Issues Associated With Accounting for Share-based Compensation

Share-based compensation is a way of paying company employees with shares from the business. It is a way of motivating employees beyond their regular salaries and bonuses, which are cash-based. It also aligns the employees’ interests with those of the shareholders. It includes stocks and stock options.

Under IFRS and US GAAP, a company needs to disclose its annual report vital elements of management compensation.

Advantages

• Requires no initial capital outlay.
• Aligns the interests of employees and shareholders.
• It can take different forms, those that are equity-settled and those that are cash-settled.
• Creates an incentive for employees to stay at the company for longer.

Disadvantages

• It is treated as an expense and thus as a reduction in earnings even when no cash changes hands.
• Stock options dilute earnings per share.
• It does not necessarily provide the desired incentives since the recipient has limited influence over the company’s market value.
• Increasing ownership may lead managers to be risk-averse due to fear of a substantial decline in market value-driving them to seek managers to seek less risky projects.
• In contrast, managers may seek more risky projects since options have skewed payouts that reward excessive risk-taking.

A compensation expense is reported during the period in which employees earn a salary. It is relatively straightforward to account for cash payments and bonuses.

Share-based compensation includes stock, phantom shares, stock appreciation rights, and stock options. Compensation expense for share-based compensation is reported as a fair value under US GAAP and IFRS.

However, the specifics of accounting depend on the type of share-based compensation. Both IFRS and US GAAP requires the following disclosures for share-based compensation:

• The nature and extent of share-based compensation arrangements during the period.
• How the fair value of a share-based compensation arrangement was determined.
• The effect of share-based compensation on the company’s income for the period and on its financial position.

Implications in Financial Modelling and Analysis

While the compensation expense does not require any cash, it has an economic impact on the business as the number of shares outstanding increases.

Analysts may decide to analyze this line of the issue by:

• Treating the expense as a cash item (don’t add it back).
• Adding it back and increasing the number of shares outstanding by the number of shares awarded to employees (both vested and non-vested).

Question

Which of the below statements is least likely accurate?

A. Share-based compensation aligns the interests of employees and shareholders.

B. Share-based compensation increases the number of shares outstanding and therefore decreases the future share price.

C. Companies do not need to recognize share-based compensation under US GAAP and IFRS.

Solution

The correct option is C.

Recognition of compensation expense for share-based compensation at fair value is a requirement under both US GAAP and IFRS to 

A is incorrect. Share-based compensation refers to rewards that a company gives to its employees in terms of equity ownership rights intending to align the interests of shareholders and the company’s employees.

B is incorrect. Share-based compensation is treated as an expense, which implies a reduction in earnings. In addition to this, stock options have the potential to dilute earnings per share. Issuing share-based compensation increases the number of shares outstanding. What this means is that each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

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

LOS 12 (g) Explain issues associated with accounting for share-based compensation.