Earnings of companies that are large issuers of employee stock options may be impacted due to changes in the new accounting standards. The new rules necessitate calculating costs, for such issuances, as per the fair value method rather than the intrinsic value method which most Indian companies use. Intrinsic value is the amount by which the market price of the underlying share exceeds the exercise price of the option. The fair value method which uses option pricing models such as Black & Scholes, binomial tree model results in the expense for the issuer increasing over time.
“The transition from intrinsic value to fair value method will definitely increase the charges for ESOPs for many companies and will impact earnings,” Ashish Gupta, Director, Grant Thornton Advisory observed.
HDFC Bank, for instance, would have incurred an additional expense of Rs 1,265.9 cr if it had used the fair value method to calculate employee stock options in FY16, the bank stated in its FY16 annual report. For ICICI Bank, the additional expense would have been Rs 373 crore.
Under the intrinsic value method if options are granted to an employee at the market price, there is no expense for the company. However, under the fair value method, even if the options are issued at the market price, the value of the option on the day of the grant increases the expense for an issuer. In order to avoid such increase in expenses, most Indian companies preferred the intrinsic value method until now, although Indian generally accepted accounting principles (GAAP) allowed them to use either of the two methods.
Moreover, many companies form separate trusts to hold shares before they are granted to employees. Securities and Exchange Board of India (SEBI) had, in 2014, allowed them to de-consolidate such trusts so that the financials need not have been a part of the company’s consolidated statements. However, the new accounting standards mandate that companies include such trusts in their consolidated statements. “ The Indian Accounting Standards require the trusts to be consolidated again,” Gupta explained.
The new rule also suggests that the expense for equity settled options once charged to the P&L with respect to the stock option cannot be reversed even if employees fail to meet any of the vesting conditions, Gupta added.