📊Advanced Financial Accounting Unit 8 – Share-based Payments & Employee Compensation

Key Concepts and Definitions

• Share-based payments involve transactions where goods or services are received as consideration for equity instruments (shares or share options) of the entity
• Employee compensation includes all forms of consideration given by an entity in exchange for services rendered by employees
• Equity-settled share-based payment transactions are those in which the entity receives goods or services as consideration for equity instruments of the entity
• Cash-settled share-based payment transactions are those in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts based on the price (or value) of the entity's shares or other equity instruments of the entity
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Grant date is the date at which the entity and another party (including an employee) agree to a share-based payment arrangement
• Vesting conditions are the conditions that must be satisfied for the counterparty to become entitled to receive cash, other assets, or equity instruments of the entity under a share-based payment arrangement
  • Service conditions require the counterparty to complete a specified period of service
  • Performance conditions require the counterparty to complete a specified period of service and specified performance targets to be met

Types of Share-Based Payments

• Stock options grant employees the right to purchase a specified number of shares at a predetermined price (exercise price) over a specified period
• Restricted stock units (RSUs) represent a promise by the company to grant a specified number of shares to the employee upon completion of the vesting period
• Performance shares are awarded to employees based on the achievement of specific performance goals, such as revenue or earnings targets
• Stock appreciation rights (SARs) provide employees with the right to receive a cash payment equal to the appreciation in the company's stock price over a specified period
• Employee stock purchase plans (ESPPs) allow employees to purchase company stock at a discounted price through payroll deductions
• Phantom stock plans grant employees the right to receive a cash payment based on the value of a specified number of hypothetical shares
• Stock awards involve the direct grant of company stock to employees, often subject to vesting conditions or restrictions on transfer

Accounting Standards for Share-Based Payments

• IFRS 2 "Share-based Payment" is the international accounting standard that prescribes the accounting treatment for share-based payment transactions
• ASC 718 "Compensation - Stock Compensation" is the US GAAP equivalent standard
• The standards require entities to recognize the goods or services received or acquired in a share-based payment transaction when it obtains the goods or as the services are received
• The corresponding increase in equity is recognized if the goods or services were received in an equity-settled share-based payment transaction
• If the goods or services were acquired in a cash-settled share-based payment transaction, a liability is recognized
• The transaction is measured at the fair value of the goods or services received, unless that fair value cannot be estimated reliably
  • If the fair value of the goods or services cannot be estimated reliably, their value and the corresponding increase in equity are measured indirectly by reference to the fair value of the equity instruments granted

Valuation Methods for Share-Based Compensation

• The fair value of equity instruments granted is measured at the grant date using an appropriate valuation model
• The Black-Scholes-Merton option pricing model is commonly used for valuing stock options
  • Inputs to the model include the current stock price, exercise price, expected volatility, risk-free interest rate, expected dividend yield, and expected life of the option
• The binomial option pricing model is an alternative to the Black-Scholes-Merton model that allows for more complex option features and dynamic assumptions
• Monte Carlo simulation can be used to value share-based payments with market-based performance conditions
• For restricted stock units and stock awards, fair value is typically determined based on the market price of the underlying stock at the grant date
• The fair value of cash-settled share-based payments is remeasured at the end of each reporting period until settlement

Recognition and Measurement in Financial Statements

• The fair value of equity-settled share-based payments is recognized as an expense over the vesting period, with a corresponding increase in equity
• The expense is allocated on a straight-line basis over the vesting period unless the vesting pattern is graded, in which case the expense is recognized based on the vesting schedule
• For cash-settled share-based payments, the fair value of the liability is remeasured at the end of each reporting period and at the date of settlement, with any changes in fair value recognized in profit or loss
• If a share-based payment is modified (e.g., change in vesting conditions), the incremental fair value granted is recognized over the remaining vesting period
• If a share-based payment is cancelled or settled during the vesting period, the entity should immediately recognize the amount that would otherwise have been recognized for services received over the remainder of the vesting period

Tax Implications of Share-Based Payments

• The tax treatment of share-based payments can vary depending on the jurisdiction and the specific type of arrangement
• In many jurisdictions, the expense recognized for share-based payments is deductible for tax purposes
  • The timing of the tax deduction may differ from the timing of expense recognition in the financial statements
• Deferred tax assets are recognized for the temporary difference between the tax base of the share-based payment and its carrying amount in the financial statements
• In some jurisdictions, employees may be subject to personal income tax on the value of the share-based payments received
  • The timing of the tax liability for the employee typically coincides with the exercise of options or vesting of shares
• Employers may be required to withhold and remit payroll taxes on share-based payments

Disclosure Requirements

• Entities are required 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
• Disclosure requirements include a description of each type of share-based payment arrangement, including the general terms and conditions, such as vesting requirements and the maximum term of options granted
• Entities should disclose the number and weighted average exercise prices of share options outstanding at the beginning and end of the period, as well as those granted, exercised, forfeited, and expired during the period
• The weighted average fair value of options granted during the period and the information and assumptions used to determine that fair value should be disclosed
• For other types of share-based payments (e.g., restricted stock units), entities should disclose the number of instruments granted, vested, and forfeited during the period
• The total expense recognized for the period arising from share-based payment transactions and the total carrying amount of liabilities for cash-settled arrangements should be disclosed

Real-World Examples and Case Studies

• Many technology companies, such as Google and Facebook, offer employee stock options as a key component of their compensation packages
  • These options allow employees to share in the company's growth and align their interests with those of shareholders
• In 2020, Tesla granted CEO Elon Musk a highly performance-based stock option award, which vests based on the achievement of market capitalization and operational milestones
  • This award structure aims to incentivize long-term value creation and align the CEO's compensation with shareholder interests
• Starbucks has an employee stock purchase plan (ESPP) that allows eligible employees to purchase company stock at a 5% discount through payroll deductions
  • The ESPP is designed to encourage employee ownership and engagement
• In 2005, Apple was required to restate its financial statements due to improper accounting for stock option grants
  • The company had backdated option grants to coincide with low stock prices, resulting in understated compensation expenses
• The use of restricted stock units (RSUs) has become increasingly popular among public companies as an alternative to stock options
  • RSUs offer employees a promise of future shares without requiring an upfront payment, and they can be structured to vest based on service or performance conditions