Sharebased payments bought to book Accounting

An October 31 deadline for responses to a controversial discussion paper dealing with how share-based payments and other similar equity-based schemes should be recorded in company accounts. These key issues in the paper recommend companies should book an expense when they pay with equity.

Millbrook Resort is in Queenstown on the South Island of New Zealand. It was in this picture postcard setting, complete with screeching ducks, rolling hills and old folks breaking the speed limits in golf buggies, that the top accounting standard setters had their final detailed discussion on a paper which recommends significant changes to the way companies tell their investors and the broader community about the remuneration deals they give to their executives, directors and employees in general. The Group of Four plus One - a body representing the accounting rule makers from the US, Canada, Australia, the UK and New Zealand - went through their detailed paper on share-based payment and agreed the proposals were significant and robust enough to be released in July. The US is the only one of the G4 jurisdictions to have existing standards in the area and a proposal to require expensing of share options was watered down in the mid-1990s following action in Congress and a landmark rally in Silicon Valley. The current rules do not require companies to take the value of options directly to the income statement.

While the paper is unlikely to lead to immediate change in the US market it represents an advance in thinking for the standard setters from the other jurisdictions where current accounting practices have been criticised for ignoring the full impact of share-based payments on companies. The paper, which was prepared primarily by the UK Accounting Standards Board staff, also rebuts the arguments used against expensing equity-based portions of remuneration deals. The fundamental notion that drives the conclusions reached by the standard setting think-tank is that consideration paid for services or goods of any kind represents an expense. A company gives something as consideration for goods or services. An exchange that has value has taken place, according to the paper, and it must be recorded in the accounts regardless of whether payment is in the form of cash or equity. It is clear from the document that the standard setters believe an expense must be recorded in financial statements as the goods or service to which the share-based payment relates are consumed.

That is the document's main premise. If Company X pays Employee Y or Supplier Z with share options it should recognise an expense in the same manner as it would if Company X had paid Employee Y or Supplier Z in cash. They propose the transaction must be measured at its "fair value" - sometimes referred to as "market value" - at a date when the employee or supplier becomes unconditionally entitled to the options or shares. That date is known as the "vesting date". The G4 members have also agreed that where the supply of goods or services takes place between "grant date", the date on which the agreement or contract begins, and the "vesting date" that an estimate of the value of the shares earned by the supplier or employee be recorded in the accounts on an accrual basis. For example, Company X might give Employee Y a package that entitled the worker to 300 shares at the end of a three-year contract period. The G4's proposed approach would mean the package would be valued at each balance date and one-third of the package would be expensed each year. The accounts would be adjusted for the changes in the valuation of the equity components of remuneration packages. It is unlike the simple straight-line method allocation exercise that you would come across when accounting for goodwill.

By far the most controversial element of this whole debate is the notion of expensing shares or share options where they are given as payment for goods or services. It is an area of major disagreement between the corporate sector and accounting standard setters. The paper notes the disagreement between two schools of thought. "Some argue that a charge for shares or options issued to employees should not be recognised, because there is no cost to the entity," the paper explains. "In other words, the granting of share options does not require the entity to sacrifice cash or other assets, hence there is no cost." An alternative argument sees the provision of share options as a completely different ballgame. Shares or share options are often issued to employees at less than "fair value". an and that there is a sacrifice of economic benefits that should be accounted for - the cash an entity might have received had those shares been purchased by individuals or institutions at a market rate. "Whether or not one accepts the opportunity cost argument, the no-cost-therefore-no-charge argument is unsound, because it ignores the fact that a transaction has occurred - the employees have provided valuable services to the entity in return for valuable shares or options," the G4 paper asserts.

UK Accounting Standards Board chairman Sir David Tweedie attacked the practice of not booking a cost for share options in accounts earlier this year. Tweedie, chairman designate for the restructured board of the International Accounting Standards Committee, said companies should be required to expense shares or share options that are given as consideration for goods or services. "When you issue shares in a business combination you sure as hell record the cost. If I give shares for cash I record the transaction," he explained. "One of the problems we have all got is the dot-com companies that often pay their suppliers - they pay everybody - in share options. So they have no costs? That's not right. It might be hard to value them but they still have a cost." Other arguments against the recommended changes to expense share options include the double hit it has on earnings per share. This perspective focuses on the fact that increasing the number of shares spreads any earnings over that greater number, but hitting the profit and loss statement with an expense related to the provision of those shares or share options reduces total earnings.

The paper notes that issuing shares or options to employees, instead of paying them in cash, requires a grater increase in the entity's earnings in order to maintain its earnings per share and that "recognising such a transaction ensures that its economic consequences are reported".

Valuation methods

Viewing the options as an expense is one thing. Choosing the appropriate valuation method by which to value the options is another. The paper supports "fair value" measures to arrive at a number to book on the balance and, consequently, expense. It dismisses historical cost and intrinsic value notions as impractical when valuing share-based payment.

Fair value measurement "tools" discussed in the paper are the use of observable market values, values of consideration received, valuation of options with reference to a cash alternative and the use of option pricing models. Two of the four methods are given serious consideration. Observable market values are seen as the preferred methods. Being able to see independent evidence of transactions in the market place and value what is being given to a director, executive or employee via that means is the preferred alternative. Where that isn't possible the paper points to the use of option pricing models as an alternative. They involve the use of mathematical models to determine the option values, which the G4 proposals concede can be complex. "[Estimating] some of the inputs necessary to use an option pricing model, such as the expected volatility of the underlying shares, may be difficult. However, their application is (reasonably) straightforward and has been facilitated by developments in technology." Several option pricing models exist and the US literature mentions two - the Black-Scholes option pricing model and the binomial option pricing model - as examples. The paper follows the sentiment of the US literature and it does not recommend or mandate the use of any one model. "Choosing between the various models that exist could be done only on the basis of resolving controversies with which the academic communities are struggling at present," the paper notes. "There would also be a risk that the model specified might be superseded by improved methodologies later."

It does, however, list specific features an option pricing model must have, including the exercise price of the option, the current market price of the share, the expected volatility of the share price, anticipated dividends, the rate of interest available in the market and the term of the options. What happens if an option deal still cannot be valued in any reliable manner for accounting purposes? The paper recognises that some remuneration packages may contain equity-based components that may be difficult to value. A solution proposed by the G4 invitation to comment is that the options be expensed at exercise date, which is when the individual who is entitled to buy the shares "exercises" that right. The invitation to comment comes at a time when the heat has been turned on the standard setters and the regulator by the Federal Opposition. Senator Stephen Conroy, shadow minister for financial services and regulation, has been nipping the ASIC at the heels during Senate Estimates Committee hearings in an attempt to understand why it was, in the Opposition's view, not enforcing parts of the Corporations Law.

During a mid-August interview with Company Director, Conroy said the Opposition was disappointed the ASIC appeared not to be enforcing the Law and the accounting profession seemed to be taking its time in coming up with guidance on methods of option valuation. He urged development of a standard on disclosure and valuation as soon as possible to fill the gaps in the framework so aspects of remuneration packages are explained better to individual and institutional investors. "It's a requirement of the Law. Two years down the track and the ASIC is saying they're not going to try and enforce it," Conroy said. "The Government should be acting if there is a need for some amendments to tidy up the legislation. The accounting profession appears to have been dragging its feet for two years to try and resolve a valuation method."

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