The new accounting treatment for share options has huge ramifications for corporate profits and the way in which high net worth executives a...

The new accounting treatment for share options has huge ramifications for corporate profits and the way in which high net worth executives are rewarded. Many commentators have predicted widespread doom and gloom but the UK’s QCA (Quoted Companies Alliance) in launching a new free comprehensive method to value share options for smaller quoted companies, called the QCA-IRS Option Valuer, have revealed that IFRS2 share option costs will be less than anticipated.

Under the new accounting rules, the fair value of options has to be estimated and will reduce profits, which may reduce a company’s stock market valuation. The choice of assumptions can add or reduce the option value by over 50 per cent.

The key assumptions affecting the valuation of share options for small cap companies are:
- Liquidity issues and the bid/offer spread, which reduce the price at which shares can be sold. A 20 per cent discount reduces the fair value by 33 per cent.
- The average length of time that options are held prior to exercise. Using a 5 year rather than a 3.5 year assumption increases the fair value by 25 per cent.
- Share price volatility of 50 per cent rather than 30 per cent increases the fair value by 50 per cent.
- Expected future dividend yield also affects the fair value, but there is rarely any choice in this assumption.

Other factors may further reduce the fair value by up to 30 per cent or more for small cap companies, e.g. some employees exercise options as soon as they can, when a significant share price increase has arisen; flaws in the Black-Scholes-Merton model which cause it to overvalue options for shares with high bid/offer spreads and low liquidity.

Background
Accountants have provided extensive advice on how to calculate the charge in the profit and loss account based on the “fair value” of an option. We are filling the gap by providing advice on how to calculate the “fair value” of an option.

“Share options are a valuable component of a comprehensive staff incentive package which should not be ruled out because of an academic formula for calculating their cost” wrote John Pierce the Chief Executive of the Quoted Companies Alliance in a letter to the Financial Times on 12 August.

The QCA have worked with Independent Remuneration Solutions, a remuneration consultancy, and City Group, a provider of company secretary, head office finance and administration services, to develop a model suited to the needs of smaller companies.

Together, they argue that smaller quoted companies are different, particularly in the width of their shares’ bid/offer spreads and liquidity which makes it impossible in many cases to sell large quantities of shares at anywhere near the mid-market price quoted. Also, in IRS’s experience, options in small companies tend to be exercised at the earliest opportunity. Their research and analysis, published today, demonstrates that options are not as valuable as some commentators have suggested.

This will be welcome news to all AIM companies who have to comply with the FRS 20 accounting standard for years commencing on or after January 1 2006. Those on the main market had to adopt the equivalent standard IFRS2 from January 1 2005.

Mr Pierce said: “The accounting standards board seem to want to fill accounts with fictional numbers arising from hypothetical transactions with imaginary people. Whilst we can complain and point out the flaws – and there are many- we have no choice. IFRS 2 and its UK equivalent FRS 20 have to adopted. I am pleased that we have developed some novel thinking which can support realistic option valuations in company accounts.”

Cliff Weight, Director of Independant Remuneration Solutions, said: “There is no doubt that some consultants and audit firms are trying to make this more complex than it really is in order to justify their fees.”

The QCA-IRS Option Valuer is free to QCA corporate members A survey of QCA members showed fees from advisers and auditors were typically in the £2,000 to £5,000 range. Mr Weight said “Advisors promoting the use of Binomial and Monte-Carlo models are wasting their clients’ money. Our model is easy to use and sufficiently robust. What matters in valuing options is the assumptions. The choice of option model is not material.”

Edward Beale, Chief Executive of City Group and the QCA’s leader in this project, said: “In the absence of an open market for share options it is not possible to validate any valuation model for smaller company share options. Companies should therefore use the simplest available model provided it gives a reasonable valuation. The QCA-IRS Option Valuer takes into account the impact of market imperfections, factors often assumed to be negligible in option valuation models, but which in reality have a major influence on valuations.“

Option accounting is a particularly big problem for the smaller quoted sector. A benchmark UK plc with a P/E ratio of 15, granting options over 1 per cent pa of its shares in issue, with a fair value of 30 per cent would have an expense cost equal to 4.5 per cent of profits. One with a P/E ratio of 30 would have an accounting charge equal to 9 per cent of profits. For start-ups and companies investing in future growth the accounting charge can wipe out profits or delay breakeven for many years. Costs are higher in companies who grant many more options.

Standard & Poor’s reckons that expensing employee options knocks 4 per cent off 2005 profits of the S&P500.

An ever present risk for smaller listed companies is that it tends to be the trading of individual investors that sets their share price, and individual investors tend to use the Financial Times, investor magazines and web sites as a primary source of information regarding investment opportunities (prior to any more detailed research).

Analysts tend to add back whatever number is used when doing their own valuations. But magazines and web sites are unlikely to adjust profit and PE listings to add back the “cost” of share options. Companies may not be considered in more detail for investment by individual investors because of a hidden, high “cost” of share options.

One problem for users of accounts is that the assumptions and methodology can produce widely different results. And it is too time consuming to investigate why. So companies should publish a profit figure prior to the IFRS 2 share schemes charge and recommend that their analysts and shareholders look at this profit figure.

Mr Weight has done much of the technical work. He explained “With options you have bifurcating outcomes. With a share option if the share price goes up, the employee can exercise the option and make some money. If the share price goes down the employee does not exercise the option.” By using contingent remuneration the company has kept down its employment costs. If the company is unsuccessful then there is no “cost”. If the company is successful there is a “cost” in that existing shareholders suffer dilution.

The problem is that the accounting rules require a single estimate of the “fair value”, but these are bifurcating outcomes - IRS analysis reveals that about 50 per cent of companies’ options would be underwater now if they had granted options on 1/1/2003; for options granted on 1/1/2001 two thirds would be underwater now. If the option expires worthless, there is no write back of the accounting charge through reported earnings. The company has received the employee’s services for “free”. But reported profits have been reduced even though the employee has no gain.

If the company offers employees the alternative of cash settlement of options the accounting is different. Mr Weight explains “with cash settled options the employee receives the notional gain in cash rather than in shares. This saves him having to pay the exercise price and subsequently having to sell the shares, and under IFRS 2 if there is no option gain then
the accounting charges are written back- the accounting charge is zero as is the cash cost. However, an identical option with no cash settlement alternative, results in an accounting charge, even if the option is not exercised. This is nonsense and the IASB should review it.”