European companies operating share option plans for their employees are likely to see their reported earnings reduced, if draft accounting standards come in to force. In November 2002, the UK and International Accounting Standards (IAS) Boards published draft accounting rules (FRED31 and ED2) requiring share-based payments to be recognised in reported earnings from 1 January 2004. This will be a major issue for many companies, particularly those in Europe who will need to comply with IAS from 2005, if not before.
Current position
Current UK and international accounting rules do not generally require share options that are granted to employees to be charged as an expense, provided the plan design meets certain criteria. Although the criteria are different in the US, the same principle applies. As such no charge currently passes through the profit and loss account in respect of the vast majority of share option plans.
However, employee share options are about to come under the spotlight and, under the new rules, they will make a significant dent in company profits. The accounting boards are proposing that from 2004 companies preparing either UK or IAS accounts must recognise an expense to reflect the fair value of the share option awards granted. This is broadly in-line with the approach voluntarily adopted recently by a number of US companies, with much publicity.
A fair value model
The new rules state that an option-pricing model is required to calculate the fair value of options. Any such model will always look to the well-known Black-Schöles formula, a standard tool for analysing traded options. However, when it comes to valuing the complexities of employee share option plans, despite its brilliance, Black-Schöles falls down.
One key supposition of Black-Schöles is that the option can only be exercised on one day, but employee options can almost always be exercised over an extended period, perhaps up to seven years. Moreover, when it comes to allowing for employees’ behaviour, Black-Schöles does not have the parameters to cope.
To provide a more robust measurement, actuaries have turned their attention to the Binomial model. This uses the powerful mathematics underlying the Black-Schöles approach, but remains flexible enough to allow for the extended exercise periods found in employee options; it can cope with the complexities of employee options and also so-called “irrational” employee behaviour.
Reactions
FRED31 and ED2 mean that significant changes are on the way for European companies granting employee options. Companies reporting under UK or IAS GAAP need to understand the likely impact of the new accounting standards on their profits. Under this new spotlight, they will need to consider whether the cost of their employee share option plans is balanced by their employees’ perceived value - if not, the plan may be removed, or at least redesigned.
European companies operating share option plans for their employees are likely to see their reported earnings reduced, if draft accounting standards come in to force. In November 2002, the UK and International Accounting Standards (IAS) Boards published draft accounting rules (FRED31 and ED2) requiring share-based payments to be recognised in reported earnings from 1 January 2004. This will be a major issue for many companies, particularly those in Europe who will need to comply with IAS from 2005, if not before.
Current position
Current UK and international accounting rules do not generally require share options that are granted to employees to be charged as an expense, provided the plan design meets certain criteria. Although the criteria are different in the US, the same principle applies. As such no charge currently passes through the profit and loss account in respect of the vast majority of share option plans.
However, employee share options are about to come under the spotlight and, under the new rules, they will make a significant dent in company profits. The accounting boards are proposing that from 2004 companies preparing either UK or IAS accounts must recognise an expense to reflect the fair value of the share option awards granted. This is broadly in-line with the approach voluntarily adopted recently by a number of US companies, with much publicity.
A fair value model
The new rules state that an option-pricing model is required to calculate the fair value of options. Any such model will always look to the well-known Black-Schöles formula, a standard tool for analysing traded options. However, when it comes to valuing the complexities of employee share option plans, despite its brilliance, Black-Schöles falls down.
One key supposition of Black-Schöles is that the option can only be exercised on one day, but employee options can almost always be exercised over an extended period, perhaps up to seven years. Moreover, when it comes to allowing for employees’ behaviour, Black-Schöles does not have the parameters to cope.
To provide a more robust measurement, actuaries have turned their attention to the Binomial model. This uses the powerful mathematics underlying the Black-Schöles approach, but remains flexible enough to allow for the extended exercise periods found in employee options; it can cope with the complexities of employee options and also so-called “irrational” employee behaviour.
Reactions
FRED31 and ED2 mean that significant changes are on the way for European companies granting employee options. Companies reporting under UK or IAS GAAP need to understand the likely impact of the new accounting standards on their profits. Under this new spotlight, they will need to consider whether the cost of their employee share option plans is balanced by their employees’ perceived value - if not, the plan may be removed, or at least redesigned.
Alex Waite is a partner and actuary at Lane Clark & Peacock’s international office based in Winchester in the UK. LC&P is part of the MGAC network. is a partner and actuary at Lane Clark & Peacock’s international office based in Winchester in the UK. LC&P is part of the MGAC network.

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