Companies apply IFRS 2, 'Share-based Payment', to account for transactions in which they receive goods or services in exchange for equity instruments such as share options or awards granted to employees. It also applies to transactions settled in cash which are based on the value of those instruments. IFRS 2 can be a complex standard as companies need to use models to value share-based payment arrangements (which require judgements and assumptions to be made) and different accounting rules apply depending on whether awards are settled in cash or equity. The accounting treatment of the tax effects of share-based payments can also be complicated and there are additional considerations in group situations. Share-based payments are most often used as part of employee compensation packages and this can lead to overlapping disclosure requirements, particularly with the directors' remuneration report, and challenges in making sure key messages are not obscured by the volume of disclosures.
The Financial Reporting Council (FRC) has published a thematic review of the accounting policies of 20 listed companies from a variety of sectors to identify (i) areas of good practice (ii) where there could be improvement and (iii) common pitfalls when applying IFRS 2. Its key observations are:
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Classification of share-based payments
IFRS 2 requires a share-based payment to be classified as either equity or cash-settled. This is important because there are different recognition and measurement requirements for each. Where the share-based payment includes a choice as to how it is settled, the accounting treatment will depend on whether it is the company or the counterparty (e.g. the employee) that has the choice. If the company has the choice of settlement, it must assess whether it has a present obligation to settle in cash. Where such an obligation exists, the transaction is accounted for as cash-settled. Where the counterparty (e.g. the employee) has the choice, the arrangement is treated as a compound financial instrument. In such circumstances, company must measure the fair value of both the cash and equity components separately. The FRC notes that the most helpful disclosures in accounts explained how awards were classified and, where settlement alternatives existed, explained who had the choice of settlement and how the company intended to settle the awards. However, the FRC also identified companies who stated their awards were equity-settled but then had unexplained cash outflows in the cash flow statement. Accordingly, where settlement flexibility exists (whether for the company or the employee) the FRC expects companies to disclose the terms of such arrangements, identify the party with the choice of settlement and explain how the arrangements have been accounted for. The FRC also states that if companies settle equity awards in cash, they should consider carefully whether they have established a practice of cash-settlement, resulting in an obligation that would require the awards to be classified as cash-settled in their entirety.
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Measurement and recognition of share-based payments
All companies in the FRC's sample used share-based payments to reward directors and employees, with the expense measured by reference to the fair value of the equity instruments. For equity-settled transactions, non-market performance conditions (such as EBITDA or EPS) and service conditions are not included in the grant date fair value of the equity instruments but instead affect the estimate of the number of awards expected to vest. Market conditions (TSR) are included in the grant date fair value but are not subsequently adjusted for. In the case of cash-settled transactions, non-market conditions will affect the vesting estimate, but current market conditions are considered when remeasuring fair value at the end of each reporting period and on settlement so that the cumulative expense recognised is equal to the cash paid. The FRC found that the companies in its selection used the Black-Scholes valuation model to estimate grant date fair value when there were no market conditions and a Monte Carlo model when the award had market conditions and notes that these are well-established valuation methodologies for share-based payments incorporating assumptions such as share price and historic volatility. The FRC notes that IFRS 2 does not mandate a particular model, so it is up to companies to decide which is the most appropriate. The review picks out examples of what it considers to be good practice in companies disclosing how they recognise and measure their share-based arrangements.
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Share-based payment transactions among group entities
The FRC found that all companies explained how transactions were accounted for in the consolidated financial statements, but information about how they impacted the parent company's individual financial statements was often missing. This is particularly important for UK companies as it is the parent's distributable reserves which need to be considered when determining whether a dividend can be paid to shareholders. Accordingly, the FRC states that where a parent company is party to a transaction in one form of another (for example, where it is the grantor of options to employees of subsidiaries) it would expect the accounting policy to give enough detail for users to understand how such awards are accounted for.
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Tax associated with share-based payments
In some cases, the FRC found that it was unclear whether excess tax deductions arising from share-based payments were correctly identified and recorded in equity. The UK gives a tax deduction for share-based payments which differs in terms of timing and amount from the related accounting expense. For example, the company may recognise an accounting expense in respect of a share option over its vesting period but not receive a tax deduction until the option is exercised. In its accounts, an entity will estimate the future tax deduction based on the share price at the end of the relevant reporting period (if the tax deduction is based on the share value at the exercise date). This estimate might differ from the cumulative remuneration expense recognised in the financial statements and in such situations, the excess of the current or deferred tax should be recognised directly in equity. It seems not all companies do this and do not always provide a sufficient explanation.
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Completeness and conciseness of disclosures
The review sets out a number of examples of companies using aggregation or cross-references to be more concise and avoid duplication.
The accounting treatment is just one of the important issues that any company planning to set up an employee share plan needs to consider. Although we are unable to provide specific advice on accounting or valuation matters, please do get in touch with a member of the Travers Smith Incentives team to discuss the other aspects of establishing and operating share-based incentives.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
