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Share-based payments stimulate risk seeking behaviour. A poorly designed plan can result in high levels of executive compensation for mediocre business results.
A small change in contract terms can lead to a completely different accounting classification. It's easy to make a financial reporting mistake.
Accounting rules do not require changes after the grant date to be reflected if payments are equity classified.
Possible. FRS102 may instruct a valuer to ignore the condition, adjust either the fair value of each financial instrument or the number of financial instruments issued.
Share-based payment (“SBP”) is a transaction in which an entity acquires or receives goods and services for equity-based payment. These goods can include tangible assets like property or inventory, intangible assets, and other non-financial assets.
A business may supplement cash compensation by awarding to employees shares of the business or the right to buy shares of the business. SBP are great tools for rewarding employees of the business for meeting a performance target, remaining loyal and in more broader terms creating wealth for shareholders.
There are three (3) types of share-based payment arrangements between an entity and a counterparty (including an employee).
exhibit 1: types of share-based payment
Cash-settled share-based payment arrangement
Equity-settled share-based payment arrangement
The auditor evaluates the appropriateness of the accounting treatment and ensures that the share-based payments are recognised and measured in accordance with FRS 102. In addition, the auditor assesses both the accuracy of the option-pricing model calculations, and the appropriateness of the underlying data used as inputs in the model, including the assumptions made by management. In practice, the nature and extent of the work done by the auditor also depends on whether the fair value has been determined by management or an external valuation specialist.
Some of the key audit procedures typically performed include:
Relying on audit work performed by parent company:
Engaging an expert to assist in the review of the valuation of share-based payments:
Common issues include:
Definitions and examples:
exhibit 2: vesting conditions
Performance and service conditions
Fair value should be based on market price wherever this is possible. Because observable market prices are generally not available for employee stock options, companies need to use an option-pricing (or equity valuation) model to estimate the fair value of employee stock options and other employee equity awards, such as restricted stock with market conditions.
The best-known valuation techniques are:
While the choice between the Black-Scholes, Monte Carlo simulation, and binomials models is important, the fair value estimates produced by any of these techniques are largely dependent upon the assumptions used. The assumptions usually have a greater impact on fair value than the choice of model. The Black Scholes is likely to be the first choice for entities performing inhouse valuations, but it may not be appropriate for all types of share-based payment schemes.
For example, the Black-Scholes model requires adjustment if the options can be exercised prior to the maturity date; share options that include market performance conditions are generally better valued with a Binomial valuation or Monte Carlo simulation.
Companies are permitted to select the option-pricing or equity valuation model that best fits their unique circumstances as long as the valuation technique:
As a result, for most employee stock options and other employee equity instruments, companies have flexibility in selecting the option-pricing or equity valuation model used to estimate the fair value of their share-based compensation schemes.
The Black-Scholes model is relatively simple to use and well understood in the financial community. Its relative simplicity stems, in part, from the fact that when estimating the fair value of an employee option, all expected employee exercise behaviour and post-vesting cancellation activity is reduced to a single average expected term assumption. The principal advantage of binomial models, on the other hand, is that they accommodate a wider range of assumptions about employees’ future exercise patterns, as well as accommodate other assumptions that may change over time. This approach may yield a more refined estimate of fair value. A Monte Carlo model simulates a very large number (as many as 1,000,000) of potential stock price scenarios over time and incorporates varied assumptions about volatility and exercise behaviour for those various scenarios. A fair value is determined for each potential outcome. The grant date fair value of the award is the average of the fair values calculated for each potential outcome.
For awards with typical service conditions and performance conditions, the Black-Scholes model will generally produce a reasonable estimate of fair value. Monte Carlo simulation and binomial models result in a more refined estimate of fair value. Additionally, companies that issue awards with market conditions or payoff conditions that limit exercisability should use either a Monte Carlo simulation model or a binomial model because those models can better incorporate assumptions about exercisability in relation to the price movements of the underlying stock and/or potential payoff outcomes related to achievement of market conditions.
Companies need to weigh the advantages and disadvantages of each model in order to choose a model that fits their particular circumstances. In deciding which model is most appropriate, some factors to consider are:
Companies may decide to change from one option-pricing or equity valuation model to a different one (e.g., from Black-Scholes to a binomial model). A change in option-pricing model is not a change in accounting principle—the underlying objective of estimating the fair value of the award is the same — and therefore does not require justification of preferability. However, changes in valuation models should generally only be made when the new model will result in an improved estimate of fair value. Additionally, companies may use one model for certain awards and another model for different types of awards. For example, the fair value of a “plain vanilla” option could be estimated using the Black-Scholes model while a Monte Carlo simulation is used for an option with a market condition.
FRS 102 requires an expense to be recognised for the goods or services received by a company. The corresponding entry in the accounting records will either be a liability or an increase in the equity of the company, depending on whether the transaction is settled in cash or in equity shares. Goods or services acquired in a share-based payment transaction should be recognised when they are received. In the case of goods, this is the date when this occurs. However, it is often more difficult to determine when services are received. If shares are issued that vest immediately, then it can be assumed that these are in consideration of past services. As a result, the expense should be recognised immediately. Alternatively, if the share options vest in the future, then it is assumed that the equity instruments relate to future services and recognition is therefore spread over that period.
Getting the value of share payments right is crucial to retaining employees. Contact VALLARIS to start a conversation.
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