Share-based payment, also known as ESOP, involves employees receiving portion of their pay in company shares or related instruments. Some ESOP also provide cash payments tied directly to the company’s equity value. The main objective is to align employees’ interests with shareholders by connecting compensation to the company’s financial performance. While share-based payment is the formal term, the generic term used for any share-based payment program is ESOP.
Share-based payment Definition
Share-based payment transaction
A share-based payment transaction occurs when a company grants its employees or other parties a certain number of equity instruments (like shares or stock options) or incurs a liability based on the value of its shares as compensation for services rendered. This type of transaction is used to align the interests of employees and the company, incentivizing long-term performance.
Share-based payments can be equity-settled or cash-settled:
Equity-Settled Share-Based Payments: In these transactions, employees are granted shares or stock options that allow them to purchase shares at a set price. The fair value of these equity instruments is measured recognized as an expense over the vesting period.
Example: A company grants 1,000 share options to an employee with a three-year vesting period. The options allow the employee to buy company stock at $10 per share. If the stock price rises, the employee benefits by purchasing at a lower share price. Cash-Settled Share-Based Payments: These involve paying the employee the equivalent value in cash instead of equity. The liability is remeasured at each reporting date based on the fair value of the company’s shares.
Example: A company offers stock appreciation rights (SARs), where the employee receives the cash equivalent of the increase in stock price over a set period. If the stock price increases from $10 to $15, the employee receives $5 per right.
About vesting, grants etc.
Grant Date: The date on which the company and the employee agree on the terms of the share-based payment arrangement, and the fair value of the equity instruments is measured.
Vesting Period: The period during which the employee must meet certain conditions (such as continued service or performance targets) before gaining full rights to the equity or cash-based reward.
Fair Value: The estimated market value of the equity instrument (e.g., shares or stock options), used to determine the expense recognized in the financial statements. Valuation is regularly based on an option pricing model.
Exercise Price: The price at which an employee can purchase company shares through stock options.
Performance Conditions: Conditions related to the company’s performance (e.g., financial targets) that must be met for the equity award to vest.
These key terms are essential for understanding how share-based payments are structured and accounted for, both for the employee receiving the benefit and the company issuing it.
Share-based payment Benefits
ESOP offers a range of benefits for both employees and employers, each deriving distinct advantages from this arrangement.
Benefits for Employees
- Financial Upside: Employees can potentially realize significant financial gains, especially if the company’s stock value increases. This is particularly true in startups or rapidly growing companies.
- Sense of Ownership and Engagement: Owning shares in their employer can give employees a stronger sense of belonging and commitment to the company. This increases motivation to contribute to the company’s success.
- Wealth Building: ESOP can be a valuable tool for long-term wealth building. This is especially beneficial if the employee holds onto their shares and the company’s value appreciates over time.
- Tax Benefits: Depending on jurisdictions and the specific type of share-based payment, there can be tax advantages compared to regular income.
Benefits for Employers
- Employee Retention: ESOP often comes with certain conditions, incentivizing employees or another counterparty to stay with the company longer in order to fully benefit from their shares.
- Alignment of Interests: This compensation model aligns the interests of employees with those of the company and its stakeholders. This is because as employees directly benefit from the company’s success.
- Attracting Talent: Competitive ESOP packages can help attract top talent, particularly in industries where this type of compensation is expected.
- Cash Flow Advantages: For startups or companies with limited cash flow, offering shares instead of high salaries can help manage cash more effectively.
- Performance Incentive: It can serve as a performance incentive, as employees are likely to be more driven to contribute to the company’s success. The reason is that their personal financial success is tied to the company’s performance via the program.
Share-based payment accounting and classification under IFRS 2 and US GAAP ASC 718
Share-based payments, such as stock options and equity grants, are commonly used by companies across the globe to incentivize and reward employees and are within the scope of IFRS 2 (published by the international accounting standards board) and US GAAP. Accounting for these transactions, however, can be complex, especially in an international context. Different countries may follow various accounting standards, such as the International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (GAAP), each with distinct guidelines for recognizing and reporting share-based payments. This introduction provides an overview of the key principles, the impact on financial statements, and the importance of consistent and transparent reporting to meet global regulatory requirements. Understanding these fundamentals ensures compliance and accurate reflection of a company’s financial performance.
Share-based payment under IFRS 2
The accounting requirements under IFRS 2 share-based payment (International Accounting Standard) including any amendment to IFRS 2 governs the accounting of share-based payment transactions, ensuring transparency and consistency in financial reporting. The key principles under IFRS 2, the standard for classification and measurement of share-based payment transactions, include:
Recognition and Measurement: A share-based payment award must be recognized as an expense in the income statement when the services are received.
Equity-Settled Transactions: For equity-settled share-based payments, the of the goods and services or the fair value of instruments is determined at the grant date and recognized over the expense period, with no remeasurement after the grant.
Cash-Settled Transactions: For cash-settled share-based payments, the fair value of the liability is remeasured at each reporting date until settlement, with changes reflected in profit or loss.
Vesting Conditions: Only service and performance conditions (including market conditions) affect the accounting, and expenses are recognized based on the probability of vesting conditions being met.
These principles ensure that the cost of share-based payments is fairly reflected in a company’s financial statements, providing clear insight into the impact of such transactions on a company’s profitability.
Generally the fair value of the goods and services received hast o be measured. If the fair value cannot be measured reliably, the entity has to measure the fair value of the instruments granted. The expense recognized is based on the price of these instruments. The standard covers transactions with employees and others. The grant of equity instruments of the entity is the center of the standard.
Share-based payment under US GAAP
Under U.S. GAAP, the accounting for share-based payments is primarily governed by ASC 718 (Compensation—Stock Compensation), which outlines the following key principles:
Recognition and Measurement: Share-based compensation is recognized as an expense, based on the fair value of the equity award.
Equity-Settled Awards: The fair value of equity-settled awards (like stock options or share appreciation rights) is expensed over the service period, with no remeasurement after the grant.
Liability-Classified Awards: For cash-settled share-based payments (such as stock appreciation rights), the fair value of the liability is remeasured at each reporting date, with changes recorded in earnings.
Vesting Conditions: Only service and performance conditions impact the vesting of awards. Compensation cost is recognized over the period during which the employee provides the requisite service.
Modifications and Cancellations: Changes to share-based payment terms, such as modifications or cancellations, may lead to remeasurement or accelerated expense recognition depending on the nature of the modification.
These principles ensure that the cost of share-based compensation is fairly represented in financial statements, reflecting the economic value of employee benefits tied to stock awards.