Accounting for Employee Stock Option Plan

In this article, we focus on how the accounting of ESOPs is done.

As a founder, your goal should always be to equip your startup with the most qualified and capable individuals possible. However, the finest talents come with a price, and a startup company may not have the capital to pay them right away. In order to instill a founder’s motivation in their founding team, many startups turn to Employee Stock Option Plans (ESOPs) as a solution. With an eye toward the future, the Employee Stock Option Plan is a useful management tool for retaining valuable employees. Employees are given a stake in the company in the form of shares or options at a price that is lower than the current market price as part of this program. As soon as the vesting period ends, the employee is free to start using the options. In this article, we focus on how the accounting of ESOPs is done.

Employee stock options plan and accounting

The accounting value is determined by calculating either the option’s fair value or its intrinsic value. The intrinsic value is the difference between the fair value of the share at the date of option grant and the exercise price. The fair value of an option is the option’s market price had it been traded on the market. When we account for employee stock options, new accounts are created, so let’s examine things in detail.

What is ESOP?

Employee stock option plans (ESOPs) are part of employee benefit programs that enable workers to acquire a company’s stock options and enjoy a secure quality of life after retirement. This clause strengthens the relationship between a business and its employees, motivating them to stay with the company for longer.

Types of ESOP

There are several types of ESOP that an employer can offer. Here’s a list of a few common ones:

Pros and cons of ESOP

Here’s a list of the pros and cons of ESOP offered by a business:

Builds motivation for employeesDilutes the shareholding proportion of the founders
Attracts the right talent for businessCompanies cannot be listed on the public market
Strengthens employer-employee relationshipLiquidity of the shares is limited

Accounting for ESOP

It is crucial to have a thorough grasp of the essential accounting principles that are used to comprehend ESOP accounting and their influence on the company.

Terms you should know to report ESOP

During ESOP accounting the following terms must be understood and remembered.

  • Grant – giving options to employees through ESOP
  • Vesting – the procedure by which an employee receives the right to apply for company shares in exchange for the option issued to him following an employee stock option plan.
  • Vesting Period – the window between the award date and the day an ESOP stated vesting criteria must all be met.
  • Option – a privilege but not a compulsion given to an employee under ESOP for a certain length of time to buy company shares at a specified price.
  • Exercise Period – the window following vesting for the employee to utilize his right to request shares under the ESOP-vested option.
  • Exercise Price – the payment made by the employee to exercise the option given to him.
  • Fair value – the price at which granted informed, consenting parties might exchange stock options or a share offered for purchase at arm’s length.
  • Intrinsic Value – the difference between the exercise and market prices.

ESOP classification for accounting purposes

ESOP arrangements are divided into three types for accounting reasons:

  • Equity-settled – Following the exercise of their option, employees are given business shares.
  • Cash-settled – Employees are paid cash based on the value of a share as of a certain date.
  • Employee share-based payment plans with cash alternatives – The employee can receive compensation in the form of shares or cash.

Tax treatment for ESOP

There are two types of stock options – statutory and nonstatutory. Under an employee stock purchase plan or an incentive stock option (ISO) plan, statutory stock options are awarded. Nonstatutory stock options, sometimes referred to as nonqualified stock options, are given out without any kind of plan.

Selling stocks obtained by executing statutory stock options results in earnings, which triggers the alternative minimum tax (AMT). The alternative minimum tax, or AMT, ensures that those who lower their normal tax via deductions and other tax benefits nevertheless pay some tax.

The grant of the option, its exercise, and the sale of shares obtained via the exercise of the option are the three non-statutory option events, each of which has its tax implications. Only if the fair market value of these options can be easily ascertained is their receipt immediately taxable. When paying taxes, you must deduct any money you paid for the shares from the stock’s fair market value at the time you bought it if you exercise the nonstatutory option.

Documents required for ESOP reporting

For ESOP accounting and reporting, IRS requires the business to provide the following internal documents;

  • Employment Contracts – May have more information about how employees are paid, such as the opportunity to partake in certain equity-based compensation plans like the award of stock options, phantom stock, SARs, restricted stock, RSU, or others based on the worth of specified stock. Even if the information in such agreements is already in the SEC filings, it is important to look over them.
  • Board of Directors and Compensation Committee Minutes – Should be examined to find out what happened when incentive compensation programs were adopted and when stock options or other equity-based pay was granted or vested. It is advisable to ask for the reports that the compensation committee issues and distributes to the BOD since they can shed light on any equity-based remuneration. The examination should confirm that the board of directors and the shareholders authorized the schemes under which statutory options may be issued. Additionally, the examiner should ensure that the taxpayer did not decrease or cancel loans made to executives so they could exercise their stock options or buy restricted shares.

How are ESOP reported as expenses?

All employee stock ownership schemes, even those intended to pay off or finance obligations for certain employee benefits, like a company’s 401(k) plan equivalent contributions, are subject to ASC 718-40. Let’s look at how ESOP accounting is done for both leveraged and non-leveraged ESOP.

Leveraged ESOP accounting

Under ASC 718-40, this is how employers who sponsor a leveraged ESOP should record the deal –

  • When a company gives out new shares or sells share capital to an ESOP, it should be documented. Payment should be made to an account called unearned ESOP shares. This account is called a contra-equity account.
  • Employers must record an expense of compensation corresponding to the securities’ fair value for ESOP shares that will be given to employees explicitly.
  • Employers must put “unearned ESOP shares” inside the contra-equity account as the shares are promised to be given out, based on how much the shares initially cost the ESOP. The gap between the sum identified for compensation expense and that put in the contra-equity account must be charged or attributed to stockholders’ equity in the same way that profits and losses on the selling treasury shares are. The amount for compensation expense is the fair value of the shares dedicated to being released, and the amount attributed to the contra-equity account is the expense of the share capital to the ESOP.
  • When an employer agrees to release ESOP shares used to pay off or settle debts for other employee compensation, they should document that the liabilities have been paid off. These benefits’ compensation costs and liabilities should be counted the same way for an ESOP that hadn’t been used to pay for them.
  • Dividends on unallocated shares should be recorded as repayment or accumulated interest or compensation expense, based on whether they are utilized for existing debt or given to members. Companies should apply dividends on allotted and promised to be issued shares to retain profits.
  • Employers must disclose the fulfillment of the obligation to pay dividends where ESOP shares pledged to be distributed for that purpose are intended to substitute dividends on allotted shares utilized for debt payment.
  • Contributions from outside financiers to ESOPs should be included by employers as debts on the financial sheet, together with interest paid on the debt. Companies with internally financed ESOPs must not record interest income or expense on the employer debt, must not show the lending payable from the ESOP as an asset, and must not show the ESOP’s debt to the company as a liability.
  • Employers must report redeeming ESOP shares as buying Treasury stock.

Non-leveraged ESOP accounting

Employers that host a non-leveraged ESOP are required to account for the arrangement in the following manner:

  • Employers must include in their compensation expense the commitment required by the plan throughout the term.
  • The ESOP should assign the shares donated or purchased with the cash provided to the accounts of the employees as of the conclusion of the fiscal year and hold onto them until the employees get them at a later time, like during termination or retirement.
  • Dividends on shares owned by the ESOP should typically be charged to retained profits by the employer.

Impact of ESOP on expenses and profit and loss statement

There are two approaches to accounting for ESOPs. Based on the techniques used by the company, the accounting treatment and ensuing effect on the Profit and Loss Account varies. The following discusses both approaches. However, it is advised to use the fair value approach.

  • Fair value method – Fair value is the price at which a share in a corporation may be bought or sold. For cash-settled ESOP accounting, it’s pretty easy to figure out how much service was received. The cash part of the agreement is worth the same as the fair value of the liability caused by the services. This fair value must be recalculated and updated yearly and on the settlement date. The Profit & loss Account must be altered as caused by this re-measurement.
  • Intrinsic value method – The difference between the listed market price of the underlying share and the option exercise price is known as intrinsic value. This is simple to determine in the instance of a listed entity. To determine the value of the ESOPs, the corporation may hire an impartial consultant or valuation expert in the event of a non-listed entity.

Additional filings for ESOP reporting

Forms 3921 (for ISOs) and 3922 (for ESPPs) must be used to file returns to the internal revenue services (IRS). Additionally, keep the ISO 100K limit when filing for stock options.

Form 3921/3922

Every business that distributes shares to an individual in exchange for them exercising an incentive stock option as defined in section 422(b) must submit Form 3921 for every transfer completed that year.

Every company that, in any year, documents a transfer of the title deeds of a share acquired by an individual who purchases the shares as a result of exercising the option granted under an ESPP (employee stock purchase plan) and outlined in section 423(c) needs to file Form 3922. For the first transfer of legal ownership of the shares of an employee deemed as a nonresident alien, Form 3922 is not necessary.

Forms 3921 and/or 3922 may be ordered by businesses by contacting the IRS via phone or their website. Please be aware that although Forms 3921 and 3922 are available on the IRS website, businesses cannot simply download and submit printed documents to the IRS. The IRS will only recognize the paper documents officially purchased directly from the IRS.

ISO 100K

Employees are prohibited from considering more than $100,000 in value of exercisable options as ISOs in a calendar year by the $100K ISO limit, popularly referred to as the $100K rule. The initial $100,000 in company stock options exercisable by an individual in a year may be granted as ISOs, with all subsequent stock options treated as non-qualified stock options (NSOs) for tax purposes. The $100K ISO prevents misuse of the tax advantage as ISOs aren’t taxed unless exercised.

Why choose Eqvista to Manage your company’s ESOP?

A straightforward and user-friendly cap table is essential for ESOP accounting and administration of taxes on employee stock options. Eqvista should be used instead of standard Excel sheets when employing Cap tables. The ESOP management software from Eqvista is accessible to all users and offers efficient information administration and analytical features useful for managing data, making decisions, and other duties. The Eqvista cap tables provide all the data necessary to track your company’s ESOP as well as individual employee information. To find out more, contact us today.

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