There are just a few months to go until the biggest accounting change to hit share schemes in several decades comes into effect. The International Accounting Standards Board (IASB) published new rules for the treatment of employee share schemes on 19 February this year. The rules, known as FRS 20, come into effect from 1 January 2005 for public companies and a year later for unlisted businesses.
The new standard means that charges will be made to a company’s profit and loss statement for the fair market value of share-based payments, including all staff share option schemes.
Even though there are several months before D-Day, Malcolm Hurlston, chairman of the Employee Share Ownership Centre (ESOC), believes in formulating strategy as soon as possible, because the choices that employers make now can have a serious impact on the company’s apparent bottom line.
The profit and loss charge is clearly identified in the accounts. To a certain extent, it is likely to be discounted by analysts, but it will have an impact on public perceptions and tax liabilities. So Hurlston recommends: “The first thing I would do is ask for a meeting with my external share scheme provider(s) because you need an assessment now of what the implications are likely to be for your company’s pre-tax profits.”
Very few UK companies to date have made any disclosure of the costs involved but HBOS has quoted an unaudited estimate of £100m in its 2003 accounts and British Land (see box below) reported a charge for share schemes in 2004 of £7.1m compared to £5.4m the previous year. Research by the Halliwell Consultancy suggests that the average profit hit would be £68m each among the top FTSE 100 companies and an average of £5.7m each among the FTSE 250. However, this masks wide variations. A number of variables, including the extent of options use, can drive the profit hit up towards 50%, while other companies may only see 1% or less.
The fact that the actual market price when options vest may be significantly different to the estimated fair market value price used in the accounts means that companies will have to use sophisticated financial models to estimate the charge. “The choice of [valuation] model and assumptions, such as volatility of share price, can have a big effect on the size of the charge,” explains Peter Jauhal, senior executive compensation consultant at Hewitt Bacon & Woodrow.
He cites the example of a company that went public several years ago. Early in its life as a listed company, the share price jumped up and down by as much as 40%. Over the past couple of years, the volatility has settled down to a much narrower range. Selecting the more recent time period and using a range of stable industry peers as a benchmark tempered the output of the financial model and significantly reduced the eventual profit and loss charge the company will take.
However, not all models are created equally. One method of valuing options is the Black-Scholes formula for calculating the value of European stock options. It is widely used in different circumstances but may not be ideal. Advisors such as Lane, Clark and Peacock recommend a ‘binomial’ model that can account for factors such as staff turnover and performance. Another valuation model that is being mentioned is the aptly-named Monte Carlo method.
This isn’t going to be a one-time valuation either. The first year should be fairly straightforward but as time goes by the books will account for leavers, lapsed options and performance-related variations. Where options do not vest because employees leave or because certain performance targets are not met, then charges made in previous years can be credited. In addition, valuations need to be re-measured each year. Getting it right from the start will be important.
The use of performance targets that are not related to the market price of the underlying shares may become very attractive. Measures such as employee performance or earnings per share allow some flexibility year-on-year to adjust the size of the charge in a conscious, deliberate way. This is likely to be a significant factor in the construction of new schemes that are optimised for the new rules.
Just as important will be the record-keeping that will enable full compliance. Justin Cooper, managing director of share plans at Capita, says: “I would be counselling companies with plans to be in contact with their professional advisers and either software providers or third-party administrators to ensure that they are all fully aware of the standards and that their software platforms will be able to generate the necessary statistics.”
Most commentators believe that very few major companies will stop all-employee schemes altogether. The link between them and company performance is well-demonstrated. The ESOC’s Hurlston says: “What is far more likely is that some big companies will perhaps rein in some schemes as they mature. They will hone in on employee share plans like the share incentive plan which is not based on options but on employees buying shares because the hit on pre-tax profit is less.” Indeed, Halliwell’s report suggests that using whole shares rather than option grants could reduce the charge by as much as 60%.
Of course, any change has significant HR implications, especially as firms are going to be looking for a bigger return on such schemes now that they are no longer ‘free’ in accounting terms. “We’re seeing varied responses at the moment,” says Capita’s Cooper. “Some companies are still sticking their heads in the sand.”
As companies wake up to the implications, there’s going to be a lot of hand-wringing and looking over well-tailored shoulders at the competition. However, the outlook is not totally bleak. There are several important decisions those companies can make today that can substantially alter the impact of share schemes on the profit and loss account and, potentially, increase their benefits. These include choice of valuation model, scheme design and target-setting. In addition, switched-on HR departments are using this opportunity to restate the case for employee share participation and communicate the benefits to staff more clearly.
British Land is one of only a handful of firms that have already implemented the new rules in their published accounts, a year early of mandatory deadlines. It saw a £7.1m hit on its bottom line for 2003. Peter Jauhal, a senior executive compensation consultant at Hewitt Bacon & Woodrow, was involved in the process. “The problem was primarily the timeframe. The rules only came out in February and their year-end was March so we didn’t have much time to analyse the data to meet the print deadlines for the annual report.”
Because their option schemes were based around net asset value rather than the market price of the shares, modelling the impact of the charge was relatively straightforward using Black-Scholes.
“In terms of scheme design they already had the optimal scheme in place from an accounting point of view,” he says. “With this sort of scheme design you can adjust the charge to allow for the fact of whether the performance condition is met. With a shareholder return basis you can’t adjust for the fact that the condition is not met.”
QinetiQ is not a public company, but with 9,000 staff and a hi-tech core business, it has a number of option schemes in place and it is looking forward to January 2006 when all companies will have to account for share-based payments, not just public ones. It is reviewing a range of new schemes and assessing existing plans.
“I’m looking at the tax-efficient side of things and looking at a share incentive plan whereby staff can purchase shares out their gross income,” says John Leighton-Jones, head of reward and performance. “We have a stock option scheme where we have given options to all the employees in the company,” he adds. “It’s an Inland Revenue-approved scheme and we’re going to have to account for that. It’s being done by the financial controller and they’re using Black-Scholes.”
He acknowledges that such modelling relies on quantifying many unknown variables and expects to use a third party firm to help with the details. “We’ll probably go forward with a restricted share or performance share basis with executives. What we’re likely to do for executives is, if they have a cash bonus, we might convert some of that bonus into shares with the potential to earn additional shares based on company and individual performance. There’s still an accrual in the profit and loss account but it comes from another angle because it gives the executives a downside.”
He argues that such a scheme may also help with retention. However, his main concern in dealing with the interrelated complexities of the new rules is that they have the potential to put HR and finance at loggerheads. “You’ve got the HR motivations to get the schemes out there but then you’ve got the financial side and the impact on the profit and loss. Before we were all going in the same direction. Not now.”