THE COUNTERVIEW
BUSINESS WORLD 19 AUGUST 2002

Harshu Ghate, Managing Director, ESOP Direct ( harshu@esopdirect.com)

ESOP Direct is India's leading ESOP administration and consulting company
 

I believe there is too much unnecessary debate on (compulsory) accounting vis a vis just disclosing. Since the disclosures of the impact are adequate and the earnings are reported on diluted equity, disclosures are fine. The core issue is about the quantum (of the impact). A difficult but unavoidable task. The existing valuation models (Black Scholes and other binomial models) have been designed for valuing traded options, whereas employee stock options (ESOPs), by definition, are non-transferable. Traded options also have a much shorter life (normally less than three years) whereas an ESOP would have a life of around 10 years. Given these basic differences the assumptions and variables used in these models, they cannot be used for valuing ESOPs. For instance, one of the variables is volatility in the stock prices. Predicting volatility for a 10 year option is far more difficult and risky than predicting it for a 3-month or 6-month option. Same is the case with the expiry life. A normal ESOP has a life of 10 years, which is reduced based on the estimated percentage of forfeiture/lapses. This discount is a subjective matter and can vary significantly from case to case. For instance, if the options are underwater by a huge margin on the vesting date, this discount can be as high as 100% because all options will have no value on that date.

The option value is very sensitive to these variables. Hence the need is to fine-tune the existing models to suit ESOPs and also standardize the assumptions on variables so that there is minimum subjectivity. So how can it be done? One approach is to disclose the cost at the time of grant using fair value as the method (as suggested in SFAS 123) and adjust the charge on the vesting date based on the actual market price on the vesting date. Here the assumption is that the cost is incurred on the date of grant and needs to be charged then, however it will be corrected when the cost is crystallized (on the date of vesting). Another assumption is that all employees exercise all their options on the vesting date and sell their shares, booking gains or losses. In reality, if the employee makes a different gain or loss from his holding, it is his investment decision and should not affect the cost to the company.

Look at the example given below,

A Fair Method
Option fair value accounted on the date of Grant Rs. 25
Option value calculated based on The market price on the vesting date Rs. 15
Exercise Price Rs. 12
Market price on the date of vesting Rs. 27
Market price on the date of sale by the employee Rs. 35

In this case, the company has disclosed Rs.25 as the cost on the date of grant and amortized it over the vesting period. On the vesting date the actual crystallized cost is Rs. 15 (27-12). So on this date the company writes back Rs.10 disclosed earlier (as a prior period item). In reality the employee may not exercise or sell the share on the vesting date. Assuming he sells it when the market price is Rs. 35 making an actual gain of Rs. 23(35-12). The company need not disclose the incremental gain of Rs. 8 because it has been realized out of an investment decision of the employee.

This treatment is similar to any other provision for expenses, say, like leave encashment. The correction could be on either side leading to write back of provision or making fresh provisions. While calculating the impact on the vesting date other variables such as volatility, tenure, expiry life, number of options lapsed or cancelled will be irrelevant For instance only those options which are live on the vesting date will be accounted for, there will be no need for factoring volatility, and so on.

In the zest to account for the option cost there is no need to go overboard and account for something that is grossly incorrect. It would be unfair for an otherwise useful compensation tool. The current disclosure requirements are adequate to bring out the impact of ESOPs on company's profits and there is no need to complicate the books of account with incorrect provisions which are known to change at a later date. The ball is now in the court of accountants and regulators to come out with an acceptable treatment. Indian authorities, the Institute of Chartered Accountants of India and Securities Exchange Board of India will have to take it up sooner than later.

Author is Managing Director of ESOP Direct, leading ESOP consulting company and can be contacted at harshu@espdirect.com


 Print this article