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Share options expensing champion to stand down

Posted on January 07, 2010

Sir David Tweedie will stand down as chairman of the International Accounting Standards Board on 30 June, 2011. Tweedie has been a major force in the development of international accounting standards, including those applicable to employee share incentives such as the Enterprise Management Incentive, Company Share Option Plan and Share Incentive Plan.

Some of these standards have proved controversial, however. In the area of employee share schemes there is still deep disquiet about IAS2, which requires companies to account for the "cost" of their employee share schemes as a charge against profits (a practice sometimes known as "options expensing"). The fundamental objection to this is that employee share schemes do not actually cost the sponsoring companies anything. The "cost" is borne by shareholders, in the form of dilution of their shareholding interest.

Further concerns surround the way in which the cost is calculated. The accounting standard favours the use of simulation models, which map all possible futures for the value of the employee benefits, and then calculate a discounted present value. These models are huge, and well outside the capability of most of the companies that are supposed to adopt them. The alternative is to use a mathematical model, known as Black Scholes Merton. This is itself a very esoteric piece of kit - so esoteric in fact, that it won the Nobel Prize for mathematics in 1996. Very few people understand it, and it is also inaccurate for many types of employee share incentive, particularly employee share options. This is because the model assumes a single exercise date, whereas employee share options are often exercisable over a period of time.

In short, to comply with IAS2, companies must use simulation models which are impossibly complex to operate, or make do with Black Scholes Merton. Either way, they are faced with operating a black box which neither directors nor shareholders understand and produces numbers which may well be inaccurate. Furthermore, these numbers represent an entirely fictional cost to the company and therefore result in profits being artificially understated, to the disadvantage of the company. To add insult to injury, many companies will have to pay external advisers to perform these calculations for them. They cannot even turn to their auditors for this task since the auditors are conflicted - they cannot audit numbers that they themselves have calculated.

We have to face facts, however, and under current accounting rules these procedures have to be followed by every UK company apart from small companies which adopt the Financial Reporting Standard for Smaller Entities (FRSSE). The RM2 Partnership is able to perform these calculations for clients, using either our proprietary binomial lattice simulation model or Black Scholes Merton. We have developed an efficient system of doing this, and believe our costs are much less than most of our competitors. If you need assistance with this please contact us for a quote.

However, it is to be hoped that with the departure of Sir David Tweedie, there will be an opportunity to look at this accounting standard again and apply some common sense. We recommend that the standard be scrapped altogether. Some readers with very long memories may recall what happened to inflation accounting - a highly complex set of rules designed to adjust for the effects of inflation on company accounts. It proved unworkable and in the end was quietly buried. We hope and expect that the same will happen to IAS2.

 
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