Most UK companies must record an expense in their profit and loss account for any employee share options and awards they make - these are called ‘share based payments’ for accounting purposes. However, share based payments can include payments in cash, where the amount paid is determined by reference to the value of the shares.
This article provides an overview of the accounting rules for share-based payments. Accounting for share plans is a complex area, and companies should take specialist advice on the accounting consequences of different types of share schemes.
Most companies in the UK that prepare their accounts using UK accounting standards must account for share based payments under section 26 of FRS 102. This is almost identical to the international standard IFRS 2, on which it is based. Many public companies (for example, quoted companies and AIM companies) are required to comply with IFRS.
The ‘fair value’ of share awards to employees are recorded as an expense in the accounts of the employing company (ie the company receiving the services provided by the employee to whom an option or award has been made). There are no exemptions from the standard for all employee plans eg Save As You Earn plans (SAYE), Share Incentive Plans (SIP) or Employee Stock Purchase Plans (ESPP).
The complexity of the accounting standard means that there are numerous factors that will determine exactly how a share based incentive is accounted for. Two of the most important factors are whether the incentive is ultimately delivered in cash or in shares and the nature of any performance conditions that are applied to an award.
‘Equity settled’ and ‘cash settled’ awards
The method of accounting depends on whether the share award is an equity-settled award, cash-settled award or an award where the employer or employee has the choice of settling the transaction in cash or equity.
Equity-settled share based payment transactions include share options and long-term equity incentive plans where the overall outcome is that the employee receives shares. For these awards, fair value is to be measured at the date of grant and charged to the profit and loss over the vesting period. The vesting period is the period of time before shares in an employee plan are unconditionally owned by an employee.
Cash-settled awards include phantom options and stock appreciation rights where the overall outcome is that the employee receives cash. For these awards, the expense is still spread over the vesting period and the carried liability is re-measured at each reporting date.
In this case, the company must make an adjustment to the expense recorded in each financial reporting period until the liability is finally settled. The adjustment takes into account: reassessment of the fair value of the award (rather than the intrinsic value of the award) and changes in the number of awards likely to vest.
The fair value for the purpose of determining the expense to be recorded for equity settled and cash settled awards made to employees would be determined according to option pricing models, such as Black-Scholes, binomial model or Monte Carlo simulation.
If it is the employee’s choice to receive cash or shares, then the award is treated as a cash settled transaction under FRS 102.
While FRS 102 is almost identical to IFRS 2, there is a difference where the employee has the choice of settlement in cash or equities. Under IFRS 2, this will be treated as a compound instrument with both an equity and liability element. The ultimate treatment and accounting will be specific to the facts and circumstances of each case so it is important to seek accounting guidance if you have settlement alternatives under IFRS.
If it is the employer’s choice, generally the event is treated as an equity settled payment. However, it will be treated as cash-settled if: there is an established pattern or policy that they settle in cash; or there is no commercial substance to an equity payment.
If performance conditions are attached to awards, the nature of the performance conditions will determine whether the award is adjusted at each reporting date for the number of shares expected to vest.
If the award has a non-market based performance condition (for example, earnings per share or performance conditions relating to continued employment), then the award will be adjusted for the number of shares expected to vest at each reporting date. This means that if the performance condition is not met, there is no charge to the profit and loss account.
This contrasts to the position of an award that has a market based performance target such as one based upon achieving a certain share price or Total Shareholder Return (TSR). In these circumstances, the probability of achieving the share price/TSR is factored into determination of the fair value at grant but is not re-measured at subsequent reporting dates. Therefore, once determined, the accounting expense will not be reduced if the performance target is not met and awards do not vest.
The accounting charge can be adjusted if awards are forfeited because employees leave, regardless of the nature of the performance target attached because service conditions are a non-market condition.
In practice, many awards are subject to both market based and non-market based conditions. For example, an award might vest only if a share price target is met and the employee is still employed on a certain date. If the award failed to vest because the employee ceased employment, the accounting charge in respect of that award would be reversed. However, if the award failed to vest because the target was not achieved, the accounting charge would not be adjusted.
There are also ‘non-vesting conditions’ which are treated the same as market conditions and so have to be factored into the fair value. Examples of these most commonly arise in SAYE schemes where companies must factor in an allowance for the number of employees the will cease to contribute (but not leave).
Determining your incentive strategy
The potential benefits of using share awards with and without market based performance conditions should be weighed against the accounting impact. Your review should focus on managing dilution, cash flow and controlling the overall cost of each plan.
How we can help
If you would like more information about FRS102 or IFRS 2 or if you have any other issues in relation to employee incentive arrangements please contact your usual BDO contact.
BDO LLP can advise on all aspects of the design and implementation of share and cash based plans. Our advice includes drafting and producing the relevant documentation, input on performance measures, exit planning, tax considerations, accounting, share valuation, communication and ongoing reporting obligations.
For help and advice on creating share plans to help your business grow, please contact Andy Goodman or Matthew Emms.
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