An introduction to what your accountant needs to reflect in your annual accounts if you have a share scheme
Introduction
Accounting for share based payments is at best complicated and for most utterly confusing. The notes following are intended as a guide to FRS 102 section 26 only and in most cases you will need to defer to your Accountant of choice, or a specialist in this area, when preparing your annual accounts.
Unfortunately accounting for share based payments under FRS 102 is mandatory for all companies however small. Larger companies requiring an Audit will also have to be able to agree the accounting policies adopted and any charges to the accounts with their Auditors. Accounts prepared that do not comply with FRS 102 will be rejected by Companies House. An exception to this will be companies preparing accounts under International Financial Reporting Standards (IFRS) although the requirements are broadly similar.
General
All companies are required by FRS 102 section 26 to account for the cost of “share based payments” to employees, contractors and other suppliers of services. There is no exception to this rule for small companies but the accounting standard accepts that valuing share based payments will not be a precise science and as such accepts that the director’s best efforts in a given set of circumstances will suffice.
Any share option scheme or transaction involving the acquisition of shares through the Vestd platform will, with hardly an exception, be regarded as a share based payment. The thrust of the reporting standard is to ensure that where goods or services are paid for using a company’s equity (share capital and similar) that the fair value of the goods and services are reflected as an expense in the company’s accounts or where this is difficult to ascertain (generally services of employees and those providing similar services) the fair value of the equity option granted or the shares given in return.
For an equity payment to an employee or those providing similar services which vests immediately the cost is charged to the accounts by reference to the time when the option is granted or the shares issued. Where options are granted but vest over a period of time the cost is spread over the vesting period. This will also be the case for shares whose value may increase over time as risk of forfeiture diminishes as conditions attached to the shares cease to have effect. For the provision of other goods and services the cost is charged as and when goods and services are delivered.
Accounting Disclosures
In practical terms, what does this mean?
Let's look at some example scenarios (the following is an indication of what accounting disclosures may look like for an individual company, and preparers of accounts may not rely on the following but must instead read and apply the provisions of FRS 102 as drafted and amended from time to time by the Financial Reporting Council).
1) Granting of an EMI or unapproved share option, vesting annually at 20% over a period of 5 years, conditional on continued employment and certain performance criteria.
Accounting disclosures required: FRS 102 accounting policy note relating to Share Based Payments: standard wording is generally available for this as it is generic and will be included in most financial accounting software packages used by most firms of accountants. Appropriate text is readily available but not copied here
Accounting Judgements note: where a company’s accounts are dependent on judgements made by directors the nature of these judgements should be noted. Typically this may read as follows: “Management is required to use an appropriate pricing model to value the issue of equity to employees or those providing similar services. Any charge to the profit and loss account is therefore a function of the chosen pricing model, which is based on a range of assumptions".
However the options in this scenario do not vest immediately but over a period of five years and the vesting conditions could be market vesting or non-market vesting. Market vesting conditions relate to the market value of the shares or company at any particular time, other non-market vesting conditions are generally over time or conditional on the employee.
The value of an option is difficult to determine as is how this value ought to be apportioned over the vesting period. The judgement note in these circumstances needs to be drafted with care and agreed with your auditors if you require an audit or your accountant if you have one. Unless your company is very small with a low market value and modest growth anticipated over the vesting period you will need professional help in making and noting these judgements.
Finally you will require a detailed note to the account that sets out the nature of the share option scheme, to how many people shares options were granted, the number of shares under option, the share price at grant, the exercise price, the vesting period. Over time you will need to note the number of options exercised, the number of options that may have lapsed and the number of options that are vested and the total number of outstanding options (vested and unvested).
The note will also need to include information that was used to value the options at grant and how this value is being charged to the accounts and spread over the appropriate vesting periods. This information if using a Black Scholes valuation model would include the risk-free rate of interest and the volatility associated with the share but may also take into account other factors. You will need professional help in drafting these notes unless your company is very small and for those subject to an Audit this note will need to be agreed with your Auditors.
2) Issue of a growth share for a price at or above its unrestricted Market Value which is subject to effective cancellation if an employment condition is not satisfied in a period of three years.
Accounting disclosure required: FRS 102 accounting policy note relating to Share Based Payments. Standard wording is generally available for this as it is generic and will be included in most financial accounting software packages used by most firms of accountants. Appropriate text is readily available but not copied here.
Accounting Judgements note: where a company’s accounts are dependent on judgements made by directors the nature of these judgements should be noted typically this may read as follows. “Management is required to use an appropriate pricing model to value the issue of equity to employees or those providing similar services. Any charge to the profit and loss account is therefore a function of the chosen pricing model, which is based on a range of assumptions. All conditional growth shares issued in the year at nominal value have a hurdle price calculated to be in excess of the current aggregate value of the company attributable to all other share classes. The cost to the company in issuing these shares at par is regarded by the directors to be £o and therefore in their judgement no charge has been made to the profit and loss in the current period nor will be applicable to future periods.”
Finally you will require a detailed note to the account that sets out the nature of the share award to how many people shares were awarded the value of the shares when issued and the amount paid for them. The note should be sufficient for a reader of the accounts to understand the nature of the award and broadly the conditions attaching to the shares including their rights to participation any conditionality and risk of forfeiture. There are many examples available of suitable notes used by companies who have already published accounts under FRS 102.
Valuations Required for Share Based Payments for Accounting Purposes
Valuations for conditional growth shares for accounting purposes has been touched upon above and little further needs to be said on the assumption that a hurdle rate is sufficient for their unrestricted market value to be no more than their nominal value/subscription price.
Valuing options is decidedly more difficult although in principle what we are trying to establish is what is the value today of an option to buy a share at a fixed price at any point over a defined period of time. The value is a function of the growth potential of the company, the volatility of the share price the prevailing risk-free interest rate and the length of the option. For a quoted company where there is a futures market or similar this is quite straightforward. For smaller private companies this is decidedly more complex and statistical modelling is required. Typically, a Black Scholes model is used, and we've created a Black Scholes calculator to help you determine a useful valuation.
Assistance can also be found relating to the risk-free rate of interest and typical values for share volatility but care needs to be taken that any judgements made are reasonable and that if the resulting valuations are material that second opinions are sought or a professional valuation is obtained.
For companies requiring an audit, the directors will have to be able to demonstrate that their calculations are robust, their judgements are sound and that the combination of the notes to the accounts and the amounts charged to profit and loss are sufficient to give a true and fair view of the cost to the Company of making its Share Based Payments.
Conclusion
FRS 102 Section 26 runs from pages 191 to 196 and is an invaluable source of information to the preparers of accounts. For those companies who will rely on a firm of accountants to prepare their accounts this reference material will assist greatly in knowing what information and in what format they will need to prepare the relevant notes and charges to the accounts.
For those preparing accounts in-house, some diligent research, analysing your peers' accounts and using a Black Scholes calculator is probably the best route.
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