it for retention and employee ownership.

• 91% of the companies said that their equity-based compensation had achieved the objectives of implementing ESOPs plans.

• 60% of the companies granting options at market price.

Contd.

• Employees get a discount of 20% to 25% for listed companies and 15% to 70% for unlisted companies.

• 23% large IT companies offer ESOPs to more than 90% of the employees & 60% small IT company provides ESOP to their employees.

• A significant portion (25%) of the companies provide for vesting linked to individual performance.

• As more and more Indian companies start following US GAAP, they are also likely to follow time-based vesting.

• Another interesting trend is that while in around 90% of the IT companies the vesting is time based, the figure is only 67% in the non-IT sector.

Contd.

• Most of the Indian companies are now following US GAAP .

• Out of 40% respondent 11% said that ESOP helps to improve profitability & rest of 29% said that it helps to improve retention & it provides an ownership sense.

• Out of 11 companies 5 companies are following disclosure under Significant Accounting Policies regarding the method of ESOP accounting and other disclosures are in Notes to Account, and remaining 6 companies are following all disclosures in Notes to Accounts.

Suggestions & Conclusion

• There is a debate about disclosure of stock option compensation expenses in foot note or in revenue statement.

• Expensing stock option is another debatable issue.

It may be the reason for the end of small, growing and start up companies’ ability to attract high quality managerial personnel and hence, the end of entrepreneurship.

• Proper disclosure of compensation expense in financial reporting may provide the investors full & accurate information about a companies’ financial position and performance.

Contd.• When Stock prices go down, ESOP became worthless.

• It defeats the very purpose of ownership & retention.

• ESOP provides various schemes which helps to motivate and retain employees for achieving company’s financial benefit , but if that employee resigns on the next day then the company will face problem.

• In India ESOP follows SEBI’s guideline.

• It has been observed that most of the small company generally adopts ESOP than the large company to attract & retain the junior employees from the large IT Company.

Contd.• ESOP helps to improve the profitability of a company by

motivating the employees

• ESOP helps to improve employees retention & it provides an ownership sense.

1. ESOP provides a compensation package to attract employees but there is no clear view about this .First of all it should be clearer and prompt.

2. ESOP should be always up to date with the present trend.

3. Disclosure procedure of ESOP expense should be always uniform for all listed & unlisted to reduce confusion & to create a clear view among the financial statement users.

Suggestion

Limitation of Study

• Here all the study regarding ESOP was based on secondary source of data .So, there is a lack of getting proper information directly.

• This study might be more perfect but lack of money and proper time was the main obstacle to make this study regarding ESOP more fruitful and effective.

Further Research

• A survey of 100 Indian companies following ESOP

• Comparative study of Indian and US companies following ESOP

THANK YOU.