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.