September 2011: 0 out of 10 for IFRS 2

When asked for my opinion on how to motivate management I recommend that the approach be kept simple and be based on what employees can influence. Giving employees a bonus based on the increase in the market price of a share makes no sense: why should employees be rewarded or penalised for increases or decreases in the market value of a share merely because of market sentiment or because the US’s debt is downgraded?

Many of the incentive schemes and scams (S&Ss) I see are so complex that employees do not understand the link between their efforts and their rewards with the result that there is little positive effect on employee motivation. And many S&Ss are designed to take advantage of tax loop-holes and protect headline earnings per share.

The economic consequence of awarding options to employees is to dilute the value of a company’s shares. IFRS 2 does not come close to recognising this consequence.

To understand the major flaw in IFRS 2, I have compared an award of a cash settled share appreciation right (SAR) with the granting of an option to acquire shares using the following information:

Number of rights granted / 1m
Market and exercise price per share at grant date / R10
Vesting period / 2 years
Market value of share when exercised right / R30

In the case of a SAR, the company expenses R20m over the two year vesting period and the employees receive a benefit of R20m at the end of the period. The company receives a tax allowance of R20m and the employees are taxed on the R20m at normal tax rates. This is how it should be.

In the case of an option the company expenses the value thereof at grant date, say R2m, over the vesting period. At the end of two years the employees acquire 1m shares at a cost of R10m from the company and sell them on the same day the company buys 1m shares at R30 each. The net outlay of the company is R20m and the net receipt in the hands of the employees is R20m, i.e. exactly the same as in the SAR.

There is no difference between the two schemes to the employees but the company shows a lower charge to profit and loss in the case of the option scheme and is out of pocket in respect of the tax allowance it could have received had it used the SAR scheme.

As a reality check on the increase in value created by a company, an analyst will add earnings per share to the opening book value per share and deduct dividends declared per share to arrive at something close to closing book value. Often material dilutions in net asset value per share take place. In many cases this is due to rewarding employees without charging such rewards to profit or loss (the option scheme combined with the share buyback).

A lesser flaw in the case of an option scheme is that a charge is taken to profit even if the employee does not exercise the option due to a fall in the share price. This is not the case in a cash settled share based payment, which IFRS 2 has got right. The apparent argument is that if you give an employee a motor vehicle and it is subsequently involved in an accident, the benefit received is not reduced by this subsequent event. Think about this. Now apply your mind to accounting for an option granted to a director that expires in five years. The director informs you at grant date that he intends to exercise the option within seven days of it being granted because he wants to avoid the tax on any possible upside (40%) thereby exposing himself to 100% of the downside risk (one must wonder about his qualification to be a director). The value of a five year option is materially higher than a seven day option. Do you measure the option at the lower value because he decides to exchange the top of the range Merc given to him by the company for a Smart Car? IFRS 2.B6 to B20 requires the expected, not the contracted, option period to be taken into account in arriving at the charge to profit or loss!

We should scrap IFRS 2 with all its convoluted rules and patches and start over with a simple principle: “The company should expense whatever benefit was ultimately received by the employee.” This will put a stop to the expensive convoluted tax S&Ss sold to companies with no impact on employee morale. We need to start telling it like it is.

Charles Hattingh