Share-based payments, such as share options (including Enterprise Management Incentive or EMI Schemes) and growth shares (sometimes referred to as “sweet equity”) have become an integral component of compensation and incentive programmes for many businesses.
They can be a cash-efficient form of remuneration for start-ups and, for larger companies, they’re a tax-efficient way of remuneration planning for a potential exit. These key factors demonstrate that the creation of such schemes is in fact remuneration for employees, just in a form other than cash. So, how do you know the value of that remuneration?
When a company enters a share-based payment arrangement with employees, it takes on obligations to provide shares or share options as compensation for employee services over the expected vesting period (the time to anticipated exit or realisation of value). Both FRS 102 (or UK GAAP) and IFRS 2 are clear that proper accounting for these schemes is required. This provides transparency and comparability for investors and other stakeholders.
What is required?
Under FRS 102 and IFRS 2, the company recognises an expense for the “fair value” of the award as at the grant date (explained further down) over the vesting period, along with a corresponding increase to equity for equity-settled plans. For such schemes, there is typically no impact on the company’s net assets due to this circular expense charge. Although the situation can be complicated somewhat in group situations where a parent enters into the scheme on behalf of a subsidiary (the employing company).
For cash-settled plans, a fair value liability is recognised instead of equity, and this is valued at each year end until settled. These add volatility risks to the profit and loss account. Cash-settled schemes are less common than equity-settled schemes, but a particular issue can arise when growth shares are issued in certain subsidiary companies – advice specific to your situation will always be needed in this case.
Some schemes also include a choice of settlement in cash or shares, either by the company or the employee; care is needed to determine the nature of the scheme.
What is the fair value of my scheme?
The fair value of share options is estimated using option pricing models, such as Black-Scholes or a Monte-Carlo simulation. These models require certain inputs like expected volatility, expected dividends, expected life of the options, and the risk-free interest rate. Companies must use their judgment in selecting appropriate assumptions for these inputs, based on historical trends and market data.
What about the tax valuation?
A tax valuation is generally not equal to fair value, as this is determined for a specific purpose. Typically, the tax value will be based on a single estimate of the company’s current value – perhaps discounted for non-controlling considerations. This contrasts to the fair value for accounting purposes, which can be viewed as a probability-weighted calculation of all possible future outcomes.
However, the two should work together. Determining the two values concurrently while designing scheme rules often allows one to inform the other; this can either get a better tax outcome or minimise any share-based payment expenses – or both!
When do I recognise the fair value?
The amount of expense recognised over the vesting period is adjusted to reflect actual forfeitures when employees leave before vesting occurs. The timing and uncertainty around vesting conditions and forfeiture rates can impact the measurement and recognition of the expense.
Clear disclosures around a company’s assumptions, methodologies and estimates provide transparency to investors.
Recording the share-based payment expense reduces reported profitability, since it is a non-cash expense. But it provides a more accurate picture of performance. Especially in more complex groups, investors often focus on non-GAAP metrics that exclude share-based payment costs (such as adjusted EBITDA) to evaluate core operating results and more closely align to cashflows.
Compliance with accounting standards like FRS 102 and IFRS 2 enhances the credibility of financial statements. Investors value the trustworthiness generated by adhering to regulations and presenting information fairly, while standardisation of accounting creates consistency which improves comparability across firms.
What do I show in my financial statements?
Other than the expense itself, there are a host of disclosures that will need to be included, although this depends on your company size, whether the company is listed, and the accounting standards being applied. Typically, this would be details of the inputs to a valuation model, the model used, and information about the number of share options outstanding.
Can a share-based payment arise elsewhere?
The scope of the standards is much broader. A share-based payment only requires the exchange of equity instruments, or cash linked to the value of equity instruments, with another party in return for goods or services. This is quite common in early-stage businesses. However, any transactions that are clearly entered into in a capacity as shareholder, and have no link to goods, services or employment, generally do not need to be accounted for as a share-based payment.
What are the next steps?
There’s no simple answer to working out fair value and you’ll likely need to seek support from our specialist financial reporting advisory and valuations team. If you have any questions or require any advice, please get in touch with a member of the team or call 0333 123 7171.
