How Companies Will React To The Expensing Of Employee Share Schemes
By Billy de Beer & Cris Blair who can be contacted at www.21century.co.za
Historically in South Africa the cost of share schemes was only reflected by the dilution of issued equity. AC139 has the effect that earnings per share are to be reduced in two ways: one from the dilution effect on issued equity (as before), and two from expensing of the equity instruments to the income statement. Obviously cash costs remain unaffected.
2. How Does The Accounting Work?
In essence AC139 requires that any increase in the value of shares allocated to employees (between the date of grant and date of vesting) should be expensed against earnings over the vesting period. This increase in value should be determined using ‘fair value’ at date of grant as the basis of valuation in most cases (i.e. when fair value can be reliably estimated at grant date and the award is in the form of equity). AC139 goes on to specify that ‘fair value’ is to be determined using a share valuation model. The choice of model is left open.
Companies need to evaluate different share valuation models and select one that is most appropriate to their circumstances. Although AC139 does not prescribe share valuation models (nor offer more than cursory guidelines as to their application), the onus regarding fair valuation rests squarely on the shoulders of the external auditor as part of the fiduciary responsibility to certify the fairness of the company’s financial statements. We will deal with the topic of valuation in a follow up article.
3. What Are The Issues Facing Companies?
Share options have been widely used in South Africa as long-term incentives for management. In recent years use of the deferred delivery construction in schemes has become popular.
South African companies have begun to evaluate whether the use of share options in future is desirable for two main reasons:
>> The expensing requirements necessitate a cost comparison with other long-term vehicles, and
>> The accounting expenses associated with equity vehicles are not tax deductible (as opposed to cash compensation).
A number of other considerations add complexity to the evaluation:
>> A statement by the Minister of Finance during the 2004 budget speech regarding intended tax changes related to deferred delivery share option schemes,
>> No clarity from Internal Revenue as yet whether the accounting costs brought about by AC139 will be tax deductible in future (as in the US and UK),
>> The tendency by Inland Revenue to question the funding structures involving Employee Share Trusts and whether profits made from share issues in Employee Share Trusts are capital or revenue in nature,
>> The implications of a recent requirement by the JSE that share scheme trusts be consolidated with company accounts,
>> Various other impacts on Employee Share Trusts from changes in Company and Tax law,
>> Increased pressure from investors to improve governance--fuelled by scrutiny from the press, and
>> The growing prevalence in recent years of underwater options.
4. How Are Companies Likely To React
The direct, and far reaching effects in some cases, of AC139 on reported earnings is expected to alter company thinking around long-term pay strategy and delivery. This will be considered in conjunction with the other factors set out above.
Ultimately, long-term incentive programs will be tailored to each company’s business strategy and approach to create shareholder value, while helping attract and retain the best talent to deliver desired business results. The following responses can be expected:
>> A wider range of vehicles tied to equity performance can be expected. Where equity is used, schemes are likely to include shorter terms and performance-contingent vesting (due to the effects on the accounting cost). Performance hurdles are particularly applicable to senior executives who are most able to drive company results. This alone may lead to greater differentiation between awards made to senior executives and those to lower level managers.
>> The transitional accounting requirements may induce companies to shorten the vesting terms for existing allocations (to reduce the accounting cost).
Specific factors that will require focus for future allocations under equity schemes are:
>> The design of performance hurdles to maximise the link between performance and remuneration and minimise the accounting expense of the scheme. The particular measure implemented in a share/share option scheme may or may not allow a true up of the expenses if the performance hurdles are missed.
>> An analysis of historical forfeitures and exercise behaviour in share/share option schemes. Whilst this is necessary to comply with the accounting and may lead to altered vesting terms (to reduce the expense effect), companies will learn more about employee behaviour and how they value equity awards. This in turn is expected to lead to more effective design of share schemes and the introduction of other incentives.
>> Companies need to analyse: whether the benefits they derive from alternative scheme constructions outweigh the accounting costs, particularly in SA where the costs are not deductible for tax; the benefits to participants, including tax changes that may reduce the tax benefit to participants (deferred delivery schemes); tax, accounting and structural issues relating to Employee Share Trusts; the effects on cash flow; the dilution effect on issued equity; the perceptual value of the scheme to participants; and, the effects from a governance perspective. In doing so, alternative instruments will be considered:
5. Alternative Instruments: description
>> Cash based (e.g. Notional/phantom shares): Cash benefit equal to growth in share price over a term, possibly with vesting conditions.
>> Share purchase schemes: Shares are purchased at date of grant and a loan granted to the participant. Repayment of the loan and delivery of shares takes place at vesting.
>> Indexed options: The exercise price is indexed to an external measure such as the JSE all-share index or a peer group.
>> Performance conditional ‘tax structured’ share options: Deferred delivery share option schemes, except number of options that vest are dependant on the company’s performance relative to a performance hurdle (e.g. EPS must exceed inflation plus a %).
>> Restricted stock units: Options are issued at par value. The number of options that vest are dependant on the company’s performance relative to a performance hurdle (e.g. EPS must exceed inflation plus a %).
>> Other instruments: Convertible preference shares or warrants
>> Combination schemes: A deferred cash bonus scheme combined with restricted stock units, where the deferred bonus is used to offset the discount on the option.
Less costly schemes will be considered, even discontinuation of the scheme, with or without a commensurate increase in other compensation. However equity based schemes are likely to remain appropriate as long-term incentives, although dilution and cost constraints may prevent companies from their use as broadly as before. Companies are expected to re-evaluate their compensation plans and ensure that their incentives—using a blend of equity and cash vehicles—drive financial performance and meet the organisation’s unique needs.
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