Executive remuneration has always been a controversial subject. Investors are constantly poring over the numbers to see whether the money they are paying their executives matches up to performance. It’s highlighted by the media’s appetite for big payday stories and fat cat headlines.

Link: Access IFRS - PwC's IFRS resource centre

The launch of IFRS2, the international accounting standard for share-based payments, has placed accounting at the centre of the executive remuneration maelstrom and is already prompting changes in the way companies compensate their directors.

The new accounting standard requires companies to charge share options, which have only previously been disclosed in footnotes, through the income statement so investors can see exactly how much company board members stand to gain from options.

Although it has been less than a year since the new standard became obligatory for listed companies, research by PricewaterhouseCoopers shows that the change to share options accounting is already affecting the way executive remuneration packages are structured. A survey of the FTSE100 by the Big Four firm found that the proportion of incentive awards for chief executives had dropped from 36% to 21%.

The PwC poll also revealed that companies were beginning to prefer using share awards to share options, with the use of share awards increasing from 57% to 68% among FTSE100 chief executives.

Brian Peters, partner in the human resources services practice at PwC, says IFRS2 has sped up the trend from share options towards share awards. ‘There is a trend of moving away from share options to share awards and IFRS2 has been a catalyst for that change,’ says Peters.

‘Before IFRS2, there was generally no cost in the profit and loss account for share options.’

The new share-based payments standard will provide more rigorous disclosure for share options, which have been a contentious form of remuneration since the 1990s when it was estimated that executives used share option plans to get their hands on £550bn of shareholder funds.

Peters says that when share option plans were free in profit and loss terms, they were an appealing method for rewarding staff. However, share option plans did not always lead to appropriate reward, and many companies had in any case been looking to change their design. ‘In recent years, we have moved into a lower inflation environment, which makes it more likely that options will be underwater.

At the same time, shareholders have been encouraging companies to toughen the performance conditions on their option plans. PwC research shows that there is now typically a 60%chance that an employee will not receive any value at all from an option award. This uncertainty makes share options less attractive as a reward tool for many groups of employees.’

Now that the cost of options appears in the income statement, it will be clear how much executives stand to earn from them, and as a result, any actions which do not match up with shareholder interests will be easier to monitor and question.

As indicated by PwC’s research there is a move away from share option schemes because of the improved disclosure required by the IFRS standard, which has helped companies and shareholders to avoid the problems suggested by Peters.

Although the added disclosure will be welcomed by investors, the news has not been good for everyone. For blue-chip companies with the resources to attract executives using other methods, the change in remuneration behaviour is something they have been able to adapt to.

Smaller companies, however, will be hit hard by the change. Small cap and AIM-listed groups have relied on share options as a ‘cheap’ way to attract good executives. The options do not cost anything initially, but reward executives later as a small company grows and its share price climbs.

Expensing options will put a brake on the profits of these growing companies and hinder their capacity to draw the best possible talent.

‘The standard is turning the design of share awards into a new ball game. The previous accounting rules favoured the use of share options, but that is changing and creating more interesting dynamics in the way reward is structured,’ says Peters.

Even more pressing concerns for companies revolve around the volatility expensing options will cause in company accounts and the difficulties involved in finding a fair value option for options, which typically only vest after a number years.

‘Until share options vest companies will need to value the options on an annual basis,’ says Shân Kennedy, director of business valuations at financial consultancy Chiltern. ‘Valuing options is difficult because so many variables come into play, and this can cause some volatility.’

According to Kennedy, the requirements of IFRS2 have made choosing and understanding an appropriate valuation model vitally important.
‘Selecting a suitable option pricing model and not over-complicating the problem is crucial,’ she adds.

Fair valuing options requires valuation models to take into account a number of factors, such as the timing of executives exercising their options, the overall performance of the equity market and how it will impact on option decisions, the number of executives that could leave the company and not exercise their options as well as tax and future company performance.

Presently three models have emerged as the most popular for valuing share-option schemes, namely the Black-Scholes model, the Binomial model and the Monte-Carlo model. Black-Scholes has been used for simple option schemes which have a fixed vesting and exercise period.

The binomial model offers the flexibility of exercising options within a window, but has a limited capacity to deal with executive options because of the way it deals with performance conditions and exercise patterns.

The Monte-Carlo is the most sophisticated but complex of the three options. It is able to produce thousands of future scenarios and calculate the value of the option in each situation.

Peters also says the complexity of IFRS makes communication between different functions of a business a necessity: ‘There is also a whole new area emerging concerned with measuring the impact of IFRS on performance conditions in incentive plans relating to earnings per share. The dialogue between different areas of a business, especially finance and HR, is going to have to improve to manage the impact of the change.’ 

Accounting spills into human resources

Stricter corporate governance, ever-increasing investor scrutiny and the lure of private equity has made it more difficult than ever for listed companies to hold on to their most talented executives.

In addition to these factors, the introduction of IFRS2, the new accounting standard for share-based payments, has made this task even trickier. Share options, which until now could be offered to executives without impacting on company accounts, will be put through the P&L for all to see. The change is likely to prompt companies into reconsidering how charitable they can be when dishing out share options.

The majority of private equity firms, however, will not be bound by the same disclosure requirements. This will enable them to offer talented executives generous share options without any impact on their profit and loss account.

The head of the financial executive practice at a leading headhunter says the ability private equity firms have to attract executive talent away from listed companies is a ‘big issue’ and happening more frequently.

‘What you are earning at a plc and what you can earn in the private equity environment is not comparable in a month of Sundays,’ says the recruiter.
He adds that any executive of a listed company could easily ‘walk into a private equity business on a similar bonus and salary and earn an extra
£7m in share options’.

Brian Peters, human resources partner at PwC, says the introduction of
IFRS means that human resources departments need to pay much closer attention to accounting treatments in order to structure appropriate executive remuneration packages.

‘A key message is that human resources departments need to be aware of the effects of IFRS,’ says Peters. ‘HR need to be in touch with the people in the heat of the IFRS transition project, so they know how it will impact on what they do. It is not just an accounting change. It’s a way of life.’

Related article: IFRS can seriously damage senior executive wealth. Visit Access IFRS – PwC’s IFRS resource centre