Share Based Payments Explained
Share-based payments are a way for companies to compensate their employees with ownership in the company, rather than cash. This can take the form of stock options, restricted stock units (RSUs), or other forms of equity awards.
Here’s how share-based payments typically work:
- The company grants an employee the right to receive shares of the company’s stock at a future date, subject to certain conditions.
- The conditions might include the employee staying with the company for a certain period of time, achieving certain performance goals, or the company reaching a certain valuation or other milestone.
- Once the conditions are met, the employee receives the shares of stock, which they can then sell or hold as an investment.
- The value of the shares received by the employee will depend on the company’s stock price at the time of the grant and at the time the shares are ultimately received.
- The company will typically record an expense on its financial statements for the value of the share-based payment. The expense is based on the fair value of the shares at the time they are granted, and is spread out over the period of time that the conditions are expected to be met.
Share-based payments can be a complex area of accounting and can have significant financial and tax implications for both the company and the employees or service providers receiving the equity awards.
Let’s say a company wants to reward a key employee with an equity award in the form of stock options. The company grants the employee the option to purchase 1,000 shares of the company’s stock at a fixed price of $10 per share, with the option vesting over a four-year period.
In year one, the employee is granted the option to purchase 250 shares of stock. In year two, the employee is granted the option to purchase another 250 shares, and so on, until the full 1,000 shares have vested after four years.
If the stock price at the time of the grant is $10 per share, the option has no intrinsic value. But if the stock price increases over the four-year period and is worth $20 per share by the time the option fully vests, the employee can exercise their option to purchase the 1,000 shares at the fixed price of $10 per share, and then immediately sell the shares on the open market for $20 per share, realizing a profit of $10 per share.
The company would record an expense on its financial statements for the fair value of the option at the time of the grant, which is based on a variety of factors such as the stock price, expected volatility, and expected term of the option. The expense would be spread out over the four-year vesting period.
In what way are share based payments represented in financial statements?
Income statement: The fair value of share-based payments granted to employees is recognized as an expense in the income statement over the vesting period of the awards. The expense is generally recognized in the same period in which the related services are received by the company, which is typically the vesting period. The amount of expense recognized is based on the fair value of the awards at the grant date, adjusted for any forfeitures that occur during the vesting period.
Balance sheet: The fair value of share-based payments granted but not yet vested is recorded as a liability on the balance sheet until the awards vest. Once the awards vest, the liability is reclassified to equity. The equity section of the balance sheet is also impacted when employees exercise their share-based awards, as the exercise price paid by employees is recorded as an increase in share capital and share premium.
Cash flow statement: The cash flow statement reflects the cash inflows and outflows related to share-based payments. Cash flows related to the purchase of shares by employees upon exercise of their awards are classified as financing activities, while the cash inflows from the exercise of stock options or the vesting of restricted stock units are classified as operating activities.
Estimate fair value of the award:
- Start of year award 100 staff, 200 units $1 shares each at option price of $1.5
- Assume fair value at date of award = $2 each
- 2 years to vesting
How much is the equity reserve?
I will assume that the fair value of the award is equal to the market value of the shares at the time of the award, which in this case is $2 per share.
The total number of units granted is 100 staff x 200 units = 20,000 units.
The total fair value of the award is 20,000 units x $2 per unit = $40,000.
Since the award vests over 2 years, the annual expense recognized by the company would be $40,000 / 2 years = $20,000 per year.
To record the equity award on the company’s balance sheet, the company would create an equity reserve of $40,000 to reflect the total fair value of the award. As the award vests over time, the company would recognize the expense of $20,000 per year and reduce the equity reserve accordingly.
How about profile and loss charge?
The profit and loss charge associated with the equity award would depend on the accounting method used by the company. There are two main methods for accounting for equity awards: the fair value method and the intrinsic value method.
The fair value method requires the company to estimate the fair value of the equity award at the date of grant and recognize the expense of the award over the vesting period. In this example, we estimated the fair value of the award to be $40,000, which would be recognized as an expense over the 2-year vesting period. Therefore, the profit and loss charge for the equity award would be $20,000 per year for two years.
The intrinsic value method, on the other hand, calculates the expense of the award based on the difference between the market price of the stock at the date of grant and the exercise price of the equity award. If the exercise price is less than the market price at the date of grant, the intrinsic value is zero, and there is no expense to recognize. However, if the exercise price is greater than the market price at the date of grant, the intrinsic value is positive, and the expense is recognized over the vesting period. In this example, since the exercise price is $1.5 and the market price at the date of grant is $2, the intrinsic value is zero, and there is no expense to recognize under the intrinsic value method.
It’s important to note that the fair value method is the more commonly used method for accounting for equity awards and is generally considered to provide a more accurate reflection of the economic value of the awards.
How about cash flow?
In general, share-based payments do not have a direct impact on a company’s cash flow. The issuance of shares or stock options does not result in a cash outflow for the company. Instead, the cost of the share-based payment is recognized as an expense on the company’s income statement over the vesting period, which reduces the company’s net income and, therefore, its cash flows from operations.
However, if the company withholds shares upon exercise of stock options to cover taxes, the company may have a cash outflow to cover the tax liability. Additionally, if the company repurchases shares to fulfill equity awards or to manage dilution, the company will have a cash outflow to pay for those repurchases.
It’s also worth noting that the issuance of equity awards can have an indirect impact on a company’s cash flow by affecting its ability to raise capital in the future. The issuance of additional shares through equity awards can dilute the ownership interests of existing shareholders, which may make it more difficult for the company to raise additional capital in the future. This can impact the company’s cash flows if it is unable to obtain necessary funding for growth or operations.
What happen to equity reserve in second year accounting?
In the second year of the equity award’s vesting period, the company would recognize an expense equal to the fair value of the portion of the award that has vested during that year. Assuming that the equity award vests evenly over the two-year period, the expense recognized in the second year would be the remaining $20,000 ($40,000 total fair value divided by 2-year vesting period) divided by 2, which equals $10,000.
To account for the $10,000 expense recognized in the second year, the company would reduce the equity reserve by the same amount, leaving a remaining balance of $30,000 ($40,000 total fair value minus $10,000 expense recognized in year 1 and $10,000 expense recognized in year 2). The equity reserve represents the total fair value of the equity award, while the expense recognized in each year represents the portion of that fair value that has been earned by the employees over that year.
Company issues 20,000 units $1 shares, in exchange for 20,000 multiply $1.5 = $30,000
- Dr Cash $30,000
- Cr share capital $30,000 (20,000 units $1 shares, $10,000 premium)
- Company can switch $40,000 from equity reserve into share premium taking this to $50,000
- Since shares are worth $80,000 at issuance company loses $80,000
Alternatively, company purchases 20,000 $1 shares in market for $80,000
- Cr cash $80,000 – $30,000 = $50,000
- Dr share based pay equity reserve $50,000 (leaving the balance on the reserve at $10,000 deficit)
What happens if the share price at exercise data is underwater?
If the share price at the exercise date is lower than the exercise price of the equity award, it is said to be “underwater”. In this case, the holder of the equity award would not exercise the award, since doing so would require them to purchase shares at a price higher than the current market price. As a result, the equity award would expire unexercised.
If the equity award is not exercised, the company would not have to issue any shares or pay out any cash to the holder of the award. Therefore, the equity reserve would remain unchanged, and there would be no impact on the company’s financial statements or cash flow. However, the company may choose to reprice or modify the equity award to make it more attractive to the holder, in which case the impact on the financial statements and cash flow would depend on the specific terms of the repricing or modification.
What happens if 20 staff leave in second year and only 80 staff exercise their options?
If 20 staff leave in the second year and only 80 staff exercise their options, then the number of vested shares would be adjusted accordingly.
Assuming that the equity award vests evenly over the two-year period, the total number of vested shares at the end of the second year would be 80% of the original 200 units per staff member, or 160 units per staff member.
Therefore, the total number of vested shares for the 80 staff members who exercised their options would be 160 units per staff member x 80 staff members, or 12,800 units.
To account for the 20 staff members who left without exercising their options, the company would reduce the equity reserve by the fair value of the unvested portion of their awards. Assuming that the fair value of each unvested award is still $10, the company would reduce the equity reserve by 20 staff members x 40 units per staff member x $10 fair value per unit, or $8,000.
The company would then record the exercise of the options by the 80 staff members who did exercise. If the exercise price of the options is $1.50 per share, and the fair value of the shares at the exercise date is $2 per share, then the company would recognize an expense equal to the fair value of the shares at the exercise date ($2 per share) minus the exercise price ($1.50 per share), multiplied by the number of shares exercised (12,800 shares). This would result in an expense of $6,400 ($0.50 per share x 12,800 shares).
The company would record a cash inflow equal to the exercise price of the shares ($1.50 per share) multiplied by the number of shares exercised (12,800 shares), or $19,200.
Overall, the company’s equity reserve would be reduced by $8,000 for the unvested portion of the awards that were forfeited, and the company would recognize an expense of $6,400 for the portion of the awards that were exercised, while receiving a cash inflow of $19,200 for the shares that were issued.
What happens if the company purchases treasury shares during the 2 years?
If the company purchases treasury shares during the two-year vesting period of the equity awards, it would affect the calculation of the weighted average number of shares outstanding (WASO) used to determine the diluted earnings per share (EPS).
Treasury shares are shares of the company’s own stock that have been repurchased from the market or issued but not outstanding. Treasury shares reduce the number of shares outstanding and, therefore, decrease the WASO used in the calculation of diluted EPS.
Assuming that the treasury shares are repurchased at fair value and cancelled, the impact on the company’s financial statements would be as follows:
- The cash balance would decrease by the amount paid to purchase the treasury shares.
- The share capital account and the share premium account would not be affected because treasury shares are not considered to be outstanding.
- The number of outstanding shares would decrease, which would increase the earnings per share (EPS).
- The equity reserve would not be affected.
If the treasury shares are not cancelled and are held as treasury stock, they would be reported as a reduction of shareholders’ equity on the balance sheet. The treasury stock account is debited when shares are purchased and credited when shares are sold. The difference between the purchase price and the sale price of the treasury shares would affect the company’s income statement as a gain or loss on the sale of treasury shares.
In terms of the equity awards, the company would still need to record the fair value of the awards granted as a compensation expense, and the unexercised portion of the awards would still be recorded as a liability on the balance sheet. However, the impact on the diluted EPS calculation would need to take into account the reduced number of outstanding shares due to the treasury stock repurchases.