Employee share ownership plans (ESOPs) have become popular in South Africa as a mechanism to drive companies’ Broad-based Black Economic Empowerment (BEE) strategies and to align stakeholder and employee values. Amongst the numerous success factors of this complex area is the accounting for these complex arrangements. Several interacting aspects of International Financial Reporting Standards (IFRS) must be carefully considered.
SHARE-BASED PAYMENTS
IFRS 2 Share-based Payment requires companies to:
- Recognise the fair value of employee share options as an expense in their financial statements. This means that companies must estimate the fair value of the options granted and recognise the corresponding expense over the vesting period. The fair value of the options is based on the market price of the company’s shares at the grant date and considers factors such as the exercise price, expected volatility, and expected dividends.
- Determine the vesting period of the options, which is the period over which the employees become entitled to exercise their options. The vesting period can be based on the service period, which is the period over which the employees are expected to provide services in exchange for the options. Companies must estimate the service period and adjust it if actual experience differs from these original estimates.
- Account for the effects of forfeiture of the options. Forfeiture occurs when employees do not meet the vesting conditions and the options are cancelled or forfeited. Companies must estimate the likelihood of forfeiture and adjust the expense accordingly. Forfeiture rates are typically based on historical experience and can be adjusted for current or expected economic conditions.
- Disclose information about the fair value of the options granted, the vesting period, the method used to estimate the fair value, and the impact of forfeiture. Companies must also disclose the total expense recognised in the financial statements and the impact on earnings per share.
Equity-settled versus cash-settled share-based payments
Equity-settled share-based payments involve the issuance of equity instruments, such as share options, to employees as part of their compensation package. In this arrangement, the company grants the employee the right to acquire a certain number of shares or options, which typically have a vesting period before they can be exercised. Once the vesting period is over, the employee can exercise the options to acquire shares or receive the shares outright.
Cash-settled share-based payments, on the other hand, involve the payment of cash to employees as compensation instead of the issuance of equity instruments. In this arrangement, the company grants the employee the right to receive a certain amount of cash, which is typically tied to the company’s share price or other performance metrics. Once the vesting period is over, the employee can receive the cash payment.
Under IFRS 2, companies must recognise the fair value of both types of share-based payments as an expense in their financial statements. However, the accounting treatment for equity-settled and cash-settled share-based payments differs in a few key aspects.
For equity-settled share-based payments, the expense is recognised over the vesting period of the shares or options granted. The expense is measured at the fair value of the shares or options granted at the date of grant and is not adjusted for any changes in the fair value of the shares or options over the vesting period. When the options are exercised or the shares are issued, the fair value of the shares or options is transferred within equity from the share-based-payment reserve to share capital.
For cash-settled share-based payments, the expense is recognised over the vesting period of the award. The expense and corresponding liability are measured at the fair value of the award at the date of grant and are adjusted for any changes in the fair value of the award over the vesting period. When the payment is made, the cash payment is recorded as an expense in the profit and loss account.
Grant date
Grant date is an important consideration when it comes to equity-settled and cash-settled share-based payments under IFRS 2. The grant date is the date at which the company grants the employee the right to acquire shares or receive a cash payment. The fair value of the share-based payment must be measured at the grant date. This means that the company must estimate the fair value of the shares or options granted or the cash payment to be made, on the date of grant. The fair value is then recognised as an expense in the financial statements over the vesting period of the shares, options, or cash award.
IFRS 2 defines the grant date as the date at which the entity and the employee or service provider have a shared understanding of the key terms and conditions of the share-based payment arrangement. It is important to accurately determine the grant date because it is used as the starting point for measuring the fair value of the equity instruments and for recognising the expense associated with the share-based payment in the financial statements. By properly estimating the fair value at the grant date, companies can ensure that they are accurately reflecting the cost of the share-based payment in their financial statements and providing stakeholders with transparent and reliable financial information.
When estimating the fair value of the share-based payment at the grant date, companies must consider a number of factors. These include the exercise price of the options, the current market price of the shares, the expected volatility of the share price, the expected dividend yield, and the expected life of the options. Companies may also need to consider any conditions attached to the share-based payment, such as performance targets or service conditions when estimating the fair value.
Vesting conditions
Vesting conditions are conditions that employees must satisfy before they are entitled to receive the shares or cash payment associated with the share-based payment.
There are two types of vesting conditions:
- Service conditions are conditions that relate to an employee’s length of service with the company. Service conditions are typically time-based and relate to the length of time that an employee must remain with the company before they are entitled to receive the shares or cash payment. For example, a company may grant an employee the right to acquire shares but require that the employee remain with the company for a certain number of years before they can exercise the options and acquire the shares.
- Performance conditions are conditions that relate to the achievement of specific performance targets by the company or the employee. Performance conditions are typically linked to specific performance targets such as revenue growth, profitability, or share price performance. For example, a company may grant an employee the right to receive a cash payment but require that the company achieves certain revenue growth targets before the employee is entitled to receive the cash payment.
Under IFRS 2, companies must consider vesting conditions when estimating the fair value of the share-based payment at the grant date. Vesting conditions are used to adjust the fair value of the share-based payment, and the fair value is then recognised as an expense over the vesting period of the shares or cash payment.
CIRCUMSTANCES WHERE IFRS 2 MAY NOT APPLY
IAS 19 Employee Benefits outlines the requirements for the recognition, measurement, and disclosure of employee benefits. The standard defines employee benefits as all forms of consideration given by an entity in exchange for services rendered by employees or for their termination benefits, other than those to which IFRS 2 applies.
The standard requires entities to recognise the cost of providing employee benefits in the period in which they are earned by the employees. This means that the entity must estimate the value of benefits that will ultimately be paid out and recognise a portion of that amount each period, based on the employees’ service to date.
In addition to recognition and measurement requirements, IAS 19 also sets out disclosure requirements for employee benefits. Entities are required to disclose information about the nature and amount of employee benefits provided, as well as information about the assumptions and estimates used to calculate the cost of those benefits.
CONSOLIDATION CONSIDERATIONS, CONTROL AND AGENCY
Consolidation considerations and control
In addition to IFRS 2, there are also IFRS 10 Consolidated Financial Statements considerations that companies must keep in mind when accounting for ESOPs. Often, shares in an entity are held in trust or special purpose vehicles for the benefit of the employees eligible to participate in the scheme.
Under IFRS 10, a company must consolidate an entity that it controls. Control is defined as the power to govern the financial and operating policies of an entity to obtain benefits from its activities. In the context of ESOPs, the company must consider whether the ESOP is a separate entity that it controls and therefore should be consolidated in the company’s financial statements.
To determine whether the ESOP is a separate entity that the company controls, the company must consider whether it has the power to govern the financial and operating policies of the ESOP. This includes considering factors such as the composition of the ESOP’s board of trustees or directors, as the case may be, the company’s ability to appoint or remove such fiduciaries, and the ability to direct the ESOP’s activities (such as determining eligibility criteria for participation).
If the company determines that the ESOP is a separate entity that it controls, then the ESOP’s financial statements must be consolidated in the company’s financial statements. In addition to consolidation, IFRS 10 also requires companies to provide disclosures about their involvement with subsidiaries, including ESOPs. Companies must disclose information about their relationship with the ESOP, the impact of the ESOP on their financial statements, and any significant risks associated with their involvement with the ESOP.
Agency accounting
Companies must consider whether, in an ESOP arrangement, a trust or SPV holds its shares on behalf of the employees, creating an agency relationship between the company, the trust or SPV and the employees. The trustees are responsible for managing the assets of the ESOP and making investment decisions that align with the best interests of the employees.
Under IFRS, the trust or SPV is required to prepare financial statements for the ESOP that provide information about the financial position, performance, and cash flows of the ESOP. The trustees must also provide information to the company about the financial position, performance, and cash flows of the ESOP. This information is used by the company to account for its involvement with the ESOP and to prepare its financial statements in accordance with IFRS.
The agency relationship between the company, the trust or SPV and the employees also has implications for the accounting treatment of the options granted through the ESOP. By following these guidelines, the trust or SPV and the company can ensure that the financial statements accurately reflect the impact of the ESOP on the business and the interests of the employees.
FINANCIAL INSTRUMENTS CONSIDERATIONS
There are also IAS 32 Financial Instruments: Presentation considerations for ESOPs. IAS 32 applies to ESOPs to the extent that the ESOP involves the issuance of financial instruments.
IAS 32 defines financial instruments as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. In the context of ESOPs, this would include share options, share appreciation rights, or any other contractual arrangement that entitles an employee to receive shares of the company.
IAS 32 requires that financial instruments be classified into one of the following categories: ESOPs that involve the issuance of financial instruments must be classified as either financial liabilities or equity instruments, depending on the terms of the arrangement. If the terms of the arrangement require the company to deliver cash or another financial asset to the employee, the arrangement would be classified as a financial liability. If the arrangement gives the employee an ownership interest in the company, it would be classified as an equity instrument.
CONCLUSION
Accounting for ESOPs is complex. Companies, working with their advisors and auditors, must carefully consider the impact of such arrangements on their financial statements over the life of the scheme.
AUTHOR:
Snehal Desai CA(SA), Director at Transcend Capital – a corporate finance firm providing specialist BEE and ESOP advisory services
