Employee Share Based Payment- Accounting & Taxability

Employee Share Based Payments, it is a payment based on price or value of shares. Share plans and share option plans are a common feature of employee remuneration, for directors, senior executives and many other employees. ESOPs are very much common among the startups where the startup gives ownership interest in the company to their employees.

Topics to be covered:

1. Key terms:

Grant: Grant means issue of options to employees under ESOP.

Option: Option means a stock option granted pursuant to the Plan, comprising of a right but not an obligation granted to an Employee under the Plan to apply for and be allotted Shares of the Company at the Exercise Price determined earlier, during or within the Exercise Period, subject to the requirements of Vesting.

Vesting: Vesting means the process by which the employee gains full rights to the options granted to him in pursuance of ESOP.

Vesting period: The period during which the vesting of the option granted to the employee in pursuance of ESOP takes place.

Exercise Period: The period from the date of vesting of options till the date the options can be exercised. On the expiry of the Exercise Period, any Options that have not been exercised will lapse and cease to be valid for any purpose.

Exercise: It is the act of an application being made by the Employee to the Company to have the Options vested in him issued as Shares upon payment of the Exercise Price. Exercise can take place as specified after Vesting.

Exercise Price: The amount to be paid by an employee at the time of Exercise of his option. This price is determined at the time of grant and remains constant over the term of the option.

Market price: Market price of a share on a given date means the closing price of the shares on that date on the stock exchange on which the shares of the company are listed.

Amortization: An accounting procedure that gradually reduces the cost or value of an asset through periodic charges against income

2. Classification of Employee Share based payments

The different types of employee share-based payment plans are employee stock option plans, employee stock purchase plans and stock appreciation rights.

For the purpose of accounting they have been classified into the following categories:

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

3. Method to account employee share-based payment plans

An employee share-based payment plan can be accounted for by adopting the following methods:

• Fair Value Method: The fair value of an ESOP is estimated using an option pricing model like the Black Scholes Merton or a Binomial Model. The most common method being used is Black Scholes Merton Model.
• Intrinsic Value Method: Intrinsic value, in the case of a listed company, is the amount by which the quoted market price of the underlying share exceeds the exercise price of an option.

In the case of a non-listed company, since the shares are not quoted on a stock exchange, value of its shares are determined on the basis of a valuation report from an independent valuer.

As per guidance note on ESOP the accounting treatment recommended is fair value method but the company can opt for Intrinsic Value method with disclosure as per Fair Value Method. As per IFRS 2 or IND AS 102 Fair value method is to be adopted.

Intrinsic Value Method

Intrinsic Value is the excess of the market price/value determined by the independent valuer of the share under ESOP over the exercise price of the Option (including upfront payment, if any)

For example

Current Market Price is Rs 100

Exercise price is Rs 70

Then Intrinsic Value is Rs 30

However, if the CMP was Rs.50 instead, there would be no intrinsic value of the option since the exercise price is more than CMP and in this case options could not be exercised and instead stand lapsed

Fair Value Method-Black Scholes Method

Under this method we will be calculating the call price of options. The benefit of this model is takes into consideration the factors like volatility, dividend yield, Risk free rate and expected life of options.

For example

Exercise price is Rs 100

Fair Value per share Rs 200

Volatility 10%

Risk Free rate 8.76 %

Expected life of option 3 Years

In this case as per Black Scholes model the value will come as Rs 123.

The formula to calculate the value is:

C = SN(d1)−Ke^−rtN(d2)

where:

d1 = logarithm of time to maturity, risk free rate of interest, Volatility, and current stock price at the date of grant

d2= function of time to maturity, volatility and d1

where:

C=Call option price

S=Current stock (or other underlying) price

K=Strike price

r=Risk-free interest rate

t=Time to maturity

N=A normal distribution

Key Points to be considered :

Expected Volatility-Listed Companies should consider historical volatility of its own shares whereas unlisted companies are recommended to consider volatility as zero. As an alternative unlisted company can consider volatility of other similar listed company

Risk free interest rate for the life of the option- The risk-free interest rate is the implied yield currently available on zero coupon government securities or bonds.

Employee Stock Option Plan (ESOP)

An organization grants ESOPs to its employees for buying a specified number of shares of the company at a defined price after the option period (a certain number of years). Before an employee could exercise his option, he needs to go through the pre-defined vesting period which implies that the employee has to work for the organization until a part or the entire stock options could be exercised.

The term ’employee’ includes a director of the enterprise, whether whole time or not.

Calculation of ESOP Expense

(Number of options expected * Fair Value or Intrinsic value)/ Vesting period* Expired Period – Recognized Expense

OR

(Number of options expected * Fair Value or Intrinsic value) * Vesting % Schedule– Recognized Expense

Employee Stock Option Plan (ESOP) – ESOP Cycle

Grant (Receives the right) ⇒ Vest (Earns the right) ⇒ Exercise (Purchase the right)

4. Employee Stock Option Plan (ESOP)- Accounting Treatment

Equity Settled:

At the date of grant

No Entry

At the end of year 1/vesting period

Employee Compensation Expense A/c Dr

To Employee Stock Option A/c

Profit and Loss A/c Dr

To Employee Compensation Expense A/c

At the time of exercise

Bank A/c Dr

To Employee Stock Option A/c

Employee Stock Option A/c Dr

To Equity Share Capital

To Security Premium

Reversal of ESOP expense

Employee Stock Option A/c Dr

To Employee Compensation Expense A/c

Options Cancelled

Employee Stock Option A/c Dr

To General Reserve

Cash Settled (or Stock Appreciation Rights)

At the date of grant

No Entry

At the End of Year 1/Vesting Period

Employee Compensation Expense A/c Dr

To Provision for Stock Appreciation Right A/c

Profit and Loss A/c Dr

To Employee Compensation Expense A/c

Fair Value to be revalued at the end of each year

At the time of exercise

Provision for Stock Appreciation Right A/c Dr

To Bank
Any excess or shortfall in provision will be settled through Profit and Loss A/c

5. Stock Appreciation Rights (SAR)

SAR means a kind of option which will be settled in cash. Under SAR, person is granted options at specific Exercise Price but shares are not to be issued instead Market Price beyond Exercise Price is paid to employee on Exercise Date.

Points to be noted:

• Employee Compensation A/c will be prepared as usual

• Instead of Employee Stock Option Account, we will prepare provision for SAR A/c

• Since provision for SAR is liability, hence its fair value will be revalued each year in calculation of expense

• Provision for SAR will be revalued till the date of exercise and its effect will be revalued till date exercise and its effect will be adjusted in employee compensation account.

6. Employee Share Purchase Plan (ESPP)

It is a scheme under which employees are granted rights to get shares at a concessional price. Such shares are allotted instantly. These shares may have some lock in period too.

Following Journal Entries are to be posted:

At the time of receiving the concessional price

Bank A/c Dr (Amount received from employee)

Employee Compensation A/c Dr (Fair value of share issued less amount received)

To Share Capital A/c ( No of shares granted*Face value of the share)

To Security Premium Reserve

Transfer of expense to profit and loss account

Profit and Loss A/c Dr

To Employee Compensation A/c

7. Taxability of ESOP

ESOPs are taxed as perquisites under section 17(2) of the income-tax Act read with Rule 3(8)(iii) of the Rules.

The taxation of ESOPs is split into two components:

i. Tax on perquisite as income from salary at the time of exercise.

ii. Tax on income from capital gain at the time of sale.

As per the recent notification, the start-ups have been given exemption to deduct TDS or treat it as perquisite. As per the notification the tax has to be to be deposited within 14 days of any of the above-mentioned event taking place

(i) after the expiry of 5 years from the end of the relevant financial year in which shares are allotted; or

(ii) from the date of the sale of such specified security or sweat equity share by the employee; or

(iii) from the date on which the employee ceases to be the employee of the person;

8. Disclosure in Financials – Notes to account

Following are to be disclosed in the notes to accounts of the company:

1. Details related to Employee Stock Option Scheme like number of options approved under the scheme, vesting requirements, exercise price, share price at the date of grant, method used, assumptions used etc.

2. Options movement during the year (for each ESOO).

Grant 1

Outstanding at the beginning of the year

Add: Granted during the year

Less: Forfeited during the year

Less: Exercised during the year

Outstanding at the end of the year (no’s)

Exercisable at the end of the years

3. Effect of ESOO on profit and loss of the company and its financial position.