Accounting for Share-Based Compensation

Share-based compensation is a form of remuneration where employees or other stakeholders are granted equity or options to acquire equity, often in the form of company stock. This method aligns the interests of employees with those of shareholders and does not require immediate cash expenditure. Despite these advantages, it may lead to misalignment with individual performance and influence behavior to protect or enhance share price.

Share-based compensation, under IFRS 2 “Share-based Payment,” follows a distinct accounting process:

1. Grant Stage: The fair value of the award is measured and adjusted based on the estimated number of awards expected not to vest.
2. Vesting Stage: Fair value is recognized as share-based compensation expense over the vesting period, with adjustments for changes in estimates if necessary.
3. Settlement Stage: Shares are issued to the employee upon vesting.

Types of Share-Based Compensation

• Restricted Stock: These are common shares with selling restrictions. They typically come with voting rights and dividends. Once vested, the recipient can freely sell these shares.
• Stock Options: These are non-tradeable call options on the employer’s stock. They are generally issued at the market price on the grant date. Employees can profit from them if the share price exceed the strike price after vesting and before expiry.
• Stock Appreciation Rights (SARs): SARs give employees the right to the increase in the value of a designated number of shares. This benefit can be paid in cash or stock.
• Restricted Stock Units (RSUs): Similar to restricted stock, RSUs represent a promise to employees to grant them shares or cash at a future date. Unlike actual stock, RSUs are not directly tied to the price of company shares and do not have voting rights.
• Performance Shares: These are awarded to employees based on the achievement of certain performance measures, such as earnings per share or return on equity.

 

Financial Reporting vs. Tax Treatment of Share-Based Compensation

Share-based compensation is generally deductible for taxable income. However, the timing and amount of the deduction often differ from the expense recognized in financial reporting. For financial reporting, expense is recognized over the vesting period based on grant-date fair value, while for tax purposes, the deduction is at settlement based on the settlement date share price (for RSUs) or intrinsic value at exercise (for options).

A higher share price at settlement than grant date results in a tax windfall, reducing taxable income and tax expense. On the other hand, if the share price at settlement is lower than at the grant date, a tax shortfall occurs, increasing both taxable income and tax expense.

Under IFRS and US GAAP, tax windfalls and shortfalls from share-based compensation are treated differently. IFRS recognizes windfalls (gains) and shortfalls (losses) directly in equity, while US GAAP reflects them in income tax expense on the income statement. This difference results in volatility in the effective tax rate under US GAAP.

Accounting Differences from Typical Salaries

Share-based compensation is accounted for distinctively from typical salaries, with expenses recognized in equity rather than as a liability. This form of compensation involves granting employees shares or options to buy shares, which aligns their interests with those of the company’s shareholders and retains talent over an extended period through vesting conditions.

The value of these awards is based on the fair market value at the grant date, and this valuation remains consistent regardless of future share price fluctuations. Vesting can be tied to the employee’s service duration or performance metrics such as EPS growth or return on invested capital. Awards that have not vested by the time an employee leaves the company are forfeited.

Valuation and Settlement

Restricted stock and restricted stock units (RSUs) are typically valued at the market price of the underlying shares at the grant date. In contrast, the fair value of options is estimated using recognized financial models, such as the Black-Scholes model or binomial lattices, which incorporate variables like volatility, risk-free rates, and dividend yields.

Upon the vesting of RSUs, there is an automatic settlement that results in the transformation of the share-based compensation reserve into common stock and additional paid-in capital on the balance sheet. For options, the settlement occurs when the options are exercised, leading to a cash inflow that is recorded as a financing activity on the statement of cash flows.

Influence on Shares Outstanding

The issuance of share-based compensation also has implications for the calculation of shares outstanding. As these awards are settled, the number of shares outstanding increases, potentially diluting the ownership percentage of existing shareholders. Companies may engage in share repurchases to mitigate this dilutive effect. When computing diluted earnings per share (EPS), the treasury stock method is employed to account for the effect of in-the-money options and unvested RSUs, which could potentially become common stock.

Effects on Financial Statements

Income Statement

When a company grants share-based compensation, it recognizes the fair value of the award as a compensation expense on the income statement. This expense is spread out over the vesting period of the award. For instance, if a company granted an employee stock options with a fair value of $100,000 that vests over five years, the company would recognize a $20,000 expense annually for five years. As the compensation expense is recognized, it reduces the net income of the company.

Balance Sheet

Share-based compensation often results in an increase in the “additional paid-in capital” (or similar equity account) on the balance sheet. When the award is granted, a “share-based compensation reserve” is increased, reflecting the future obligation. As the award vests, this reserve is decreased, and the “common stock” and “paid-in capital” accounts are adjusted. If the share-based award is cash-settled (like some SARs), then a liability is recognized on the balance sheet, which will be adjusted as the fair value of the award changes.

Statement of Cash Flows

For equity-settled awards (like stock options and restricted stock), there’s no immediate cash impact when the award is granted or vests. However, when an employee exercises a stock option, the cash received from the employee (equal to the strike price times the number of options exercised) is recorded as a financing activity. For cash-settled awards, the cash paid to settle the award is recorded in operating activities.

Disclosures for Share-Based Compensation

Under IFRS 2, companies must disclose details of share-based arrangements. Disclosures often appear in financial statement notes and governance reports.

Example: Innovative Tech Solutions Stock Option Grants

In this example, we explore the stock option grants at a hypothetical company named Innovative Tech Solutions (ITS), which offers stock options under its Equity Compensation Plan. ITS granted 15 million stock options to its executives on 1 January 20X1. These options, vested over a three-year period, are set to vest on 31 December 20X3. The options were granted at the money. The share price and the fair value per option on the grant date were EUR 3,000 and EUR 900, respectively. These options are set to expire seven years after the grant date.

For the fiscal years 20X1, 20X2, and 20X3, ITS recognizes the share-based compensation expense. The aggregate fair value of the option grants is calculated as 15 million times the EUR 900 fair value per option, resulting in EUR 13,500 million. ITS will recognize one-third of this aggregate fair value annually over the three years as the options vest, amounting to an annual share-based compensation expense of EUR 4,500 million.

The financial statement impacts are as follows:

On the Income Statement, there is an increase in general and administrative expense by EUR 4,500 million each year. On the other hand, there is an increase in equity by EUR 4,500 million each year under the share-based compensation reserve on the Balance Sheet. Finally, on the Statement of Cash Flows, the share-based compensation expense of EUR 4,500 million is added back to reconcile net income to cash flows from operating activities if using the indirect method, as this does not impact cash flows.

If the share price remains below EUR 3,000 by the end of the year on 31 December 20X4, the options will be out of the money, making it unlikely for the grantees to exercise them. In this case, there would be no financial statement impact related to these options in 20X4. However, if the share price increases to EUR 4,500 and 5 million options are exercised in 20X5, the financial statement impact would be as follows:

Upon exercise of the options, there is cash inflow from the exercise calculated as the strike price of EUR 3,000 times the number of options exercised, resulting in EUR 15,000 million. Regarding the financial statement impact, there is no effect on the Income Statement from the exercise of options. On the Balance Sheet, the entry made to the share-based compensation reserve account for the exercised portion, which is EUR 4,500 million, is transferred to paid-in capital. Consequently, the balance in the share-based compensation reserve decreases by EUR 4,500 million, and paid-in capital increases by EUR 15,000 million. On the Statement of Cash Flows, there is a cash inflow from financing activities of EUR 15,000 million.

 

Question

Under IFRS, how are tax windfalls most likely recognized on the financial statements when the settlement share price exceeds the grant date share price in share-based compensation?

1. As a decrease in income tax expense on the income statement.
2. Directly in stockholders’ equity as a loss.
3. Directly in stockholders’ equity as a gain.

Solution

The correct answer is C:

Under IFRS, when the share price at the time of settlement exceeds the share price at the grant date, the tax windfall is recognized directly in stockholders’ equity as a gain. This is because the windfall is considered to be an equity item as it results from fluctuations in the market value of the shares, which is a transaction between shareholders.

A is incorrect: Under IFRS, tax windfalls are not recognized as a decrease in income tax expense but are instead recorded directly in equity.

B is incorrect: A tax windfall results in a gain, not a loss, to stockholders’ equity.

Reading 12: Employment Compensation: Post-Employment and Share-Based

Los 12 (b) Explain how share-based compensation affects the financial statements.