Accounting For Employee Share Based Payments.

1. Accounting For Employee Share Based Payments.

2. What we are discussing today. • Objective and Importance. • Some important Terms. • Practical Example. • Various Forms of Employee Share Based Plan. • Types of Transactions • Transactions Not treated as Employee Share Based Payments • Methods of Employee share based Payment and a Illustration. • Accounting Treatment for ESOP. • Variation in vesting Period • Graded Vesting • Accounting Treatment for Modification. • Cancellation and Settlement during the vesting Period. • Dilution of Earning Per share. • Accounting treatment for Employees Stock Purchase Plan (ESPP) • Accounting treatment for Stock Appreciation Rights (SAR’S)

4. Terms which should be known before understanding the accounting for ESOP.

5. Vesting Vesting means the process by which the employee gets the right to apply for and for which the shares are issued under the option granted to him. Ex : If ABC Ltd issues 100 shares to every employee who has worked for more than 20 years and if those employees apply for these shares, then we say that these shares are vested to the employee.

6. 2.Vesting Period Vesting period means the time period over which the vesting of the options of the employee take place. Ex : ABC Ltd issues 1000 shares to employees who work for a continuous period of three years from today. Here, the period of 3 years from today is the vesting period.

7. 3. Exercise Period It means the time period after vesting within which the employee should exercise his right to buy the shares by payment of the option price on the options vested in him. If the exercise period lapses the vested option lapses and no right shall accrue to the Employee thereafter. The act of exercise implies an application being made by the employee to the company to have the options vested in him be issued as shares upon payment of option price.

8. 4. Share Option A contract that gives the holder the right, but not the obligation to subscribe to the entity’s shares at a fixed price for a specified period of time.

9. 5. Vesting Conditions The conditions that must be satisfied for a person to become entitled to receive cash, other assets or equity instruments under a share based payment arrangement. Eg : Employees service period or the employees Performance level or traget sales or target market price and many more

10. Practical Example • Practical example on ESOP and ESPP :- Often companies adopt indirect route for alloting shares to the companies. It works Like this : A company creates a trust for the employees and the trust receives its stock either by fresh allotment or by purchase of shares from shareholders or the promoters may sell their shares to the trust. The trust obtains its funds through loans and allots these shares to the employees on exercise of their right in exchange for cash and repays its loan.

11. The various forms of Employee Shares-based Payments • Employee Stock Option Plan [ESOP] • Employee Stock Purchase Plan [ESPP] • Stock Appreciation Rights [SARs]

12. Employee Stock Option Plan [ESOP] • It is a plan under which the enterprise grants employee stock option. • It 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.

13. Employee Stock Purchase Plan [ESPP]: It is the plan under which the enterprise grants rights to its employees to purchase its shares at a stated price at the time of public issue or otherwise. • Stock Appreciation Rights [SARs]: It is the right that entitles the employees to receive the cash or shares for an amount equivalent to any excess of the market value of a stated number of enterprise’s shares over a stated price. The form of payment may be specified when the rights are granted or may be determined when they are exercised. However, in some plans, the employee may choose the form of payment.

14. Types of Transactions There are three types of standard that can be identified 1. Equity Settled. 2. Cash Settled. 3. Share based with cash alternatives

15. Transactions are not treated as Employee Share – Based Payment. • Transaction in the capacity of Share holder. 2. Right to acquire Shares on the same terms as applicable to the investors.

16. Methods of accounting EmployeeShare based payments.Fair Value Method Intrinsic Value MethodFair Value Method : A fair value is the amount for which stock option granted or a share offered for purchase could be exchanged between the knowledgeable, willing parties in an arms length transaction.Intrinsic value : An 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 a independent valuer in case of an unlisted enterprise exceeds the exercise price of an option. This method may be followed as an alternative but with fair value disclosure.

17. Illustration - 1Determine the amount of Fair Value of options expected to vest to be recognized as an expense during each accounting year in respect of the employee stock option plan: At the end of third year it has been re-estimated that all vesting conditions have been fulfilled and no other further conditions are required for options to vests

18. Solution • No. of employees expected to take options = 2500 * 0.8*0.85*0.90*0.90 = 1377 • No. of options to be granted to each employee = 500 • Fair value of each option = 5 • Total fair value of each options expected to vest ( A*B*C) = Rs 3442500 • Amount of fair value of options to be recognized as an expense 1st year [3442500/4] = Rs 8,60,625 2nd year [3442500* (2/4) – 860625] = Rs 8,60,625 3rd year [(1530 employees*500 options*Rs 5) – (860625 + 86025)] = Rs 21,03,750 Since vesting period has been revised in 3rd year all the remaining liabilities in respect of employees stock option plan has been recognized at the end of 3rd year and data for the 4th year has been ignored. Note: where the right to obtain shares or stock option expires unexercised, the balance standing to the credit of the relevant equity account should be transferred to General Reserve.

19. Accounting Treatment for Employees Share Based Payment. Journal Entries. 1.To recognize an appropriate proportion of the Total Fair value of Options or Shares Expected to Vest as an Expense at the end of each accounting Period during the vesting period. Employee’s Compensation Expense A/c …… Dr To Employee Stock Option O/S A/c 2. To transfer Employees Compensation Expenses Account to Profit and Loss Account at the end of each Accounting Period during the vesting Period. Profit and Loss Account ………………………………….Dr To Employee’ Compensation Expense A/c

20. 3. To record the issue of Shares when the options are exercised during the exercise Period Bank A/c …………………………………….. Dr Employee stock Option O/S …………… Dr To Share Capital A/c To Securities Premium A/c 4. To Cancel Fair Value of Options Lapsed. Employee Stock Option O/s A/c …………. Dr To General Reserve Note : Stock options outstanding account will continue to appear on the liabilities side of the Balance Sheet under the head Share Capital until the options are lapsed or exercised.

21. Variation in vesting period The vesting period i.e. the time taken to satisfy the vesting conditions can be uncertain. For ex, if employees are granted ESOP subect condition that the enterprise achieves a 50% market share, the vesting period can be known only when the market share of the company actually reaches the specified 50% level. In these cases, allocation of option value for recognition as expense in a particular accounting period should be based on estimated vesting period. The initial estimate of vesting period on grant date should be reviewed and revised if necessary, at the end of each accounting period. In case of revision of vesting period, the basis of allocation of option value to a particular accounting period should be based on revised estimate of vesting period.

22. Graded vesting

23. Graded vesting refers to a situation where options under a plan vest on different dates. • For ex, a plan may provide that shares offered to an employee shall vest in proportion of 2:3:5 in three years commencing from fourth year. Thus if an employee is offered 100 shares under the plan, 20 shares shall vest in year 4, 30 shares shall vest in year 5 and 50 shares shall vest in year 6. in these cases, based on vesting dates, the plan is segregated in into different groups. • Each of these groups is then treated as a separate plan with specific vesting period and expected life. • Since one of the factors affecting fair value of an option is expected life, the fair value for each group should be computed separately. Fair value of a group is then allocated to accounting periods and recognized as expense for the period with reference to vesting period for the group.

24. Modifications If the modification reduces the fair value of the options granted, the modifications should be ignored. If the modification increases the fair value of the options granted, the incremental fair value is recognized as expense over the remaining vesting period.

25. The incremental fair value is difference between (i) Fair value of the option modified option estimated on the date of the modification (ii) Fair value of the original option estimated on the date of modification. If the modification occurs after vesting date, the incremental fair value Is recognized immediately, or over the additional vesting period if the Employee is required to complete an additional period of service Before becoming unconditionally entitled to the options.

26. Accounting treatment of modification Occurrence of modification Accounting treatment Modification should be ignored. The incremental fair value is recognised as an expense over the remaining vesting period The incremental fair value is recognized immediately or over the additional vesting period, if the employee is required to complete an additional period of service before becoming unconditionally entitled to the option. • If the modification occurs before the vesting date • If the modification reduces the fair value of the option granted • If the modification increases the fair value of the options granted. (Ex: when exercise price is reduced) • If the modification occurs after the vesting date

27. Cancellation and settlements during vesting period j If an enterprise cancels or settles a grant of shares or stock options during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied): • The entire amount of unamortized value of option should be recognized immediately. • Payments made to the employees on cancellation or settlement should be debited to ESOP Outstanding A/c to the maximum extent of fair value of options granted, measured at the cancellation/ settlement date. Any payment in excess of the fair value is recognized as an expense. • If new options are granted to the employees in replacement for the cancelled options, the replacements is regarded as modification. • The incremental fair value for the purpose is the difference between the fair value of replaced option and net fair value of cancelled option, as on the date of replacement.

28. Dilution of Earning Per Share (EPS) due to ESOP granted • Dilution of EPS is anticipated fall in EPS. • Dilution occurs when expected proportionate increase in number of shares is more than expected proportionate increase in profit available to equity shareholders. • For ex: if number of shares increases from 10000 to 11000 (10% increase) and profit available to equity shareholders increases from Rs 50000 to Rs 52500 (5% increase) the EPS falls from Rs 5 to Rs 4.77. The Accounting Standard (AS) 20, Earning Per Share, requires disclosure of basic and diluted EPS. • One factor contributing to dilution of EPS is issue of shares at less than fair value. • Issue of shares at less than fair value implies issue of certain number of shares for no consideration.

29. For example, • Consider the case of a share warrant for 4000 shares at exercise price Rs 40. • On exercise of the warrant, the issuer collects Rs 160000. • If fair of the shares is Rs 50, the issue proceed is equivalent of price of price 3200. • The issuer, by setting the exercise price at Rs 40, instead of Rs 50, allows the warrant holder to have 800 shares for no consideration. • The shares issued for no consideration increase number of shares but does no increase resources available to the issuer and consequently, no increase in profit can be anticipated. • These shares are taken in computation of diluted EPS as potential equity.

30. Number of shares issued for consideration = expected issue proceeds/ fair value per share Number of shares issued for no consideration = number of shares issued – number of shares issued for consideration. Issue of shares under a scheme of share based payment, increases the number of shares outstanding. Since the shares are issued at exercise price, which is lower than the fair value of shares issued , in the same way as share warrants, an ESOP gives rise to situation of dilution of EPS In calculating the number of shares issued for no consideration, the expected proceeds from the exercise of option is taken as sum of • Exercise price • Value of services to be rendered by employees in future upto the vesting date. This value of services is measured as unamortized value of option.

31. Accounting Treatment for ESPP • Same as that of ESOP • Step 1 : Compute the total Fair Value of ESPP • Step 2 : Recognise Expense over the vesting period in the same way as ESOP. • Journal Entry : Bank A/c …………………….. Dr Employees compensation A/c……………. Dr To Share Capital A/c To Securities Premium A/c

32. Accounting Treatment of Stock Appreciation Rights (SARs) Meaning : SAR is a call option held by employees who are entitled to claim cash payment to the extent of Excess of Market Price of underlying shares on exercise date over the Exercise Period. SAR are not exercised if MP of the underlying shares on exercise date is less than the Exercise Price. Accounting Treatment : 1. The employer recognizes the value of call as an expense over the vesting period. 2. The accounting procedure for ESOP and SAR are similar except that the liability for SAR is recognised as provision instead of ESOP Outstanding and Value per option is reassessed at each reporting date.

33. Accounting on the date of grant date and during vesting period • Calculate Fair Value of SAR to be recognized as expense each year. 2. Recognize Liability for SAR as Provision. Employee Compensation A/c ……………… Dr To Provision for Liability A/c 3. Transfer Recognized total expense each year to Profit and Loss A/c Profit and Loss account ………………………… Dr To Employees Compensation A/c

34. Accounting of Settlement Date Provision for Liability A/c ………….. Dr To Bank A/c Cash Paid is multiplication of No of SAR’s and Intrinsic Value of SAR Per Unit.

35. Doubts

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