This chapter briefly describes the main stock-based compensation plans. These plans include all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. I first describe the main plans. I then review the IFRS accounting for these plans. Finally, I describe a case that covers the hedging of equity-settled stock option plans with equity swaps.
Equity-based compensations plans are a tool to further align employee interests with those of the company's shareholders by enhancing the link between pay and long-term performance. These compensation plans are typically discretionary, providing flexibility to reward particular achievements or exceptional performance. As a result, most compensation plans are granted to key senior executives who are actively leading the drive to achieve sustained profitability at the company and who are expected to contribute most significantly to its long-term future and economic success.
In this section I will briefly describe the most common share-based compensation plans. Human resources consulting firms are constantly developing new types of plans. Additionally, changes in tax regimes usually bring new types of plans. However, most plans can be classified under one of the following categories.
An employee stock option plan (SOP) represents the right awarded to certain employees to purchase a number of common shares of the company at a pre-agreed exercise price, commonly subject to certain conditions. The exercise price is usually set at the market price of the underlying shares on the date of the award or an average of the stock price during a period up to the date of the award.
A stock appreciation rights (SAR) plan provides eligible employees of the company with the right to receive cash equal to the appreciation of the company's common shares over a pre-established strike price. Therefore, an SAR is a cash-settled SOP.
There are many kinds of share plan. In general, employees of the company either voluntarily buy shares of the company on advantageous terms, or are granted a number of shares for free.
The most common type of share plan, so-called “equity plus plan” or “leverage share savings plan”, is a voluntary plan that gives eligible employees the opportunity to purchase shares of the company at the stock price on the purchase date and generally to receive at no additional cost a number of shares for each share purchased, up to a maximum annual limit, after a certain vesting period of several years. Commonly, the free shares to be received are forfeitable in certain circumstances.
Another typical design of a share plan is the so-called “discounted purchase plan”, a voluntary plan that gives eligible employees the opportunity to purchase shares of the company at a discount to the stock price on the purchase date. Shares purchased under the share plan cannot be sold for a certain period from the time of purchase.
As mentioned earlier, there are all sorts of variations to the two previous designs. At the end of this chapter, share plan awarded by HSBC is covered, which in my view is remarkably complex.
An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to a trust for the benefit of the company's employees. This type of plan should not be confused with employee stock option plans, also called ESOPs, described earlier. The structures of trust ESOPs vary, but typically a trust is set up by the company to acquire shares in the company for the benefit of the employees. Therefore, in a trust ESOP, its beneficiaries do not hold the stock directly (i.e., beneficiaries do not actually buy shares). Instead, the company contributes its own shares to the trust, contributes cash to buy its own stock, or, quite commonly, the trust borrows money from the company to buy stock. The structure of the plan is designed to benefit from significant tax advantages for the company, the employees, and the sellers. Employees gradually vest in their accounts and receive their benefits when they leave the company (although there may be distributions prior to that).
There are specific terms used in relation to SOPs and SARs. The main terms are the following:
This section reviews the accounting under IFRS for equity-based plans. The accounting standard that guides the recognition of share-based payments is IFRS 2 Share-Based Payment. IFRS 2 defines a share-based payment as a transaction in which the entity receives or acquires goods and services either as consideration for its equity instruments or by incurring liabilities for amounts based on the price of the entity's shares or other equity instruments of the entity. The accounting requirements for the share-based payment depend on how the transaction will be settled:
Frequently, an option right may only be exercised if specific performance targets, called conditions, are met during the vesting period (see Figure 10.2). IFRS 2 classifies all conditions as either vesting conditions or non-vesting conditions:
Vesting conditions are further divided into service and performance vesting conditions:
Performance vesting targets are in turn divided into market and non-market vesting conditions:
Recall that SOPs can only be settled by delivering shares to the beneficiary. The settlement exclusively in shares establishes the rules for the plan's recognition, as follows.
On grant date, the fair value of the award is estimated. An important ingredient in this estimate is the fair value of the equity option embedded in the award (see Figure 10.3), which is determined using an option pricing model, typically the Black–Scholes model.
The model takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, its expected dividends and the risk-free interest rate over the expected life of the option. The expected life of the option is estimated using various behavioural assumptions, such as exercise patterns of similar plans.
Market vesting conditions and non-vesting conditions are taken into account when estimating the fair value of the equity option. Non-market vesting conditions and service conditions are not taken into account.
No accounting entries take place on grant date.
At each reporting date, the total compensation expense associated with the award is calculated (see Figure 10.4). The expense is measured by adjusting the fair value of the equity option that was calculated on the grant date for the expected likelihood of meeting the non-market vesting and service conditions. For example, if there is an 80% chance of achieving the non-market vesting and service conditions, the number of options is adjusted by multiplying the equity option fair value by 80%. Consequently, the compensation expense takes into account the expected number of options that are expected to vest. One of the ingredients of this adjustment is the estimation of the forfeiture rate for service conditions. Based on historical employee turnover data, the company estimates the percentage of beneficiaries who will leave the company before the vesting period lapses.
The total compensation expense is evenly allocated over the expected life of the award. For example, suppose that a company reports its financial statements on an annual basis. If at the first reporting date the total compensation was estimated to be EUR 16 million and the vesting period of the award was 4 years, the yearly compensation expense to be recognised on this date would be EUR 4 million (=16 mn/4). The compensation expense allocated to the first year would be charged to the profit or loss statement and a corresponding increase in equity recognised.
IFRS 2 is not prescriptive on the accounting required for the credit to equity in respect of an SOP. Practice varies, depending on local regulatory requirements. One approach that is common in some jurisdictions is to credit a share-based payment reserve until the award has been settled and at a later stage to reclassify the amounts in that reserve to share capital (however, this may not be permitted in some jurisdictions) or other reserves. In other jurisdictions, the credit entry may be directly applied to retained earnings. In our example, the credit to equity was made to a share-based payment reserve (SOP reserve), as follows:
At each subsequent reporting date, the adjustment due to non-market and service vesting conditions was re-estimated. Using our previous example, suppose that the total compensation was revised upwards at the second yearly reporting date from EUR 16 million to EUR 20 million. The yearly compensation expense to be allocated over the 4-year vesting period would become EUR 5 million (=20 mn/4). The compensation expense allocated to the second yearly period would be as follows:
As mentioned previously, if exercised, SAR plans are settled by paying to the beneficiary the intrinsic value of the underlying option in cash. The accounting recognition of cash settled awards is covered next. The accounting recognition for awards in which either the beneficiary or the company can choose between settling the award in cash and in shares follows a similar procedure, except that if the physical settlement is chosen on the exercise date there is an additional accounting entry to recognise the physical delivery of the shares.
No actions take place on the grant date.
At each reporting date, the total compensation expense associated with the award is calculated (see Figure 10.5). The expense is measured by fair valuing the embedded equity option and adjusting it for the likelihood of achievement of all the vesting (market, non-market and service) and non-vesting conditions.
The total compensation expense is evenly allocated over the expected life of the award. For example, suppose that a company reports its financial statements on an annual basis. If at the first reporting date the total compensation was estimated to be EUR 16 million and the expected life of the award is 4 years, the yearly compensation expense to be recognised on this date would be EUR 4 million (=16 mn/4). The compensation expense allocated to the first year would be charged to the profit or loss statement and a corresponding increase in liabilities recognised, as follows:
At each subsequent reporting date, the compensation expense was re-estimated. Using our previous example, suppose that the total compensation was revised upwards at the second yearly reporting date to EUR 20 million from EUR 16 million. The yearly compensation expense to be allocated over the 4-year expected life of the award became EUR 5 million (=20 mn/4). The compensation expense allocated to the second yearly period would be as follows:
Also on the second reporting date an adjustment was made to the previous compensation expense to take into account the revised total compensation figure. This adjustment brought the already recognised compensation expense in line with the new total compensation estimate. As the company already had recognised a EUR 4 million expense at the first yearly reporting date, it would need to make a EUR 1 million adjustment to bring it in line with the new EUR 5 million yearly compensation expense, as follows:
The accounting recognition at the subsequent reporting dates was similar to the recognition outlined for the second yearly reporting date. Therefore, on a cumulative basis, no amount is recognised if the equity instruments granted do not vest because of a failure to satisfy market and/or non-market vesting conditions.
In order to illustrate the hedging and accounting of SOPs and SARs, let us look at an example. Suppose that ABC, a European company, on 1 January 20X1 granted two share-based plans, an SOP and an SAR, with identical terms (except the settlement feature) to its top management. The main terms of the SOP were the following (see Figure 10.6):
Under the SOP, if a beneficiary exercised his/her options, he/she would pay the exercise amount (i.e., the EUR 50.00 strike times the number of options exercised) and receive his/her options' underlying ABC shares. The SOP had a 3-year vesting period. After completion of the vesting period, each beneficiary could exercise his/her vested options during the year commencing on the end date of the vesting period, subject to the achievement of three vesting conditions: (i) that ABC's stock price outperformed the European most liquid stock index, the Euro Stoxx 50; (ii) that the beneficiary remained an employee during the vesting period; and (iii) that during the vesting period ABC's EBITDA grew at least 10% annually.
Under the SAR, the mechanics were the same except for its payoff upon exercise. If a beneficiary exercised his/her options, he/she would receive in cash the intrinsic value of his/her options. The intrinsic value of the options was defined as the difference between the value of ABC's stock at expiry and the EUR 50.00 award exercise price, for the number of options the beneficiary had exercised. Figure 10.7 depicts the SAR payoff as a function of the stock price on exercise date (the volume-weighted average price on that date).
ABC's embedded equity stock option (including the market conditions) was fair valued only when the SOP was granted. The compensation expense was calculated at each balance sheet date by adjusting the fair value of the embedded equity option for the likelihood of achievement of the non-market and service conditions. The total fair value was recognised as a personnel compensation expense spread over the vesting period of the plan and an equity reserve.
On grant date, ABC estimated the fair value of the equity option, ignoring the non-market and service vesting conditions, but taking into account the non-vesting conditions (in this case there were no non-vesting conditions). Based on historical data, ABC estimated that on average the beneficiaries would exercise the fair value of the option at the end of the first 6 months of the exercise period (i.e., 3.5 years after the grant date). Thus, the best estimation of the expected life of the award was 3.5 years. The fair value of the equity option was calculated by pricing a call option on ABC stock with a strike of EUR 50.00 (i.e., at-the-money), an expiry of 3.5 years, a volatility equal to the implied volatility for such options on ABC stock, and a 2% expected dividend yield of ABC stock during its life. The option valuation also included the market vesting condition (the outperformance of the Euro Stoxx50 index), assuming a 60% correlation between ABC's stock price and the index. ABC used the Monte Carlo simulation method to estimate the fair value of this option, coming up with a fair value of EUR 21 million. Note that the fair value of the option did not include any estimates regarding the non-market and service conditions.
No accounting entries took place on grant date.
At each reporting date, the total compensation expense associated with the award was calculated (see Figure 10.8). The expense was measured by adjusting the equity option fair value (which was calculated on the grant date) for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest. Based on historical top employee turnover data, ABC estimated the percentage of the beneficiaries expected to leave the company before the vesting period lapsed. Also ABC estimated the likelihood of ABC's EBITDA achieving a 10% annual growth rate during the vesting period.
The total compensation (i.e., personnel) expense was evenly allocated over the 3-year vesting period of the award. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.
Date | Equity option fair value (EUR mn) | Adjustment due to non-market conditions | Total personnel expense (EUR mn) | Period personnel expense (EUR mn) | Adjustments to previous entries (EUR mn) |
31-Dec-X1 | 21.0 | 80% | 16.8 | 5.6 | — |
31-Dec-X2 | 21.0 (1) | 70% (2) | 14.7 (3) | 4.9 (4) | <0.7 > (5) |
31-Dec-X3 | 21.0 | 75% | 15.8 | 5.3 | 0.8 (6) |
Notes:
(1) Calculated on grant date, and fixed during the life of the award
(2) Estimated at each reporting date
(3) Calculated as (1) × (2) = 21 mn × 70%
(4) Calculated as (3)/Number of accounting periods = 14.7 mn/3
(5) 4.9 mn – 5.6 mn
(6) (5.3 mn × 2) – (4.9 mn × 2)
On 31 December 20X1, ABC estimated the expected likelihood of meeting the non-market vesting conditions to be 80%. A EUR 16.8 million total compensation expense was calculated by multiplying the EUR 21 million equity option fair value by the 80% estimate. The compensation expense allocated to the first year was charged to profit or loss and a corresponding increase in equity recognised as follows (amounts in EUR million):
On 31 December 20X2, the expected likelihood of meeting the non-market and service vesting conditions was re-estimated to be 70%. A EUR 14.7 million total compensation expense was calculated by multiplying the EUR 21 million equity option fair value by the 70% estimate. The compensation expense allocated to the second year was charged to profit or loss and a corresponding increase in equity recognised as follows (amounts in EUR million):
Also on 31 December 20X2, a EUR 0.7 million adjustment to the compensation expense was implemented as the new annual expense was EUR 4.9 million while the personnel expense recognised on 31 December 20X1 was EUR 5.6 million. The adjustment was recorded as follows (amounts in EUR million):
Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):
Following each exercise and at maturity of the SOP, the balance of the SOP reserve was recycled to another account of the shareholders' equity section. There were two scenarios to consider: (i) all (or part of) the plan options expired unexercised; and (ii) all (or part of) the plan options were exercised.
In order to describe the accounting entries under the first scenario, suppose that under ABC's SOP all the beneficiaries behaved identically and that on the SOP's expiration date on 31 December 20X4 no beneficiaries exercised their options. On that date, the SOP reserve had a carrying amount of EUR 15.8 million. Therefore, a compensation expense of EUR 15.8 million was recognised during the SOP's vesting period. It would have been illogical to leave an amount on the SOP reserve related to an SOP that no longer existed. Therefore, the balance of the SOP reserve was reclassified to some other account(s) of the shareholders' equity section. In this example I use the “retained earnings” account, but depending on the legal jurisdiction of the entity another equity account could have been used (e.g., “share premium”). The accounting entries were the following (amounts in EUR million):
Under the second scenario, exercise of the SOP, there was also a transfer within the shareholders' equity section, but the accounts affected depended on the action taken by the company. Suppose that upon exercise of the SOP, the company could either (i) issue new shares or (ii) deliver treasury shares.
Suppose that the SOP was exercised simultaneously by all the beneficiaries at the end of the fourth year and that ABC issued 2 million new shares, with a nominal value of EUR 2 million. Upon exercise of the SOP the beneficiaries paid the EUR 100 million (=2 mn × 50.00) strike amount in exchange for the new shares. The accounting entries were the following (amounts in EUR million):
If the company delivered treasury shares instead, the accounting entries would be the following (amounts in EUR million), assuming that the treasury shares delivered were previously recognised at EUR 15 million:
If at the end of the vesting period, the non-market condition (i.e., a 10% growth in EBITDA) had not been achieved, a reversal of the SOP's personnel expense already recognised would have taken place. Thus, on a cumulative basis no amount of personnel expense would not be recognised if the equity instruments granted did not vest because of a failure to satisfy non-market vesting conditions or service conditions.
If the non-market vesting conditions and the service conditions were satisfied while an SOP's market and non-vesting conditions (in our case there were no non-vesting conditions) were met, the personnel expense would not be reversed, and the total expense would end up increasing shareholders' equity, even if the SOP expired unexercised. Thus, if an SOP has a market vesting condition or a non-vesting condition, the company might still recognise an expense even if that condition is not attained and the option does not vest.
From the grant date ABC knew the maximum amount of compensation expense that it could end up recognising in profit or loss. This maximum amount was the fair value of the equity option on grant date (i.e., EUR 21 million).
The whole SAR award was fair valued periodically at each balance sheet date. The fair value was recognised as a personnel expense spread over the life of the plan and a liability.
No actions and no accounting entries took place on the grant date.
At each reporting date and at maturity, the total compensation expense associated with the award was calculated (see Figure 10.9) by estimating the fair value of the embedded equity option expense and adjusting it for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest.
The total compensation (i.e., personnel) expense was evenly allocated over the 3-year vesting period. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.
Date | Equity option fair value (EUR mn) | Adjustment due to non-market conditions | Total personnel expense (EUR mn) | Period personnel expense (EUR mn) | Adjustments to previous entries (EUR mn) |
31-Dec-X1 | 20.0 | 80% | 16.0 | 5.3 | — |
31-Dec-X2 | 26.0 (1) | 70% (1) | 18.2 (2) | 6.1 (3) | 0.8 (4) |
31-Dec-X3 | 29.0 | 75% | 21.8 | 7.3 | 2.4 (5) |
Notes:
(1) Calculated at each reporting date
(2) 26.0 mn × 70%
(3) Calculated as (2)/Number of accounting periods = 18.2 mn/3, assuming a 3-year vesting period
(4) 6.1 mn – 5.3 mn
(5) (7.3 mn × 2) – (6.1 mn × 2), assuming a 3-year expected life of the SAR
On 31 December 20X1, ABC estimated both (i) the fair value of the embedded equity option (EUR 20 million) and (ii) the expected likelihood of meeting the non-market and service vesting conditions (80%). A EUR 16 million total compensation expense was calculated by multiplying the EUR 20 million equity option fair value by the 80% estimate. The compensation expense allocated to the first year was charged to profit or loss and a corresponding increase in liabilities recognised as follows (amounts in EUR million):
Repeating the process executed on the previous reporting date, on 31 December 20X2 ABC estimated a EUR 18.2 million compensation expense. Of this expense, EUR 6.1 million was allocated to the second year, charged to profit or loss and to liabilities as follows (amounts in EUR million):
Also on 31 December 20X2, a EUR 0.8 million adjustment to the compensation expense was implemented as the new annual expense was EUR 6.1 million while the personnel expense recognised on 31 December 20X1 was EUR 5.3 million. The adjustment was recorded as follows (amounts in EUR million):
Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):
Suppose that no beneficiaries exercised their rights prior to the SAR's expiry date. Suppose further that at expiry, on 31 December 20X4, all the beneficiaries behaved identically. As a consequence, there were two scenarios to consider: (i) that all the SAR options expired unexercised; and (ii) that all the SAR options were exercised.
Under the first scenario, the SAR lapsed fully unexercised. Thus, the SAR's fair value was zero. At the previous reporting dates a total EUR 21.8 million compensation expense was recognised. Therefore, this compensation expense had to be reversed on 31 December 20X4. The accounting entries were the following (amounts in EUR million):
Under the second scenario, the SAR was fully exercised. Suppose that on 31 December 20X4 ABC's share price was EUR 68. The SAR's fair value was EUR 36 million (=2 mn × (68 – 50)). As ABC had already recognised a total EUR 21.8 million compensation expense, an additional EUR 14.2 million (=36 mn – 21.8 mn) expense was recognised as follows (amounts in EUR million):
Additionally, the EUR 36 million cash award payment to the beneficiaries was recognised as follows (amounts in EUR million):
At each reporting date ABC had to fair value the SAR award. This had several implications:
In this section I cover the main strategies to hedge SOPs and SARs, based on ABC's share awards (see Figure 10.10).
One not unusual hedging strategy is to do nothing. ABC would be exposed to the risk inherent in the plans. The risks in an SOP and in an SAR differ due to their accounting and settlement differences. Thus, hedging strategies for an SOP may not work for an SAR, and vice versa.
Under its SOP, ABC was not exposed to equity market risk. Remember that from an accounting perspective, the equity option embedded in the SOP award was estimated at grant date. During the expected life of the award, the equity option was not further fair valued. Only the expectations of meeting the non-market conditions were reassessed at each reporting date. Therefore, ABC's profit or loss statement was not exposed to changes in ABC's stock price or changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the Euro Stoxx 50 index). In other words, ABC's profit or loss was not exposed to equity risk. While ABC's profit or loss was exposed to non-market risk (i.e., a 10% average EBITDA growth), its hedge was unavailable in the market.
ABC's shareholders were exposed to dilution risk. If the SOP ended up being exercised, ABC needed to deliver shares to the beneficiaries. Probably these shares would be newly issued, increasing the number of shares outstanding, and thus diluting existing shareholders. Nonetheless, the dilution risk was limited as new shares would be issued at a pre-established fixed price (EUR 50.00 per share).
ABC was exposed to equity market risk. Remember that, from an accounting perspective, under the SAR the equity option was fair valued at each reporting date. Therefore, ABC's profit or loss was exposed to changes in ABC's stock price and to changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the Euro Stoxx 50 index).
ABC's profit or loss was exposed as well to the achievement of a non-market condition (i.e., a 10% average EBITDA growth). However, hedging this risk was unavailable in the market.
ABC was also exposed to liquidity risk. Upon exercise, ABC needed to pay a cash amount to the beneficiaries. A large amount of cash may require ABC to use precious liquidity resources or/and to raise financing.
ABC was not exposed to dilution risk as upon exercise no shares were delivered to the beneficiaries.
Hedging with treasury shares is the most common way to hedge SOPs and SARs. In order to fully hedge the SOP/SAR with treasury shares, on 1 January 20X1 ABC needed to acquire 4 million shares in the market, investing EUR 100 million. The treasury shares were held on its balance sheet in a quantity that coincided with the number of unexercised stock options. Each time a beneficiary exercised his/her option rights:
At maturity of the plan, ABC needed to decide what to do with the remaining shares. In theory, ABC sold the shares in the market, but alternatively it could retain any remaining shares for future SOPs/SARs.
This strategy can be optimised by taking into account the likelihood of meeting the non-market conditions and the market conditions not directly related to ABC's stock price. As a result, ABC would acquire a number of shares equivalent to the number of options expected to vest.
The strategy had the following strengths:
The strategy had the following drawbacks:
One relatively common hedging strategy is to enter into an equity swap. Due to their significantly different effects, I will separate the analysis for each type of award.
Suppose that ABC hedged its SOP plan with an equity swap. The strategy was in a way similar to a combination of a financing and an acquisition of treasury shares. Suppose that ABC entered into a total return equity swap with the following terms:
The strategy was executed as follows:
The equity swap was classified for accounting purposes as an equity instrument. The initial accounting entry under IFRS was to recognise a liability for an amount equal to the present value of the equity swap notional, with a debit to an equity account.
The equity swap was not fair valued during its life. As a result, the equity swap did not add volatility to ABC's profit or loss statement as both the plan (ignoring service conditions) and the equity swap did not require fair valuing after the grant date. However, a liability was recognised, increasing ABC's leverage metrics.
Suppose that ABC hedged its SAR plan with an equity swap. The terms were identical to those of the equity swap traded to hedge the SOP, except its settlement terms. The equity swap hedging the SAR allowed for cash settlement only. Therefore, at each partial early termination and/or at maturity, ABC received, if its stock price was above EUR 50.00, an amount equal to
or paid, if its stock price was below EUR 50.00, an amount equal to
Figure 10.11 shows the equity swap settlement amount as a function of the final price at maturity (i.e., the volume-weighted average price on that date). It can be seen that if the final price was above EUR 50.00 and ignoring the SAR's service conditions, ABC perfectly hedged its commitment under the SAR. However, if the final price was below EUR 50.00, ABC lost a substantial amount.
The strategy was executed as follows:
The equity swap was classified for accounting purposes as a derivative. It was unlikely that ABC could apply hedge accounting as the payoffs of the SAR (a call option) and the equity swap (a forward like) were very different when ABC's stock price was below EUR 50.00. Assuming that the equity swap was undesignated, it was fair valued through profit or loss at each reporting date. Remember that the SAR was also fair valued at each reporting date, but the change in fair value was allocated over the 3-year vesting period. Therefore:
In summary, hedging an SAR with an equity swap may cause substantial distortions in an entity's financial statements. In the next subsection I will discuss a friendlier variation on the equity swap.
The strategy had the following strengths:
The strategy had the following drawbacks:
It was concluded in the previous subsection that hedging an SAR with an equity swap can create substantial distortions in an entity's financial statements, especially in profit or loss. In this subsection I will discuss a friendlier variation on the equity swap.
A long position in an equity swap can be viewed as the combination of a purchased call option and a sold a put option, with a strike equal to the equity swap's reference price (see Figure 10.12).
In our case, ABC bought a call option and sold a put option with the following common terms to hedge the SAR:
Now, from an accounting point of view, ABC would be likely to apply hedge accounting for the call option. As a result, the change in the fair value of the SAR (excluding the effect of the service conditions) and that of the call option, after both have been allocated to the vesting period, would cancel each other in profit or loss (see Section 10.4.5). The put would be recognised as a speculative derivative, and therefore, the full change in its fair value would be recognised in profit or loss. This way, the accounting mismatch between the SAR and its hedge would be caused only by the put. For example, if the put became deeper out-of-the-money, the accounting mismatch would gradually disappear.
One relatively uncommon hedging strategy is to acquire from a bank a call option that perfectly mirrors the equity option embedded in an SOP/SAR plan. Therefore, ABC would buy two call options with the following common terms:
The strategy was executed as follows:
As we can see, the exercises under the awards were perfectly hedged by the call options exercises. From an accounting point of view:
The strategy had the following strengths:
The strategy had the following drawbacks:
This case study covers the accounting of SOPs hedged with equity swaps. Suppose that on 1 January 20X0 ABC granted an SOP to its executives with the following terms:
Stock option plan terms | |
Grant date | 1 January 20X0 |
Vesting period | 3 years (from 1 January 20X0 until 31 December 20X2) |
Exercise date | 31 December 20X2 |
Strike | EUR 10.00 |
Underlying shares | Ordinary shares of ABC |
Number of options | 10 million (each option was on one ABC share) |
Settlement | Physical delivery |
Service conditions | Each grant was conditional upon the beneficiary remaining in service over the vesting period |
Non-market vesting conditions | Each grant was conditional upon ABC's EBITDA achieving a 10% annual growth rate during the vesting period |
Other | ABC was committed to meet the potential exercises by delivering its own treasury shares (i.e., by not issuing new shares) |
In order to hedge future exercises under the plan, ABC considered the following possibilities:
Equity swap terms | |
Start date | 1 January 20X0 |
Counterparties | ABC and XYZ Bank |
Maturity date | 31 December 20X2 (3 years) |
Reference price | EUR 10.00 |
Number of shares | 10 million shares |
Nominal amount | EUR 100 million |
Underlying | ABC ordinary shares |
Settlement | Physical delivery (ABC was obliged to buy on maturity date the number of shares at the reference price) |
ABC paid | Euribor 12-month plus 0.50% annually, actual/360 basis, on the nominal amount |
ABC received | 100% of the gross dividend distributed to the underlying shares. ABC received these amounts on dividend payment date |
On the SOP grant date, ABC had to value the award granted, excluding the service and non-market vesting conditions. ABC used the Black–Scholes valuation model with the following inputs: a 3-year time to expiry, a EUR 10 strike, a 20% volatility, a 10 million share nominal, a 4.50% interest rate and a 3% dividend yield. The value of the equity option underlying the SOP using this model, excluding the non-market conditions, was EUR 14 million.
At each reporting date, ABC calculated the adjusted fair value of the SOP (i.e., also including the service and non-market conditions). The SOP's EUR 14 million initial value had to be adjusted to incorporate only the expected number of options that would vest. Vesting was conditional on the beneficiary's continual employment and the achievement of a 50% growth in ABC's EBITDA during the SOP term. ABC's estimates at each reporting date are shown in the following table:
Date | Expected number of options to vest | Adjusted fair value of plan | Annual expense |
31-Dec-X0 | 8.5 million | EUR 11.9 million (=8.5 mn/10 mn × 14 mn) |
EUR 3,967,000 |
31-Dec-X1 | 8 million | EUR 11.2 million (=8 mn/10 mn × 14 mn) |
EUR 3,733,000 |
31-Dec-X2 | 8.2 million | EUR 11.48 million (=8.2 mn/10 mn × 14 mn) |
EUR 3,827,000 |
Under the equity swap, on 31 December 20X2 ABC was obliged to pay EUR 100 million to XYZ Bank, and in exchange XYZ Bank was obliged to deliver 10 million shares to ABC. This obligation to purchase a fixed number of shares for a fixed amount of cash represented a forward on ABC's own shares. The present value of the consideration to be paid was initially recognised as a liability and an equity instrument. Assuming that at the beginning of the transaction 3-year straight debt issued by ABC yielded 4.50%, the present value of the EUR 100 million was EUR 87,630,000 (=100 mn/(1 + 4.5%)3). The liability carrying value increased at each reporting date to reach a final EUR 100 million consideration, as follows:
Date | Interest expense | Liability carrying value |
1-Jan-X0 | 87,630,000 | |
31-Dec-X0 | 3,943,000 | 91,573,000 |
31-Dec-X1 | 4,121,000 | 95,694,000 |
31-Dec-X2 | 4,306,000 | 100,000,000 |
The required journal entries were as follows.
ABC recognised a EUR 87,630,000 liability representing the present value of ABC's future commitment to pay EUR 100 million.
The estimated fair value of the SOP on 31 December 20X0 was EUR 11.9 million to be spread over the 3-year vesting period (i.e., EUR 3,967,000 per annum). Thus, ABC recognised a EUR 3,967,000 employee benefits annual expense.
The estimated fair value of the SOP on 31 December 20X1 was EUR 11.2 million, to be spread over the 3-year vesting period (or EUR 3,733,000 per annum). As EUR 3,967,000 was already recognised on 31 December 20X0, a EUR 3,500,000 (=3,733,000 × 2 – 3,967,000) amount was recognised as employee benefits compensation expense.
Through the equity swap, ABC paid an annual interest of Euribor 12-month plus 50 bps. Suppose that the Euribor 12-month rate was 4.20% and that there were 365 days in the interest period. The interest expense for the period was EUR 4,765,000 (=100 million × (4.2%+0.50%) × 365/360). This interest was paid on 31 December 20X1 as well.
Through the equity swap, ABC received an amount equivalent to the dividends distributed to the underlying shares. Suppose that ABC distributed a EUR 0.32 dividend per share on 31 December 20X1. As a result ABC received a EUR 3,200,000 manufactured dividend which was recognised as income in profit or loss.
Finally, ABC had to recognise the liability's EUR 4,121,000 interest accrual.
The estimated fair value of the plan on 31 December 20X2 was EUR 11.48 million, to be spread over the 3-year vesting period. As a total of EUR 7,467,000 was already recognised, a EUR 4,013,000 (=11,480,000–7,467,000) amount was recognised as employee benefits compensation expense.
Through the equity swap, ABC paid an annual interest of Euribor 12-month plus 50 bps. Suppose that the Euribor 12-month rate was 4.40% and that there were 365 days in the interest period. The interest expense for the period was EUR 4,968,000 (=100 mn × (4.4% + 0.50%) × 365/360). This interest was paid on 31 December 20X2 as well.
Suppose that ABC distributed a EUR 0.34 dividend per share on 31 December 20X2. As a result, a EUR 3,400,000 manufactured dividend was recognised.
Additionally, ABC recognised the liability's EUR 4,306,000 interest accrual.
The hedge via the equity swap worked very well because the SOP ended up being exercised. The combined effect on ABC's financial statements of the SOP and the equity swap during the 3 years was as follows:
Nevertheless, the hedge was imperfect and exposed ABC from a cash flow perspective (although not from a profit or loss perspective) to a decline in its share price. Suppose that on exercise date the shares were trading at EUR 8.00 per share and, as a consequence, that the SOP beneficiaries did not exercise their options. Suppose further that ABC decided to sell in the market (at EUR 8.00 per share) the shares it acquired through the equity swap. The effects on ABC's financial statements would have been (see Figure 10.15) as follows:
This case study covers the accounting of an SAR plan when hedged with a call option on own shares. As explained previously in this chapter, an SAR is an award entitling beneficiaries to receive cash in an amount equivalent to any excess of the fair value of a stated number of shares of the employer's common shares over a stated price. Suppose that on 1 January 20X0 ABC granted an SAR to its executives with the following terms:
Share appreciation rights plan terms | |
Grant date | 1 January 20X0 |
Vesting period | 3 years (from 1 January 20X0 until 31 December 20X2) |
Exercise date | 31 December 20X2 |
Strike | EUR 10.00 |
Number of rights | 10 million (each right was for one ABC share) |
Settlement | Cash settlement |
Vesting conditions | Beneficiary being in continual employment and achievement of a 50% growth of ABC's EBITDA during the SAR term |
Each right provided for a cash amount payment equivalent to the appreciation of ABC's share price above EUR 10.00. Subject to meeting the vesting conditions, ABC was exposed from a cash flow perspective to a rising share price from EUR 10.00.
In order to hedge future exercises under the SAR, ABC bought from XYZ Bank a call option indexed to ABC's own stock and paid a EUR 11.9 million up-front premium. The number of call options equalled the number of SAR options that ABC expected would vest (8.5 million). The call allowed for cash settlement only, to match the cash payment under the SAR. The remaining terms of the call option were identical to those of the SAR:
Call option terms | |
Trade date | 1 January 20X0 |
Option buyer | ABC |
Option seller | XYZ Bank |
Underlying | ABC ordinary shares |
Expiry date | 31 December 20X2 |
Strike | EUR 10.00 |
Number of options | 8.5 million |
Up-front premium | EUR 11.9 million |
Settlement | Cash settlement |
Ignoring the up-front premium, this was the best hedge possible: if the SAR was exercised ABC would exercise the hedging call option, and conversely, if the plan was not exercised then the call option would not be exercised. If the SAR vesting conditions were not met, a potential call payoff would be kept by ABC and not passed on to the SAR beneficiaries.
The call was designated as the hedging instrument in a cash flow hedge of the highly expected cash flow stemming from the SAR. I have not included the hedge documentation or the effectiveness assessment performed at hedge inception and at each reporting date to avoid unnecessary repetition (see the cash flow hedges in other chapters).
When defining the hedging relationship, ABC had to make several key decisions:
Under IFRS 9, when hedging with an option, and entity may choose to assess hedge effectiveness on either (i) changes in the entire value (i.e., both intrinsic value and time value) of the purchased call option or (ii) changes in the intrinsic value of the option. Commonly, designating only the intrinsic value as the hedging instrument enhances effectiveness as in most instances the hedged item does not have time value. This common rule does not hold in this case. An SAR's resulting liability is adjusted to fair value each reporting period rather than to an amount equivalent to the excess of the then current fair value of the stated number of shares over a stated price (i.e., the SAR's intrinsic value). In other words, the fair valuation of an SAR consists of a time value portion and an intrinsic value portion. Therefore when the hedge item is an SAR, hedge effectiveness would be assessed based on changes in the entire fair value of the purchased call option, rather than just the intrinsic value. As a result, ABC designated the call option in its entirety as the hedging instrument in a cash flow hedge.
The fair values of the call option at each reporting date are shown in the following table:
Date | ABC share price | Call fair value | Period change | Call intrinsic value | Call time value |
1-Jan-X0 | 10.00 | 11.9 mn | — | -0- | 11.9 mn |
31-Dec-X0 | 9.00 | 3.4 mn | <8.5> mn | -0- | 3.4 mn |
31-Dec-X1 | 11.00 | 11.05 mn | 7.65 mn | 8.5 mn | 2.55 mn |
31-Dec-X2 | 13.00 | 25.5 mn | 14.45 mn | 25.5 mn | -0- |
At each reporting date and on the SAR maturity date, ABC had to fair value the granted rights:
Date | Unadjusted fair value of SAR (EUR) | Expected number of options to vest | Adjusted fair value of plan | Annual expense |
31-Dec-X0 | 4 million | 8.5 million | EUR 3.4 million (=8.5 mn/10 mn × 4 mn) |
EUR 1,133,000 |
31-Dec-X1 | 13 million | 8 million | EUR 10.4 million (=8 mn/10 mn × 13 mn) |
EUR 3,467,000 |
31-Dec-X2 | 30 million | 8.2 million | EUR 24.6 million (=8.2 mn/10 mn × 30 mn) |
EUR 8,200,000 |
The SAR was granted, no accounting entries were needed to record the award. The call purchase was recognised. ABC paid EUR 11.9 million.
The adjusted fair value of the SAR was EUR 3.4 million, which corresponded to an annual expense of EUR 1,133,000 (=3.4 mn/3) over the SAR's 3-year term.
The adjusted fair value of the SAR was EUR 10.4 million, which corresponded to an annual expense of EUR 3,467,000 (=10.4 mn/3) over the SAR's 3-year term. This amount represented a total EUR 6,934,000 (=3,467,000 × 2) to be expensed over the first 2 years. Because EUR 1,133,000 had already been expensed, a EUR 5,801,000 (=6,934,000 – 1,133,000) personnel expense was recognised during the period.
The adjusted fair value of the SAR was EUR 24.6 million, which corresponded to an annual expense of EUR 8,200,000 (=24.6 mn/3) over the SAR 3-year term. Because EUR 6,934,000 had already been expensed, a EUR 17,666,000 (=24,600,000 – 6,934,000) personnel expense was recognised.
The hedge worked reasonable well. The entity spent EUR 11.9 million buying the call, which corresponded to an expected EUR 3,966,000 annual compensation expense. As shown in the following table, there was a relatively small total deviation of EUR <61,000> (=132,000 + <193,000>) from that target.
Reporting date | 31-Dec-X0 | 31-Dec-X1 | 31-Dec-X2 |
SAR compensation expense | <1,133,000> | <5,801,000> | <17,666,000> |
Call compensation expense | <2,833,000> | 1,967,000 | 13,507,000 |
Total compensation expense | <3,966,000> | <3,834,000> | <4,159,000> |
Target compensation expense | <3,966,000> | <3,966,000> | <3,966,000> |
Deviation | -0- | 132,000 | <193,000> |
In addition, ABC recognised in profit or loss a EUR 960,000 other financial income stemming from the ineffective part of the hedge.
The hedge worked reasonably well in part because the amount of underlying shares in the call (8.5 million) was relatively similar to the amounts of SAR awards being exercised. The hedging instrument must be constructed in such a manner as to consider the vesting provisions of the hedged SAR. A larger than expected achievement of an SAR's vesting conditions would result in underhedging, leaving the entity exposed to its own share price. Conversely, too optimistic an expectation of vesting conditions achievement would result in overhedging, implying that the entity paid a higher than needed premium to hedge the SAR.
A call option indexed to own shares has to be classified as a derivative in order to be eligible for designation as the hedging instrument in a hedge accounting relationship. In other words, a call option classified as an equity instrument would not be eligible as the hedging instrument in a hedge accounting relationship. Remember that a contract indexed to a company's own shares is classified as a derivative if its settlement may result in other than the entity paying/receiving a fixed number of shares in exchange for a fixed amount of cash (or other financial assets) – the fixed-for-fixed requirement. In our case, the call's cash settlement provision contravened the fixed-for-fixed requirement, allowing its designation as the hedging instrument in a hedging relationship. A similar result would have been achieved were a net share settlement alternative included or an election right between physical settlement and cash settlement (or net share settlement).
Ignoring vesting conditions, an SAR exposes an entity to its own share price risk. The higher its share price relative to the SAR's strike price, the greater the amount of cash that the entity would be required to pay to the SAR beneficiaries. This exposure starts as soon as the SAR is granted.