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Accounting for directors' share options

by David Towers

The financial statements of listed companies show that directors’ remuneration includes: basic salary, benefits in kind, bonus, pension entitlements and share options. This article considers the last topic, share options, and how they should be treated in companies’ financial statements using the UK Standard FRS 12, Provisions, Contingent Liabilities and Contingent Assets, (ref: 1). For candidates taking the International variant paper, the relevant standard is IAS 37, Provisions, Contingent Liabilities and Contingent Assets and the topic will be studied through the following worked example (see Table 1).

Bonuses and Share Options
Bonuses to directors based on the current year’s profit can lead to short termism, in that the directors will maximise the current year’s profit by not investing in new products and not developing existing ones (these costs would reduce the current year’s profit). Not investing in new products and not developing existing ones will adversely affect future profits and may threaten the long-term existence of the business.

It is argued that Share Options are an effective way of paying directors and of avoiding ‘short termism’, as the value of a share should be a reflection of the long-term profitability of the company.

Until recently, there has been no charge in the company’s profit and loss account for share options, so the shareholders are not aware of the value of the options granted to the directors. However, share options can be very valuable to directors. Excluding the cost of share options from the financial statements understates directors’ remuneration.

Table 1: Worked Example on Share Options
The Chief Executive of CD plc was awarded, on 31 December 2000, the option to purchase 1,000,000 shares in the company at £2.50 a share on 30 June 2004 (the market price of CD’s shares at 31 December 2000 was £2.50). This option was subject to her achieving specified performance targets for the three years ending on 31 December 2003. The following information has been provided on the cost of an option to purchase a share in CD plc on 30 June 2004 at 250p a share:
Date Option price (p) Probability of
achieving option (%)
31.12.00 5p 60%
31.12.01 15p 70%
31.12.02 25p 85%
31.12.03 35p 100%


The market value of a share of CD plc at 30 June 2004 was 290p

Required:
(a) Calculate the charge for the share option to be included in the financial statements and the provision to be included in the balance sheet for the years ended 31 December 2000, 2001, 2002, 2003 and 2004 using:
(i) the FRS 12 method;
(ii) the US FAS 123 method;
(iii) the UK ASB recommendation.
(b) Discuss the different answers you have calculated in part (a).

Explanation of Share Options
Firstly, we will define the dates (ref: 2):

The grant date (i.e. 31 December 2000) is the date when the employee and employer enter into an agreement that will entitle the employee to receive an option on a future date, provided certain conditions are met.

The service date (1 January 2001 to 31 December 2003) is the date or dates on which the employee performs the services necessary to become unconditionally entitled to the option. The vesting date (31 December 2003) is the date when the employee, having satisfied all the conditions becomes unconditionally entitled to the option. The exercise date (30 June 2004) is when the option is exercised.

Normally, the option is granted at the market price of the shares at the grant date (i.e. 250p a share). If, at the exercise date of 30 June 2004, the value of the shares is 290p, the director will buy the shares from the company for £2,500,000 and immediately sell them in the market for £2,900,000, making a gain of £400,000. If the value of the shares is less than 250p on 30 June 2004, the director will not purchase the shares (as he/she would make a loss), so the director’s gain on the option will be zero.

Interestingly, most directors of UK listed companies buy and sell the shares at the exercise date (30 June 2004 in this case). Only a small minority of directors buy the shares at the option price and continue to hold them.

Share Options as a Measure of long-term Profitability
The ‘theory’ of share options is that the share price on 30 June 2004 will be based on the company’s long term profitability, so if the company is doing well, the share price will be higher and the director’s profit on buying the shares (and subsequently selling them) will be higher. So the director’s gain on selling the shares will reflect the director’s success in increasing the long-term profits and hence the share price of the company.

To a certain extent, this ‘theory’ is correct in that the share price tends to increase if the company’s profitability increases. However, share price movements also depend on other factors, such as the general price movement of other shares and investors’ views about the future profitability and growth in the particular type of trade the company is in. For instance, in late 1999 and early 2000 there was an enormous increase in the value of telecom and dot.com shares, yet many of these companies had never made a profit. Thus, the increase in the share price did not depend on the profitability of the companies, and it could be argued that the prices of these shares increased because this was a fashionable sector of the market in which to invest. At the same time as the increase in value of telecom and dot.com shares there was a substantial fall in the value of other shares, including well-known retailers. Sometimes, share prices were falling, despite the fact that the companies’ profits were increasing. So, it can be seen that the increase in the share price of a company may be more related to market conditions than its long-term profitability. Thus, awarding options on shares may not be a very effective way of paying directors, as the change in the share price may have little to do with profitability of the company and the directors’ contribution to increasing those profits.

Accounting for Share Options
As has been discussed earlier, share options have become an important way of paying directors, which motivates them to ensure the long-term profitability of the company. There has been disclosure of these options in the financial statements of companies for a number of years (see UITF 10, Disclosure of Directors’ Share Options (ref: 3)), but no cost of the share options has been included in the Profit and Loss Account. However, as explained below, there is a cost to the company of awarding these options.
The problems are:

  1. when should the cost of the options be charged in the financial statements; and
  2. how much should be charged in the financial statements.

Using the figures in the question, we will show how these affect the charge to the Profit and Loss Account for three methods:

  1. A proposal based on the UK ASB’s FRS 12, Provisions, Contingent Liabilities and Contingent Assets;
  2. The US Financial Accounting Standards Board in FAS 123, Accounting for Stock-Based Compensation, which uses the Grant Date as the date when the charge should be made to the Profit and Loss Account;
  3. The UK Accounting Standards Board (ASB), which proposes that the Vesting Date should be used to measure and date the charge for the option in the financial statements.

FRS 12 Method – Calculation of Provision and Charge to Profit and Loss Account
Under FRS 12, a provision is a “present obligation where it is probable that a transfer of economic benefits will be required to settle the obligation” (Para 13(a)). Para. 36 says the provision should be the “best estimate of the expenditure required to settle the present obligation, which is the amount an entity would rationally pay to settle the obligation at the balance sheet date”.

So the value of the provision at each year-end is the product of:

  1. the option price at the year end to purchase the shares at 250p on 30 June 2004;
  2. the number of shares granted in the option; and
  3. the probability of the director achieving the profit (performance) target by 31 December 2003.

The calculation of the provision and its value is shown in Table 2 below for each year-end from 31 December 2000 to 31 December 2003.

The expense in the Profit and Loss Account under FRS 12, as shown in Table 2, is calculated as:

Provision at the current year end (e.g. 31.12.01) – provision at previous year end (i.e. 31.12.00)

Table 2: FRS12 Method – Calculation of Provision and Charge to Profit and Loss Account
Year ended Provision at 31 Dec Charge to Profit and Loss Account
31 Dec 2000 5p x l,000,000 x 60% = £30,000 £30,000 – 0 = £30,000
31 Dec 2001 15p x 1,000,000 x 70% = £105,000 £105,000 – £30,000 = £75,000
31 Dec 2002 25p x 1,000,000 x 85% = £212,500 £212,500 – £105,000 = £107,500
31 Dec 2003 35p x 1,000,000 x 100% = £350,000 £350,000 – £212,500 = £137,500

FRS 12 Method – at Exercise Date – 30 June 2004
At the exercise date, the value of the company’s shares is £2.90. By buying the shares from the company and immediately selling them, the director’s profit will be:
= 1,000,000 x (£2.90 – £2.50)
= £400,000

The expense in the Profit and Loss Account for the 6 months ended 30 June 2004:
= (market value of shares at 31 May 2004 – 1,000,000 x £2.50) – provision at 31 December 2003
= (£2,900,000 – £2,500,000) – £350,000
= £50,000

The total cost of the option to the company is the difference between the proceeds of selling 1,000,000 shares in the market at 290p a share (i.e. £2.9m) and the sum received from the director in exercising the options of selling 1,000,000 shares at 250p each (i.e. £2.5m). At 31 December 2004, there will be no provision in the balance sheet. The charge to the profit and loss account will be £50,000 (to directors’ remuneration). The total accumulated provision (£400,000) will be credited to the share premium account.

FAS 123 Method
Under FAS 123 the only charge occurs at the grant date of 31 December 2000 (ref: 2).
This charge (and provision at 31.12.00) is the same as for FRS 12 at that date:
= value of option at 31.12.00 x number of shares x probability of exercising the option
= 5p x 1,000,000 x 0.6
= £30,000

There is no charge to the profit and loss account at the other year-ends of 31 December 2001, 2002, 2003 and 2004.

The provision at 31 December 2000 continues to each year-end (31 December 2001, 2002 and 2003) until the exercise date of 30 June 2004. At the exercise date, the director buys the shares for £2.50 each, and the provision of £30,000 is transferred to the share premium account. So, there is no provision in the balance sheet at 31 December 2004.

UK ASB Proposal
Under the UK ASB proposal, the cost of the option is charged at the vesting date (ref: 2).

The method of calculating the provision at the vesting date of 31 December 2003 is the same as for the FRS 12 method:
= value of option at 31.12.03 x number of shares x probability of exercising the option;
= 35p x 1,000,000 x 100%;
= £350,000.

There is no charge for the director’s option until the vesting date of 31 December, so there is no provision at previous year ends (i.e. 31 December 2000, 2001 and 2002), and there is no charge to the profit and loss account in those years.

So the charge to the profit and loss account for the year ended 31 December 2003 is:
= provision at 31.12.03 – provision at 31.12.02
= £350,000 – 0
= £350,000

At the exercise date of 30 June 2004, the director buys the shares for £2.50 each, and the provision of £350,000 is transferred to the share premium account. Thus, there is no provision in the balance sheet at 31 December 2004.

The justification of the UK ASB’s proposals is that the share option is not certain until the vesting date, so no charge should be made for the options prior to that date. This appears to be a very conservative approach, and it would appear better if the cost of the options is charged over the service period, which is the way the FRS 12 method proposes.

Presentation of the Results
The annual charge and the total charge for the Chief Executive’s options using the three methods is:

Table 3: Comparison of Profit and Loss Account Charge for Different Accounting Methods
Year ended FRS 12 method
(£)
US FAS 123
(£)
UK ASB
(£)
31 Dec 2000 30,000 30,000 0
31 Dec 2001 75,000 0 0
31 Dec 2002 107,500 0 0
31 Dec 2003 137,500 0 350,000
31 Dec 2004 50,000 0 0
Total charge 400,000 30,000 350,000

Considering each of the methods:
(i) The FRS 12 method gives a cost for the option which is consistent with the UK and International Accounting Standards and the IASC’s Framework for the Preparation and Presentation of Financial Statements.
Taking the value of the option and the probability of the option being granted tends to give an uneven charge for the option, with a higher charge in later years because:

  • the probability of the option being granted is higher near the end of the option entitlement period (and less in earlier years);
  • there is an element of discounting in determining the option price, so the option price will be lower in earlier years than later ones; and
  • the option price will tend to be lower in earlier years as it is less certain that the share price will be above the option price in earlier years than later ones.

(ii) In this example, FAS 123 gives a charge to the profit and loss account of only 7.5% of the cost of the FRS 12 method (and only 8.6% of the UK recommendation). This charge occurs in the year ended 31 December 2000, and there is no subsequent charge in the profit and loss account.

(iii) The UK recommendation gives a charge of 87.5% of the FRS 12 method, which is a more realistic figure than using the US method. However, the charge only occurs at 31 December 2003, which is three years after the option was granted to the director. It would be better if the charge was made during the service period (i.e. the period the director earned the entitlement to the share option).

It appears the ‘FRS 12 method’ is not acceptable to the US or UK Accounting Standards Committees. Accounting standards are often an acceptable compromise between the views of the representatives of listed companies and those of the financial institutions represented on the accounting standards committees. The US proposal has met with hostility from the listed companies, as it makes them charge the cost of the options in the financial statements, and the costs can be very high. The directors of the listed companies would prefer if there was no charge for the cost of the options, as had previously been the case. The ‘hostility’ of the listed companies to the FAS 123 proposals probably set a line beyond which they would not go, so the FAS 123 proposal is set at valuing the option at the grant date. In our example, this gives a charge of £30,000.

The UK ASBs proposal of using the vesting date gives a charge which is much closer to the actual cost to the company. However, its weakness is that this charge is made at a relatively late date, and it would be preferable if this charge was made over the service period when the CEO earned the right to the options.

So, it can be seen that the US FAS 123s and the UK ASBs proposals give a lower charge to the Profit and Loss Account for the share options than the ‘FRS 12 method’. However, the correct method to use would be the ‘FRS 12 method’, which is consistent with FRS 12, Provisions, Contingent Liabilities and Contingent Assets, and with Financial Management principles.

Discussion of FRS 12 Result
The individual years’ charge to the profit and loss account using the FRS 12 method is superior to FAS 123 and the UK ASB proposals. However, it does not give the ‘perfect’ result. Looking at the result:

Table 4: Annual Profit and Loss Account charge for Share Options using the FRS 12 Method
Year ended FRS 12 method
(£)
31 Dec 2000 30,000
31 Dec 2001 75,000
31 Dec 2002 107,500
31 Dec 2003 137,500
31 Dec 2004 50,000
Total charge 400,000

Ideally, the charge for the option to the profit and loss account should produce an equal charge for each year during the service period. It is valid to make a charge at the grant date, as the granting of the option does give a valuable contingent asset to the director.

From Table 4 above, it can be seen that the charge each year for the years 2001 to 2003 is not even, but it increases as one approaches the vesting date. There are three reasons for the increase in this charge:

  1. the probability of the director achieving the performance target increases with time;
  2. the value of the option will increase with time, and there will be greater certainty in determining the share price at the exercise date of 30 June 2004; and
  3. there is an element of ‘interest’ in calculating the provision, which increases as one approaches the exercise date.

To illustrate the ‘interest’ element, if you had to pay off a loan of £1,000 on 31 December 2001, and interest rates were 10%. Then in the balance sheet at 31 December 2000 you would include a provision of £909 (i.e. £1,0001/1.10). However, at 31 December 2001 you would make a payment of £1,000 to pay off the loan. This would produce a charge to the profit and loss account for the year ended 31 December 2001 of £91, which is the ‘interest’ on the provision.

The £50,000 expense for the year ended 31 December 2004 comprises:

  1. the ‘interest’ on the provision between the vesting date of 31 December 2003 and the exercise date of 30 June 2004; and
  2. the uncertainty in the company’s share price at 31 December 2003 compared with the actual share price on 30 June 2004. This ‘uncertainty’ may have a negative contribution to the expense in the final 6 month period, as investors in the options may charge a higher price for the option at 31 December 2003 because of the risk of a rapid increase in the company’s share price in the 6 months to 30 June 2004 (e.g. if the option price at 31 December 2003 is 40p and the share price at 30 June 2004 is 340p, the person supporting the option will make a loss of 50p a share (ignoring the immaterial interest on 40p for 6 months)).

It is acknowledged that FRS 12 gives an increasing charge for the option in the profit and loss account. However, FRS 12 is the best method to use at each year-end, because of the uncertainty of the share price at 30 June 2004. If the share price at 30 June 2004 was known at the earlier year ends (i.e. 31 December 2001, 2002 and 2003), then it would be possible to spread the charge evenly over the service period. As the future share price cannot be determined accurately, it is not possible to spread the charge for the option evenly over the service years. The use of option prices is the best data available at each year end, it produces a valid value for the value of the share options at each year end, and it is consistent with the definition of a provision in FRS 12.

Option Prices and Fluctuating Charge
In this example, we have increasing values for the option price at each successive year-end.
In practice:

  1. there may be substantial changes in the option price between each year end; or
  2. option prices may not be available.

If the option price at 31 December 2001 was 25p and the option price at 31 December 2002 was 15p, with the same probabilities as in the worked example.

Provision at 31 December 2001
= 25p x 1,000,000 x 0.7
= £175,000

Provision at 31 December 2002
= 15p x 1,000,000 x 0.85
= £127,500

Charge for year ended 31 December 2002
= provision at 31.12.02 – provision at 31.12.01
= £127,500 – £175,000
= (£47,500)

For the year ended 31 December 2002 there would be a negative charge to the profit and loss account (i.e. a credit) of £47,500 for the director’s share option.

So, it can be seen that using FRS 12 could give large fluctuations in the cost of the options in each year’s financial statements, including a negative charge.

Also, a negative charge would occur where a provision is built up for the director’s share options, but the director does not achieve the performance target at the vesting date of 31 December 2003. This would result in the provision built up over the period being credited to the profit and loss account at 31 December 2003 (another example of negative charge to the profit and loss account for directors’ remuneration).

As explained earlier, the ‘insurance’ element of option prices may give an unrealistic value to the option used in calculating the charge in each year’s profit and loss account. If one paid 40p for the option at 31 December 2003, then, if the actual share price at 30 June 2004 was 340p, the person providing the option would lose 50p a share (i.e. 350 – (250 + 40)p). The risk of a loss for the person providing the option is unlimited, but the most profit he/she can make is 40p a share (i.e. when the share price is 250p or less and the director does not exercise the option). This ‘insurance’ element is likely to increase the market price of the option, which will increase the cost of the option in the periods to the exercise date. However, for the FRS 12 method, the eventual total cost of the option of £400,000 will be correctly charged in the profit and loss account (although the allocation of the cost to the different periods may not be exactly correct). The ‘insurance’ element of the option price will increase the cost of the option using the US FRS 123 basis and the UK ASB’s proposal.

The other problem is that there may be no market for options on the company’s shares, so no reliable value for the option can be obtained. In this situation, an estimate will have to be made of the value of the option at each year-end. If the current share price is less than 250p, then the option could have a low value. If the current share price is greater than 250p, then the value of the option could be taken as being close to the difference between the company’s current share price and 250p The ‘current share price’ will be taken as the average share price for a few months before and after the year-end.

Profit of Options to the Director and Cost to the Company
It can be seen that the cost of the share option charged by FRS 12 is equal to the profit the director would make on selling the shares at the exercise date. It seems sensible that the charge made in the company’s accounts should be the same as the profit the director makes in selling the shares at the exercise date. In most transactions like this (e.g. payment of wages to an employee), the cost to the company is the same as the income to the employee. So, from a ‘reasonableness’ point of view, it appears that the FRS 12 method produces the correct result.

It is wrong to say the value of the share options is ‘zero’ and thus make no charge in the company’s profit and loss account. Share options are valuable to directors, so they must involve a cost to the company. In this example, the cost to the company is the difference between what it would receive from selling the shares at the market price (290p) and the amount it receives for selling the shares to the director at the option price (250p). This cost should be reflected in the profit and loss account. For the shareholders, the issue of shares results in a ‘dilution’ in their ownership of the company. After the shares have been issued, the existing shareholders own a smaller proportion of the company.

Conclusion
This article has shown that the cost of providing directors’ share options is either understated (under US FAS 123 or UK ASB proposals) or taken as zero. A method which is consistent with FRS 12,Provisions, Contingent Liabilities and Contingent Assets, should be used to determine the annual cost of these options to the company.

A final thought! Share options are made to employees, and no cost is included in companies’ financial statements for these options. If the cost of directors’ share options is included in companies’ financial statements, should not the cost of employees’ share options be included as well?

References

  1. FRS 12, Provisions, Contingent Liabilities and Contingent Assets, ASB, Sept 1998.
  2. R Patterson, ‘Grasping the Nettle’, Accountancy, Sept 2000, p102.
  3. UITF 17, Disclosure of Directors’ Share Options, ASB, Sept 1994.