Audit of stock options: tracking grants, vesting, and fair value across years

Stock options are one of the few accounting areas that touches HR, finance, legal, and tax simultaneously. The grant is approved by the board. The accounting follows Ind-AS 102. The tax is governed by Section 17(2)(vi). The Companies Act requires specific disclosures. And by year three of any meaningful ESOP scheme, at least one of those four systems has drifted from the others.

The audit of stock options is where the drift surfaces. Auditors test the same items every year — grants, vesting, fair value, exercises, forfeitures, expense recognition — and find the same gaps. The gaps are not technical. They are bookkeeping gaps that compound when no one keeps the ESOP register live.

What Ind-AS 102 actually requires

Ind-AS 102 — Share-based Payment — covers two main categories. Equity-settled share-based payments — where the company issues equity instruments — and cash-settled share-based payments — where the company pays cash linked to share value. Most Indian ESOPs are equity-settled. Phantom stock and stock-appreciation-rights schemes are cash-settled.

For equity-settled awards, the accounting principle is direct. The fair value of the award is measured at the grant date. That fair value is recognized as an expense over the vesting period, with a corresponding credit to equity. Once the award is granted, the fair value is fixed — it does not get re-measured for changes in the share price.

Three inputs to fair value at grant date matter. The exercise price. The fair value of the underlying share. The fair value of the option itself, typically computed using Black-Scholes or a binomial model, with inputs for volatility, risk-free rate, expected term, and dividend yield.

The grant-date fair value calculation

For listed companies the inputs are observable. The share price comes from the exchange. Volatility comes from historical price data or implied volatility from listed options. Risk-free rate comes from the government bond yield curve. Expected term comes from the company's historical exercise patterns or, for new schemes, from a simplified midpoint of the vesting and contractual life.

For unlisted companies the inputs are judgmental. The share price comes from a valuation — typically a DCF prepared by a registered valuer or a merchant banker, depending on the purpose. Volatility comes from a basket of comparable listed companies. Expected term is harder for unlisted companies because there is no exercise history, and the absence of a public market changes the optimal exercise behavior.

The audit risk on unlisted-company fair values is the volatility input. Choosing comparables from a different sector or a different stage produces wildly different volatility numbers. We have seen the same company report grant-date fair values that differ by 40% across two consecutive years because the comparable basket was changed without explanation.

Vesting and the expense schedule

Vesting can be cliff (all options vest at the end of a specified period) or graded (options vest in tranches over the period — say 25% per year over four years).

For cliff vesting, the expense is recognized straight-line over the vesting period. For graded vesting, Ind-AS 102 requires each tranche to be accounted for as a separate award with its own vesting period. Tranche one (vests at end of year one) gets expensed over one year. Tranche two (vests at end of year two) gets expensed over two years. And so on. The cumulative expense pattern is front-loaded compared to straight-line.

Companies sometimes apply straight-line expense to graded vesting because it is simpler. Under Ind-AS 102 that is technically incorrect, although the difference is small enough in most cases that the auditor does not require restatement. For larger schemes, the difference compounds and gets flagged.

The forfeiture rate problem

Forfeitures — options that lapse because the employee leaves before vesting — reduce the expense over time. Ind-AS 102 allows two approaches: estimate the forfeiture rate at grant and reduce the expense accordingly each period, or recognize the full expense and reverse it when forfeitures actually occur.

Most Indian companies pick the first approach because it produces a smoother expense pattern. The estimate is typically based on the company's historical attrition rate among option holders.

The audit issue is the estimate. A 20% forfeiture rate assumed at grant produces materially lower cumulative expense than a 10% rate. Auditors test the estimate against actual experience. If the company assumed 20% forfeiture for three years and actual forfeitures were 8%, the auditor will require a true-up to actual.

The true-up under Ind-AS 102 paragraph 21 happens at each reporting date. The cumulative expense is recomputed using the best estimate of awards that will ultimately vest. The difference flows through the P&L in the current period. This can produce a one-off catch-up expense that distorts the year's results.

Modifications, cancellations, and replacements

Companies modify ESOP schemes more often than founders realize. The exercise price gets reduced when the share price falls. The vesting period gets accelerated for a key hire. A grant is cancelled and replaced with a new grant at a different strike.

Each of these triggers specific accounting under Ind-AS 102. A modification that increases the fair value of the award requires the incremental fair value to be recognized over the remaining vesting period. A modification that decreases fair value is ignored — the company continues to recognize the original expense. Cancellations are treated as accelerated vesting — the remaining unrecognized expense is recognized immediately, unless the cancellation is paired with a replacement that's treated as a modification.

The audit work on modifications is to test that each event was identified, classified correctly, and accounted for in the right period. Companies often miss modifications because they happen one employee at a time and do not flow through a centralized ESOP schedule.

ESOP Trust accounting

Many Indian companies route ESOPs through a Trust — the company funds the Trust, the Trust holds the shares, and the Trust transfers shares to employees on exercise. The Trust structure is permitted under the Companies Act and SEBI's ESOP regulations for listed companies.

For accounting, the Trust is consolidated with the company under Ind-AS 110 because the company controls it. The shares held by the Trust are eliminated against the company's equity — they are treated as treasury shares for consolidation purposes. The funding from the company to the Trust does not produce a separate asset on consolidation.

The audit work tests the Trust's books separately and then the consolidation entries. Trust accounts often have gaps because the Trust trustees are not finance professionals, the Trust's bookkeeping is part-time, and the company's accounting team does not review the Trust's books with the same rigor as the operating books. We have seen Trust accounts with three-year-old reconciliation items that nobody traced.

Exercise mechanics and tax

On exercise, the employee pays the exercise price, the company issues shares, and the difference between the fair value on the exercise date and the exercise price is a taxable perquisite under Section 17(2)(vi). The company is required to deduct TDS on this perquisite under Section 192.

For listed companies, the fair value on exercise date is the closing price. For unlisted companies, the fair value is determined under Rule 11UA — a merchant-banker DCF valuation. We have written separately on the Rule 11UA framework. The audit work on the perquisite is to confirm the fair-value source, the TDS calculation, and the deposit of TDS with the tax department.

For listed companies, the SH-6 filing with the registrar of companies on issue of shares against ESOP exercise is the regulatory step. The auditor will test that filings were made for all exercises during the year. Missing filings are a compliance gap and surface in the audit report.

Year-end disclosures

Ind-AS 102 requires detailed disclosures: outstanding options at the start and end of the year, options granted, exercised, forfeited, and expired, weighted-average exercise prices for each category, range of exercise prices for outstanding options, weighted-average remaining contractual life, and the model and inputs used to value the grants made during the year.

Most disclosures fail at the reconciliation. The number of options outstanding at year-end as per the disclosure must tie to the ESOP register. The expense recognized must tie to the cumulative expense schedule. The number of shares issued during the year on exercise must tie to the share-allotment register. Each of these reconciliations should be performed by the company before the auditor arrives. They rarely are.

What a clean ESOP audit pack looks like

Before fieldwork, the company should have ready: the ESOP scheme document approved by the board and shareholders, the master ESOP register with all grants, vesting, exercises, forfeitures, and expirations, the grant-date fair-value calculation memos with model inputs, the expense schedule by employee and year, the forfeiture-rate estimate with historical data, the modifications log, the Trust financial statements if applicable, and the TDS calculation memos for exercises during the year.

Eight documents. Most companies have one or two. The audit takes three weeks to clean up what those eight documents would have answered in an hour.