1. PwC FRS 20 - Accounting for share-based payment

2. PWC 1 A transaction in which an entity obtains goods or services as consideration either for its own equity instruments or a payment based on the price of its equity instruments “It seems to me that the realities of stock options can be summarised quite simply: If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into a calculation of earnings, where in the world should they go?” Warren Buffett, 1993 What is a share-based payment?

3. Introduction PWC FRS 20 is a major change for almost all UK companies (not just listed companies) Will result in charge to profit and loss accounts when options/ rights to shares are issued in nearly all circumstances Changes the landscape for share scheme planning and transactions

4. PWC 3 FRS 20 covers share-based payments for goods or services Choice of settlement Goods and services Equity-settled Cash-settled Financial instrument transactions Business combinations Applies to: Does not apply to: x x Grants to all shareholders x

5. PWC 4 Non-identifiable services Nil or inadequate consideration is received Must account for the unidentifiable consideration

6. PWC 5 Equity-settled transactions EQUITY-SETTLED Measure at fair value of good/services received (direct) Measure at fair value of equity instruments granted (indirect) Not with employees With employees RequiredPresumed What about unidentifiable services?

7. PWC 6 Equity-settled transactions Equity instrument measured at date of grant Charge recognised over vesting period Credit entry reported in equity Dr P&L Cr Equity

8. PWC 7 Grant date and spreading period Grant date is the measurement date for employee services Grant date definition: when share-based arrangement is agreed and parties have a shared understanding of the terms and conditions Service commencement date may be before the grant date

9. PWC 8 Measuring fair value Use market prices, if available Otherwise, use an option pricing model taking into account: Market-based performance conditions also taken into account Option pricing model Exercise Price Current price of underlying shares Life of option (expected life) Share price volatility Expected dividends Risk-free rates for the period of the option

10. PWC 9 A Black-Scholes valuation model C= Se (-Dt) N(d1) – Xe (-rt) N(d2) Where: C= Value of a option S= Share price (£) X= Option exercise price (£) D= Dividend yield on underlying share (%) t= Time to expiry s= Volatility of the share price (%) r= Risk-free rate over the life of the option N(d n )= Value of d found from standard normal distribution curve And: d1= {Ln(S/X)+(r-D+s 2 /2)t}/s√ t d2 = {Ln(S/X)+(r-D-s 2 /2)t}/s√ t

11. PWC 10 Equity-settled transactions Measurement Fair value (FV) of each equity instrument granted (A) At grant date, estimate the total number of awards that will vest at the end of vesting period (ie. include assumptions of leavers during vesting period) (B) Each period’s compensation expense = B x A Vesting Period

12. PWC 11 Complete development project Market and non-market vesting conditions Achieve TSR above median in comparator group Exceed a TSR target Outperform share price index Achieve minimum share price Exceed EPS target Stay in employment until a specific date Exceed sales target MarketNon market x x x x Occurrence of an IPO x

13. PWC 12 AdjustmentNo adjustment Leavers (provided forfeit right to instrument) Awards vested with counter-party, not exercised Non-performance (provided not market based condition) Awards vested with counter-party, forfeited Market based performance conditions Equity-settled transactions Adjustment during vesting period

14. PWC 13 Example Entity grants 100 options to each of its 500 employees. Conditions: –Three years service –18% increase in share price by end of third year Estimate: –20% of employees will leave during the vesting period and forfeit options Fair value of one option at grant date is 15 (adjusted for probability of achieving market based performance condition)

15. PWC 14 Example (continued) So: Total fair value of the award (100 options) for each employee = 1,500 Total number of awards expected to vest is 400 (500 x 80%) Total expense = 600,000 (400 x 1,500)

16. PWC 15 Example (continued) Everything turns out as expected (ie. 20% of the 500 employees leave) Year 1 charge200,000 (400 x 1,500 x 1/3) Year 2 charge200,000 (400 x 1,500 x 1/3) Year 3 charge200,000 (400 x 1,500 x 1/3) Total charge600,000

17. PWC 16 Example (continued) At end of year 2, entity changes estimate from 400 to 440. The actual leavers are 10% at end of year 3. Year 1 charge200,000 (400 x 1,500 x 1/3) Year 2 charge240,000 (440 x 1,500 x 2/3) – 200,000 Year 3 charge235,000 (450 x 1,500 x 3/3) – 440,000 Total charge675,000

18. PWC 17 Modifications and cancellations Which of these are modifications? Lower exercise price Increase in number of awards granted Longer exercise period Longer vesting period ?

19. PWC 18 Cash-settled transactions Measure goods or services acquired and liability incurred at fair value of liability Spread over vesting period/period of goods and services Re-measure at each reporting date Credit entry is a liability D r P & L C r L i a b i l i t y

20. PWC 19 Disclosures Nature and extent of share-based payment arrangements that existed during the period How fair values were determined Effect of share-based payment transactions on the profit or loss for the period and financial position Catch all: Sufficient information

21. PWC 20 Transitional arrangements Some relief: Equity-settled transactions granted pre 7 November 2002 Equity-settled transactions granted post 7 November 2002, vested by effective date Cash-settled transactions settled during the comparative period Modified before specific dates

22. PWC 21 Group situations Parent Plc Subsidiary Ltd Parent company shares awarded to subsidiary employees

23. PWC 22 Share-based payments – summary Scope is broad Charge is taken to P&L over the vesting period based upon the scheme’s fair value Credit entry (equity-settled vs cash-settled) Fair value: measured & fixed at grant date for equity-settled Measurement can be complex – specialists? Disclosures Transitional rules - awards pre 7 November 2002 Group situations

24. PWC 23 Further guidance UK Manual of Accounting – chapter 12 IFRS Manual of Accounting – chapter 12 Hot topics UK ACS (Ask Us via PwC Inform) HRS valuation specialists

25. PwC FRS 20 - Accounting for share-based payment