How to Account for Employee Share Options Under FRS 102
Summary
- FRS 102 prescribes the accounting treatment for share-based payments to both employees and non-employees
- Most share-based payments arrangements with employees in the UK are set up as equity settled transactions
- Vesting requirements relating to service and non-market performance conditions impact the number of equity instruments that will ultimately vest
- Vesting requirements relating to market performance and non-vesting conditions are taken into account when estimating fair value of equity instruments granted at grant date
- Modifications, leavers’ provision, forfeitures and cancellations have special rules prescribed in FRS 102
Background
Employee share options, also known as share-based payments arrangements with employees, are accounted for under section 26 of FRS 102. Whilst this article focuses on accounting for SBP arrangements with employees, it is pertinent to note that section 26 of FRS 102 also deals with share-based payments arrangements with non-employees such as contractors, advisors and suppliers.
Types of Share-based Payments Arrangements
Share-based payments arrangements with employees can be of three types:
- Equity settled: Arrangements where a company receives services and either settles the transaction using its own equity instruments or has no obligation to settle the transaction.
- Cash settled: Arrangements where a company acquires services by incurring a liability to transfer cash or other assets for amounts that are based on the price of equity instruments of the company.
- Transactions with settlement alternatives: Arrangements that offer the company or the employees a choice of settling the share-based payments arrangement in cash or equity.
The accounting treatment under FRS 102 differs for the three types of share-based payments arrangements above. However, most employee share option plans in the UK are usually set up as equity settled plans. This article explores some of the key accounting concepts that are applicable to equity-settled share-based payments arrangements and their implications on a company’s primary financial statements.
Equity Settled Share-based Payments Arrangements
Share-based payments arrangements under FRS 102 are measured at the fair value at grant date of the options or shares granted. The grant date, as per FRS 102’s definition of the term, is not necessarily the same as the date when the share-based payments agreement is signed by the employee. The primary objective of section 26 of FRS 102 is to account for share-based payments arrangements over the period over which an employee becomes unconditionally entitled to their award. This is known as the vesting period.
Often, share-based payments arrangements come with vesting conditions. FRS 102 categorises these in the following four broad categories:
Service Conditions
These conditions require an employee to complete a specified period of time in employment before they become entitled to shares or options under a share-based payments arrangement. Often, the Plan Rules will entitle an employee to shares or options in tranches, but FRS 102 does not specify how the expense for share-based payments arrangements should be recognised – that is, on a straight-line basis or graded/tranched basis. On the contrary, US GAAP requires share-based payments arrangements to be recognised on a straight-line basis and EU IFRS requires share-based payments arrangements to be recognised on a graded basis. In the UK, we typically see companies recognise their expenses in relation to share-based payments arrangement on a graded basis. This means that the expense in the profit and loss account is front-loaded in the first half of the vesting period. In the balance sheet however, the credit is typically presented in retained earnings where it nets to nil with the expense when it rolls into retained earnings within profit/loss for the year.
Non-market Performance Conditions
These conditions are defined in a share-based payments arrangement by reference to a company’s own operations or those of the same group. These include, for example, the successful conclusion of a financing round or product development milestones etc. Non-market performance conditions, similar to service conditions, vest over the vesting period if they are expected to be met. When non-market performance conditions are not expected to be met anymore, these are treated as forfeitures in the year in which that conclusion is reached.
Market Performance Conditions
These vesting conditions are defined in a share-based payments arrangement by reference to the price of a company’s own equity instruments or those of the same group. Market performance conditions do not change how a share-based payments arrangement vests. Rather, these are accounted for within the fair value of the award.
Non-vesting Conditions
Where a condition is not a service condition, nor a non-market or market condition, it is known as a non-vesting condition. An example of such a condition is the procedures an employee has to follow to exercise their options, including the time frame in which they may exercise after the options have vested. Similar to market performance conditions, non-vesting conditions do not affect how a share-based payments arrangement vests. These are also accounted for within the fair value of the award.
Key Concepts that Apply to Share-Based Payments Arrangements Under FRS 102
Modifications
Sometimes, a share-based payments arrangement may be modified to add or remove vesting conditions, or make existing vesting conditions harder or easier to achieve. Such modifications are accounted for under FRS 102 depending on whether these are beneficial to the employee or not. Different rules apply to beneficial modifications and non-beneficial modifications.
Leavers’ Provision
A leavers’ provision may be thought of as an estimate of how many employees are expected to leave in the future, measured onwards from a reporting date. This is not the same as the number of employees who have left during a reporting period or just after, and whose forfeitures have already been taken into account at the end of the reporting period.
Section 26 of FRS 102 does not explicitly require a leavers’ provision. However, the phrasing of the standard indicates that a leavers’ provision should be estimated at each reporting date. This is a complex estimate to make and account for, and is highly judgmental. The leavers’ provision when recorded in the accounts, has the overall effect of reducing (but may in some circumstances, increase) the expense for the year.
Forfeitures
A forfeiture occurs when an employee does not meet either a service or non-market performance condition over the vesting period. This is not the same as a cancellation, which is a cancellation or settlement of a share-based payments arrangement by a company during the vesting period. The rules under FRS 102 to account for forfeitures differ significantly to those relating to cancellations. Whereas forfeitures reduce the expense for the year (and the cumulative expense over the vesting period), cancellations increase the expense for the year.
How Frazier & Deeter Can Help
The accounting rules in relation to share-based payments arrangements can be complex and hard to navigate. Schedules to track how many options have vested, what the accounting charge should be in a year (which under graded vesting in the UK is not reflective of the number of instruments that have actually vested) and how many options may not vest in the future are difficult to construct and require at least annual maintenance. Estimates for fair value of equity instruments at grant date require specialist understanding of various valuation models such as the Black-Scholes model or Monte Carlo simulation, and sourcing of accurate inputs. Therefore, companies are strongly encouraged to consider carefully the advisory partner they want to accompany them on this journey over the vesting period.
Frazier & Deeter’s accounting advisory team is highly experienced in the application and navigation of the accounting standards relating to share-based payments arrangements in the UK. Our team has constructed and maintained FRS102-compliant vesting schedules and fair value estimates for our clients, ranging from large listed companies with over 600 awards to small-scale start-ups with 10 employees. Contact our team today to learn how we can support your organisation.
Contributors
Ali Amar, Audit Senior Manager
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