Jason Haseldine October 2002
This paper identifies the current lack of international accounting standards within the use of employee share options. It highlights the debate amongst users and preparers of financial statements over the accounting treatment of the ‘cost’ associated with employee options.
An analysis of share options is provided. This analysis whilst brief, identifies what type of options are available and to what extent they are used within society.
The report then defines expense under SAC 4 and provides arguments both for and against, concluding that share options are an expense and should be treated as such.
The economic consequences associated with the adoption of accounting standards are addressed. It raises concerns that the industry (principally the technology industry) may be subject to adverse effects based on the elimination or reduction of employee share options. A decline in this industry could affect the economy on a larger scale. The report signifies the importance of neutrality when setting standards, whilst economic consequences are also important they need to be addressed by a body separate from the standard setter.
There has been considerable debate within the business community regarding the appropriate accounting treatment of employee share options within the General Purpose Financial Reports. The debate consists of whether the transaction associated with employee share options is an expense and how it should be recognised within the financial statements?
The International Accounting Standards Committee Foundation (IASCF) has raised concerns about the lack of an international standard, despite the increasing use of share-based payments.
Few countries have adopted an accounting standard on this topic, thus promulgating a Discussion Paper “Accounting for Share-Based Payment: G4+1 Proposals” released in July 2000. The Paper proposed “employee share options be recognised in an entity’s financial statements to reflect the receipt and consumption of employee services and the issue of equity instruments.”
The majority of responses to the Discussion Paper were from prepares of accounts within the USA who strongly opposed proposals set forth by G4+1. Preparers of accounts reacted negatively to the proposal on the basis that it would reduce their ability to recruit; it would raise their expenses and ultimately reduce economic growth.
Users of accounts unanimously agreed with the proposal, expressing concerns that the elimination of share options from the financial statements can impact a users economic decision.
The purpose of this paper is to identify the nature of share options and articulate this form of transaction as an expense according to the Statement of Accounting Concepts 4 (SAC 4): “Definition and Recognition of the Elements of Financial Statements”. This paper assesses the economic consequences and their role within accounting standards and identifies arguments both for and against the expensing of employee share options.
NATURE OF SHARE OPTIONS
Share options were first used in the 1940s and 1950s as bonuses for key executives. Today they are a device principally used to induce and retain both employees and senior executives.
The nature of share options is articulated within the “Employee Share Scheme Guidelines” May 2000, as having a purpose, “Employee share schemes enhance and promote the achievement of common goals between employees, shareholders and the company. Participation in share ownership schemes provides major incentives for employees to increase productivity and share the rewards of the success of the company.”
Today there are a number of share options available within organisations. Two of the more common types, as stated in “Accounting for Share-Based Payment: G4+1 Proposals” are:
These plans offer an employee the right to purchase a number of common shares at a fixed price for a specific period of time.
Performance vesting share options:
Options do not vest until some performance criteria are met e.g. share price increases or meeting specified share price targets.
According to the National Centre for Employee Ownership in the United States, between 7 to 10 million employees are in receipt of options as at June 2000, this has increased from 1 million employees since 1990. The technology industry are the greatest user of options at 100% and also grant the highest percentage of outstanding share as options being 5-8% compared to 1.25% within the non-technical industries.
Employee shares options do not incur a ‘cost’ to the company from a cash flow perspective, as they are a paper transaction issued from the company’s share reserve.
Currently there are no statutory requirements to expense the value of employee shares or options against profits in the company’s accounts. Companies within the US and Canada are also entitled to ignore the value of share options within their financial statements however there is a requirement to present the value of such benefits with the notes to the accounts.
EMPLOYEE SHARE OPTIONS - EXPENSE
Are employee share options an expense? To answer this question we must establish the definition of an expense according to the Statement of Accounting Concepts 4 (SAC 4): “Definition and Recognition of the Elements of Financial Statements”.
Paragraph 117 states, “Expenses are consumption or losses of future economic benefits in the form of reductions in assets or increases in liabilities of the entity, other than those relating to distributions to owners, that result in a decrease in equity during the reporting period.”
The issue of shares within a company would result in an inflow of resources based on the fair value of the shares at that time. As these shares are offered to staff in return for services there is a consumption of that resource, hence reducing the company’s assets (albeit immediately), which must be disclosed within the financial statements based on the definition above.
By not accounting for employee share options within the financial statements, assumes the employee’s services were offered for free. This lack of reporting distorts the running costs of the company, as users of this information would be misled about the true input costs necessary to generate the revenues recorded. This could lead to users making incorrect economic decisions.
The user ought to know for example that Microsoft had $US 60 billion in outstanding employee stock options in 1999 and that it’s reported profits would have reduced some 18% in 1996 had these options been expenses in their financial statements.
SAC 4 identifies the criteria for recognition of revenues under paragraph 125. Using this definition “For a revenue to qualify for recognition, it must be probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred.” (emphasis added) supports the adoption of reporting the cost of employee share options. The revenue from the issue has been forgone for ‘another enhancement’ being employee’s salaries.
Certain members of the community believe that an employee share option is not an expense as defined by SAC 4, hence there is no requirement to report this ‘cost’ within a company’s financial statements.
Those that are against expensing include President George Bush and the New York Stock Exchange as mentioned in “AAR: Publication: Focus: Employees Share & Options Plans” July 2002, believe that this form of remuneration should not be expensed as this is a capital transaction resulting in a change of proprietorship, rather than an expense. It is the shareholders who pay the employee, not the company.
As stated in “AAR: Publication: Focus: Employees Share & Options Plans” July 2002, a “High Court decision Pilmer v Duke Group Limited 2001, held that a company suffers no loss when it issues shares as consideration for an acquisition where the shares have a market value greater than the value of the asset acquired”.
This case identifies from a legal perspective that a company’s economic value has not been reduced because of the options issued, the profitability is unaffected and there is no depletion of assets.
The National President of the Group of 100 Inc, Mr Tom Pockett, states in a letter to the IASB dated 15 December 2000,“that from an entity concept point of view the issue of shares and options does not constitute a cost to the entity on the grounds that the effect is to dilute the equity of existing shareholders.”
Their argument is that there is neither a reduction in the assets or an increase in the company’s liabilities, which is a requirement of an expense as defined by SAC4 above.
Economic consequences are a pertinent issue when discussing employee share options. Leo and Hoggett (1998) state “the consequences that an accounting standard may have on an industry, or the economy, as a result of those decisions being made.”
The anti expense lobby group raise a number of concerns over the expensing of options within the financial statements. Some of the concerns are based on the economic consequences that will be sustained as a result of expensing.
Mr Andrew Green Chief Executive of the Australian Venture Capital Association Limited highlights how expensing could result in the elimination or reduction of employee share schemes, thus reducing the capacity for start-up companies to attract and motivate high quality entrepreneurs. Moreover, expensing could potentially create an additional layer of contingent liabilities, thus placing companies on a more stringent solvency test.
The arguments against expensing within Australia can be derived from the Australian Conceptual Framework, as this Framework does not consider economic consequences when creating or revising accounting standards.
This conclusion is based on the comments from Malcolm Miller (AASB member 1991-1995) who did not believe the AASB took economic consequences into consideration. Further, Leo and Hoggett (1998) review SAC 2,3 and 4, review the international standard-setting bodies and analyse CLERP 1 to conclude that no clear guidance is provided as to whether the standard-setters need to consider economic consequences.
With recent corporate collapses both internationally (Enron, WorldCom) and nationally (HIH, Harris Scarfe) corporate governance is at the fore.
As the shareholder community continues to grow via privatization of government utilities, flexible superannuation structures and through employee share options, users are demanding transparency in employee remuneration and greater accuracy and consistency in reported earnings.
If users are suggesting that improvements are required to ensure reported earnings are true, then by not expensing employee share options results in a lack of neutrality. General purpose financial reports should be reliable and free from bias.
The exclusion of employee share options can mislead users about the true input costs necessary to achieve the revenue and reported earnings. This could increase the risk of users investing in that company and possibly lead to the excessive issue of shares. This argument enforces the concept of neutrality; the economic consequences are aligned by the market investing where true earnings are reported.
Contrary to this argument, is the ability of start-up companies (specifically technology company’s) to flourish by not expensing employee share options. Clearly there are economic consequences at play within the technology industry and the economy as a whole. The technology boom has carried the economy over the past 10 years and created vast job opportunities in its wake. An analysis of the economic consequences within this industry would be vital prior to the commencement of an expense standard.
SAC 3 Qualitative Characteristics of Financial Information preside over the debate to expense or not to expense employee share options.
SAC 3 analysises terms such as relevance, reliability and understandability. These terms are described in detail for a particular purpose and that purpose is to protect the user.
The user ought to know for example that Microsoft had $US 60 billion in outstanding employee stock options in 1999 and that it’s reported profits would have reduced some 18% in 1996.
Employee share options should be expensed. Companies don’t generate vast revenues and profits without paying vast salaries. The expense standard needs to be neutral and the economic consequences need to be assessed by a body independent of the standard setter.
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