UK: Accounting for Share Based Payments - the Effect on Employee Share Schemes

At present employee share options and other employee awards are accounted for only on the basis of any "intrinsic value" i.e. the difference between the market value of shares awarded to employees and the price they will eventually pay for them. If options are granted at market value there is no discount and no charge to the P&L account. Under important new proposals¹ supported by international accounting standard setters, it is expected that in future options and awards will be accounted for on their "fair value" at the date of grant. This will mean valuing the option, usually by reference to an option pricing model, and charging the fair value to the P&L account over the award period. For companies which presently grant options at the current market value of their shares, this will mean a new P&L charge. This charge to P&L will also apply to SAYE schemes for which at present there is an exemption. This briefing considers the scope of the proposals and some possible effects on employee share schemes.

The proposals set out in FRED 31 introduce a very significant change to the accounting treatment of employee share schemes because the basic principle of the FRED is that all share-based payment transactions should be recognised in a company’s financial statements using a fair value measurement basis estimated at the grant date.

To estimate the fair value of a share option, where a tradeable market price for such options does not exist, an option pricing model, such as Black-Scholes or the binomial model, will need to be used. FRED 31 does not specify which particular model should be used, but the company must disclose the model used, the inputs to that model as well as various other inputs into the fair value calculation. FRED 31 contains various proposals on estimating the fair value of employee share options, to allow for the differences between employee share options and traded options. For example, the valuation should take into account all types of vesting conditions, including service conditions and performance conditions.

One consequence of grant-day estimations is there is no reversal of the accounts charge if the option lapses. However, the grant date valuation will be reduced to allow for the possibility of forfeiture because of failure to satisfy vesting conditions. Under the methodology in the FRED, this fair value is divided by the expected units of service to be received from employees under the option grant. The resulting "fair value per unit of employee service" is then applied to the actual service received over the vesting period. This means that the charge will vary depending on how the number of actual leavers varies from the expected number of leavers.

The new standard will create a P&L charge for grants of share options to employees where currently there is no charge at all (e.g. on grants of "market value" options or options under a SAYE scheme). This is because the fair value of a share option is always worth more than just its intrinsic value (i.e. the difference between the strike price and the share price at the date of grant), due to the time value of the option and expected share price volatility. So, remuneration charges will rise and consequently corporate earnings will fall, but by how much?

There have been figures quoted in the press suggesting that, on average, UK corporate earnings will fall by 5%. However, this is an average, and it was quoted before the detailed methodology was laid out as in FRED 31. Some aspects of the calculations are easy and companies can supply the inputs to the traded options models, such as Black-Scholes, and do their own calculations. However, some of the adjustments to the value of traded options to reflect restrictions on employee share options are subjective and quite hard to work out and companies may need some help. But be reassured: although the 5% is an average, many analysts believe that this is dragged up by some companies that are heavily reliant on share options as remuneration – for the bulk of UK companies the impact should be rather less than a 5% hit on earnings.

Many companies are likely to take the view that it is still better to accept the accounting charge of granting options rather than replacing them with cash schemes as cash schemes are likely to require an increase in pay in excess of the equity charge that gives equivalent benefit. The accounting charge is only on the value of the option when granted and, if one assumes a share price increase, the potential gain that an employee can realise should be considerably in excess of the charge to the P&L account.

Cash-based schemes do not provide the hedging of liability which share-based schemes involve where there is no cash outlay for the group (by contrast, cash-based schemes are limited by the cash reserves that a company actually has). Cash schemes would also be fully liable to national insurance, whereas the national insurance cost of options can be passed on to employees. Share options are likely, therefore, to remain an important part of a company’s remuneration policy.

Further, the accounting change must be seen in the context of the changes to the tax treatment of options announced in the Pre-Budget Report on 26 November (which provides for companies to receive a statutory corporation tax deduction for option gains, regardless of whether the options are approved or unapproved). The new corporation tax relief should go a long way towards compensating for the accounting charge.

The ASB would like to see the standard adopted in the UK as soon as possible, which means that, under the current IASB timetable, it would take effect for accounting periods beginning after

1 January 2004 (the date on which the international standard comes into effect). The ASB will withdraw most of the existing accounting guidance, much of which is in the form of Urgent Issues Task Force Abstracts, rather than a full accounting standard.

One particular concern is that, were the UK to introduce the new accounting charge before other countries, particularly the US, this may harm the competitive position of companies conforming to UK standards.

The Law Society has written to the ASB outlining an opinion that the new standard will require a change in the law before it can be implemented. The letter has been copied to a number of other regulatory bodies including the European Commission and the Financial Reporting Review Panel. The ASB has stated that it does not believe a legal impediment exists and presumably this matter will have to be dealt with during the consultations on the proposals. If there is an impediment, the impact of the standard would nevertheless be delayed only for a year in the UK, at least for listed companies, which will in any case have to follow the international standard that is drawn up under ED 2 from 2005 under the EU Regulation on international accounting standards. Further implementation in the UK of this standard may depend on changes to the EU Directive.

The transitional arrangements when the standard comes into force are worth noting. The normal approach for a new standard is that it should be applied retrospectively, i.e. it would be necessary to go back and restate all past transactions. In this case, the draft standard allows limited exemptions from retrospection, so that the requirements of the standard would not apply:

• to any share-based payments that vested prior to 1 January 2004, or
• retrospectively to grants of share awards that were made prior to the publication of FRED 31.

© Herbert Smith 2002

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