What counts as debt in the Debt management ratios?

Question

I am a finance student doing a project with a company's financial statements. I want to calculate Debt over assets.

My problem is that the company has listed its stock options that the executives may exercise in the future as debts in the annual statement. I know this is usually not on the balance sheet, but should I add these options in when calcuation the above ratio?

I would like to know what the rule is in both accounting and finance regarding if stock options are debt.

Answer 1

You're in deep water here. Rewarding employees through share-based compensation is a common business practice. Share-based payments are classified into three categories:
1) equity-settled,
2) cash-settled, and
3) transactions with settlement alternatives.

Equity-settled transactions are those in which the entity receives goods or services as consideration for issuing its own equity instruments (for example, shares or share options) [IFRS2.2(a)]

Different recognition and measurement methods should be applied to:
a) equity-settled purchases of goods and non-employee services,
b) equity-settled transactions with employees, and
c) cash-settled transactions.

The accounting treatment of options depend on who is the grantor of the options. If the grantor is the co. whose shares will be issued when exercised by the employee, then the co will reflect the proportionate FV of the options under equity and not under liability. (In this case since it's not under liab it won't affect your debt/asset ratios) If the grantor of the share options is a related company of the entity whose shares will be issued when the options are exercised, then the granting entity will account for the option as a liability. (In that case since it's under liability, it would be treated as a debt for your debt/asset ratio purpose). This can happen, for e.g. Co. A tells its employees, "If you perform well, you'd get share options to buy shares in our sister co. B" Since the grantor is co. A, in A's books, the options are under liabities.

If Co. A is the grantor, and the options are to buy shares in Co. A itself, it should account for the options under equity. This is at least consistent cos we use share options to calculate diluted EPS, so in that sense again, they're equity, not liabilities.