Accounting for the expense associated with equity compensation awards can be daunting, especially to folks who are new to equity compensation or those of us without a background in finance. To help your company determine if it should be expensing its equity compensation awards, read on.
The determination begins with a quick primer on IFRS 2, the accounting standard that governs the expensing of stock-based compensation issued to employees. IFRS stands for International Financial Reporting Standards, which are set by the IFRS Foundation’s standard-setting body, the International Accounting Standards Board (IASB). First released in 2003, IFRS aims to bring transparency, accountability and efficiency to financial markets around the world. The standards are currently required in more than 140 jurisdictions (all of the EU, Canada and Australia, to name a few), and permitted in many more.1 IFRS 2, the second standard issued by the IASB back in 2004, governs the proper accounting for share–based payments.
Why does IFRS 2 matter?
Equity compensation is an increasingly important part of a competitive compensation package design. Originally used as a way for early-stage technology startups to leverage equity instead of cash wages, equity compensation quickly spread across most high-growth industries as a tool to attract, retain and incentivize increasingly sophisticated employee populations. Incentivizing employees with equity has many advantages:
- Conserving cash – Equity compensation allows companies to redirect cash to other areas of the business. This is particularly relevant for startups and early-stage private companies that may be cash-strapped.
- Enhancing loyalty – Employees who hold company stock and equity awards find themselves in the same boat as the owners. This often makes them more invested in the success of the company and more motivated to help that company thrive. This type of motivation can be very powerful.
- Reducing employee turnover – Strategic vesting periods provide additional incentive for employees to stick around. Oftentimes, vesting periods include a three-year cliff, which means that if employees choose to leave before three years, they forfeit unvested equity compensation awards. An additional motivation to longevity with the company is watching the value of the company’s stock, and an employee’s awards, increase over time.
Despite these benefits, using equity compensation is not a walk in the park. It is a highly regulated activity, which is why smart companies generally rely on the expertise of advisors knowledgeable in securities laws, tax regulations, accounting standards and administration procedures. From an accounting perspective, equity compensation can be complicated to expense and even more complicated to track (we might be biased, but Shareworks Financial Reporting can help!). IFRS 2 sets out the principles for the accounting treatment, but doing the actual calculations can be a real challenge. Throw in a few different performance awards, people who leave the company before their awards vest, mobile and international employees, and you might be ready to pull your hair out.
When do you need to consider IFRS 2?
If a company issues any sort of stock-based compensation and is required to follow IFRS, then it will need to expense this compensation in accordance with IFRS 2. There are multiple steps involved to properly ascertain and report equity compensation expense under IFRS 2:
- You will need to calculate a proper grant date fair value, using an option-pricing model, most commonly the Black-Scholes method. You might need to adjust for your vesting conditions when estimating the fair value of the equity instruments granted.
- Once valued, you’ll need to estimate the number of equity instruments expected to vest and determine the total expense to the company over the vesting period. This number must be revised if the number of equity instruments expected to vest differs from previous estimates.
- You’ll then have to recognize this expense over the vesting period, in the location your participants are located and provide service, always using the graded (accelerated) method, with true-up for adjustments. Finally, you’ll need to make disclosures on your financial statements.
Employer Social Security liability, also known as National Insurance Contributions (NIC), on share-based compensation is an important consideration. In some jurisdictions, your company will accumulate Social Security liability on your share-based compensation. This can quickly become expensive to the company, driven by the nature of the calculation and the fact that in some jurisdictions Social Security is uncapped. Social Security liability is important to include in your planning and budgeting, because an equity allocation can have very different cost, depending on the location of the employee.
Need help with IFRS 2?
Feeling overwhelmed, need some help ensuring you are IFRS 2 compliant, or wanting to learn more about our financial reporting solution? Shareworks has an experienced team of equity compensation professionals standing by to help. Get in touch with us today.