IFRS update October 2005 - Bonuses

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