Download Treatment of employee stock options granted by non

Room document 4
Statistics Directorate
National Accounts
Note on the treatment of employee stock options granted by non-resident corporations
Paper prepared by theCentral Bureau of Statistics, Israel
OECD MEETING OF NATIONAL ACCOUNTS EXPERTS
Château de la Muette, Paris
8-11 October 2002
Beginning at 9:30 a.m. on the first day
Note on the treatment of employee stock options granted by non-resident
corporations
Central Bureau of Statistics Israel
The granting of stock options to employees of all levels has become common in
recent years, especially in high-tech companies. The complicated issue of treatment
of employee stock options has been analyzed by Eurostat and some NSO’s – a
conclusion has yet to be reached, but it seems that there is an agreement to include
such stock options in compensation of employees at the time the options are vested,
even though this time does not coincide with the period that the labour input is made.
Since data on employee stock options are often only available when they are
included in wage data at the time they are exercised, it may also be difficult to
estimate their size at the vesting date. However, the International Accounting
Standards Board has recently decided to count stock options granted to employees
as a cost of business, so that perhaps data will be more readily available in the
future.
There are however further complications to the issue, since in many cases the
companies granting stock options are subsidiaries that grant stock options of parent
companies abroad.
In Israel no complete statistics on the stock options exist, but data collected for
balance of payment purposes show that quite large amounts appear in financial
reports of foreign owned companies. Since these transactions could not be ignored,
we carried out an analysis of the problem. Below a proposed treatment and its
implications are shown, through a numerical example.
As is the case in other countries, the employee stock options have become more and
more popular in Israel, since they tie the employees to their employers and also allow
the firm to pay higher wages without lowering liquidity in the first years after a firm is
established.
Tax laws in Israel allow firms to choose two different paths of taxation of options
given to employees:
1. The firm may choose to grant options without placing the options in
trust. In that case the income from the options will be taxed up to 50%.
2. An alternative that may be chosen is to place the options in trust until
they are sold. In that case the income from the options can be
registered as expenditure on wages and taxed up to 50%, or as
capital income and taxed up to 50% if the company is domestic, but
only 35% if the company is a foreign one.
Many foreign firms have affiliates in Israel and many originally domestic firms for
various reasons also choose to register as foreign firms and place management
abroad – according to experts from venture capital firms most new hi-tech companies
established in Israel in recent years have chosen to register abroad and to place
management abroad. This means that in many cases stock options are granted by
foreign owned firms, and many will choose the second path of taxation. This also
means that the problem how to register such transactions in the rest of the world
account is quite an important one in Israel.
Data on employee stock options granted by firms that chose the second tax
alternative should be available from trust firms.
Wage data from the National Insurance Institute will include all stock options granted
to employees the moment they are taxed (when they are exercised). But such data
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are not separated from other wage components and also are not included at the
moment options are vested if not exercised.
To get full coverage and separate data on employee stock options data will have to
be collected in business surveys. On the other hand, as mentioned above the data
will perhaps be more readily available from business reports in the future.
In cases where firms grant stock options of foreign parent corporations the relevant
data have to be collected. The fact that the transaction is to be registered at the
vesting date may also complicate the compilation of the rest of the world accounts
(and balance of payments), since it will not be sufficient to rely on banking
transaction data.
To analyze the transactions involved in the granting of options of a foreign owned
company and the realization of gains by the unit receiving the options, we examined
the following example of a domestic subsidiary of a foreign corporation.
A numerical example
The subsidiary of a foreign corporation offers stock options for 1,000 shares to its
employees, to be issued by the parent corporation. The strike price is 100 units per
share, equal to its market price, and the vesting date is the end of the next year The
employees may exercise the option in any moment of the year following the vesting
date. The option is not tradable and employees exercise it one year later.
At the vesting date the market price of a share is 105. The value of the option will be
registered as part of the subsidiary’s compensation of employees (CE) at the vesting
date. Another possibility would have been to distribute the increase in the CE from
the granting date to the vesting date, in order to have a better relation between the
period employees services are provided and the CE paid for them (this could be
done retroactively once the value of the option is known at the vesting date).
Given that at the vesting date the market price is higher than the strike price, a
liability for the parent corporation, adopting the form of a financial derivative, covers
the value of the CE increase registered by the subsidiary. Its value per share is equal
to the difference between the market and the strike price at the vesting date.
Subsequent changes in the market price of the shares will be accounted as
revaluation of the financial derivative. When the option is exercised, the financial
derivative position is closed.
A. Entries in the accounts at the vesting date
It was assumed that the total value of the option is allocated to CE at the vesting
date, consequently an increase of 5,000 in CE is registered in the generation of
income account (5 monetary units per 1,000 shares).
Since output, intermediate consumption and added value of the subsidiary do not
change, its operating surplus (OS) should decrease in a value equal to the increase
in CE. Being a subsidiary of a foreign parent corporation all its profits are shown as
distributed abroad, in the national accounts and the balance of payments. These
transactions are registered in the generation and allocation of income account. The
undistributed profits are registered as reinvested through the financial account,
affecting the net equity of the parent corporation on its subsidiary. But in fact the
increase of CE is covered by a financial derivative that is a financial asset for the
households and a liability for the parent corporation (that will have to sell the shares
to the employees at the strike price, when the option is exercised after the vesting
date).
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Since the subsidiary acts as an intermediary between the parent company and the
employees when granting the options, we propose to register the transfer of the
financial derivative to the employees through the subsidiary. The subsidiary receives
the derivative from the parent corporation which increases its net equity in the same
amount of the decrease originated by a lower OS. The subsidiary subsequently pays
CE using the financial derivative. As a result, the parent corporation maintains the
same net equity on its subsidiary but has increased its liabilities with the subsidiary’s
employees.
In what follows the transactions are registered in the accounts without netting them.
Entries in the accounts of the subsidiary:
Subsidiary
Generation of income account
Uses
D.1
B.2
Resources
Compensation of employees
Operating surplus
+5,000
-5,000
Allocation of primary income account
Uses
Resources
B.2 Operating surplus
D.43
-5,000
Reinvested earnings on foreign
direct investment
-5,000
Financial account
Changes in assets
Changes in liabilities and net worth
F.7 Financial derivative
+5,000
(received from parent co.)
F.5 Shares and net equity
-5,000
(reinvested earnings on DFI)
F.7 Financial derivative
-5,000
(given to employees as CE)
F.5 Shares and net equity
+5,000
(the financial derivative received
as a DFI of the parent corporation)
Transactions to be registered by the Household sector:
Households
Allocation of primary income account
Uses
Resources
D.1 Compensation of employees +5,000
Financial account
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Changes in assets
F.7 Financial derivative
Changes in liabilities and net worth
+5,000
The rest of the world accounts are also affected:
Rest of the World
Account of primary income and current transfers
Uses
Resources
D.43
Reinvested earnings on direct
foreign investment
-5,000
Financial account of the rest of the world
Changes in assets
Changes in liabilities and net worth
F.5 Shares and net equity -5,000
(reinvested earnings on DFI)
F.5 Shares and net equity +5,000
(the financial derivative provided
as a DFI of the parent company)
F.7 Financial derivatives
+5,000
As noted above, as a result of these transactions the parent corporation maintains
the same net equity on its subsidiary, however it has increased its liabilities with the
subsidiary’s employees.
B. Exercise period
The value of the option was already registered as a financial derivative asset/liability
on the vesting date. Subsequent changes in its value will be registered in the
revaluation account
Assuming that at the end of the next period (the exercise date) the market price of
the share has increased from 105 to 109 monetary units, the revaluation account will
show the increase of the derivative value during this period (4 units per share for
1000 shares).
The balance sheet will register the total liability of the foreign parent corporation in
respect of this financial derivative as equal to 9,000
At the exercise date the parent corporation sells shares (with a market value of
109,000) to the employees (at the strike price value of 100,000). The difference
between the market value of the shares and the cash payment received for them is
registered as a transaction in financial derivatives, which corresponds to its new
value after revaluation.
When the option is exercised, the following additional transactions will be registered
in the accounts:
Assuming that the employees retain the shares bought at the strike price, the
following transactions will appear in the Households accounts:
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Households
Financial account
Changes in assets
F.2 Currency and deposits
F.5 Shares and other equity
F.7 Financial derivatives
Changes in liabilities and net worth
-100,000
+109,000
-9,000
Revaluation account
Changes in assets
K.11 Nominal holding gains (+)/losses (-)
F.7 Financial derivatives
+4000
Changes in liabilities and net worth
K.11 Nominal holding gains (-)/losses (+)
Changes in balance sheet
Assets
AF.2 Currency and deposits
AF.5 Shares and other equity
AF.7 Financial derivatives
Liabilities and net worth
-100,000
+109,000
-5,000
B.10 Changes in net worth
+4,000
Due to: B.10 Nominal holding gains/losses +4,000
Transactions registered in the Rest of the World accounts:
Rest of the World
Financial account
Changes in assets
Changes in liabilities and net worth
F.5 Shares and other equity
F.2 Currency and deposits
+100,000
F.7 Financial derivatives
+109,000
-9,000
Revaluation account
Changes in assets
K.11 Nominal holding gains (+)/losses (-)
Changes in liabilities and net worth
K.11 Nominal holding gains (-)/losses (+)
F.7 Financial derivatives
+4000
The following are the changes in the parent corporation’s balance sheet due to these
transactions at the exercise date:
Parent Corporation
Changes in balance sheet
Assets
AF.2 Currency and deposits
Liabilities and net worth
+100,000
AF.5 Shares and other equity +109,000
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AF.7 Financial derivatives
Due to:
-5,000
B.10 Changes in net worth
-4,000
B.10 Nominal holding gains/losses -4,000
Conclusion
The increasing globalization of production means that the issue of employee stock
options is of importance not only in domestic sector accounts but also in the accounts
for the rest of the world and the balance of payments.
Subsidiaries of foreign corporations grant stock options of the parent corporations to
employees. The rise in CE means that their OS and reinvested earnings on direct
foreign investment fall. As a result, the net equity of the foreign parent corporations
on their subsidies will be shown as decreasing. However, the increases in CE are
really not paid for by the subsidiaries but covered directly by the parent corporations
that issue the options. The proposed registration of the transfer of the financial
derivative from the foreign parent company to the employees through the subsidiary
as a direct investment maintains net equity of the parents corporations on their
subsidiaries unchanged.
A decision to register employee stock options at the vesting date, will also affect the
timing of registration of these flows in the accounts of the rest of the world (and also
in the balance of payments which should ideally be harmonized with the national
accounts).
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