Accounting for ESOP Transactions _ Guide to Recording Employee Stock Options

1. Accounting for ESOP Transactions | Guide to Recording Employee Stock Options Employee Stock Option Plans (ESOPs) are a cornerstone of modern compensation—especially for startups and high-growth companies—because they align employee incentives with long-term enterprise value, help conserve cash, and support retention through vesting mechanics. However, Accounting for ESOP Transactions can be complex, spanning fair value measurement, expense recognition, true-ups for forfeitures, journal entries on exercise and expiry, tax effects, and disclosures. This end-to-end guide provides a practical, controller-ready playbook to record employee stock options accurately and consistently. For a complementary overview, see: https://stratrich.com/insights/accounting-for-esop-transactions-guide/ What is an ESOP? An Employee Stock Option Plan grants employees the right—but not the obligation—to purchase company shares at a predetermined exercise (strike) price within a specified term. Key features typically include: ● Grant date and option terms ● Vesting schedule (e.g., 1-year cliff, then monthly/quarterly vesting)

2. ● Exercise window post-termination (e.g., 90 days) ● Contractual life (often 7–10 years) ● Settlement in equity (common) or cash (less common, e.g., cash-settled SARs) Unlike RSUs, options require exercise at the strike price to receive shares. Accounting focuses on grant-date fair value of the option and recognizing compensation expense over the vesting period. Standards and Principles While specifics vary by jurisdiction, accounting frameworks converge on core principles: ● US GAAP: ASC 718 (Compensation—Stock Compensation) ● IFRS: IFRS 2 (Share-based Payment) ● Ind AS: Ind AS 102 Core themes: ● Measure equity-settled awards at grant-date fair value. ● Recognize expense over the requisite service period for awards expected to vest. ● True-up for service- and performance-based forfeitures; do not reverse for market conditions once service is met. ● Cash-settled awards are remeasured to fair value each reporting date until settlement. Key Terms and Their Accounting Impact ● Grant date: Date of mutual understanding/approval of terms. Establishes measurement. ● Vesting conditions: ○ Service condition: Requires continued employment through vesting. ○ Performance condition: Requires achieving operational/financial targets; expense recognized when probable (or expected under IFRS).

3. ○ Market condition: Based on share price/TSR; embedded in grant-date fair value; not reversed for outcomes if service is met. ● Forfeiture: Loss of unvested awards; triggers true-up adjustments. ● Modification: Change to terms (e.g., repricing, acceleration, extension); may create incremental fair value. Measuring Grant-Date Fair Value Equity-settled options are measured at grant using an option-pricing model (e.g., Black-Scholes-Merton or binomial). Common inputs: ● Exercise price vs. current fair value of underlying shares ● Expected term (behavioral estimate; may be shorter than legal life) ● Expected volatility (historical or peer-based, especially for private firms) ● Risk-free rate (maturity-matched) ● Expected dividend yield (often 0 for growth companies) ● Effects of market conditions (if any) Private companies often engage valuation specialists to support method and inputs. Establish and document a valuation policy for consistency and audit support. Recognizing Compensation Expense Total compensation cost equals grant-date fair value times the number of awards expected to vest. Recognize over the vesting period: ● Attribution method: ○ Straight-line: Evenly over requisite service period. ○ Graded (accelerated): Treat each vesting tranche as a separate award; front-loads expense. ● True-ups: ○ Service condition: Adjust for estimated/actual forfeitures based on policy.

4. ○ Performance condition: Recognize when probable; reverse if probability decreases. ○ Market condition: Included in grant-date FV; continue expense if service is met even if market target fails. Tip: Choose a consistent forfeiture policy (estimate upfront versus account as they occur, as permitted/required by framework) and apply consistently. Core Journal Entries Below are common journal entries for Accounting for ESOP Transactions. Replace placeholders with actual amounts and dates. 1. Periodic expense during vesting ● Dr. Compensation Expense ● Cr. Equity—APIC: Stock Options Outstanding 2. Forfeiture of unvested options (service condition not met) ● Dr. Equity—APIC: Stock Options Outstanding ● Cr. Compensation Expense 3. Performance condition becomes probable (recognition catch-up) ● Dr. Compensation Expense (cumulative to-date) ● Cr. Equity—APIC: Stock Options Outstanding 4. Market condition awards (no reversal if target missed, service met) ● Continue periodic expense as scheduled; no special reversal entries. 5. Exercise of options ● Dr. Cash (exercise price × options exercised) ● Dr. Equity—APIC: Stock Options Outstanding (amount related to exercised awards) ● Cr. Share Capital/Common Stock (par × shares) ● Cr. Equity—APIC: Common Stock (balancing figure)

5. 6. Expiration of vested, unexercised options ● Dr. Equity—APIC: Stock Options Outstanding ● Cr. Equity—APIC: Expired Options (or reclass within APIC per policy) 7. Cash-settled awards (e.g., SARs paid in cash) ● During vesting and remeasurement each period: ○ Dr. Compensation Expense ○ Cr. Liability—Share-based Payment ● At settlement: ○ Dr. Liability—Share-based Payment ○ Cr. Cash 8. Tax effects (jurisdiction-specific, coordinate with ASC 740/IAS 12) ● Excess tax benefit: ○ Dr. Deferred Tax Asset (or tax receivable) ○ Cr. Equity—APIC (or P&L depending on framework/policy) ● Tax shortfall: ○ Dr. Equity—APIC (or P&L) ○ Cr. Deferred Tax Asset Note: Local rules vary materially (e.g., US ISO vs NSO; India perquisite tax at exercise). Align accounting and payroll withholding processes. Worked Example Assumptions: ● Grant: 100,000 options at $10 strike, grant-date FV $4 per option. ● Vesting: 4-year graded (25% each year), service-only.

6. ● Estimated forfeiture: 5% cumulative; ultimately 93,500 vest. Total expected cost initially: 100,000 × $4 × 95% = $380,000. Year 1 (25% service): ● Expense Y1: $380,000 × 25% = $95,000. ● Entry: Dr. Compensation Expense 95,000; Cr. APIC—Options 95,000. Year 2 (no change in estimates): ● Cumulative at 50%: $190,000; recognize $95,000 incremental. Year 3 (forfeitures rise; expected to vest revised to 92,000): ● Revised total: 92,000 × $4 = $368,000. ● Cumulative at 75%: $276,000; prior cumulative $190,000 → recognize $86,000. Year 4 (actual 93,500 vest): ● Final total: 93,500 × $4 = $374,000. ● Cumulative through Y3: $276,000 → recognize $98,000 in Y4. On exercise of 60,000 options: ● Dr. Cash = 60,000 × $10 = $600,000. ● Dr. APIC—Options = proportional amount related to 60,000 exercised (using total APIC for vested options). ● Cr. Share Capital/Common Stock (par value × shares). ● Cr. APIC—Common Stock (plug). Graded vs. Straight-Line: Which to Use? ● Straight-line simplifies monthly close and aligns with many plans that vest evenly. ● Graded better reflects economics when earlier tranches represent more service completed and may be preferred/required when tranches are treated as separate

7. awards. ● Document the policy, apply consistently, and ensure disclosures align. Performance and Market Conditions ● Performance-based options: ○ Recognize expense when achievement is probable; reverse if probability decreases. ○ Common traps include late recognition when targets become probable late in the cycle—be ready for catch-up entries. ● Market-based options: ○ Reflect condition in the valuation; do not reverse simply because the market hurdle isn’t met, provided the service condition is satisfied. ○ Results in expense recognition even if share price targets are ultimately missed. Modifications, Repricings, Cancellations Modifications frequently occur during downturns or retention efforts. ● Incremental fair value method: ○ Incremental FV = FV(modified award at modification date) − FV(original award immediately pre-modification). ○ Recognition: ■ Continue recognizing unrecognized original grant-date cost over remaining service. ■ Recognize incremental FV over new requisite service (or immediately if vested). ● Repricings typically create incremental FV. ● Cancellations:

8. ○ Without replacement: Reverse unvested portions; accelerate any necessary recognition for vested portions if settlement occurs. ● Documentation: ○ Maintain board approvals, employee consents, modification calculations, and disclosure narratives. Illustrative entry for incremental FV over new vesting: ● Dr. Compensation Expense (periodic) ● Cr. Equity—APIC: Options Private Company Considerations ● Valuation support: ○ Independent analyses (e.g., 409A in the US) inform fair value inputs. ○ Peer-based volatility, expected term assumptions, and risk-free rates require disciplined policy. ● Admin controls: ○ Use an equity management platform for cap table, vesting, exercises, cancellations, and accounting exports. ● Post-termination rules: ○ Short windows (e.g., 90 days) affect expected term assumptions and behavior. ● Disclosure readiness: ○ Even when audits aren’t mandatory, robust roll-forwards and input disclosures increase investor confidence. Tax Overlay and Payroll Mechanics ● US:

9. ○ ISOs: No corporate deduction unless disqualifying disposition; potential AMT for employees. ○ NSOs: Corporate deduction at exercise equal to intrinsic value; may create excess/shortfall vs. book expense; ensure withholding and payroll tax remittance on exercise if required. ● India: ○ Perquisite tax at exercise on FMV less strike paid by employees; companies may claim deductions subject to tax law; ensure TDS/withholding and timely remittance. ● IFRS jurisdictions: ○ Deferred tax asset measured on deductible temporary differences, often linked to intrinsic value expected at settlement. ● Operationalize: ○ Align payroll, tax, and treasury for cashless exercises, sell-to-cover, and employee communications. Presentation and Disclosures Financial statement presentation and footnotes commonly include: ● P&L: Share-based compensation within employee benefits or SG&A. ● Equity: APIC balances for options; roll-forward tables. ● Cash flows: Exercise proceeds in financing activities; excess tax benefits classification per framework. ● Disclosures: ○ Plan description (terms, range of exercise prices, contractual life). ○ Valuation methodology and key inputs (volatility, risk-free rate, dividend yield, expected term). ○ Expense recognized by period and by award type. ○ Roll-forward of options: beginning, granted, exercised, forfeited, expired; weighted-average exercise price and remaining life.

10. ○ Details of modifications and performance/market conditions. Operational Controls and Close Process Establish a repeatable monthly routine: ● Update vesting and forfeiture activity; reconcile to HR data. ● Recompute period expense under selected attribution method. ● Book monthly compensation expense entries. ● Process exercises: cash receipts, share issuance, APIC reclassifications; validate against cap table. ● Record expirations/cancellations; reclassify APIC per policy. ● Refresh deferred tax calculations for current period activity. ● Maintain roll-forward schedules; tie to the GL and cap table. ● Archive approvals, valuation reports, and audit-ready workpapers. Common Pitfalls (and Fixes) ● Ambiguous grant dates: ○ Ensure clear acceptance/communication and board approval documentation. ● Inconsistent forfeiture policies: ○ Elect and disclose a policy; apply consistently across awards. ● Ignoring graded vesting economics: ○ Consider graded attribution when tranches are substantively separate awards. ● Overlooking modifications: ○ Any change in strike, vesting, term, or settlement can be a modification; assess incremental FV. ● Cap table and GL mismatches:

11. ○ Reconcile monthly; leverage automated exports from equity platforms. ● Tax and withholding gaps: ○ Pre-plan for exercise events, sell-to-cover mechanics, and payroll/tax remittances. Step-by-Step Blueprint to Implement and Account for an ESOP 1. Define plan economics: Pool size, eligibility, grant sizes, vesting norms, exercise windows. 2. Draft and approve plan: Board/shareholder approvals, jurisdictional compliance. 3. Establish valuation policy: Model choice, peer set, input sources, documentation cadence. 4. Choose an equity administration platform: Vesting engine, exercise workflows, accounting exports. 5. Write policy memos: Measurement, attribution, forfeiture, performance/market conditions, tax, and disclosures. 6. Build accounting model: Tranches, amortization, forfeiture true-ups, GL mapping. 7. Integrate with payroll and treasury: Exercise proceeds, withholding, remittance workflows. 8. Educate employees: Option mechanics, timelines, tax basics, and exercise alternatives. 9. Operate and improve: Monthly close rhythm, quarterly reviews, annual audits. Final Takeaways ● Anchor on grant-date fair value, choose a clear attribution method, and document policies. ● True-up for service and performance conditions; do not reverse for market conditions when service is met.

12. ● Track exercises, expirations, and modifications meticulously and reconcile cap table to GL monthly. ● Coordinate early with tax and payroll for exercise events and withholding. ● A disciplined process turns Accounting for ESOP Transactions from a pain point into a reliable, auditable reporting cycle. For further reading and another perspective, see: https://stratrich.com/insights/accounting-for-esop-transactions-guide/