FRS 20 (IFRS 2) Share-based payments

Scope

These standards apply to any form of share-based payment, including payments and awards to directors and other employees and payments to suppliers. Examples include:

Bonus arrangements for directors, including awards of share options, shares, or cash bonuses based on achieving share price targets
All-employee share schemes
Grants by a start up or newly floated company of shares or warrants to its professional advisers in lieu of fees

The basic idea

The fundamental idea is that the value of the award is recorded as an expense (or conceivably as an asset, for example if a company pays for stock, tangible fixed assets or development costs with shares or share options) when the expense is incurred (or when the asset is received).

If the settlement will be made in shares or other equity instruments, the credit is to reserves.

If the settlement will be made in cash, the credit is to liabilities.

If there is a choice (for either side) a company may have to recognise both of an additional liability and an additional reserve in order to recognise the full value of the transaction.

Goods or services from external suppliers

If the share based payment relates to goods or services from suppliers other than employees or directors:

The company recognises the expense (or asset) when it receives the goods or services
The value of transaction is the normal market value of the goods or services received (e.g. the cash price)
If it really is impossible to estimate the value of the goods or services received, the company must estimate the value of the shares/options granted.

Share-based payments to employees and directors

If a share-based payment is to an employee or director it is simply not possible to estimate the fair value of the services received for that particular component of a person's total remuneration package. So:

The company recognises the expense when it receives the employment services. If there are no criteria to be met before the award vests in the employee (that is, there are no remaining "vesting conditions") it recognises the expense immediately. If the vesting conditions include a period of service, the company spreads the expense over that period. If there are other conditions that will affect the award (for example if the amount of the award will vary in proportion to future profits) the company estimates their effect. If the period involved is more that a year the company revises its estimate at each year end.

The amount of the expense is based on the estimated market value of the items awarded (e.g. the options), at the time of granting them. The estimated market value per share, or per share option, is not re-assessed.

Example: A scheme may pay a bonus in the form of shares in three years time. The number of shares to be awarded is nil if an employee leaves beforehand, and otherwise varies according to some designated profit targets. The expense will be accounted for at "today's" share value, and be spread over three years, but the number of shares that will finally have to be awarded is re-estimated at each year end, taking into account the latest expectations for achieving the target, and the amount set aside in reserves is revised accordingly.

Practical problem

The major practical difficulty is estimating the market value of the award. Even the value of awards of ordinary shares will be subjective in an unlisted company.

More difficult still is to estimate the value of an option. The standard requires valuations to be based on an established methodology that takes in to account all of:

exercise price
life (duration)
current share value
expected volatility of share price
expected dividends
the expect risk free interest rate prevailing over the life of the option

These methodologies are from the realm of the derivatives trader, and indeed some businesses active in this world have made option pricing models available, free, over the internet. The better versions also allow the user to see how sensitive the option value is to any of the given parameters. This feature is particularly useful given that any parameter relating to the future can only be estimated.

Diligent preparers of accounts without relevant market expertise and unsure of the provenance of "derivatives'ß§us.com" can perhaps hope that their bank, using knowledge from its capital markets business, will be able assist them in preparing valuations.

The standard does also recognise the possibility that the fair value of a share-based payment cannot be estimated reliably, but describes these as "rare cases". In these circumstances the expense should be based on "intrinsic value" that is to say, the extent to which the underlying share value exceeds the exercise price of the option.

Other accounting requirements

For equity-settled transactions, the standard is silent on "what happens to the credit". Internationally this may be justifiable on the grounds that different countries will have different laws relating to capital and capital maintenance, but within the UK it is our view that this makes the standard incomplete. In the UK the ASB has had legal advice to the effect that the share premium account should be used only for any premium within the actual share subscription payment, so it appears that this quasi share premium should simply sit forever in some "other reserve".

There are extensive disclosure requirements.

Effective date

FRS 20 is effective for non-listed companies for accounting periods beginning on or after 1 January 2006; IFRS 2 is of course in force for listed companies from 1 January 2005.

Transitional rules

For equity-settled payments, the standards must be applied retrospectively to awards that were granted after 7 November 2002 and had not vested by 1 January 2005 (or 2006 as the case may be). Companies may also elect to make prior year adjustments in respect of awards that vested prior to the implementation of the Standard.

For cash-settled payments the Standards must be applied retrospectively to awards that were granted after 7 November 2002.

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