Implementing IFRS 2 - Grappling with the practicalities

There are some pitfalls and problems to overcome in accounting for share options for the first time. Joanna Osborne reports.

Companies preparing for International Financial Reporting Standards are now familiar with the requirement to recognise an expense over the vesting period for share options granted to employees. But there are still many practicalities to grapple with. As many companies are finding, there are some pitfalls and problems to overcome in accounting for share options for the first time.

Achieving comparable expense

Some companies are choosing to apply

IFRS 2 or FRS 20, Share-based Payment, to more share options than they are required to under the transitional rules. Applying the standard to all share options has the merit that the expense is comparable between one year and another. The pitfall is that neither IFRS 2 nor FRS 20 permits the inclusion of additional share options unless the fair value has been previously published. Many are remedying this. Difficulties determining grant date

The standard requires the fair value of the share option to be evaluated at grant date, but determining grant date can be problematic. It is defined as the date when the company and the employee have a shared understanding of the terms and conditions of the arrangement. Where there is a significant approval process, grant date is deferred until approval is obtained. Thus, for a scheme that is notified to employees in May, but subject to the approval of the agm on 30 June, grant date will be 30 June.

As an added complication, the standard requires the 'cost' of services to be recognised when received, even if this is before grant date. In this example, if the employees started to provide services immediately, an estimate of the fair value at 30 June should be made and the relevant proportion should be booked from May.

It can sometimes be difficult to determine when a shared understanding is achieved. For example, a share option scheme approved on 30 June 2005 is conditional on revenue growth exceeding a given target in 2006; however, target growth will not be notified to employees until 31 December 2005.

The employees may not have a full understanding of the scheme until 31 December 2005, which would be grant date. However, if the participants were the board of directors, they might become fully aware of what target will be set as part of the company's budgeting process; if this takes place in October, that is where grant date would fall.

Choosing the right model

Deciding which model to use to calculate the fair value that market participants would use is not straightforward. Many people are attracted to the relative simplicity of the Black-Scholes-Merton formula, but market participants would only use it for share options with a narrow range of possible dates for exercise and over shares where volatility is likely to be steady throughout the life of the option (see Accountancy, September 2004, p88).

Repeated calculations using Black-Scholes-Merton can give a reasonable estimate of the range of values for accounting purposes if either the exercise date or volatility is expected to change only by a small number of incremental amounts. Outside this range, binomial lattice models that can incorporate many of the features that are unique to employee options (such as close periods and sub-optimal exercise) should probably be used.

However, even these models can't readily incorporate the probability of meeting any conditions into the valuation.

IFRS 2 requires the probability of meeting the condition to be incorporated into the valuation when the condition is dependent upon the share price.

The 'total shareholder return' benchmark favoured by institutional investors is an example. If the share-based payment falls in this category, then fair value is particularly difficult to calculate and almost invariably requires the use of a Monte Carlo simulation model (and the charge is not subsequently trued up for forfeiture).

It is easy to see why, other than in the simplest cases, many companies are turning to option valuation specialists to assist them.

Understanding settlement terms

Usually it is obvious whether a scheme is cash or equity settled. But watch out for arrangements where the company agrees to repurchase the share from the employee at some date in the future - the share issued to the employee is redeemable and therefore cash-settled. This arises frequently for unquoted companies, where there isn't a market for the shares. It can also be the unintended effect of the arrangement if the company bears price risk in arranging to sell the employee's shares after exercise.

Adjusting for variable vesting

Accounting for a variable vesting date follows the general rules for performance conditions. For example, where vesting is dependent on achieving a certain level of earnings per share, an estimate is made at the outset and the expense is recognised on this basis. In the earnings per share example and for other non-market-based conditions, vesting date would be adjusted as new information became available about the likely outcome ('trued up') until the final date is known. However, if the vesting date depends on a market-based condition such as the share price, no adjustment is subsequently made.

National insurance

National insurance (NI) is payable on the exercise of share options and the amount is currently based on the intrinsic value at the time of exercise.

Some companies reimburse the option-holders for employee's NI cost as part of the arrangement. This squarely meets the definition of a cash-settled share-based payment, and the accounting should follow

IFRS 2 or FRS 20.

The accounting requirements for employer's NI are less obvious; in the UK we would probably choose to continue to follow the approach of UITF 25 and calculate intrinsic value at each year end's share price and spread NI over the vesting period, somewhat like the

IAS 12 deferred tax calculation.

However, it is unclear whether this will emerge as best practice under IFRS.

Future developments

There are some unresolved issues. Cancellation of SAYE schemes is the subject of a hotly-debated exposure draft from IFRIC, the IASB's interpretative body, and the final position remains unclear although everyone agrees that reversing the charge is not appropriate.

For individual financial statements, there is an unresolved issue: the accounting by subsidiaries for options granted to subsidiary employees over their parent's shares. A draft interpretation is still being finalised by IFRIC, although the direction in which they are heading now seems clear.

IFRIC's tentative conclusions are that the subsidiary should account for share options granted by the parent as cash-settled share-based payments in all cases except when the subsidiary is not party to the arrangement and the employee receives parent entity shares or share options and not cash.

So when all this has bedded in, and when it has become second nature to calculate fair value of share options before making a decision to grant the option, what does the future hold?

Companies may begin to question whether share options are worth all the effort. In the light of all the apparent complexities and practical difficulties, we may well see a trend back to cash bonuses that are straightforward to calculate and simple to account for. Of course some would maintain that remuneration in shares has other benefits such as alignment of the interests of employees with shareholders. So, perhaps, share-based payments are here to stay.

Joanna Osborne is a partner at KPMG.

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