ESOP Accounting & Bookkeeping

There is a pandora of misconceptions around ESOP accounting treatment, the requirement of valuation reports and disclosure, etc., across the startup ecosystem.

The 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 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 Accountants (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. Still, ICAI has issued ‘IndAS 102 – Share-Based Payments’ that govern ESOP accounting for companies where Ind AS is applicable.

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.

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 them:

1. Intrinsic Value Approach
2. Fair Value Approach

Which method is more appropriate? Intrinsic or fair?

The intrinsic value approach and the fair value method are the two methods for ESOP valuation.

#1. Intrinsic Value Approach

The difference between the market price of the ESOP share and the exercise price of the option is known as “intrinsic value.” Example: A company offers its employees an ESOP with a current market price (CMP) of INR 150 that can be exercised for INR 110 after two years. The intrinsic value, in this case, is INR 40.

However, if CMP is INR 90 instead, the option has no inherent value because the exercise price is greater than CMP, thus options cannot be exercised and must instead be lapsed.

Let’s start with the Intrinsic Value Approach: We have structured our discussion in an industry-accepted chronology and 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 trica equity.com and their channel partners, ABC Limited could draft an ESOP scheme that was best suited to them.

They 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 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 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 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 monthly 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 the 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 grant date and the 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 need to have an option value in place, as discussed above. Accounting entries typically come into the picture on the completion of the 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 the 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 vesting, 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 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

Note:

• If the grant date is in between the financial year, then one can book the proportionate expenses as of 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 he 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.