Why options expensing is wrong
A recent case involving one of our clients has again brought home the absurdity of the expensing rules introduced by accounting regulators in relation to employee share schemes.
Recently, our client made an award of nil cost EMI share options with immediate vesting. The result of this is an immediate charge to profit and loss account equal to the whole value of the shares over which the options had been awarded. Although we had made calculations previously for the client in relation to previous awards, the scale of this latest charge took the client by surprise.
The problem arises because the Accounting Standards Board (ASB) together with their international counterparts requires that the economic costs of equity based incentives are shown as a cost to profit and loss account. The cost is calculated using an option pricing or simulation model which takes account of the probability of a rise or fall in the price of the underlying share. In the case of nil cost options, the cost of the option is the value of the underlying share.
All UK companies have to comply with this rule except those entitled to use the Financial Reporting Standard for Smaller Entities.
Share options do not cost companies a penny. They are a cost to shareholders. So why show this fictitious cost to profits? In their booklet, "IFRS 2 share based payment, basis of conclusions" the UK Accounting Standards Board attempts to explain. It claims that when an employee receives a share option or other share award, their services are an asset which is partly purchased by the shares. Therefore, the asset has to be expensed over the period that the asset is used (and this is taken to be the vesting period of the share award) in effect, depreciated and a cost shown to the accounts.
This is fundamentally wrong. If a company purchases a wasting asset, such as a machine, the calculation of profits must take account of the eventual cost of replacing the asset hence the depreciation charge against profits. But if a company effectively makes a gift of shares (such as the nil cost option offered by our client) there is no wasting asset. There is nothing to replace, and nothing to depreciate. All that has happened is the ownership of the company has changed. True, the company could have offered cash, thus reducing profits. But instead the shareholders chose to dilute their ownership, thus reducing not the company's profits but the profits available to them. It makes no sense for the shareholders then to take a second charge for cash they have not expended.
Or to look at it another way: what difference does it make to a company's value if it has many or few shareholders?
The situation becomes worse when we consider the methods. Almost universally, the charge against profits is calculated using a mathematical model known as Black-Scholes-Merton, after its inventors. To say the model is abstruse is an understatement; it was the subject of a Nobel Prize for mathematics in 1997. But it also inappropriate for several reasons, including the fact that it was designed for traded options rather than employee options which generally cannot be traded.
So what we have is a charge which is wrong in principle and is calculated (at significant cost to companies) by a method that very few people fully understand and is probably inappropriate anyway. Fortunately, there is evidence that for most purposes banks and investors just disregard the charge, although one real world effect of the charge can be to reduce distributable reserves. The accounting standard IAS2 should be withdrawn.
The Accounting Standards Board has launched a consultation on the future of share based payment accounting for unquoted UK companies. The consultation closes on 31st July 2013 and we will update our guidance once the outcome of the consultation is known. Amongst possible changes considered are (i) the complete abolition of the accounting expense for equity-settled share based payments for unquoted companies on the grounds that the calculation of the expense is too artificial and (ii) its replacement with an enhanced disclosure regime for equity based awards, such as options.
If you would like to discuss the implications of this accounting standard for your own company, and how the impact might be reduced, please call us on 020 8949 5522 and ask to speak to one of our advisers. If you are obliged by the accounting standard to expense your share awards, your own auditors cannot assist since they cannot both perform the calculation and audit it. We offer an inexpensive options expensing service which is designed to reduce the charge as far as permissible under IAS2.