The art of accounting options

Stock options once unheard of in India, are now a reality for Corporate Inc. Global competition makes it all the more crucial to retain the best and the brightest and stock options serve as an effective HRD tool. The SEBI has issued the SEBI scheme and employee stock Guidelines, 1999. These comprehensive guidelines also lay down the accounting policies, which are to be adhered to by all listed companies, who issue options to their employees under an Employee Stock Option Scheme. (ESOS) Accounting policies have been prescribed in Schedule I of these guidelines. The 'accounting value' of stock options is to be treated as another form of employee compensation in the financial statements of the issuing company. The accounting value (or fair value) of stock options is to be calculated by either using the Black Scholes formula or a similar valuation method, or at the option discount (difference between market price of share and the option exercise price.) (This is the same as the 'intrinsic value method', which is explained subsequently). Though not very well known in India, accounting for stock options has become a contentious issue in the USA with both the aforesaid alternative methods being adopted. Historically, American companies were not accounting for the cost of the benefits conferred upon the employees by the issue of stock options. In 1972 the Accounting Principles Board issued APB option No 25 'Accounting for Stock Issued to Employees', which requires companies to account in their financial statements, the compensation cost of the stock options, using the 'intrinsic value method'. The compensation cost of a stock option is equal to the difference between the Fair Market Value (FMV) of the relevant share and the option exercise price on the 'measurement date' (typically the date of grant of the option). Thus for e.g., if the market price of a listed share on the option grant date is say Rs. 250 and the exercise price of the option is say Rs100, then the Compensation cost under the APB 25 method would be Rs.150 (250-100=150). However, if the market price of the relevant share on the grant date was the same as that of the Compensation Cost under APB 25. This method faced criticism as not being truly indicative of the value of the stock option. A year later, in 1993 the financial accounting standards board (FASB) issued statement No. 123, 'Accounting for stock based Compensation' (SFAS No. 123). This was adopted in 1995 and it introduced the concept of determination of the fair value of the stock option. The logic was that a stock option has an inherent value due to its potential to earn a profit for the employee to whom it has been granted by an appreciation in the price of the shares during the option period. Under the SFAS 123 the compensation cost of an option is calculated by way of complex mathematical formula comprising various variables such as: Market Price of the underlying share (on grant date); Exercise Price of the stock options; Expected life of the Stock Option (this may be less than the Maximum permitted option period based on past experience); Expected volatility of the share price (this is also an estimate and can be based on past experience); Expected Dividend Yield and Risk Free Interest rate. A stock option can have a value under SFAS 123 even though its value under APB 25 is zero. The Value suggested under SFAS 123 can be calculated by the well-known 'Black Scholes method' or the 'Binomial method'. There was major resistance against SFAS 123 mainly due to the adverse impact it could have on the profit of companies as compared to the APB 25 method. Therefore the SFAS 123 was made recommendatory with a rider that where companies followed the APB 25 method, they would still have to disclose, in the Notes to the Accounts, the impact on profits if the SFAS 123 had been followed. Infuses Technologies LTD follows the APB25 method while also disclosing the impact on earnings, if the SFAS 123 would have been followed. Method of Accounting in India: A company is permitted to adopt the option value calculated under the Black Scholes / other method (as suggested by SFAS 123) or the Intrinsic value method propounded by the APB 25. The illustration provided in Sebi guidelines is based on the simpler 'intrinsic value' method. Unlike the SFAS 123, the SEBI Guidelines do not require mandatory disclosure in the 'Notes to Accounts', of the impact on profits had the 'Fair Value Method' been followed. Under the SEBI guidelines the 'accounting value' of the stock options is to be calculated and amortized over the vesting period ( beginning with the date of grant of the option and ending with the date after which the employee can exercise the option for acquiring shares of the company). Thus if the FMV of a share (Face Value Rs 10) on the date of the grant is Rs 250 and the exercise price is Rs 100, with a vesting period of 36 months, then the difference of Rs 150 shall be the employee compensation. This is to be amortized pro-rata to the profit and loss account of the company over a period of 36 months from the date of the grant. The amortized portion shall be charged to the relevant profit and loss account while the unamortized portion is to be debited to a 'Deferred employee compensation expense' account pending amortization. The net result of the accounting entries over the 36-month period would be that the employees compensation expenses account is debited with Rs 150 and the employee's stock options outstanding account is credited likewise. In case any options lapse or are forfeited, the above entry in respect of such lapsed or forfeited options will be reversed in the accounting period in which such lapse or forfeiture takes place. If shares are allotted to the employee upon exercise of the option, the following entry is to be passed in the accounts. The company issuing the stock options takes a charge on its P&L A/c, of an amount equivalent to the accounting value. When the shares are allotted on exercise of the option the same amount is to be credited to the share Premium A/c, together with the excess payable as exercise price over the face value of the shares. In our illustration, to the extent of the accounting value being transferred from the employees stock outstanding A/c to share premium account, such share premium is not directly collected in cash. Yet, the amount equivalent thereto, undoubtedly has been charged to the profit and loss account as an expense, even though a direct nexus between the issue of shares and collection of cash as share premium is missing. Various issues now arise. To begin with, can the share premium created by transfer of the aforesaid 'accounting value' of the stock option, constitute a share premium as defined in the companies Act, 1956. According to the section 78(1): Where, a company issues shares at a premium, 'whether for cash or otherwise', a sum equal to the aggregate amount or value of the premiums on those shares shall be transferred to an account, to be called a share premium account. The provisions of this section imply that the aforesaid section envisages the premium to be received either in cash or some other benefit or advantage being conferred upon the company, which is measurable in monetary terms. Section 78 indicates that the benefit or advantage should flow directly to the company from the allottee of the share as a quid pro quo (consideration) for the shares issued. However, the logic behind accounting for the cost of stock options is that the issue of shares below their fair market value results in the shareholders bearing the cost thereof, indirectly, by dilution of their stake. The said share Premium (constituting the accounting value) is collected by the company itself. No benefit flows to the company, as envisaged under the company act. Therefore creation of a share premium based on the 'accounting value of the shares' may not constitute share premium as envisaged under the companies act, 1956. Sebi's intention seems to be to ensure the transfer of the amount equivalent to the accounting value of the stock option to a reserve, which cannot be distributed to the shareholders as dividend but can only be utilized for limited purposes like issue of bonus shares. The analogy can be that the capital redemption Reserve created at the time of redemption of preference shares. However, the nomenclature Share Premium seems inappropriate and some other suitable term needs to be coined. Furthermore, the DCA should issue the necessary clarifications as to whether, the amount traffnsferred constitutes a share premium as envisaged under the Companies Act. Sebi should also clarify whether bonus shares can be issued from such share premium.