Understanding the recognition of share-based payments in the UK

Why is it relevant?

Share-based payments are a widely used form of employee compensation in the UK, particularly in sectors where talent acquisition and retention are critical. These payments provide employees with the right, but not the obligation, to purchase company shares at a predetermined price over a specific period. Share-based payments can be either cash-settled or equity-settled. Equity-settled options are particularly popular among businesses, especially start-ups, due to the absence of immediate financial commitments. Accurate accounting for, and taxation of, these share-based payments is essential, as it ensures transparency and enables stakeholders to assess the true costs associated with employee compensation.

Who does it affect?

Under FRS 102, companies must recognise the cost of share-based payments granted to employees in their financial statements. This recognition reflects the economic cost of providing these options, even though there may be no immediate cash outflow. However, such payments can have a long-term impact on the company’s financial position.

What do you need to know?

1. How are equity-settled share-based payments accounted for?

The expense associated with share-based payments is recognised over the vesting period, which is the time during which employees must remain with the company before they can exercise their options. The length of the vesting period varies depending on the terms of the scheme.

The cost is recorded as an expense in the profit and loss statement. The key point here is that the expense is recognised in the company providing the service. For example, if a UK subsidiary receives share-based payments from a foreign parent company, the UK entity must still recognise the related expense, even though the options are issued by a foreign entity.

On the balance sheet, the recognition of share-based payments results in an increase in equity, as these payments are linked to potential future share issues.

The value of the options granted is typically calculated using a fair value model, such as the Black-Scholes Model. This model considers several factors, including the exercise price, the expected life of the options, stock price volatility, the risk-free interest rate, and any dividends that may be paid during the option’s life. This fair value calculation ensures that the cost of share-based payments is accurately reflected in the financial statements, even if the options are not exercised immediately.

2. The impact on the financial statements

The recognition of share-based payments as an expense affects both the profit and loss account and the balance sheet. On the profit and loss statement, the expense is recorded over the vesting period, which may reduce reported profits, particularly in the early years. This gradual recognition of the expense reflects the fact that employees earn the right to exercise their options over time, even if the actual exercise occurs later.

There are different vesting methods to consider. For example, two common types of vesting are straight-line vesting and graded vesting. Under straight-line vesting, the vesting is evenly distributed over the vesting period. For instance, in a four-year vesting period, the employee would vest 25% each year. This method is consistent and linear, without any acceleration in later years. In contrast, graded vesting involves incremental vesting portions. For example, an employee might vest 25% at the end of the first year, then vest an additional 1/36th of the remaining portion each month thereafter.

On the balance sheet, the company’s equity increases as share-based payments are accounted for. As options are granted, a corresponding increase is recorded in share-based payment reserves within equity.

The final impact on equity materialises when the options are exercised, and new shares are issued, potentially diluting the ownership percentage of existing shareholders of the issuing entity.

This accounting treatment can also affect key financial ratios, such as earnings per share (EPS) and return on equity (ROE), which are closely monitored by investors. The recognition of share-based payments as an expense reduces EPS in the short term but offers a more accurate reflection of the company’s financial performance by recognising the cost of employee compensation.

3. What are the taxation implications of recognising share-based payments?

Companies that use share-based payments as a means to incentivise and reward their staff may expect a full Corporation Tax relief for the accounting expenses relating to the reward schemes. However, where employee rewards are provided for less than their market value (e.g. of share option award or restricted stock unit), the UK’s tax legislation allows a specific statutory deduction which is not linked to the accounting entries. The general rule is that statutory deduction is given in the period of account in which the rewards are awarded. The deduction is equal to the market value of the rewards at the time they are exercised less any amount paid by the employees for these rewards.

It is worth noting that this deduction is not automatic and requires that certain conditions covering the rewards, the taxable position of the employees and the companies granting them are met. No statutory deduction is available if the rewards are net cancelled, or cash cancelled when they are issued to the employees. If companies operate multiple reward schemes with numerous grants and exercises in the year, being able to collate appropriate data could create further complexities.

Given the above, companies that have implemented share-based payment schemes should ensure they understand the tax impact of operating such schemes and keep it under review to capture any changes to the UK tax legislation or the reward schemes themselves.

What should you do next?

Accounting for share-based payments is complex with both accounting and tax implications. The recognition of share-based payments in the UK ensures that companies account for the full cost of employee compensation, providing stakeholders with a clearer picture of the company’s financial health. By using a fair value model to calculate the cost of share-based payments and recognising this cost over the vesting period, companies can maintain transparency and accuracy in their financial reporting. This approach not only reflects the true economic cost of employee compensation but also assists investors and analysts in making more informed decisions about the company’s future prospects. Furthermore, UK companies controlled by foreign entities must recognise share option expenses for UK employees, regardless of the entity granting the options.

Additional consideration is required to understand the Corporation Tax relief available to companies operating share-based schemes as the relief is not automatic and is not linked to the accounting entries. As such, accounting for and taxation of share-based payments is complex and, in many cases, requires liaison with advisors at an early stage to ensure the impact is fully understood.

Contact us

If you would like to discuss the impact of share-based payments, please get in touch with James Smith, Evelina Panchal or your usual Blick Rothenberg contact using the details below or this form to see how we can assist with any future planning.