ESOP (Employee stock option plan) is a stock option conferring an employee the right to purchase the share of the company at a set price, after a set period of time.

Advantages of ESOPs

ESOPs provide advantages like aligning the interest of the managers with those of the owners. It is a non-cash compensation tool to compete for the best human resources.

The main advantage is the accounting advantage that gives an opportunity to the corporate to pay, without a reduction in book profits.

US GAAP(Generally Accepted Accounting Principles) laid by FASB (Financial Accounting Standard Board), is the standard setting body of the US. India also follows this standard for new instruments like ESOP.

US GAAP

The FASB has given two choices for accounting of ESOP

1. To take the cost of stock options to the financial statements directly.

2. To make pro forma disclosures of cost by way of notes to accounts.

Almost all companies chose the second option, as it did not reduce the profit figures. For calculating the fair value of the option, the Black and Scholes model can be used. Again, the market argued that this model understates the value of the option as it gives the liberty of choosing the variables to the corporate. If variables like standard deviation of the scrip and interest rate are changed, the value of option will also change. So, it was found that FASB’s accounting regulations for stock based compensation have some loopholes.

Variations in option value using Black and Scholes model

There are five variables that could change the option value:

1. Fall in the share price at the time of announcement of ESOP.

2. Increase of the exercise price.

3. Use of lower interest rate.

4. Use of lower standard deviation.

5. Use of shorter vesting period

Costs

Companies may sell shares to their employees under ESOP in any of three ways:-

• Sell from treasury stocks
  
• Sell after issuance of new shares
  
• Buyback shares and sell.
  

All these options either bear opportunity cost or borrowing cost. Any method will dilute control for the owners. In some cases, a Corporate may resort to borrowing for buyback and get into a debt trap that is not beneficial.

SEBI guidelines

A guideline issued by the SEBI for stock options requires companies to show expenses in either of the following ways.

• Show in the form of option discount (difference between issue price and exercise price).
• Or, the fair value of the option measured by the Black and Scholes model.

The accounting value as measured above should be accounted as employee compensation and has to be amortised on a straight-line basis over the vesting period.

An individual should evaluate the choice of a stock option with respect to personal as well as external factors.