Pinsent Masons' guide to accounting for employee share plans

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PINSENT MASONS' GUIDE TO ACCOUNTING FOR EMPLOYEE SHARE SCHEMES

CONTENTS

Section Page

Evolution of Share Based Payment 1 Reason for Standard 1 FAS123 1 UITFs 13 and 17 1 G4 plus 1 Discussion Paper 2 Enron 2 Exposure Drafts 3 EU Adoption of International Accounting Standards 3 Publication and Future Development of IFRS2/FRS20 3 Share Based Payment Standards: IFRS2 and FRS20 4 Fair Value 4 Vesting Conditions 4 Truing Up 4 Exemptions 5 Scope of Standards 5 Accounting 5 Cash Based Awards 5 Variable Vesting Period 6 Modifications 6 Cash Cancellation Payments 6 Comparative Results 7 Option Pricing Theory 7 Black Scholes 7 Cox Ross Rubinstein 8 Black Scholes Six Assumptions 9 Volatility 9 Expected Life 9 Capital Structure 10 Intrinsic Method 10 Disclosure Requirements of Standards 10 Principle of Disclosure 10 Award Disclosure 10 Disclosure of Fair Value Assumptions for Options 11 Disclosure of Fair Value Assumptions for Non-Options 11 Modifications Disclosure 12 Accounting Disclosure 12 Accounting for Employee Benefit Trusts 13 De facto Control 13 Accounting for Shares 13 Dividends and Earnings per Share 13 Financial Assistance 13 Distributable Reserves 14

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EVOLUTION OF SHARE BASED PAYMENT

Reason for Standard

As employee share schemes became more widespread during the 1980s and 1990s concern grew amongst Accounting Standard Boards ("ASBs") around the world that there were no modern and comprehensive accounting standards ("Standards") for employee share schemes. It was considered that there was a risk of inconsistent and unsound treatments which could materially distort results and detract from the comparability of corporate performance.

FAS123

The first serious attempt at a comprehensive accounting Standard occurred in the United States in the mid-1990s when the United States Financial Accounting Standards Board ("FASB") released Financial Accounting Standard No. 123 ("FAS123"). This required US companies to account for the awards of shares or share options at fair value and charge an expense through the Income Statement on the basis that equity incentives were a form of compensation. The proposals met with considerable resistance and, facing a threat by Congress to suspend its funding, FASB backed down and allowed FAS123 to be a voluntary Standard.

Essentially companies were allowed to choose whether to include fair value based expenses in their Income Statements. By 2002 only two of the Fortune 500 companies had done so. Those companies that chose not to adopt FAS123 for their Income Statements were instead required to make footnote disclosures stating what would have been the impact on reported earnings if they had applied the Standard.

One of the key arguments of opponents of FAS123 was that its adoption by the United States alone without similar Standards elsewhere in the world would put US businesses at a relative competitive disadvantage. Partly in response to these concerns the next step in the development of an accounting Standard involved an attempt to internationalise the issue with the publication in 2000 of a discussion paper by a group known as the G4 plus 1. This consisted of representatives of the US, Australian and New Zealand, UK and Canadian ASBs plus the International Accounting Standards Board ("IASB"). Its key proposals were broadly similar to those of FAS123.

UITFs 13 and 17

By this time accounting for employee share schemes in the United Kingdom was governed primarily by two Accounting Abstracts – UITF13 and UITF17. They were intended as short term solutions while a full scale accounting Standard was developed. UITF13 was concerned with accounting for employee benefit trusts ("EBTs") while UITF17 took the first steps towards establishing a basis for recognising an accounting expense.

UITF13 was essentially an extension of FRS5 which is the UK accounting Standard ("Reporting the Substance of Transactions") which requires financial accounts to reflect the economic substance of transactions rather than their legal form. The Abstract required that, if an EBT was under the de facto control of the company that had sponsored the trust, the assets and liabilities of the EBT should be treated "as if" they were assets and liabilities of the sponsoring company. As trust assets are only available for the beneficiaries, many people found quite troubling an accounting treatment that ignored the legal distinctions between the company and the trust.

Furthermore the "as if" accounting required by UITF13 whereby the assets and liabilities of the trust were treated as belonging to another entity was in itself somewhat novel. The Abstract could merely have required the trust to be treated as if it were a quasi subsidiary of the sponsoring company so that its assets and liabilities would be included only within the consolidated accounts of the sponsoring company. The "as if" treatment was apparently

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preferred to the subsidiary treatment on the grounds that the trust was thereby spared the burden of the additional disclosure requirements of being classified as a quasi subsidiary.

UITF13 caused a number of accounting problems and paradoxes. For example it was not clear how it should be applied within groups. Eventually it became the generally accepted view that it would be difficult to apply "as if" accounting to subsidiaries as well as the parent. Another unusual feature of UITF13 was the requirement that shares in the EBT were treated as fixed assets despite having few of the normal characteristics of fixed assets. This treatment at least had the advantage of requiring less frequent revaluations of the shares than a current asset treatment might have required. Instead only if the fall in the value of the shares was permanent was it necessary to reflect it in the corporate accounts.

UITF17 required equity instruments to be valued at fair value. However, it did not specify how fair value should be measured. It merely required that as a minimum the company should recognise as an expense the difference between the market value of the shares at the date of grant and the employee's cost of acquiring the shares. If the award were satisfied by shares acquired on the market, then for the UITF13 expense the cost to the EBT of acquiring those shares had to be substituted for the market value. As a consequence of UITF17, share awards normally resulted in a charge to the profit and loss account. However for options, unless they were granted at a discount to market value, there would normally have been no expense. For SAYE options, UITF 17 gave an exemption for the 20% discount available under such options. The overall result was a patchwork of rules with little intellectual coherence where the accounting expense could vary depending on how the shares were sourced.

G4 plus 1 Discussion Paper

The G4 plus 1 discussion paper published in 2000 provoked considerable controversy in the United Kingdom and a certain amount of debate in some other countries. However, FASB kept a low profile on the subject and in the United States, the paper attracted scarcely any attention. The key proposal of the paper was that an expense should be recognised for the fair value of employee share options and that the fair value should reflect the "hope value" of the option as measured by mathematical techniques known as option pricing theory.

The G4 plus 1 discussion paper argued that financial statements should reflect the cost of the services provided by employees and that the fair value of equity compensation arrangements should be recognised in that cost. Opponents argued that the equity arrangements were not necessarily compensation for services provided by employees and that where share options were satisfied by the issue of new shares there was no need for the accounts to recognise an expense because existing shareholders already suffered a dilution of their interests when the options were exercised. There was little common ground between these positions and it seemed that the outcome would be determined by the relative strength of the forces marshalled by each side, rather than the merits of their arguments. It was generally felt that non-American companies would be reluctant to accept the proposals unless the US position moved in the same direction, something which in 2000 seemed quite unlikely.

Enron

Although not directly linked with share scheme accounting, the collapse of Enron in 2001 and the subsequent crisis of confidence in US accounting and auditing Standards provoked a number of US corporations to reassess their opposition to FAS123. In some quarters support for Share Based Payment and voluntary adoption of FAS123 became a touchstone of good corporate governance and a significant minority of Fortune 500 companies chose to voluntarily adopt FAS123.

Exposure Drafts

On 7 November 2002 the IASB, which by this time had taken over responsibility for pioneering Share Based Payment from the by then defunct G4 plus 1, published ED2, its Exposure Draft

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on Share Based Payment. On the same day the UK's own ASB published its own Exposure Draft FRED31 which was virtually identical to ED2. Following their publication a consultation process attracted an unusually large number of comments. Although no clear consensus emerged in favour of the proposals, the IASB and the UK's ASB claimed that the support they had received from the financial analyst community gave them the authority to press on with producing final Standards broadly along the lines of the Exposure Drafts. However, one significant change from the Exposure Drafts was announced following the end of the consultation period. The IASB decided that the final Standard would require the "truing up" of awards. "Truing up" is an American expression which means that only an option or share award which vests counts towards an accounting expense.

EU Adoption of International Accounting Standards

In order to reduce barriers to capital markets, including differences in national accounting Standards, the EU announced in 2002 a Regulation (1606/2002) which requires all European companies on a regulated market within the EU to prepare their consolidated financial statements for all years beginning on or after 1 January 2005, in accordance with International Accounting Standards. This decision significantly enhanced the importance of International Accounting Standards. It also indirectly gave fresh impetus to Share Based Payment as successful implementation of the Standard came to be seen as crucial to the credibility of the new International Accounting Standards regime.

Publication and Future Development of IFRS2/FRS20

On 19 February 2004 the IASB published IFRS2 on Share Based Payment. It covers all Share Based Payment transactions other than business combinations (dealt with by IFRS3) but its main impact was intended to be on employee share schemes. On the same day the UK's ASB issued a press release announcing that it would in due course issue its own Standard FRS20, derived from the international Standard. FRS20 was published on 7 April 2004 and superseded UITF17. The Effective Date of IFRS2, 1 January 2005, was to set to coincide with the start date of the EU's Regulation requiring international Standards. FRS20 also set its Effective Date for listed companies as 1 January 2005 but for unlisted companies the Effective Date was 1 January 2006. Therefore for listed companies Share Based Payment is intended to apply for accounting periods beginning on or after 1 January 2005 and for unlisted companies for accounting periods beginning a year later.

After having allowed the IASB to make the running with Share Based Payment FASB issued its own Exposure Draft on revisions to FAS123 on 31 March 2004. This Exposure Draft proposed that for accounting periods beginning on or after 15 December 2004 the optional application of FAS123 would cease and instead an expense based on FAS123 would be a mandatory requirement.

The EU Regulation requiring the adoption of international accounting Standards by European listed companies only applies if the Standards have been approved by the EU. Approval is a relatively new process whereby the EU must satisfy itself that the Standard is "conducive to the European public good". A committee of experts known as the European Financial Reporting and Accounting Group (EFRAG) accepted representations until 5 April 2004 and its recommendations are awaited. However as far as UK companies are concerned because the UK ASB has decided to establish FRS20 based on the principles of IFRS2, UK companies will be required to apply Share Based Payment regardless of any ratification of the International Standard by the EU.

Within the IASB there is a committee known as International Financial Reporting Standards Interpretation Committee (IFRIC) and it is anticipated that it will in future issue interpretations on the application of IFRS2. The revised FAS123 may also have significant implications on how IFRS2 and FRS20 are interpreted as the IASB and FASB intend to begin a convergence programme in 2005. The programme is intended to eliminate, as far as possible, differences between the International and American Share Based Payment Standards.

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SHARE BASED PAYMENT STANDARDS: IFRS2 and FRS20

Fair Value

IFRS2 and its sister Standard FRS20 require that all equity instruments are valued at their fair value at the date of grant. Equity Instruments are defined to include shares and share options. Furthermore it would appear that Equity Instruments are intended to include all equity interests including interests in shares. For share based awards the fair value is measured by reference to the market value of the shares at the date of grant. For share options, in the probable absence of a market value for the employee share option, fair values are to be determined by reference to mathematical methodologies known as option pricing theory.

Vesting Conditions

These fair values can be adjusted to take into account the impact of vesting conditions. Vesting conditions are defined as including performance and service conditions but unlike the proposed revised FAS123, do not appear to be exclusively limited to these. If an option pricing model is used the model may itself be adjusted to incorporate vesting conditions. However, it is also acceptable to adjust the outcome of an option pricing calculation for the probable outcome of a vesting condition. The resulting cost is then spread over the relevant period of service of the employee which the Standards envisage in most cases will be equivalent to the vesting period.

Truing Up

In general, the Standards require accounting expenses to be "trued-up" to reflect the outcome of the vesting conditions. This means that the cumulative expenses charged in the Accounts should only reflect the equity instruments that actually vested. Therefore if following the award, in the earlier years, charges were accrued which assumed that certain awards would vest but subsequently did not vest, these expenses should be reversed. Similarly if, at the outset of the award, fewer instruments had been assumed to vest than actually did the accounting expenses in later periods should be adjusted upwards.

There is a major exception to this treatment in respect of market conditions. These are defined to include performance conditions based on share price or share price growth or the achievement of a specified target that is based on the market price of the company's shares relative to an index of other companies. Although the Standards make no reference to Total Shareholder Return ("TSR") we understand that the IASB concluded that TSR targets were market based. The effect of treating a vesting condition as a market condition is that truing up is not permitted. This means that at the time of grant the vesting assumptions and resulting accounting expenses are fixed regardless of whether market conditions are satisfied.

The requirement for truing up only applies to non-market based vesting conditions. Truing up does not apply to the six key assumptions of option pricing theory. Truing up is not permitted merely because an option lapses or fails to be exercised. Under the Standards there can be expenses even if no shares are issued or awarded.

Exemptions

Unlike UITF17 with its exemption for SAYE schemes, the Standards make no exemptions for all employee or broadly based employee share schemes. The Standards apply to both listed and unlisted companies. There are therefore no exceptions for private companies apart from in the UK where small enterprises can prepare their accounts under the Financial Reporting Standard for Small Enterprises known as FRSSE. This is a simplified accounting regime for small companies, defined in s274 Companies Act 1985, as being a company which meets at least two of the following conditions for at least two of the last three financial years:-

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• turnover of £2.8 million or less;

• balance sheet total (gross assets) of £1.4 million or less;

• average number of employees, 50 or less.

By preparing accounts under FRSSE a company is exempt from all other accounting Standards and Abstracts. A company which adopts FRSSE has to do so in its entirety – it cannot pick and choose which Standards to adopt. FRSSE is not available to PLCs or certain companies in the financial sector.

Scope of Standards

Under Share Based Payment the method of delivery of shares is considered to be irrelevant to determining the accounting expense. Therefore it is of no consequence to IFRS2/FRS20 whether the shares are satisfied by an employee benefit trust, treasury, new issue or from an existing shareholder. The Standards are effective for all equity instruments granted after 7 November 2002 (the date of the Exposure Draft) which have not vested by the Effective Date. This is 1 January 2005 for listed companies and 1 January 2006 for unlisted companies. Therefore, generally, options and awards made before 7 November 2002 can be ignored for the purposes of Share Based Payment and awards made after that date can also be ignored providing that they have vested by the Effective Date.

Accounting

The Standards apply to awards of equity instruments which the Standards call equity settled Share Based Payment transactions and to cash based bonuses where the bonus is determined by reference to the share price of the company. These are described by the Standards as cash settled Share Based Payment transactions. Therefore phantom option schemes are within the scope of the Standards. The accounting entries for equity based compensation and cash based compensation are different. In both cases the expense is recognised as a debit to wages and salaries. For equity based compensation the corresponding credit is to an equity account within shareholder funds whereas for cash based awards the corresponding credit is to a liability account within creditors on the balance sheet.

Cash Based Awards

The Standards distinguish between two types of cash based awards or phantoms. Awards where the bonus is based on the appreciation in the share price (ie equivalent to an option) and awards where the value is based on the actual value of the shares and so is more akin to a share award or L-TIP. For appreciation awards the Standard requires the calculation of a liability at each financial year end using option pricing theory with the ultimate overall expense "trued up" to equal the final bonus actually paid. Where the bonus is based on the value of the share itself, at each financial year end the creditor is determined by reference to the market value of the share at the year end in a process known as "marking to market".

If an employee can choose whether to receive an award as a cash based bonus or an equity based bonus then the Standards require the award to be accounted for as a cash settled Share Based Payment transaction. If the employer is required to treat the award as a cash based bonus or where there is a choice for the employer but there is a regular pattern of awards being satisfied by cash payments then the Standards require that the award should be accounted for as a cash settled Share Based Payment transaction. Therefore companies which have a discretion but habitually satisfy awards by making cash payments may through establishing a pattern of regular payments find that a cash settled Share Based Payment treatment is mandatory.

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Variable Vesting Period

If the vesting period varies depending on when a vesting condition is satisfied (eg if the vesting condition is an exit event such as a flotation) the expected vesting period should be estimated on the basis of the most likely outcome of the condition. If the condition is a market condition the estimated length of the expected vesting period shall not be subsequently revised. If the performance condition is not a market condition the company should revise its estimated length of the vesting period if subsequent information indicates that the actual length differs from a previous estimate.

Modifications

One of the most complex areas of the Standards concerns the treatment of modifications to awards. A modification could include for example a change in performance conditions, a change in the terms of an option or at its most extreme outright cancellation of an option. The general rule for modifications is that whatever the accounting cost calculated at the time of the original grant, at least that cost must be charged to the profit and loss account. There is therefore no scope for a modification to reduce the overall accounting expense. If the option is cancelled then any cost which has yet to be charged must be expensed immediately. However if the modification gives rise to a change in the equity instrument then it is necessary to compare the fair value of the instrument before and after that change. If there is an increase, that increase must be recognised as an additional expense over the remaining period over which the option is expensed.

Modifications would arise where there are surrenders and regrants of options either as a result of an internal reorganisation or an external takeover. In a takeover although replacement options might be equivalent for tax purposes, their fair value using option pricing theory might be substantially different. The wide definition of modifications means that any change in the terms of award potentially could give rise to additional expenses. A further pitfall for the unwary is that a modification of a pre 7 November 2002 award could be sufficient to bring the award within the scope of the Standards.

Cash Cancellation Payments

If a company chooses to make a cash cancellation payment to an optionholder equivalent at least to the option gain and a pattern of such payments has not been established, the share option continues to be treated as an equity settled Share Based Payment transaction. The cancellation is a modification of the award and any outstanding expenses will have to be expensed immediately through the Profit and Loss Account. The cash cancellation payment itself must first be deducted against the credit balance in equity arising from the Share Based Payment transaction with only the excess (if any) being charged through the Profit and Loss Account. In SAYE schemes employees may choose to reclaim their savings rather than exercise their options. This return of savings is not a cash cancellation payment as the employees merely recover their own money (with possibly interest).

Comparative Results

For equity settled Share Based Payment transactions the Standards are partially retrospective as they apply to grants of shares, share options or other equity instruments that were granted after 7 November 2002 and had not yet vested at the Effective Date. However, for cash settled awards the Standards are fully retrospective and apply to all outstanding awards. Companies are encouraged, but not required, to apply the Standards to other grants of equity instruments but only if the company has previously publicly disclosed the fair value of these instruments. For all grants of equity instruments to which the Standards apply, the company must restate comparative information and, where applicable, adjust the opening balance of retained earnings for the earliest period permitted.

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OPTION PRICING THEORY

Black Scholes

The Standards require options to be valued at their fair value. In the likely absence of actual market values existing for employee share options, the Standards direct preparers of accounts towards option pricing theory as a means of calculating the fair value. Option pricing theory involves the use of advanced mathematical techniques to measure the value of an option including its "hope" value. The best known form of option pricing theory is Black Scholes which may mathematically be expressed as follows.

For the less mathematically inclined, the formula can appear quite daunting and its formulation was sufficient to win Black and his co-worker Merton the 1997 Nobel Prize for Economics. In fact the formula involves the application of long standing thermo-dynamic equations to financial derivatives. Underpinning the mathematics is an assumption that share prices move in a largely random manner and despite this at first sight somewhat implausible assumption, Black Scholes and its derivatives have been found to be useful bases for pricing traded options and other quoted financial derivatives. However, it remains questionable whether the methodology is transferable to employee share options which are inherently non-tradable and can have quite different features and conditions.

SN(d1) – e-r∆ t XN(d2)

where:

d1 = ln(S/X) + (r + σ2/2)(∆t)

σ√∆t

d2 = ln(S/X) + (r - σ2/2)(∆t)

σ√∆t

and where:

S = share price

X = exercise price

t = amount of time remaining to expiration

σ = volatility

r = risk free interest rate over the life of the option

e = exponential constant

N = normal distribution function

N(d1) = rate of change in the option’s price with respect to a change in the share price

N(d2) = probability that the option will be exercised

and ln means log normal

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Cox Ross Rubinstein

In response to some of these concerns the IASB, while making clear that it did not wish to be prescriptive about the particular methodology or option pricing theory used by companies, nonetheless suggested that a derivative of Black Scholes known as Cox Ross Rubinstein (otherwise known as the binomial method or the lattice method) was preferable in most circumstances. Cox Ross Rubinstein allows considerably more factors to be modelled than a basic Black Scholes formula. For example options can be assumed to be exercised over a period of time rather than on the single date Black Scholes requires. Different assumptions can be made for different time periods. However it remains to be demonstrated conclusively that the greater range of choices afforded by Cox Ross Rubinstein provides a significantly improved accounting expense compared with Black Scholes.

Black Scholes Six Assumptions

While not prescribing any particular form of option pricing theory the ASB nevertheless has made it a mandatory requirement of the Standard that the six basic Black Scholes assumptions are used in whatever model is applied. These are:-

• the exercise price of the option;

• the market value of the shares at the date of grant;

• the risk free rate of return;

• the expected dividend yield;

• the expected life of the option; and

• the volatility of the share price.

Volatility

For many companies the key factor that will determine the value of the option and the resulting accounting expense will be the company's share price volatility assumption. In option pricing theory, volatility is a mathematical concept which in the Standards is defined as the "annualised Standard deviation of the continuously compounded rates of returns on the share over a period of time". The Standards give some guidance as to how it should be determined. They suggest that if the company has a market in derivatives of its own shares then an implied volatility figure may be derived from the derivative prices. However quoted financial derivatives often have a much shorter life than employee share options so their relevance is debatable.

Most quoted companies will wish to refer to their historical record of share price volatility but a company's share price volatility can vary substantially over different historical periods. The Standards state that the volatility period might be assessed historically over a period equal in length to the expected life of the option. However as the past is not necessarily a guide to future volatility the Standards also suggest that times of exceptional volatility may need to be excluded from any forward projection.

Unlisted companies will normally not have historical share prices from which to estimate future volatility. The Standards suggest such a company could consider the historical or implied volatility of the share prices of similar listed companies where it has based its estimate of its own share value on the share prices of those companies. Alternatively the Standards propose that unlisted companies could consider the volatility of their net assets or earnings.

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Expected Life

Option pricing theories were developed for traded options and use contractual lives in their calculations. For consistency the Standards might have required the use of contractual lives in the option pricing calculations. However had they done so the Standards would probably have had to accept that some discount would be necessary for the non-marketability of an employee share option. Rather than allow the issue of discounts for non-marketability to be opened up the Standards require the use of expected option lives rather than contractual lives, arguing that the use of the shorter expected lives compensate for the lack of a discount for non-marketability. The Standards define expected life as "the period of time from grant date to the date on which the option is expected to be exercised" and identify a number of factors which may be relevant in assessing the expected life.

Capital Structure

Option pricing theory assumes that the shares which satisfy options will be acquired on the market. However if employee share options are satisfied by new issue, there will be a dilution which in turn will reduce the value of the options. Therefore the Standards accept that a discount may be necessary to reflect this capital structure or dilution effect. In many cases the effects on the value of an option may be immaterial.

Intrinsic Method

In exceptional circumstances the Standards concede that it may not be possible to apply option pricing theory. In what the Standard expects to be rare cases a company is allowed to account for options using what the Standards call the Intrinsic Method. This involves recognising at each year end the difference between the market value of the share at that date and the exercise price of the option so that over the vesting period of the option an expense is charged equivalent to the optionholder's gain on exercise.

DISCLOSURE REQUIREMENTS OF STANDARDS

Principle of Disclosure

The Standards refer to a "principle of disclosure" which requires companies to: "disclose information that enables users of the financial statements to understand the nature and extent of Share Based Payment arrangements that existed during the period".

Award Disclosure

To give effect to this principle companies are required to disclose at least the following:-

• a description of each type of Share Based Payment arrangement that existed at any time during the period, including the general terms and conditions of each arrangement, such as vesting requirements, the maximum term of options granted, and the method of settlement (eg whether in cash or equity). A company with substantially similar types of Share Based Payment arrangements may aggregate this information, unless separate disclosure of each arrangement is necessary to satisfy the principle;

• the number and weighted average exercise prices of share options for each of the following groups of options:-

• outstanding at the beginning of the period;

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• granted during the period;

• forfeited during the period;

• exercised during the period;

• expired during the period;

• outstanding at the end of the period;

• exercisable at the end of the period;

• for share options exercised during the period, the weighted average share price at the date of exercise. If options were exercised on a regular basis throughout the period, the entity may instead disclose the weighted average share price during the period;

• for share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life. If the range of exercise prices is wide, the outstanding options shall be divided into ranges that are meaningful for assessing the number and timing of additional shares that may be issued and the cash that may be received upon exercise of those options.

Disclosure of Fair Value Assumptions for Options

There are also disclosure requirements for the assumptions made in the calculation of the fair value of equity instruments. For share options granted during the period the Standards require disclosure of fair value of those options at the measurement date and information on how that fair value was measured, including:-

• the option pricing model used and the inputs to that model, including the weighted average share price, exercise price, expected volatility, option life, expected dividends, the risk-free interest rate and any other inputs to the model, including the method used and the assumptions made to incorporate the effects of expected early exercise;

• how expected volatility was determined, including an explanation of the extent to which expected volatility was based on historical volatility; and

• whether and how any other features of the option grant were incorporated into the measurement of fair value, such as a market condition.

Disclosure of Fair Value Assumptions for Non-Options

For other equity instruments granted during the period (ie other than share options). the number and weighted average fair value of those equity instruments at the measurement date, and information on how that fair value was measured, including:-

• if fair value was not measured on the basis of an observable market price, how it was determined;

• whether and how expected dividends were incorporated into the measurement of fair value; and

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• whether and how any other features of the equity instruments granted were incorporated into the measurement of fair value.

Modifications Disclosure

For Share Based Payment arrangements that were modified during the period:-

• an explanation of those modifications;

• the incremental fair value granted (as a result of those modifications); and

• information on how the incremental fair value granted was measured, consistently with the requirements set out above, where applicable.

Accounting Disclosure

In order for users of the financial statements to understand the effect of Share Based Payment transactions on the company's profit or loss for the period and on its financial position the company shall disclose at least the following:-

• the total expense recognised for the period arising from Share Based Payment transactions including separate disclosure of that portion of the total expense that arises from transactions accounted for as equity settled Share Based Payment transactions;

• for liabilities arising from Share Based Payment transactions:-

• the total carrying amount at the end of the period; and

• the total intrinsic value at the end of the period of liabilities for which the counterparty's right to cash or other assets had vested by the end of the period (eg vested share appreciation rights).

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ACCOUNTING FOR EMPLOYEE BENEFIT TRUSTS

De facto Control

On 15 December 2003 the Urgent Issues Task Force ("UITF") of the UK's ASB issued UITF Abstract 38 ("UITF38") on Accounting for ESOP trusts. It superseded UITF13 for accounting periods ending on or after 22 June 2004. The new Abstract is similar to UITF13 in that it requires the same controversial "as if" accounting for trust assets and liabilities if the sponsoring company has de facto control of the trust. UITF38 states that there will generally be de facto control "where the trust is established in order to hold shares for an employee remuneration scheme and may be so in other circumstances".

Accounting for Shares

However the treatment of the company's own shares in the trust is significantly different. UITF 38 requires the consideration paid for unallocated shares in an EBT to be treated as a deduction from the shareholders' funds of the sponsoring company. Under UITF13 shares were treated as fixed assets own shares. The immediate consequence of this change is that net assets of the parent company and consolidated accounts of the group are reduced because the shares in the trust are removed from fixed assets.

The Abstract states that "consideration paid or received for the purchase or sale of the company's own shares in an ESOP trust should be shown as separate amounts in the reconciliation of shareholders funds" and that "no gain or loss should be recognised in the profit and loss account or statement of total recognised gains and losses on the purchase, sale, issue or cancellation of the company's own shares".

In respect of corresponding amounts UITF38 requires that "balance sheet amounts should be restated to reclassify the company's own shares as deductions in arriving at shareholders' funds at the amount of the consideration paid for the shares. Amounts in respect of the profit and loss account should be restated where applicable, for comparative periods. Therefore if there have been any provisions made in the past against the carrying value of the shares, say, because of a permanent fall in their value or because options have been granted at an exercise price below the cost of acquiring the shares, these expenses shall be reversed. Furthermore, in the future, the profit and loss account will not recognise any profits or losses in respect of shares held in an EBT.

Dividends and Earnings per Share

UITF38 confirms the existing practice for dividends and states that "any dividend income arising on own shares should be excluded in arriving at profit before tax and deducted from the aggregate of dividends paid and proposed. The deduction should be disclosed if material". UITF38 also confirms the treatment in FRS14 (Earnings per Share) that shares in an EBT should be treated as if they were cancelled when calculating Earnings per Share. UITF38 requires that finance costs and any administration expenses should be charged as they accrue and not as funding payments made to the ESOP trust.

Financial Assistance

The reduction in net assets arising from UITF38 may have implications for banking covenants, but the greatest implication may concern financial assistance. In the past, when a company made a loan to an EBT for the purchase of shares, this was financial assistance under section 151 Companies Act 1985. However, it was exempt financial assistance, as it was in connection with an employee share scheme. If the company was a PLC, for the exemption to apply, a further test needed to be satisfied, namely that, under section 154 Companies Act 1985, there had been no reduction in net assets as a result of the financial assistance.

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The problem that UITF 38 creates is that, by removing shares in the EBT from the net assets of the company, there is such a reduction. This reduction in net assets is not the conclusive issue because the exemption can still apply, providing there are sufficient distributable reserves in the company to cover the reduction in net assets. However, for companies with nil or small distributable reserves, it may be difficult for EBTs to acquire shares.

Within the Companies Acts, there are no provisions whereby the operation of the test to compare distributable reserves with the reduction in net assets follows through into a direct reduction of distributable reserves. However, there is some concern that the "debit" or reduction in shareholders' funds required by UITF 38 for the EBT's shares is tainted by the section 154 test and, as a result, creates a reduction in distributable reserves.

Distributable Reserves

The treatment of distributable reserves is the subject of some uncertainty at present as a result of UITF 38 and FRS 20. It is understood that the Institute of Chartered Accountants (England and Wales) ("ICAEW") has a working party currently reviewing its advice concerning distributable profits. This was last published as ICAEW: TECH 7/03 Guidance on the Determination of Realised Profits and Losses in the Context of Distributions under the Companies Act 1985 in April 2003. Until it reports or there is a case heard before the courts on the issue, uncertainty as to the impact on distributable profits is likely to remain.