Financial Reporting - Share-based payment - End of a relaxed regime

William Franklin considers some of the practical implementation issues of IFRS 2/FRS 20.

William Franklin is an associate in the Pinsents share schemes team.

Until recently, when employee share options were granted their cost was an issue that was usually ignored. The relevant accounting pronouncement was Abstract UITF 17, which required an expense if the options were granted at a discount. However, this expense rarely arose in practice because most options were granted at market value unless they were SAYE options for which there was a special exemption.

The Association of British Insurers' (ABI) guidelines for the design of executive share schemes called for the disclosure of the 'expected value' of employee share awards. However, in the absence of a generally accepted basis for quantifying expected value, this guideline tended to be followed more in the breach than the observance.

This relaxed regime comes to an abrupt end with the imminent implementation of the international standard

IFRS 2, Share-based Payment, and its near identical UK domestic twin sister FRS 20 for share-based payment (the 'standards').

Shareholder circulars and notes to resolutions adopting new share schemes are now starting to refer to expected value based on the standards' methodologies.

The domestic UK standard applies to listed companies for accounting periods beginning on or after 1 January 2005 and for unlisted companies a year later. Compliance with

IFRS 2 (providing it is approved by the European Union) will be required for the consolidated accounts of European-based listed groups for accounting periods beginning on or after 1 January 2005.

In general these standards require an expense to be calculated based on the fair value of the options at the date of grant. The fair values are to be determined by using mathematical techniques known as option pricing theory of which the best known is Black Scholes (see Accountancy, September, p88). Although the mathematical techniques can be reduced to standardised processes, companies will be required to select from a veritable witch's cauldron of assumptions, with each assumption potentially having a substantial impact on the actual accounting expense.

Black Scholes Six

First there are the 'Black Scholes Six', which are the six factors (future share price volatility, future dividend yield, expected life of the option, risk-free rate, exercise price and market value) which the standards require a company to take into account regardless of the form of option pricing theory used. However, it will often then be necessary to make other assumptions such as the length of the vesting period, the probability of employees leaving in circumstances in which they forfeit their options and the probability of satisfying performance conditions. There might be other vesting conditions to take into account such as whether a savings contract had been completed by the option holder and whether an individual had maintained a minimum shareholding.

The 'Black Scholes Six' assumptions are fixed regardless of subsequent events. So even if the assumptions about say future share price volatility prove completely wrong there is no opportunity to revise the assumptions and change the accounting expense. However, for the other assumptions the standards require 'truing up' to revise the assumptions so that the resulting accounting charge reflects actual events. Where 'truing up' is required the accounting expense should be more accurate but perhaps more volatile. However, to further complicate matters there is an exception from the requirement for 'truing up' for conditions which are classified as market conditions.

The standards define a 'market condition' as 'related to the market price of the entity's equity instruments such as attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving a specified target that is based on the market price of the entity's equity instrument relative to an index of market prices of equity instruments of other entities'.

Total shareholder return

Curiously the standards are silent on whether one of the most popular measures for performance conditions, total shareholder return (TSR), is a market condition although we understand the International Accounting Standards Board did conclude that TSR was a market condition during its deliberations in the development of


The concepts of 'truing up' and market conditions were only introduced after the end of the consultation period for the exposure draft and so there was no real opportunity for outsiders to contribute to this issue.

This may be a pity as TSR is a hybrid reflecting share price growth (which is a market-based measure) and dividends (which are not) and during a period of stagnant or falling capital values dividends can be the dominant factor in the TSR.

For unquoted companies where options may only be exercisable if an exit event occurs such as a sale or flotation, the exit event itself would be the performance condition. At the time of grant a judgment would be required as to whether an exit event was likely or not likely to occur.

If it was considered not likely to occur there might initially be no cost to charge to the accounts.

However, if eventually the exit event did occur then an expense would need to be recognised. Paradoxically, if the exit event requires a minimum price to be achieved then the exit linked assumption and related cost would not be 'trued up' as the condition would then be market based.

When 'truing up' was first proposed it was seen as a welcome simplification to an over complicated basis of spreading costs that had been proposed in the exposure draft. However, with potentially so many different variables, keeping track of whether a particular option vests or not and the reasons why may well present some serious practical challenges even for companies that maintain robust option records. Without such detailed information, companies will not be able to correctly calculate their accounting expense under the standards.

Transatlantic complications

In the future the IASB and US Financial Accounting Standards Board say they aim to achieve convergence in their share-based payment standards.

However, for those simply trying to operate the share-based payment rules correctly this could create another complication if it becomes necessary to look across the Atlantic for guidance on some issues. For example, companies that have US-style phased vesting whereby a proportion of the options vest each month over a period of time might want to adopt an average vesting period rather than go to the trouble of treating the original grant as a series of separate awards for valuation purposes. However, the series of grants approach seems likely to emerge as the preferred practice since the proposed revised FAS 123, which FASB recently issued, proposes to outlaw the averaging methodology.

Unless unexpectedly the EU derails the share-based payment project by declining to approve

IFRS 2, companies with employee share schemes would be wise to review their share option record-keeping procedures to ensure that they will be able to provide the data necessary to comply with the new standards.
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