The ESOPs gravy train rolls again

Stock option plans could be on a comeback trail, thanks to coming changes in US accounting laws

In the late 1990s, no self-respecting information technology company was without its Employee Stock Option Plan (ESOP). And every cybercoolie worth his salt insisted on having stock options as part of his or her compensation package.

The prospect of becoming millionaires from ever-rising tech stock prices made the employee salivate, while the company was overjoyed because, although stock options were a form of payment for services rendered, they didn't show up as an expense in the Profit and Loss Account, thanks to the accounting norms prevailing at the time.

The only people who were concerned were auditors, accountants and savvy investors who worried whether the accounting norms allowed companies to overstate profits.

In India, employee stock option plans hit the headlines when they created millionaires virtually overnight, and tales about Infosys Technologies many millionaires have become the stuff of legend.

Into this Garden of Eden, however, several snakes intruded. The first of them was the fall in the values of tech shares from the dizzying heights reached in the late 1990s.

The changed outlook for tech stocks made stock options unattractive. And just when tech stocks were beginning to recover, the International Accounting Standards Board (IASB) delivered a body blow to ESOPS.

It issued International Financial Reporting Standard 2 Share-based Payment (IFRS 2) on accounting for share options.

The IASB pointed out that there are two methods of valuing share options "� one called the "intrinsic value" method and the other the "fair value" method. The detailed valuation exercise is complex.

But the upshot is that companies that use the intrinsic value method don't have to recognise any charge in the profit and loss account as a result of granting stock options.

Accordingly, said the IASB, their expenses are understated, their profits are overstated, and this could mislead users of their financial statements. IFRS 2, therefore, ruled that companies would compulsorily have to use the fair value method of accounting, under which ESOPs would have to be treated as an expense in the P&L account.

But the coup de grace to ESOPs was delivered in the United States. The US Financial Accounting Standards Board (FASB) too recommended that all ESOPs should be treated as an expense in the P&L account. This would cover all accounts written under US Generally Accepted Accounting Principles (US GAAP).

Since many Indian tech companies are listed in the United States and have to conform to US GAAP, the new rules would increase their expenses, reduce their earnings "� and possibly affect their share price as well. The result "� Indian information technology companies like Infosys Technolgies (which pioneered the concept of ESOPs in India) and Wipro suspended their ESOP schemes.

That's because they would have to take a hit on their bottomline if they indeed had to expense stock options.

For example, for 2003-2004, Infosys has in its annual report pointed out that under the "Statement of Financial Accounting Standards 123, Accounting for Stock Based Compensation, under US GAAP, requires the pro forma disclosure of the impact of the fair value method of accounting for employee stock valuation in financial statements."

This means that if Infosys were to pro forma adjust the value of the stock options it had granted, its net profit at the end of March 31, 2004, would be Rs 1,016.10 crore versus the Rs 1,243.47 crore it reported for the last financial year.

Similarly, the basic earnings per share would plummet from Rs 187.38 to Rs 154.14 for the last financial year. No wonder tech companies were upset.

But surprise, surprise "� the ESOP gravy train may once again be rolling soon. The move to "expense" stock options had, predictably, led to intense lobbying in the US Congress by corporate interests.

In the last week of June, a Bill was introduced in the US Congress requiring companies to write the ESOPs granted only to the chief executive officer and the top four compensated executives as an expense in their P&L accounts.

In other words, ESOPs to other employees need not be a charge on the P&L account. This compromise formula will soon be tabled in the US Congress.

If the Bill sails through the House of Representatives and is ratified by the Senate, it will hugely benefit Indian companies listed abroad.

According to an IT analyst at a leading data tracking firm, Indian companies have traditionally paid below market wages and offset this by granting stock options to their employees.

"If this legislation is pushed through and is restricted to the CEO and top four most compensated executives, just imagine the savings that Indian companies can realise on cash outflow in terms of salaries, given the fact that staff costs are the single biggest expenditure for IT services companies," he points out, adding the caveat that the particular stock also should do well on the bourses.

The ABC of an Esop

An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, to which it contributes new shares of its own stock or cash to buy existing shares.

Alternatively, the trust can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax deductible, within limits.

Why Esops make sense for companies and employees

The stock prices of the top four offshore listed companies, in the last 52 weeks, on US exchanges such as NASDAQ and NYSE have gone up by at least 50 per cent.

At the low end, Infosys' stock was up 58 per cent; at the high end Wipro's was up 90 per cent. And the price earnings multiple commanded by these companies are still very high, with Cognizant Technologies commanding the highest at 49 and Satyam the lowest at 26 per cent.

On an average, staff costs account for between 40 per cent and 45 per cent of an IT company's revenues; travel and communication-related costs weigh in with between 10 per cent and 15 per cent. The rest of it is total gross margins.
 

	52-week  change	Trailing  P/E
Cognizant	75.65	48.93
Infosys	57.63	42.98
Wipro	89.63	48.24
Satyam	70.36	25.52

So if a company saves on salaries, the impact on the bottomline is immediate. Take the case of a company like Infosys, where the ESOP scheme covered the entire organisation, unlike companies like Cognizant where the ESOP scheme is restricted to middle and senior management.

This also meant, according to human resource (HR) practitioners, that Infosys paid salaries that were slightly lower than market benchmarks but offset this by offering ESOPs.

An executive at a rival unlisted software company which plans to go public soon points out that the real question is what the ESOP can do?

"The idea of an ESOP is to attract and retain talent rather than offer it as part of the regular salary package, but some Indian companies have always done this," he says. He should know "� staff costs at the unlisted software company are among the lowest in the industry.

However, Infosys' chief financial officer T V Mohandas Pai says that Infosys never used stock options to offset lower salaries. "Stock options always were an additionality at Infosys and were never substituted for salaries," Pai says.

Others make the same point. Says a Satyam Computer Services spokesperson: "In our company, ESOPs have been in addition to the salary and not in lieu of salary. It is more important to gauge the opinion of employees than the ruling. Other than the recent buoyancy in the stock market, the benefit on account of ESOPs for employees has been very low as the markets were down. Hence, the importance attached to ESOPs has come down significantly as compared to the late nineties. Moreover, it is also necessary to study the retention benefits of ESOPs."  Adds Pratik Kumar, corporate vice president, human resources, Wipro Technologies: "We do not know what kind of rules FASB will recommend for ESOP expensing but at Wipro we have used our stock option plan as a tool for retention rather than compensation. The scheme is meant only for those who have been identified as key talent and strategic to the company's interests in the long term."  Infosys, in fact, announced a performance-linked salary scheme once its ESOP scheme was suspended, which raised the potential for cash outflow.  "The idea to expense stock options came in because of the abuse that this went through in the US, thanks to high profile disasters like Enron. The present move by the US Congress supported by companies like Intel to write off ESOPs granted only to the CEO and the top four compensated executives as an expense in their P&L account is a good thing. It is a good compromise but there is no certainty which way this will go yet," Pai says.  Wipro, which too suspended its ESOP programme more than a year ago, has now taken shareholder approval to offer stock units to employees, like Microsoft does, rather than ESOPs.  The basic difference between an ESOP and a stock unit is that the ESOP is always offered at the prevailing market price to the employee while the stock unit is offered at a discount to the market price "� a discount that cannot be below the face value of the share.  The stock unit creates immediate value for the employee. Under the ESOP programme, the employee does not know what kind of value the share will have by the time it vests.  Yet the issue may go beyond the expensing of stock options. "Just think about start-up companies that need to attract talent. Start-ups typically work on disruptive technologies which can unsettle big companies. How will they get the best talent on board if they have to expense stock options," Pai asks.  This view is echoed by Keshav Murugesh, chief financial officer of the Nasdaq listed Syntel Inc: "Forcing expensing of stock options had some detractors arguing that innovation would be hampered and probably would have not allowed companies like Microsoft being built in the first place, since expensing on the P&L would affect EPS and therefore stock price negatively," Murugesh points out.  These views, however, are pooh-poohed by those who favour treating stock options as an expense. Gartner India's vice president, research, Partha Iyengar, is dismissive of the issue of expensing ESOPs affecting the ability of start-ups to attract talent and hampering innovation in the long run.  

"This argument is something I don't subscribe to. The whole idea is that you give an employee stocks so that he participates in the company's growth from inception. For the employee it is the appreciation of the stock's price that matters and expensing does not take away the original intent of giving options to employees. Though I must admit that companies may view it differently because of the way it impacts their P&L account."  Francisco D'Souza, chief operating officer of the Nasdaq-listed Cognizant, agrees with Iyengar.  "In the economics of business, the fundamental value of the company remains and doesn't change. The value of what it has historically been remains. Expensing options will not change things fundamentally or require doing anything different than what was done."  These experts say that a company's fundamentals don't change merely because there's an accounting change in the way ESOPs are treated.  Iyengar is also critical of companies that were offsetting ESOPs against actual salary compensation. "For companies which were using ESOPs as part of the compensation package, the prospective expensing rule has ensured that compensation is now all about real money," Iyengar says. But Murugesh of Syntel goes a step forward and predicts that the move to restrict expensing to a select few could lead to a windfall for companies.  "This development is indeed a surprise as generally corporate America expected that expensing would become mandatory and it was only a matter of time for that final announcement to be made. We now expect many technology companies that reward the bulk of employees (not just the CEO and top four officers) through stock compensation to continue the practice of issuing ESOPs and thereby reap the twin benefits of not having to recognise the cost in the P&L but also take advantage of stock disposition which would have a positive cash flow effect since the tax payout also will be reduced," he predicts.  Accountants point out the inconsistency in accounting for ESOPs of the CEO and the top four officials as an expense while the ESOPs of other employees are not.  While the final verdict on the expensing of stock options is still being debated in the US, there are concerns that Indian accounting policies may also change and imitate US laws.  "An expensing rule, like the one which the US is proposing, exists in Europe. Look at the impact it has had on technology innovation in Europe, which has almost died. Now India is slowly becoming a hotbed for innovation, but a rule like this could ensure that start-ups will flounder here also," the chief financial officer of a leading blue-chip IT services company points out.  The Chennai-based B. Ramakrishnan, a partner at the chartered accountants' firm of CNGSN & Associates, points out that the Securities & Eaxchange Board of India has since 1998 allowed companies to charge ESOP as a revenue expenditure.  Others like S. Gurumurthy, chartered accountant, columnist and convener of the Swadeshi Jagran Manch, point out that in the US companies that issued ESOPs kept the EPS high by not charging the ESOP to the expense account, leading to large scale misuse.  "In India there is no known case of company managements colluding with stock market players and manipulating prices. Hence there is no need to charge ESOPs to the P&L account," Gurumurthy argues.  If the US Bill becomes law, ESOPs are poised to make a grand comeback, benefiting both Indian IT companies and their employees.  (Additional reporting by S Kalyana Ramanathan in Chennai)