How do ESOPs Impact the Profit and Loss Account of a Company?
Employee Stock Option Plans strike a balance between compensating employees well and conserving the company’s monetary resources as much as possible. Coupled with tax benefits, ESOPs are an excellent tool. This article explores how ESOPs are accounted for in a company’s Profit and Loss Account (P&L Account).
Accounting Concepts Relevant to ESOPs
To understand the accounting of ESOPs and their impact on the P&L Account of a company, it is imperative to have a sound understanding of the following accounting concepts which are applied in this context:
- Dual Entity Concept: Every transaction has two aspects – a debit aspect and a credit aspect. Every debit must have a corresponding credit. This is the basis for accounting.
- Money Measurement Concept: All goods and services must be measured in terms of money. This concept is the basis for valuation techniques discussed later in this article.
- Going Concern Concept: It is assumed that an entity will continue indefinitely or at least well into the future. It is based on this assumption that companies do not have a finite period or end date for their capital and other major accounts. An individual asset or other components might have a life, but the entity as a whole has an infinite life.
How Are ESOPs Accounted For and What Is The Impact on a Company’s P&L Account?
Legality Pertaining to the Accounting of ESOPs
Accounting for various types of transactions is globally standardized by GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
In India, companies are expected to adhere to the reporting guidelines issued by the Institute of Chartered Accountants of India, which are known as Accounting Standards. Currently, there are two official guidelines for the accounting of ESOPs, based on which the impact on the P&L Account can be gauged. Of these, the latter sheds more light on the topic. These are:
- Accounting Standard on Share-based Payments ( Ind AS 102 )
- Guidance Note on Accounting for Employee Share-based Payments
Classification of ESOPs
For accounting purposes, ESOPs are classified into three categories, viz.:
- Equity-settled, in which employees receive shares of the company upon exercising their option
- Cash-settled, in which employees receive cash commensurate to the value of a share as on a particular date
- Employee share-based payment with a cash alternative, in which the employee has a choice between being compensated through shares or cash
According to the Guidance Note, there are two methods of accounting for ESOPs. The accounting treatment, and consequently the impact on the P&L Account, change depending on the method chosen by the company. Both methods are discussed below. However, the fair value method is the one that is recommended.
Fair Value Method
Fair value is defined as ‘the amount for which stock option granted or a share offered for purchase could be exchanged between knowledgeable, willing parties in an arm’s length transaction.’
In other words, fair value is the value at which the purchase or sale of a company’s share can occur.
The term recognition in accounting parlance refers to the time period or instance in which a particular transaction is taken cognizance of, and the same is reflected in the financial statements. In this context, recognition is the period in which the accounting impact of ESOPs is felt on the financial statements, which includes the P&L account.
In an equity-based settlement, the services of a salaried employee to which shares are being offered are recognized in the period in which such services are rendered and utilized by the organization. The compensation for such services is seen as an expense and is debited to the P&L account. The other half of the transaction (refer to the dual entity concept mentioned above) involves crediting an account named ‘Stock Options Outstanding’. If and when the stock options are exercised, this account will be debited at the time of exercise.
If there is no vesting period, i.e., an employee can exercise their option immediately after the grant date, the employing company must recognize the services received from the employee and the compensation in shares in the same period. Therefore, the relevant equity account has to be credited, and the compensation has to be debited. The latter is then shown in the P&L account.
If there is a vesting period, the company must account for the services of the employee during the vesting period on a time proportion basis, and the corresponding credit has to go to the relevant equity account.
At the time of exercise of an ESOP by the employee, the shares are issued to him from the Stock Options Outstanding Account created earlier. In case the right to exercise such an option expires or the employee is terminated prior to the exercise of options, the balance in the account will be transferred to the General Reserve.
Once the time period or instance of recognition is established, the value pertaining to the options has to be ascertained or measured. According to the Guidance Note, the value of the ESOPs granted must be based on the market price when a company is following the fair value method. However, in case the market price is unavailable, other valuation techniques, particularly option pricing models like the Black Scholes model, Binomial Option Pricing, or Monte-Carlo simulation, might be used to ascertain the value. Fairly measuring this value, considering the factors that influence the price, is important since this will impact the P&L account by increasing the compensation value if the value of an option increases.
For cash-settled and ‘share with cash alternative’ plans, the measurement of services received is quite simple. The cash portion of the settlement is valued at par with the fair value of the liability incurred owing to the services provided. This fair value must be remeasured and updated annually, as well as on the settlement date. The profit and loss arising from such remeasurement must be adjusted through the P&L Account.
Intrinsic Value Method
According to the Guidance Note, intrinsic value 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 listed entity, this is easy to ascertain. However, in the case of a non-listed entity, the company can engage the services of an independent consultant or value to ascertain the value of the ESOPs.
In a Nutshell
It is common knowledge that the higher the cost, the lower the profit. Since the accounting of ESOPs involves various nuances, it is necessary to refer to officially issued documents to know when to recognize and at what value to do so. Higher the value, higher the cost of compensation, and consequently, lower the profit. To better understand the accounting and valuation of ESOPs, click here.
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