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Updated: December 31, 2009 15:07 IST

ESOP valuation for financial reporting

D. Murali
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Photo: Special Arrangement.
Photo: Special Arrangement.

It is not unusual for companies to offer employee stock option plans (ESOPs) as a part of their employee’s remuneration package. ESOPs align interests of employees with that of shareholders (mainly improvement in company’s performance and consequential appreciation in share prices), and organisations offering ESOPs are required to provide for ESOPs as expense in profit and loss statement.

Providing for ESOPs as expense has significant impact on the determination of distributable profits for dividend declaration, calculation of EPS (earnings per share), determination of profits for senior management remuneration, and payment of MAT (minimum alternate tax), observes Mihir Gada, Associate Director, Transaction Advisory Services, Ernst & Young. “Therefore, it is important that ESOPs are expensed appropriately in the profit and loss statement,” he adds, during the course of a recent email interaction with Business Line.

Excerpts from the brief interview.

On the Indian vs international standards.

International accounting standards require companies to undertake fair valuation of ESOPs when quantifying ESOPs expense amount, while in the case of Indian GAAP (generally accepted accounting principles) there exists an option to either account for ESOPs expense as: (i) the amount by which the market price/ value of underlying share exceeds exercise price, or (ii) undertake fair valuation of ESOPs.

Thus, the Indian accounting norms are fairly liberal when it comes to ESOPs, as the ESOP expense under the first alternative is mostly lower than that under the second alternative.

That said, it is important that Indian accounting norms are modified such that companies are mandated to follow ESOPs fair valuation treatment as this is followed internationally and financial statements in this scenario are better appreciated globally.

On the methods of fair valuation.

For undertaking fair valuation of ESOPs, either the Black-Scholes model or the binomial model can be used, which are option valuation models. Simply stated, these models compute the value of option as difference between: (a) likely value of share at the time of exercise of option as discounted to present value; and (b) the present value of paying the exercise price.

Option pricing models consider a few variables such as the life of the option, exercise price, fair value per share, expected volatility of share price, expected dividend yield, and risk-free interest rate for computing the value of options.

On determining each of these variables.

Organisations can consider the following for determining each of the variables:

a) Expected life of the option: Organisations need to consider the likely life of option and not the total life of the option. So, while a stock option is available to the employee for say 10 years, there exists a possibility that the employee will exercise the stock option at the end of say 7 years, pay exercise price, take the shares and then sell the shares in the open market.

It will be challenging for companies (especially unlisted companies) to estimate the “expected” life of an option. Here, companies can take guidance from the prescription suggested by the Securities Exchange Commission’s Staff Accounting Bulletin No. 107 of USA.

b) Exercise price: Organisations will not face any challenge in determining this variable as the exercise price is normally mentioned in the stock option plans.

c) Fair value: For listed companies, the share price applicable on stock option grant date should be considered. For unlisted companies, an independent valuer may be appointed to determine the share value of the company as of options grant date.

d) Expected volatility of share price: While listed companies can consider historical volatility in their own share prices for the period that is same as the expected life of the option, unlisted companies can consider historical volatility in share prices of other listed comparable companies.

Indian accounting norms offer flexibility to unlisted companies to consider volatility as zero which leads to incorrect fair valuation analysis of ESOPs. International accounting norms do not give this flexibility. Thus, Indian accounting norms need immediate amendment and this flexibility that is given to unlisted companies should be reconsidered.

e) Expected dividend yield: Companies are required to estimate the future dividend yield rate (i.e. dividend per share divided by value per share). Here, companies can take a clue from their own historical dividend yield rate or dividend yield rates of listed companies in the same industry. Start-up companies (that need capital for growth for next few years) can consider lower dividend yield rates or even ‘nil’ depending on their capital requirements.

f) Risk-free interest rate: The current yield rates in Government securities (with similar residual maturity as expected life of stock options) can be considered. Data on yield rates in Government securities is widely available in newspapers or on the Internet.

A rigorous analysis needs to be undertaken to determine each variable used in option pricing models and if required an independent valuer may be appointed by companies to undertake ESOPs valuation. The value of ESOPs needs to be expensed over the period during which options will vest with the employees.

**

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