ESOP Accounting and Valuation – Improper accounting is not an Option!

ESOP Accounting and Valuation – Improper accounting is not an Option!

ESOP Accounting and Valuation – Improper accounting is not an Option!

  • Posted by kalyani
  • On February 5, 2024
  • 0 Comments

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The boom in the startup culture has witnessed innovative ways through which founders share their growth with their employees. Employee Stock Option Plans (ESOP) and Share Appreciation Right (SAR) methods have become a favourite among employers, be it startup owners or major corporates. While these schemes are great motivators for employees, there needs to be more clarity regarding the valuation and accounting treatment of these benefits.

An ESOP gives employees an option to buy the company’s stock at a specific rate, and SAR provides appreciation on the shares and are generally settled in cash over time. While ESOP dilutes ownership, SAR provides an economic benefit through an effective share in profit.

For formulating the above schemes, management seeks advice from professional consultants. While the consultants can provide the framework for developing the plan, what is generally missed out are the accounting implications of the schemes and the valuation approach to be used to derive the fair value.

The valuation of these schemes falls within the purview of US GAAP ASC 718/IFRS 2/Ind AS 102, which mandates fair valuation; however, the standards do not emphasize the use of a particular valuation method. The standards generally define ‘Fair Valuation’ as the arm’s length price at which an equity instrument granted can be exchanged between knowledgeable and willing parties. The accounting treatment, valuation frequency, and recognition principles are based on the terms of the scheme.

The valuation approach for ESOP and SAR is similar, the only difference being in the model parameters such as Strike Price, the value of the underlying share, performance conditions, exercise and vesting periods, etc.

KNAV’s recommended approach for accounting of ESOPs and SARs

From our global audit experience, we have noticed some common misses that leave the management worried about share-based remuneration:

We highlight the common challenges and our recommendations here below:

Challenges Recommendations
Management is unable to envisage the accounting impact of a scheme. While formulating the plan, management must seek a 360-degree view and get opinions from auditors, accounting advisors, and valuation experts.
Excessive reliance on EBITDA to determine future share price. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) can be one of the many factors determining the financial health and profitability of the organization and has some influence on the share price. Reliance on EBITDA to be reduced and all factors to be considered in determining the share price.

 

Consider factors like market trends, regulatory requirements, geopolitical events, and competitor behavior which affect the share price.

 

A thorough analysis should be conducted to factor in the non-financial factors impacting the financial aspects.

 

Use different methods, including fundamental analysis, technical analysis, and market trends analysis, to ensure informed decision-making.

Determining future EBITDA accurately is not a simple formula; it depends on uncontrollable variables like economic factors, industry trends, and unpredictable factors like company performance, which make the prediction challenging.

 

The selection of valuation method is generally skewed towards the method that is easy to use rather than the one that would be best suited. Monte Carlo valuation is avoided as it requires assumptions backed by data, which can be time-consuming and less cost-effective. Increased use of Monte Carlo simulation, as it has a more scientific approach. Reduce resistance in its application and seek professional help wherever required.
In instances where the vesting option is dependent on certain occurrences, like the achievement of EBITDA, employees could be entitled to minimum returns even in the absence of the occurrences.

 

Companies tend to use Black Scholes as it is simple.

Black Scholes model works only in a simple, straightforward valuation of options and warrants with no conditions attached.

 

Monte Carlo and Lattice are more robust methods that can accommodate the impact of conditions of fair value and consider the expected cash outflow in case the share price is not achieved. Select the method as per the requirement.

 

The appropriate choice of a valuation method determines the accounting impact of share-based compensation, and envisaging all the aspects of it before implementation will ensure that while employees stay motivated, the financial statements of the company stay accurate.

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