Overview
A new accounting landscape
With the exception of certain smaller companies, all listed and private companies must now account for share based payments provided to their employees. IFRS 2 and its UK counterpart FRS 20 are the new financial reporting standards (the “Standards”) for share based payments.
The Standards assume that share based payments are made by a company to its employees in return for the employees’ services; these services are “consumed” and therefore have to be charged to the profit and loss account over the vesting period. The charge is the “fair value” of the share based payment as an equity instrument itself and not just the value of the underlying shares.
What are share based payments?
Share based payments can be either:
- “equity settled” - share options, share purchase or share award arrangements
- “cash settled” - any cash payment arrangement, where the amount of the payment, is determined by reference to the company’s share price (e.g. phantom options or share appreciation rights)
Financial implications
Although all share based payments need to be considered, the most significant impact of the Standards arises with share options. Under the previous accounting standards only the intrinsic value of share options was measured. Based on “intrinsic value” (the difference between the market value of the shares and the exercise price of the options on the date of grant), there was no charge if options were granted with a market value exercise price and satisfied by new issue shares.
Under the new Standards the concept of fair value takes into account the likelihood that the share price, to which the share base payment relates, will move favourably in the future, allowing the award to exercise or vest at a profit. This means that a profit and loss charge is far more likely to be recognised and as a consequence the fair value measurement of share options can give rise to a significant accounting expense.
The measurement of fair value, especially for options, requires the use of complex valuation models.
Other implications for your business
The Standards will not just impact on company profits, but also on the reward and performance structures put in place for employees. This is because the potential financial impact for the company in applying the Standards, will indirectly influence a company’s remuneration strategy and as such its ability to effectively recruit and retain employees in an increasingly competitive employment market.
Companies now have the difficult balancing act of understanding and controlling the financial issues, whilst also providing an attractive remuneration strategy. Careful management of the relationships with key employees and shareholders will be core to a company successfully ensuring, remuneration strategies remain competitive in the eyes of key employees, whilst still operating within a controlled budget.
Main features of the Standards
From when do the Standards apply?
For equity settled awards, the Standards apply to all awards granted since 7 November 2002 (or modified, e.g. re-priced, if granted before 7 November 2002), that were outstanding (unvested), as at January 1 2005 for listed companies and 1 January 2006 for unlisted companies.
For cash settled awards the Standards apply to all outstanding past grants as at 1 January 2005 for listed companies and 1 January 2006 for unlisted companies, not just awards made from 7 November 2002.
Exempt companies
Only those entities applying the Financial Reporting Standard for Smaller Entities (FRSSE) are exempt from applying the Standards. However, such companies will be required to disclose the principal terms of any equity settled awards (e.g. the number of shares or options, number of employees, grant date exercise prices and details of any performance conditions). They will also have to recognise an expense for cash settled share based payments.
Fair value approach to equity settled awards
The cost of equity settled awards should be recognised over the period from the grant date to the vesting date, with a corresponding credit to shareholders’ funds on the balance sheet. If the award vests immediately, the cost will be recognised at that date.
The fair value of equity settled awards should be based on the market prices (where there is a market) or estimated using a valuation technique. The estimate must take account of the rights and conditions of the shares awarded or the terms and conditions on which any options were granted.
As options granted under share plans are not traded, determining fair value requires the use of an option pricing model, that reflects the movement of the underlying share price. There are a number of alternative option pricing models including the Black-Scholes method, the Binomial Model and Monte Carlo Simulations. The Standards only require that an appropriate model is used and the appropriateness depends on the complexity and design of the share plan. However, the Standards do require assumptions to be made as inputs to the valuation model, which must include as a minimum:
- the current share price of underlying shares
- exercise price of the option
- the expected volatility of the price of the underlying share
- the expected life of the option
- expected dividends on the underlying share
- the expected risk free interest rate prevailing over the life of the option
The Standards also require evidential disclosure in the accounts to support the assumptions, including a review of share price movement (where available) and historic patterns of exercise. There are a range of acceptable assumptions.
Performance conditions and forfeiture
- Market-based performance conditions affecting the likelihood that options will vest (e.g. share price or total shareholder return), must be taken into account in estimating the fair value of the option.
- Non market-based performance conditions (e.g. earnings per share or growth in profits) may not be taken into account in estimating the fair value of an option. Instead, an estimate of the number of options that will vest is used and this is “trued-up” at the end of each year, when a better estimate of the likely outcome of the non market-based performance condition can be made.
- Service conditions under which leavers forfeit unvested options are also not taken into account in estimating the fair value of an option. Instead, an estimate of the number of options that will vest is used and this is also trued-up at the end of each year, when the numbers of leavers are known and better estimates for future leavers may be made. The higher the estimate of leavers, the lower the initial accounting expense.
Fair value approach for cash settled awards
These are viewed as liabilities not equity and are treated differently. At the end of the first year the company estimates the fair value as at the date of grant, using an option pricing model and spreads this amount over the period of the award. This amount is then recalculated at the end of each year and the charge for the year is adjusted up or down accordingly. Thus at the date of settlement, the cumulative charge shown in the accounts is the actual amount the employee receives.
What if an award may be settled in either cash or shares?
Where there is a cash alternative, the company accounts for the award as a cash-settled award where it has incurred a liability to settle in cash, or an equity-settled award if there is no such liability. Whether there is a liability, depends on who has the option over the method of settlement and the company’s past practice with similar awards. Awards may need to be split into cash-settled and equity-settled components.
Some practical issues with share based payment
Replacing of share options
Where previously granted options are no longer incentivising employees, perhaps because significant falls in the company’s share price have caused the options to go “under water” (where the exercise price is higher than the market value of the underlying shares), the company may consider issuing replacement options with a lower exercise price or longer vesting period. If so, the company will need to identify the new issue as replacement options in order to avoid a higher charge to the profit and loss account. If not, when the existing options are cancelled, the company will have to charge the rest of the expense that would be recognised over the remaining vesting period, as well as the fair value expense related to the new issue of options.
However, if the new issue of options is identified as replacement options, then the charge to the profit and loss account is based on the difference between the fair values of the new issue options and the existing options at the date of grant of the new options (hence a lower charge).
Share based payment issued by a parent company to a subsidiary’s employees
Where in a group company, a parent provides share options to employees of a subsidiary group (perhaps as part of a group wide employee incentive scheme), it is the company receiving the benefit of the employees’ services that must recognise the charge to profits, regardless of the fact it is the parent company providing the shares. It is important therefore that the correct systems are in place to identify these share based awards and to ensure the correct charge is recognised in the correct group company.
Unlisted Companies
Calculating the fair value of share based payments for unlisted companies will be complex given the absence of a public market to ascertain the market value of the shares at grant and the expected volatility of the share price.
Action to be taken
Identifying the issues
All non FRSEE accounting companies, already providing share based payments to their employees or are intending to do so, must consider what FRS 20 (or IFRS 2) means for them.
While estimating both the amount and the timing of the charge to their profit and loss accounts, companies may also wish to consider the sensitivity of these charges to variations in the inputs to the relevant option pricing model.
Determining strategy
Determining the correct strategy for your company will depend on the role share based payments play in its remuneration policies. Where company policy actively supports the use of such payments, the potential benefits of granting awards with or without market based performance conditions should be carefully considered against the accounting impact.
In determining strategy, the company should focus on managing dilution, cash flow and controlling the overall cost of providing the share based payments to its employees.
Actions to take ahead of this years accounting year end
Companies both listed and unlisted, need to consider:
- what type of option pricing model is most appropriate for their circumstances;
- ensure that they have the data (e.g. forfeiture history and historical exercise patterns) available to implement the valuation requirements of the Standards;
- gather the inputs for the selected option pricing model;
- simulate the effect of implementation on the financial statements; and
- carry out sensitivity analysis of the valuation to the key assumptions in the model
Unlisted companies will have a significant amount of extra work, as valuations of the underlying shares will also have to be carried out and expected volatility assessed. Under auditor independence rules the company auditors will not be able to undertake these valuations.
If you need further information, please contact Chris Page.