Valuing Stock Options under IndAS 102
02 December 2020
This standard to specify the financial reporting by an entity when it undertakes a share-based payment transaction.
An entity shall apply this standard in accounting for all share-based payment transactions, whether or not the entity can identify specifically some or all of the goods or services received, including:
- Equity-settled share-based payment transactions,
- Cash-settled share-based payment transactions, and
- Transactions in which the entity receives or acquires goods or services or the terms of arrangements provide either the entity or the supplier with a choice of whether the entity settles the transaction in cash or by issuing equity instruments.
Followings are the exceptions:
i. A share-based payment transaction may be settled by another group entity (or a shareholder of any group entity) on behalf of the entity receiving or acquiring the goods or services. Share Based Payments also applies to an entity that:
(a) receives goods or services when another entity in the same group (or a shareholder of any group entity) has the obligation to settle the share-based payment transaction, or
(b) has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services.
ii. A transaction with an employee (or other party) in his/her capacity as a holder of equity instruments of the entity is not a share-based payment transaction.
iii. Entity acquires goods as part of the net assets acquired in a business combination as defined by Ind AS 103, Business Combinations, in a combination of entities or businesses under common control as described in Ind AS 103, or the contribution of a business on the formation of a joint venture as defined by Ind AS 111, Joint Arrangements.
iv. Share-based payment transactions in which the entity receives or acquires goods or services under a contract within the scope of Ind AS 32 (Financial Instruments: Presentation), or of Ind AS 109 (Financial Instruments).
An entity shall recognize the goods or services received or acquired in a share-based payment transaction when it obtains the goods or services are received.
When the goods or services received or acquired in a share-based payment transaction does not qualify for recognition as assets, they shall be recognized as an expense.
Equity-settled share-based payment
The entity shall measure the goods or services received and the corresponding increase in equity, directly, at fair value. If the entity cannot estimate reliably the fair value then it is to be recognized by reference to the fair value of the equity instruments granted.
Transactions in which services are received
If the equity instruments granted vest immediately, the counterparty is not required to complete a specific period of service before becoming unconditionally entitled to those equity instruments. In absence of evidence, the entity presumed that services rendered by the counterparty as consideration for the equity instruments have been received. In this case, on the grant date, the entity shall recognize the services receives in full, with a corresponding increase in equity.
If the equity instruments granted do not vest until the counterparty completes a specified period of service, the entity shall presume that the services to be rendered by the counterparty as consideration for those equity instruments will be received in the future, during the vesting period. The entity shall account for those services as they are rendered by the counterparty during the vesting period, with a corresponding increase in equity.
Transactions measured by reference to the fairvalue of the Equity Instruments Granted
Determining the Fair Value of Equity Instruments Granted
An entity shall measure the fair value of the equity instruments granted at the measurement date, based on market price.
If market prices are not available, the entity shall estimate the fair value of the equity instruments granted using a valuation techniqueon measurement date in an arm’s length transaction between knowledgeable, willing parties.The valuation technique shall be consistent with generally accepted valuation methodologies or pricing financial instruments, and shall incorporate all the factors and assumptions that the knowledgeable, willing market participants would consider in setting the price. A corresponding increase in equity, the equity shall make no subsequent adjustment to total equity after the vesting date. However, this does not include the transfer from one component of equity to another.
In rare cases only, if the fair value of the equity instruments cannot be estimated reliably the equity shall instead:
a) Measure the equity instruments at their intrinsic value.
b) Recognize the goods or services received based on the number of equity instruments that ultimately vest or are ultimately exercised.
Treatment of Vesting conditions
A grant of equity instruments might be conditional upon satisfying specified vesting conditions. For example, a grant of shares or share options to an employee is typically conditional on the employee remaining in the entity’s employment for a specified period of time. There might be performance conditions that must be satisfied, such as the entity achieving a specified growth in profit or a specified increase in the entity’s share price.
Vesting conditions, other than market conditions, shall not be taken into account when estimating the fair value of the shares or share options at the measurement date. Instead, vesting conditions shall be taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount so that, ultimately, the amount recognised for goods or services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest. Hence, on a cumulative basis, no amount is recognised for goods or services received if the equity instruments granted do not vest because of failure to satisfy a vesting condition, e.g. the counterparty fails to complete a specified service period, or a performance condition is not satisfied.
Market conditions, such as a target share price upon which vesting (or exercisability) is conditioned, shall be taken into account when estimating the fair value of the equity instruments granted. Therefore, for grants of equity instruments with market conditions, the entity shall recognize the goods or services received from a counterparty who satisfies all other vesting conditions (e.g. services received from an employee who remains in service for the specified period of service), irrespective of whether that market condition is satisfied.
Inputs to Fair Value the ESOP’s granted
a) Many employee options have long lives, are usually exercisable during the period between vesting date and the end of the options’ life, and are often exercised early. Black-Scholes-Merton formula does not allow for the possibility of exercise before the end of the option’s life and may not adequately reflect the effects of expected early exercise. It also does not allow for the possibility that expected volatility and other model inputs might vary over the option’s life. For options having relatively shorter lives or exercise period after vesting date, the above mentioned factors may not apply. In these cases, the Black-Scholes-Merton formula may produce a value that is substantially the same as a more flexible option pricing model.
b) Separating an option grant into groups for employees with relatively narrow range of lives included in its weighted average life, reduces the overstatement.
c) A share option granted to an employee typically cannot be exercised during specified periods (during the vesting period or during periods specified by securities regulators). This factor shall be taken into account if the option pricing model applied would otherwise assume that the option could be exercised at any time during its life. However, if an entity uses an option pricing model that values options that can be exercised only at the end of the options’ life, no adjustment is required for the inability to exercise them during the vesting period (or other periods during the options’ life), because the model assumes that the options cannot be exercised during those periods.
An entity should not simply base estimates of volatility, exercise behavior and dividends on historical information without considering the extent to which the past experience is expected to be reasonably predictive of future experience.
Factors to consider in estimating expected volatility include:
a) Implied volatility from traded share options on the entity’s shares, or other traded instruments of the entity that include option features (such as convertible debt), if any.
b) The historical volatility of the share price over the most recent period that is generally commensurate with the expected term of the option (taking into account the remaining contractual life of the option and the effects of expected early exercise).
c) The length of time an entity’s shares have been publicly traded. A newly listed entity might have a high historical volatility, compared with similar entities that have been listed longer. If a newly listed entity does not have sufficient information on historical volatility, it should nevertheless compute historical volatility for the longest period for which trading activity is available. It could also consider the historical volatility of similar entities following a comparable period in their lives.
a) If employees were granted options and are entitled to dividends on the underlying shares or dividend equivalents (which might be paid in cash or applied to reduce the exercise price) between grant date and exercise date, the options granted should be valued as if no dividends will be paid on the underlying shares, i.e. the input for expected dividends should be zero.
b) When the grant date fair value of shares granted to employees is estimated, no adjustment is required for expected dividends if the employee is entitled to receive dividends paid during the vesting period.
c) If the employees are not entitled to dividends or dividend equivalents during the vesting period (or before exercise, in the case of an option), when the fair value of an option grant is estimated, expected dividends should be included in the application of an option pricing model. In this case the valuation will be reduced by the present value of dividends expected to be paid during the vesting period.
d) An entity that does not pay dividends and has no plans to do so should assume an expected dividend yield of zero.
Risk-free interest rate
The risk-free interest rate is the implied yield available on zero coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term of the option being valued (based on the option’s remaining contractual life and taking into account the effects of expected early exercise).
Capital structure effects
The entity should consider whether the possible dilutive effect of the future exercise of the share options granted might have an impact on their estimated fair value at grant date. Option pricing models can be adapted to take into account this potential dilutive effect.
Let suppose company A has granted options with market based and non-market based performance vesting conditions to its eligible employees as per terms and conditions provided in ESOP scheme.
- Out of the total options granted, 1/3 of the options shall vest in equal proportions, on the 1stof December every year, over a period of 5 financial years. First such vesting shall happen in the 1stof December 2018 (Category 1 Options).
- 1/3 of the granted options may vest by way of annual vesting of up to 20% of the granted options falling in this category (out of the said 1/3), commencing in the month of December of the financial year immediately ensuing the financial year during which the letter of offer is issued. The said vesting shall happen on the basis of employee’s performance during the previous financial year ending 31stMarch, for a period of 5 financial years as rated in yearly performance appraisal process in employment with the company/affiliate company (Category II Options).
- The balance 1/3 of the granted options (Category III Options) shall vest upon the company achieving the Target Share Price of INR 30 as on March 31, 2020 or Target Share Price of INR 50 as on March 31, 2022.
In above analysis, Monte Carlo simulation has been used to model out the probability of stock price to be more than INR 50 per share milestone date i.e. 31st March, 2016 to estimate the expected number of options related with market based performance vesting. We ran 100,000 iterations to model out the probability of scenarios where market based options get vested.
Once market based vested option count has been estimated along with other category options granted as on measurement date, we should calculate the fair value of options using Black Scholes Option pricing Method (BSOPM).