Share Scheme Accounting
All forms of employee (as well as other) share-based awards - referred to as "share-based payments" ("SBPs") - now give rise to an accounting expense, and a consequent reduction in profits, unless the company is small enough to qualify to prepare its accounts under the accounting standard for small enterprises (known as "FRSSE"). For UK companies, the rules for determining the timing and amount of the expense to be recognised are set out in the International Accounting Standard "IFRS2: Share-Based Payment", and the near-identical domestic standard, FRS20.
These standards contain two distinct regimes: the more complex is for an "equity-settled share-based payment" such as an award of shares, grant of a share option or acquisition by the employee of a joint beneficial interest in shares; the other is for a "cash-based share-based payment" such as a 'phantom' share option or an option which is intended from the outset to be settled in cash, or a cash bonus linked to the price of shares. In the case of an "equity-settled share-based payment", the accounting expense is determined by reference to the fair market value of the award at the time of grant, whereas, in the case of a cash-settled share-based payment, the total cost to be recognised can only be finally determined when the employee ultimately receives the benefit of the award, usually in the form of a cash payment after the award has become vested.
The overall accounting cost of a cash-settled share-based payment to be recognised by the company making the award will (or should) be broadly the same as the value of the benefit to the employee of that award. However, in the case of an equity-settled share-based payment, as the amount of the expense is determined at the time of making the award, that cost will not necessarily equate to the value of the benefit which the employee ultimately derives when, or after, the award has become vested. In some circumstances, for example, the employee may not ultimately receive any benefit whatsoever (e.g. because the share price falls below the exercise price of a share option), but the company will, nevertheless, still be required to recognise an accounting expense.
If an equity-settled share-based payment takes the form of an immediately-vested award of shares, then it may be relatively easy to determine the fair value of the award as this will typically be the market value of the award shares at the time it is made. However, a share option does not itself normally have a clearly defined market value at the time of grant. In this case, it is necessary to determine a theoretical fair value using advanced mathematics based upon what is known as the "Black-Scholes formula". This has six assumptions (or inputs). These are:
- the exercise price;
- the market value of the option shares at the time of grant;
- the expected life of the option;
- the expected volatility of the share price;
- the expected dividend yield; and
- the risk-free rate of return.
Spreadsheet-based Black-Scholes calculators are now widely available on the internet to enable these calculations to be made. More complex forms of the formula, such as "binomial models" have been developed and there are versions that use so-called "Monte Carlo” simulation techniques to determine such theoretical values. Collectively, these are known as "option-pricing theories". Despite their seeming differences, they are all based on the Black-Scholes formula.
If a share option has an unusual structure or vesting depends upon certain performance conditions, a Monte Carlo-based approach may be appropriate for accounting purposes. However, the standards do not specify the use of any particular form of option-pricing theory and, in most cases, a basic Black-Scholes approach will be sufficient.
As well as determining the basic fair value as at the time of the award, it is also necessary, in the case of awards which do not immediately become vested, to estimate the likelihood that the award will become vested to any extent, as this too is taken into account in determining the accounting expense. In this respect, the standards distinguish between three factors which might affect vesting. These are:
- service conditions (i.e. any requirement that the employee remain in service as a condition of vesting);
- performance conditions (e.g. conditions relating to the attainment of target levels of performance expressed by reference to growth in Earnings per Share ("EPS") or Total Shareholder Return ("TSR"), etc.) and
- non-vesting conditions (i.e. any conditions other than a service or a performance condition, such as the need to have made monthly savings under a SAYE savings contract).
The interaction of these conditions and an option-pricing theory can be highly complex. For service, and non-market, performance conditions, the company is able to revise its estimate of likely vesting made at the time of grant so as to reflect the actual level of vesting. This process is referred to as "truing up". A consequence of being able to "true up" is, for example, that if the business fails to meet a non-market performance condition (such as an EPS-based performance target) and none of the award shares become vested, there will be no overall accounting expense to be recognised. In the case of market-based performance conditions, such as performance targets linked to growth in share price or relative or absolute growth in TSR, the estimate made at the time of grant, of the level of vesting, cannot thereafter be changed, regardless of the actual level of vesting achieved.
Once the anticipated total cost of an equity-settled share-based payment at the date of grant has been determined, it is spread over the accounting periods making up the vesting period. For a cash-settled share-based payment, estimates of the accrued liability to date are made at the end of each accounting period. These are later revised when the ultimate liability becomes known.
For a cash-settled share-based payment, the accounting double entry that corresponds with the expense is a real liability recorded in 'Creditors'. However, in the case of an equity-settled share-based payment, the accounting expense is a notional cost and the corresponding double entry is in 'Shareholders' funds', not 'Creditors'.
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