UK: Share Schemes - Draft ICAEW Guidance on the Impact on Distributable Profits of Employee Share Trusts and Accounting for Share Based Payments

Last month the English and Welsh Institute of Chartered Accountants (ICAEW) published a Technical Release (TECH 21/04) containing draft guidance concerning how changes to the accounting regime for employee share schemes affect companies' distributable and realised profits.

The Technical Release considered the implications of UITF 38 ‘Accounting for ESOP trusts’ and UITF 17 (revised 2003). UITF 17 will be replaced by the new Share Based Payment Standard FRS20 but the guidance set out in the Technical Release will also be applicable to that new Standard.

UITF 38 which was issued in December last year provides that shares held in an employees' trust are to be deducted in arriving at shareholders' funds. The previous UITF 13 required them to be recognised as assets of the sponsoring company and there has been uncertainty as to the effect of the change on a company's distributable profits.

Distributable profits are defined as realised profits less realised losses and the draft guidance considers that the acquisition of shares by an employees' trust is not itself a distribution and the purchase of shares into an employees' trust is not an immediately realised loss affecting distributable profits under Companies Act 1985 section 263.

Section 264 sets a further limitation on profits which can be distributed. A public company can only make a distribution to the extent its net assets exceed its called up share capital and undistributable reserves as defined in the Companies Acts.

• For a public company, the purchase of shares in the market by an employees' trust will reduce distributable profits under Companies Act 1985 section 264, because there will be a reduction in net assets equal in amount to the consideration paid for the shares, but the new account for the shares within shareholders funds, required by UITF 38, is not called up share capital nor undistributable reserves.

• Likewise, a subscription for new shares by an employees' trust will reduce distributable profits under Companies Act 1985 section 264, because although there is no change in net assets, the issue of new shares creates more called up share capital and increases the share premium, which is an undistributable reserve.

The exemption from the Companies Act financial assistance rules for employee share schemes is subject to a special restriction for public companies. Under Companies Act 1985 section 154, either net assets must not be reduced or, if they are, the reduction must be covered by distributable profits.

As UITF 38 has the effect of reducing net assets when a trust purchases shares, public companies with little or no distributable profits may therefore be prevented from sourcing shares for their employee share schemes using existing shares acquired by an employees' trust. Instead, they may only be able to grant rights to subscribe for new shares.

In some cases, a change of accounting policy to reflect UITF 38 may have the effect of reducing net assets below the level of distributable profits. The Technical Release considers this will not affect the lawfulness of earlier financial assistance at the time it was given. It may however prevent a public company from entering into any further transactions involving financial assistance.

This will be a particular problem where there is little or no 'headroom' within the institutional shareholder dilution limits in the company's share plans.

UITF 17 required an accounting expense, through the profit and loss account, with a matching credit to shareholders funds, for share or option awards based on the difference between the fair value of shares at grant and the amount payable by the employee. Fair value was defined as the market value of the shares, so an expense only arose if options were granted at a discount.

To date, accounting expenses for share options as a result of UITF 17 have been fairly uncommon. For quoted companies, discounted options have been discouraged by institutional guidelines. SAYE options were usually granted at a 20% discount but benefited from an exemption under UITF 17. For unquoted companies where it was more common to grant options at a discount, the potential expense was often regarded as immaterial and not recognised in the accounts.

In future, under the new accounting rules on Share Based Payment, the fair value of options will usually be derived using some form of option pricing theory (such as Black Scholes). This is likely to give rise to a much larger cost than arose under UITF 17 and much more frequent expenses, as option pricing theory normally gives a positive value even to market value options.

The Technical Release has concluded that it will be appropriate to regard the expense in the profit and loss account and the matching credit to shareholders' funds as realised losses and realised profits respectively such that the required accounting treatment will have no effect on distributable profits.

Copies of TECH 21/04 are available from the website of the ICAEW and the deadline for sending comments to the ICAEW is 27 August 2004.