ESOP trusts in doubt

Employee Stock Option Plans, or ESOPs, have evolved to become a common means of compensating employees. While the employees benefit from the appreciation in share price of the employer company (ESOPs allow them to buy the shares at a predetermined price on a future date), it also serves as an effective retention tool as the employee should remain with the company for a predetermined period to be eligible for the shares.

A common method listed companies use to administer such schemes is to set up a trust, which acquires the shares either from the employer company or the secondary market and issues them to the employees when the options are exercised according to the approved scheme. The purchase of shares is generally funded through a loan by the employer company.

Of late, however, such trusts have attracted regulatory attention, particularly from the Securities and Exchange Board of India. ESOP schemes of listed companies have historically been governed by the SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines 1999. They also provide specific accounting requirements for the ESOP trusts.

According to the guidelines, “In case of Employee Stock Option Scheme (ESOS)/ Employee Stock Purchase Scheme (ESPS) administered through a Trust, the accounts of the company shall be prepared as if the company itself is administering the ESOS/ESPS.” Therefore, all transactions undertaken by the ESOP trust should be reflected in the financial statements of the employer company as if it undertook them. While this is inconsistent with the CA Institute’s guidance note on employee share-based payments, listed companies should mandatorily follow the SEBI guidelines for both standalone and consolidated financial statements.

This would mean including the trust’s financial statements within the standalone and consolidated financial statements of the employer company. This would eliminate all inter-company transactions between the employer company and the trust, including any interest on the loan and dividend on the shares held by the trust; reduction of the investment in the equity shares held by the trust from the net worth of the employer company; and the resultant impact on the earnings and EPS of the employer company.

Further, no subsequent ‘gain or loss’ is recorded in the profits-and-loss of the employer company when the shares held by the trust are ultimately issued to the employees or otherwise disposed of. This treatment is consistent with international reporting. While the requirement to consolidate the financial statements of the trust for both standalone and consolidated financial statements appears clear from the guidelines, practice varies among companies.

Thus, while some include the financials of the trust in the standalone and consolidated financials, others do not include them in the standalone financials and, in some cases, even in the consolidated statements.

Companies that do not consolidate trusts end up recognising interest income on loans, and sometimes recognise losses when the loans given to the trust are not recoverable (due to a decline in the value of the shares).

Inclusion of the trust in the financial statements would reflect the true substance of the transaction and ensure that the standalone net worth and profitability reported by companies also covers the transactions undertaken through the trusts, which are nothing but an extension of the company (similar to a branch).

On a related note, SEBI through a circular in January 2013 expressed concern that some entities may frame such schemes for dealing in their own securities with the object of inflating, depressing, maintaining or causing fluctuation in prices through fraudulent and unfair trade practices, including concerns on insider trading. Accordingly, the same circular prohibited listed companies from setting up schemes to administer ESOPs that deal in the employer company’s shares in the secondary market.

While the prohibition has been deferred to December 31, 2013, it is apparent that the regulators are closely monitoring transactions by such trusts and similar structures. Accounting guidelines, too, are likely to evolve for greater certainty and consistency in the treatment of such trusts.

The author is Global Head of Accounting Advisory Services, KPMG

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