The ASB's Discussion Paper has raised many issues of interest to a treasurer. The Paper focuses primarily on employee share plans, particularly those based on share options. Since these options are a financial derivative, treasurers will be familiar with many of the concepts introduced by the ASB.
The method of accounting for share options inevitably impinges on the schemes actually used and, perhaps in consequence, has become a highly contentious area on which a diverse range of views is held, often with considerable fervour! The ACT has accordingly had difficulty in formulating an 'ACT view' that will command general support, however, the topic is of vital interest to treasurers and the purpose of this paper is to advance the discussion. The paper seeks to identify the main points and, where appropriate, seeks to draw reasonable conclusions from the arguments.
There are two key issues being addressed by the ASB:
1. How should share-based payments be recognised in the accounts (the most important being share option costs)?
2. How should share options be valued?
Setting aside ad hoc disclosures, such as those in remuneration committee reports, the issue of share options is not normally recognised in the employing company financial statements provided that the exercise price is no less than the market price when the option is granted. Some companies buy their own shares via an independent trust for the purpose of hedging their exposure and settling the liability arising when options are exercised, and the cost of funding this has to be charged against profit. Others, however, will issue new shares at the time of exercise, thus avoiding this cost.
The first question is whether it is correct that firms should be able to issue employee share options without incurring a charge in the financial statements. It is undeniable that these options have a value and so if a firm is giving away value, how should this be recognised? The ASB is recommending that recognition should be by charging profit, over the period preceding vesting, with the fair value of the option at the vesting date.
At this point treasurers might reflect on the wider treatment of equity options that they may deal with in other circumstances. A case arises with the issue of bonds and warrants where the coupon on the bond is lower than normal market levels to take account of the 'free' warrant issued in conjunction with the bond. Here it has been accepted that a charge against profit is appropriate. The warrant is given a fair market value at the time of grant, which is also the time of vesting, provided that there are no conditions on the warrant. The bond is treated as a deep discount instrument whose initial value reflects a discount from par equal to the value of the warrant. The company's interest charge is increased above the bond's coupon by amortising the original issue discount. The value of the warrant is taken into equity.
However there is a counter example to this, in the case of convertible bonds, which are economically equivalent to deep discount bonds and warrants, the difference being purely one of mechanics. A distortion exists because there is no requirement to account for the value of the embedded share option with a convertible. This is clearly inconsistent and it is presumed that the ASB will want to change this at some time, but interestingly the same distinction exists in the tax treatment of these instruments where the Revenue argue that in theory the issue of a warrant constitutes the disposal of a chargeable asset for capital gains purposes, but do not argue the point with convertibles. At the end of the day however it is obviously wrong for real business choices to be swayed by inconsistent accounting and tax treatments.
There are a number of arguments put forward for not recognising the cost of share options against profit :
1. Profit and cash should be equivalent so that if a company does not pay out cash in relation to the option there should be no cost recognised against profit. This can be viewed as a somewhat traditional approach but there are still relatively few areas of accounting where we have moved totally away from this line into a purely valuation based approach.
The ASB's main concern is that large amounts of remuneration are being missed from the profit and loss account. To take this argument to its extreme, would it be accepted that if all of a firm's expenses were settled by share-based payments then its profit and loss account should show only revenue?
It can also be argued that there is at least a deemed cash movement taking place, which is not visible because of an offsetting cash movement. Shares will be issued (if the option turns out to have value) creating a 'deemed' cash receipt and employees will be paid creating a matching 'deemed' payment, at least to the extent of the excess of the market price over the option exercise price. However the fact remains that cash has not actually left the company and what arguably has happened is a direct transaction between the shareholders and the employees.
2. The impact on earnings per share of the dilution from the options is sufficient recognition. The issue of options is already reflected in the EPS number and a further charge against the profit and loss account would be double counting.
This argument does not square easily with the economics of the transaction in that if the transaction is analysed as being the issue of shares followed by the spending of those proceeds on remuneration, as outlined in 1 above, then it is correct to hit EPS twice.
3. The cost is to the shareholders and not to the company.
Given that the only interest that the shareholders have (as shareholders) is their interest in the company, this argument has its limitations , but what can be said is that share options may create a class of gain or loss of a different type than that normally reflected in the profit and loss account. The issue of the option does not in itself give rise to a gain or loss, assuming that it is issued at market value, but such a gain or loss will arise over the life of the option.
In issuing employee share options a company is writing options which it gives to those employees. The company can be thought of as having received a 'deemed' premium from the employees. If the options are not exercised the company realises a gain (it keeps the premium). Any payment on exercise exceeding the premium represents a loss. The ASB is recommending that this type of difference is not recognised in the profit and loss account. However, the impending authority for firms to deal in their own treasury stock will increase the importance of similar 'shareholder profit' and the ASB may need to give this matter renewed thought, and whether there is a need for a separate statement reflecting a company's transactions in its own share capital, including such transactions as the issue of employee share options.
4. Profit is not charged in other similar circumstances and so the status quo is reasonable.
The convertible bond example supports this argument whilst the warrants example goes the other way and there are perhaps other areas of accounting with such apparent inconsistency. The key question however is whether the current approach is right or wrong.
5. It doesn't happen elsewhere and we would put the UK at a competitive disadvantage by adopting this proposal alone.
This is a fair practical argument that the ASB will have to address in conjunction with other regulators if its proposals are to go further, and indeed we acknowledge the considerable efforts of the ASB in working with other standard setters to produce this paper. However the simple fact is that thus far other accounting standard setters, for whatever reason, have not taken this step.
6. Share schemes are a good means of remunerating staff and to create an accounting cost is economically damaging.
It seems reasonable to assume that firms will institute remuneration policies that they see as offering the best value for money incentive. At present their choice may be distorted by the opportunity to avoid showing any cost for share-based schemes. If such a cost is instituted, many schemes will no doubt continue on the basis that they are indeed the most effective way of providing an incentive to staff. Removal of the accounting advantage that such schemes currently enjoy should serve to level the playing field and reduce economic distortions.
Of course, this would only really happen if the costs of share-based schemes were tax deductible. Since government policy is to encourage such schemes for employees it might be assumed that it would not want to see the playing field tilted against them. This would require the government to look again at both employee and employer tax reliefs.
A reasonable conclusion from the above is that there is a good case to be made that share options represent a cost which should in some way be reflected in a company's accounts. However, that is not the end of the argument. Even if it is accepted that a charge to the profit and loss account is appropriate nothing can be charged unless a reasonable estimate of that cost can be agreed.
This second issue has two key elements: agreeing the valuation date and agreeing the valuation method.
A treasurer's normal expectation might be that an option should be valued at the date of grant. However, the vesting conditions may be tough and therefore, with an exercise price which is normally close to market price at the time of issue, only a small part of the value may arise at this point. The structure is one which treasurers will recognise as a compound option, i.e. an option on an option. A small cost is incurred at the date of the grant of the compound option, which entitles the holder to purchase, at either a known quantified cost or on an agreed formula basis, a defined option at a future date for a known premium. If this right is abandoned, the company has nonetheless incurred the compound option premium. If taken up, the further premium is payable. The ASB's conclusion that vesting date valuation is preferable is probably more practical though much less theoretically satisfactory than the compound option method just described.
The case for using the exercise date as the valuation date is still less theoretically satisfactory. The exercise date is at the whim of the employee and a rising price would effectively imply that the company achieved greater value from the employee just because the employee held on to their options without exercise. To circumvent this the first available exercise date could be set as the valuation date.
A more important objection however is that once an option unconditionally vests the asset has changed ownership, and why should share options be revalued after issue when shares themselves are not.
Having settled on a valuation date, the ASB acknowledges that there are real problems in fixing the fair value at vesting date. They recommend the use of option pricing models whilst acknowledging the enormous practical problems that many, particularly smaller companies (start-ups being a major user of share-based remuneration), will have. A type of model must be chosen, inputs must be estimated and particular scheme features, such as non-transferability, must be allowed for.
Some will no doubt argue that the proposal collapses at this point, a fine theory with no practical means of implementation and it must be accepted that charges to the profit and loss account based on inaccurate or meaningless valuations would serve little purpose. Treasurers are likely to have had more experience of option valuation models than anyone else within their company. They need to be at the forefront of this debate but it should not be forgotten that the majority of companies with extensive share option schemes are relatively small and lack treasury expertise.
Treasurers have a particular interest in this issue because of the distortions caused by inconsistent accounting. Companies that issue options direct to employees and those that buy the options or shares via third parties before granting them to employees are currently treated differently. The two transactions are different in that one relates to shares which are already in issue and the other results in the issue of new shares, but should they be treated differently?
If in the end it is concluded that valuation models are just not a practical means of valuing options, then perhaps the case for using exercise price valuation should be reconsidered. It does not help with consistency, but it has the necessary certainty and may be better than the do-nothing option. Exercise price is also a good measure of the actual benefit delivered and puts quoted and unquoted companies on a more equal footing, the latter being more frequent users of cash payments reflecting increases in an agreed valuation price.
This paper is designed as a prompt for more discussion, but some views and conclusions can de drawn.
Perhaps the process needs to start with better disclosure rather than with a profit and loss charge and move on to making a charge when what is practical has become clearer. We should not lose sight of the fact that the purpose of accounts is to convey information. There is no point in producing theoretically perfect valuations in accounts if those valuations mean nothing to the readers of those accounts. Clearly if options are issued to employees something has happened. Value has been given to employees and the full consequences of that should be conveyed to shareholders. It may be that at this stage of reader understanding simple factual disclosure of those consequences is the best we can achieve. However if we fail to act it may lead to even more payments being made this way and even greater distortion.
In addition the timing of any change in accounting for share schemes is clearly critical particularly in relation to the activities of other countries. It is important that consideration is given to the likelihood of "planning blight" affecting UK competitive advantage, arising from uncertainty over the balance sheet and P&L impact of existing and new share schemes pending a decision on accounting.