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.