ESOP accounting issues
ASC 718 and IFRS 2 accounting for ESOP is quite challenging. Getting to know the key issues and how to handle these is crucial. If you are new to ESOP, please visit head to our ESOP introduction.
Grant date according to ASC 718 and IFRS 2
ASC 718 and IFRS 2 Background
Under IFRS 2 and ASC 718, share-based payment agreements must be measured on the measurement date. This often corresponds to the grant date. Grant date is defined as the date on which the parties enter into a share based payment agreement. It is the date on which the company and the employee have reached a common understanding of the terms of the agreement. On the grant date, the company grants the employee the right to receive cash, other assets or equity instruments of the company, which may be subject to the fulfillment of certain vesting conditions. If this agreement is subject to an approval procedure, the grant date corresponds to the approval date. However, uncertainty often arises when the negotiations regarding the contractual structure and conditions of the program extend over a longer period.
Verbal agreement
It is often difficult to determine from oral agreements when ASC 718 and IFRS 2 criteria for the grant date were met. The standard does not require a written agreement. Difficulties in determining the grant date can also arise from an undocumented negotiation process. In this case only an in-depth analysis of the contract and the negotiation process as well as interviews will allow the grant date to be properly determined. In many cases, minutes of meetings and email correspondence between the parties can also serve as a point of reference.
Relevance
The significance of this date in the context of the valuation lies not only in its influence on the length of the term of the respective program, but also in its influence on the amount of the option value through the share price at the time of granting. In recent years, several suspected cases of backdated option programs have been reported in the press. Backdating is often carried out if the share price has risen significantly by the time the contract is concluded in order to set the exercise price at a low price level and thus benefit from a higher increase in value. As a result, the options already have a considerable value at the time the agreement is actually concluded, i.e. on the actual grant date.
Example
Employee M is granted share options by company U. Time t1 was identified as the grant date within the meaning of ASC 718 and IFRS 2. The regulations stipulate that the exercise price of the options corresponds to the share price on the grant date.
- The share price on date t1 was € 10.
- The share price on date t0 was € 5.
By backdating the contract, the exercise price would only be € 5 and the options would already have an intrinsic value of € 5 on date t1, The actual intrinsic value of the options on this date would be € 0. If backdating had been taken into account in valuation, the options would have been incorrectly recognized at too high expense.
Summary
For these reasons, it is essential to take into account all relevant information when determining the grant date. A simple approach based on the date the contract was concluded could result in a serious accounting error. Backdating has no influence on the grant date.
US GAAP & IFRS vesting period
IFRS 2 and ASC 718 Background
In addition to the the correct measurement date, the period over which the calculated personnel expenses are distributed is critical. This period is referred to in IFRS 2 and ASC 718 as the vesting period . It is the period in which all existing vesting conditions are met. Vesting conditions are either service conditions or performance conditions. Service conditions require the employee to complete a certain period of service. If the employee leaves the company before this time, the entitlements are generally forfeited without compensation. Performance conditions additionally require the fulfillment of certain performance targets. Examples are an increase in company profit within a defined period. If there are no such vesting conditions, the employee receives an unrestricted right to the remuneration instruments when they are issued. In this case, calculated expense is recognized in full on grant date.
Accounting practice
However, it is often unclear from which date the expense is to be recognized. In accordance with the provisions of IFRS 2 and ASC 718, expense recognition can begin before the grant date if the employees begin to render their services to the company before this date. This is particularly the case if the employee is promised remuneration instruments but the grant is still dependent on the decision of the Supervisory Board or another body. For share options whose fair value is only determined once on the grant date, this means that if the vesting period begins before the grant date, a provisional valuation must be carried out, which is subsequently adjusted on the grant date. In practice, the main challenge is to identify the date from which the expense is recognized. Other challenges are the assumptions and parameters on which the provisional measurement is based.
Grant date vs. vesting period in ASC 718 and IFRS 2
The divergence between the grant date and the vesting period can also have an impact on the accounting treatment of multi-tranche remuneration commitments. For example, an employee could be promised to receive a fixed or variable number of share options annually over a period of three years under certain predefined conditions. At first glance, it could be concluded that these are three separate tranches. Each with a one-year deferral from the grant date and the expense is only recognized from the actual grant date. However, depending on the specific terms of the agreement, this conclusion only applies in the rarest of cases. If the key terms and conditions for the future tranches are already known at the time the employee accepts the agreement, this date is already the grant date and therefore the start of the vesting period for all three tranches.
Solution
The absolute amount of all variables and conditions for the tranches to be issued in subsequent years does not necessarily have to be fixed. Rather, it is sufficient if the formula or methodology is known on the basis of which. Example is the exercise price of the options which will be calculated in the future. In order to avoid the premature recognition of expenses for future tranches, it is necessary to carry out a precise analysis of the contractual conditions and their influence on accounting in accordance with IFRS 2 and ASC 718 in advance, when the remuneration plan is drawn up.
Expected volatility
Background
The expected volatility represents the degree of fluctuation of the share price during a period. Formally, this risk parameter can be defined as the annualized standard deviation of the steady returns of the share. Volatility represents one of the strongest parameters influencing the level of the option price. The particular significance of volatility for the measurement is underlined by the ASC 718 and IFRS 2 reference to the problem. In practice, volatility tends to be set too low. Given the demonstrably high influence of volatility on the option price, this is not surprising. Nevertheless, careful estimate of this factor is essential in the valuation of share options in the context of accounting.
Concepts
IFRS 2 deals in detail with various factors that must be taken into account in the calculation:
- the implied volatility
- the historical volatility of the share price in the most recent period, which generally corresponds to the expected option term
- the tendency of volatility to return to its mean value, i.e. its long-term average.
The use of implied volatility is to be preferred, as it is based purely on market data. However, in the case for which no options are traded on the market, implied volatility cannot be used. In accordance with the standard, the historical volatility of the share price and the tendency of volatility to return to its long-term average must be taken into account. In many cases, this means that the average historical volatility of the share price over a period that generally corresponds to the remaining term of the option is used for the expected volatility.
Challenges with historical volatility under ASC 718
For unlisted companies, historical volatility cannot be used for estimation purposes. In both cases, the standard stipulates the volatility of comparable companies to be taken into account when estimating the expected volatility. However, a comparison of the volatilities of the DAX 40 companies shows that historical volatility does not necessarily correspond to the volatility that has actually occurred. It can be seen that over a period of 8 years, the volatility estimated using historical volatility deviates from the volatility that actually occurred by an average of 9.8%. It is worth noting that the mean value of the maximum deviations of the 30 companies is 54.7%.
Alternatives
In recent years, other models allowed for estimating expected volatility under ASC 718 have become established in the financial world, including the EWMA model (exponentially weighted moving average) and the GARCH model (generalized autoregressive conditional heteroscedasticity). The advantage of these models is that they take into account the fact that volatility is not constant but fluctuates over time. These models have the basic characteristics that they calculate the expected volatility from the current value of volatility and the estimator of the previous period(s), i.e. the GARCH or EWMA equation of the previous period. The GARCH model also takes into account the tendency of volatility to return to its long-term average. It is questionable whether these models will also prevail in the estimation of volatility in the course of the valuation of stock options.
Fair Value of shares
Background
The fair value of the equity instruments granted should be determined on the basis of market prices, if such prices are available [IFRS 2.16]. If market prices are not available, a valuation technique should be used to estimate “the price that would have been received for the equity instruments at the measurement date in a transaction between knowledgeable, willing parties […]”. The valuation technique must be consistent with generally accepted valuation techniques. It has to take into account factors and assumptions that knowledgeable, willing market participants would consider in setting the price. [IFRS 2.17]
Challenges in ASC 718 and IFRS 2
When applying the standard in the context of unlisted companies, market prices are naturally not available; accordingly, suitable valuation methods must be used for estimation. In principle, a variety of valuation methods can be used. In practice, discounted cash flow methods (DCF) and multiple methods (multiples) are frequently used. DCF methods are based on the payment surpluses of integrated corporate planning. These are discounted to the valuation date using a discount rate appropriate to the risk and term. In the multiple method, the value is determined on the basis of financial parameters of comparable listed companies. Both methods have advantages and disadvantages, which should be taken into account in the decision-making process. The following table outlines the main advantages and disadvantages of both methods.
| Pros | Cons | |
| Multiple |
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| Discounted Cashflow |
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Considerations and critics ASC 718
The appropriate method must always be selected after weighing up the requirements. This must be done under the consideration of a consistent parameter derivation and the exact objective of the individual case. In the literature, the so-called multiple method is one of the application-related valuation approaches, as the value of a company is derived using the market prices or stock market prices of comparable listed companies or the actually realized market prices of analogous transactions in order to reflect the view of the capital market, which is intended to replace the subjective view of a valuer with the objectivity of the capital market.
Summary
In practice, the frequent use of the method is regularly justified by the easy-to-understand implementation and the comprehensible results. As a result, this method is intended to provide a value range. In combination with its correct interpretation, provides the user with a basis for a possible price determination. The multiple method for determining the share price proves to be advantageous in practice, particularly with regard to the interactions of the practical problems described in determining volatility and the consistency in determining the individual valuation parameters. In analogy to the determination of volatility in approach two, comparably listed companies form the starting point. On the one hand, this makes it possible to ensure sufficient data availability and, on the other, to derive the share price on the basis of listed share prices of comparable companies within a comprehensible value range.