Our advice on accounting for share-based payments includes:
We can also help at the design stage, advising on how various different structures and performance conditions impact on the probability of awards vesting and expected accounting valuations, as well as providing performance monitoring reporting.
International Financial Reporting Standard 2 (IFRS 2) is the international accounting standard covering share-based payments. Section 26 of Financial Reporting Standard 102 (FRS 102) is the equivalent UK accounting standard and has the effect of implementing the requirements of IFRS 2 for UK companies that do not prepare their financial statements in accordance with international accounting standards.
Share-based payments include all types of Executive and Employee share plans and awards such as stock options and share grants under Long Term Incentive Plans (LTIP), Performance Share Plans (PSP) and employee share save schemes. The accounting standards require a value to be placed on share-based payments which is then recognised as an expense in the Profit & Loss account.
The basic principle is that share-based payments must be assessed by reference to ‘fair value’ using an option pricing model which takes into account expected future movements in the company's share price. Share awards may be subject to a variety of market-related and/or non-market-related performance conditions and vesting conditions which must be taken into account. The accounting treatment differs for awards settled in cash compared with those settled through receipt of shares.
The Black-Scholes formula is one common type of option-pricing method which is relatively simple to apply. However, this model is not flexible enough to cope with many features of share awards such as performance conditions.
In most cases it is more appropriate to build a more powerful stochastic model, otherwise known as the Monte Carlo model. The projected path of the share price or Total Shareholder Return (TSR) is modelled to derive the payoff from the award taking into account any market-related performance conditions. Many thousands of simulations are run through the model to determine the distribution of the potential outcomes. The fair value of the award is the present value of the average payoff from all the simulations.
The model requires a number of assumptions to be made, in particular regarding the future volatility of the share price, potential correlations between comparator groups, and future dividend policy. These assumptions are usually set based on an analysis of historic share price data, but are necessarily subjective meaning that there is not a single possible answer. We can advise on the choice of underlying assumptions and the sensitivity of the results to changes in these assumptions.