Attempting to explain to (non-accountant) directors of a private company why there is an expense in the financial statements for something that will never cost the company anything is a conundrum that many accountants in practice and finance directors will be familiar with. Explaining the charge isn’t tax deductible either seems to only add to their confusion. The cause of this challenge? Share-based payments.

Conceptually sound

It is nearly 15 years since UK private companies first had to measure and recognise share-based payments with the arrival of FRS 20 Share-based Payment (an almost carbon copy of the equivalent international accounting standard IFRS 2 Share-based Payment). In that time, accountants and finance directors have learned to talk with an air of confidence about Black-Scholes, binomial models and the exotic sounding Monte Carlo simulation.

The conceptual answer to the problem is sound. With more and more companies exploring and exploiting the tax-friendly nature of share option schemes, it is appropriate to ensure financial statements reflect these arrangements. Two companies may operate in the same way and produce similar results but, while company A decides to reward its high performers with a bonus, company B issues share options. In theory, both companies should carry a charge for the perceived cost of the services they are getting in return from the employees. But, in company B’s case, how do you go about quantifying that charge?

Problematic in practice

For many listed companies, share-based payments have long been a fact of life. They are more likely to be issuing options on a frequent basis and, crucially, have the market data to allow them to provide relatively meaningful inputs into an option valuation model.

But for a privately owned company, valuing a share option has always been a problem area. Even the most fundamental and basic element of a Black-Scholes model, the share price at exercise, is not necessarily straightforward to quantify. And there are other equally, if not more, challenging inputs to deal with:

• What is the ‘expected life of the option’ when it is only exercisable on the sale of the company, as is the case for many option schemes? 
• How to estimate a dividend yield for a growing company?
• Should discounts be applied for small companies, or for sub-optimal behaviour? If so, how much?
• Where to start with estimating the volatility of a share that has zero trading data?

Time to question?

It is, of course, not impossible to value an option; the tools are there and have been used for many years. But given the level of judgement and estimates involved, and the lack of data on which to base such a valuation, is the end result meaningful, or indeed reliable, for the average user of private company financial statements? Whisper it quietly, but is this ‘valuation’ no more than a series of guesses, with the output being given an air of respectability by the use of a complicated mathematical model? As a profession, should we be asking ourselves whether, if the concept is so abstract and technical that only a qualified accountant with a good grasp of mathematical models can understand it, is it relevant?

With the next periodic review of FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland on the horizon, is it time to carry out a cost-benefit analysis of this complex requirement? I am sure many will be hoping for this area of accounting to be simplified. Perhaps requiring only disclosure of the terms of the share-based payments for private companies is a potential way forward.

About the author

Martin Howard, Partner, Hazlewoods