8.4 Disclosure requirements for share-based payments
5 min read•august 16, 2024
Share-based payments are a crucial part of employee compensation. Companies must disclose details about these arrangements, including types, terms, and numbers of options granted and exercised. This transparency helps investors understand the impact on financial statements.
Disclosures cover valuation methods, key inputs, and assumptions used to determine . Companies must explain how they calculate things like expected volatility and option life. This info helps users assess the reliability of reported expenses and potential future impacts.
Disclosure Requirements for Share-Based Payments
Key Accounting Standards and General Disclosure Requirements
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- and govern share-based payment disclosures for international and U.S. companies
- Companies must disclose nature and extent of share-based payment arrangements during reporting period
- Disclosure includes information about types of arrangements (, , )
- Entities provide description of each arrangement type, including general terms and conditions
- Standards require disclosure of number and weighted average exercise prices of stock options for various categories (outstanding at beginning of period, granted, exercised)
- Companies disclose weighted average share price for options exercised during period
- Total expense recognized for share-based payment transactions and effect on profit or loss and financial position must be disclosed
Specific Disclosure Requirements for Financial Statements
- Companies provide reconciliation of outstanding share options at beginning and end of reporting period
- Disclosures include method used to estimate fair value of goods/services received or equity instruments granted
- For options granted during period, companies disclose weighted average fair value and measurement information
- Impact of share-based payment transactions on entity's profit or loss and financial position clearly presented
- Companies disclose total intrinsic value of liabilities arising from share-based payment transactions
- Entities explain modifications to share-based payment arrangements during period and their impact
- Disclosures organized in clear, concise manner, often in tabular format, to enhance readability for financial statement users
- Example: Table showing number of options outstanding, granted, exercised, and forfeited during the year
- Example: Reconciliation of share-based payment expense from previous year to current year
Share-Based Payment Disclosures in Financial Statements
Valuation Methods and Inputs
- Companies disclose option pricing model used (Black-Scholes-Merton, binomial)
- Key inputs disclosed include weighted average share price, exercise price, expected volatility, option life, expected dividends, risk-free interest rate
- For expected volatility, companies explain determination method and reliance on historical volatility
- Entities disclose how expected option life determined and incorporation of employee exercise behavior
- Other features of option grant incorporated into fair value measurement clearly communicated (market conditions)
- For performance-based awards, companies disclose nature of performance conditions and probability assumptions
- Companies using alternative measurement method disclose this fact and provide reasoning
- Example: Disclosure of Monte Carlo simulation for valuing performance shares with market conditions
- Example: Explanation of how expected volatility calculated using blend of historical and implied volatility
Comprehensive Disclosure Presentation
- Impact of share-based payment transactions on profit or loss and financial position clearly presented
- Companies organize disclosures in clear, concise manner, often using tabular format
- Reconciliation of outstanding share options at beginning and end of reporting period provided
- Weighted average fair value of options granted during period disclosed with measurement information
- Total intrinsic value of liabilities from share-based payment transactions disclosed
- Modifications to share-based payment arrangements during period explained with impact assessment
- Disclosures enhance readability and comprehension for financial statement users
- Example: Summary table of share-based payment expense by award type (stock options, RSUs, performance shares)
- Example: Graphical representation of outstanding options by exercise price range
Valuation of Share-Based Payment Awards
Option Pricing Models and Inputs
- Companies disclose option pricing model used (Black-Scholes-Merton, binomial)
- Key inputs disclosed include:
- Weighted average share price
- Exercise price
- Expected volatility
- Option life
- Expected dividends
- Risk-free interest rate
- Expected volatility determination explained, including reliance on historical volatility
- Expected option life determination disclosed, incorporating employee exercise behavior
- Other features affecting fair value measurement clearly communicated (market conditions)
- Example: Disclosure of use of 5-year historical volatility for estimating expected volatility
- Example: Explanation of how expected option life adjusted for early exercise patterns observed in employee behavior
Performance-Based Awards and Alternative Valuation Methods
- For performance-based awards, companies disclose:
- Nature of performance conditions
- Assumptions about probability of achieving conditions
- Companies using alternative measurement methods disclose:
- Fact of using alternative method
- Reason for using alternative method
- Any other features of option grant incorporated into fair value measurement clearly communicated
- Example: Disclosure of Monte Carlo simulation used for valuing performance shares with market conditions
- Example: Explanation of lattice model used for valuing options with market-based vesting conditions
Analyzing Share-Based Payment Disclosures
Financial Impact Analysis
- Analyze trend in share-based payment expenses over multiple reporting periods to assess profitability impact
- Evaluate dilutive effect of outstanding share options and other equity instruments on earnings per share calculations
- Assess potential future impact of unvested share-based payment awards on company's financial position and performance
- Compare company's share-based payment practices and disclosures with industry peers to identify significant differences or trends
- Analyze relationship between share-based payment awards and key performance indicators to understand effectiveness as compensation tool
- Example: Calculation of year-over-year change in share-based payment expense as percentage of total compensation
- Example: Comparison of diluted EPS with and without the effect of outstanding share options
Valuation Sensitivity and Cash Flow Implications
- Evaluate sensitivity of share-based payment valuations to changes in key assumptions (volatility, expected option life)
- Consider cash flow implications of share-based payment arrangements, including:
- Potential tax effects
- Impact on company's capital structure
- Assess how changes in share price affect the value of outstanding awards and potential future expenses
- Analyze the impact of share-based payments on the company's equity and potential dilution for existing shareholders
- Example: Sensitivity analysis showing how a 10% change in expected volatility affects option fair value
- Example: Calculation of potential cash outflow for tax withholding on vesting of restricted stock units
Key Terms to Review (17)
Asc 718: ASC 718 refers to the Accounting Standards Codification Topic 718, which governs the accounting for share-based payments. This standard outlines how entities should recognize, measure, and disclose share-based payment transactions, including both equity-settled and cash-settled arrangements, ensuring transparency in financial reporting related to employee compensation.
Binomial model: The binomial model is a mathematical method used to calculate the theoretical value of options and other financial derivatives, incorporating the potential future movement of an asset's price over time. It is particularly useful in valuing share-based payments, allowing for different possible outcomes in the value of equity instruments based on fluctuating market conditions. This model supports the accounting for both equity-settled and cash-settled share-based transactions by providing a structured way to estimate fair value and recognize expenses accordingly.
Black-Scholes Model: The Black-Scholes Model is a mathematical model used to determine the theoretical price of European-style options. It helps in valuing share-based payments by estimating the fair value of options granted to employees, which is crucial for accurate financial reporting and understanding the impact on equity and cash flows.
Cash-settled transactions: Cash-settled transactions refer to agreements in which the payment is made in cash rather than through the transfer of equity instruments or shares. These transactions are typically used in share-based payment arrangements where the entity compensates employees or other parties by providing cash based on the value of the equity instruments, rather than delivering the actual instruments themselves. This method simplifies the process of compensation and aligns with specific accounting standards, impacting how these payments are disclosed and recognized in financial statements.
Compensation expense: Compensation expense refers to the cost that a company incurs when providing salaries, wages, bonuses, and benefits to its employees. This term becomes particularly relevant when discussing share-based payments, as companies often issue stock options or other equity-based awards as part of their compensation strategy. Understanding how to report and disclose these expenses is crucial for financial transparency and compliance with accounting standards.
Dilution effect: The dilution effect refers to the decrease in existing shareholders' ownership percentage and earnings per share that occurs when a company issues additional shares. This often happens in transactions where new equity is introduced, such as equity-settled share-based payments, which can lead to a larger total number of shares outstanding and thus reduce the value of existing shares. It is essential to consider how this effect influences shareholder value and the company's capital structure.
Earnings per share impact: Earnings per share (EPS) impact refers to the effect that specific financial activities, particularly those involving share-based payments, have on a company's reported earnings per share. This metric is crucial as it helps investors assess a company's profitability on a per-share basis and influences their perception of the company's financial health. Understanding the EPS impact of share-based payments is essential for evaluating how these compensation methods can dilute existing shares and alter overall shareholder value.
Equity-settled transactions: Equity-settled transactions refer to agreements where a company compensates its employees or other parties by granting shares or share options, rather than paying cash. This type of compensation affects the company’s equity since it results in the issuance of new shares or the transfer of existing ones, reflecting the costs associated with share-based payments. Recognizing these transactions in financial statements is crucial for understanding how they impact a company’s performance, shareholder equity, and overall financial position.
Expense recognition: Expense recognition is the accounting principle that determines when an expense should be recorded in the financial statements. This principle ensures that expenses are matched with the revenues they help to generate, aligning with the matching concept in accounting. By recognizing expenses at the right time, it provides a clearer picture of a company's financial performance and helps stakeholders make informed decisions.
Fair value: Fair value is the estimated price at which an asset or liability could be exchanged between knowledgeable, willing parties in an arm's length transaction. This concept is crucial for accurately reflecting the true value of financial instruments, assets, and liabilities in financial statements, impacting recognition, measurement, and disclosures across various scenarios.
Footnote Disclosures: Footnote disclosures are additional notes that accompany financial statements, providing essential information and context about a company's financial activities. These disclosures help users understand the details behind the numbers, including significant accounting policies, risks, and any material events that could impact the financial position of the company. They are particularly important for transactions related to share-based payments, whether settled in equity or cash, as they offer transparency into the nature and valuation of these transactions.
Grant date: The grant date is the specific date on which an entity's board of directors or an authorized committee formally approves a share-based payment award to an employee or other service provider. This date is significant because it marks the point when the recipient becomes entitled to the benefits of the award, and it is crucial for determining the measurement of the fair value of the equity instruments granted, which has implications for accounting, tax purposes, and disclosure.
IFRS 2: IFRS 2 is the International Financial Reporting Standard that governs the accounting for share-based payments, primarily focusing on how to recognize, measure, and disclose share-based transactions. This standard ensures that companies account for employee benefits in a way that reflects their economic reality, helping to provide more accurate financial statements. It applies to both equity-settled and cash-settled transactions, emphasizing the need for transparency in disclosure and proper accounting for compensation related to key management personnel.
Modification Accounting: Modification accounting refers to the accounting treatment applied when there are changes or modifications to existing contracts, particularly in lease agreements or share-based payment arrangements. This process ensures that the financial statements accurately reflect the new terms of the contract, maintaining transparency and consistency in reporting. The modifications can involve changes in payment terms, duration, or other significant aspects that impact the accounting and financial position of the lessee or lessor, as well as the entity offering share-based payments.
Performance shares: Performance shares are a type of share-based compensation awarded to employees, typically executives, that vest based on the achievement of specific performance goals over a designated period. These shares align the interests of key management personnel with the company's performance, providing incentives tied to metrics such as revenue growth, earnings per share, or total shareholder return. By linking compensation directly to performance outcomes, companies aim to motivate executives to enhance shareholder value.
Restricted stock units: Restricted stock units (RSUs) are a form of equity compensation offered by employers to employees, where the company promises to grant shares of stock at a future date, contingent upon certain conditions such as continued employment or performance goals. RSUs are an important tool for aligning employee interests with those of shareholders and are often used as incentives to attract and retain talent.
Stock options: Stock options are financial derivatives that give employees the right, but not the obligation, to buy a company's stock at a predetermined price within a specific timeframe. This compensation mechanism aligns the interests of employees with shareholders, encouraging them to work toward increasing the company's value, which relates to various accounting practices and disclosure requirements.