Option-based employee compensation models: selected balance sheet ratios in the light of the compensation plan design

Option-based employee compensation models

Following the newsletter article "Option-based employee compensation models: design in practice" , we now turn our attention to the analysis of plan designs of a stock option program: to what extent do these designs qualitatively impact (accounting in principle) the selected balance sheet ratios of an industrial enterprise? Company cash flows and the equity ratio are considered in the following.

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The accounting principles for equity and cash settlements specified by IFRS 2 can be identified as the main cause of the various financial effects of a stock option program. The accounting logic to be applied to this categorization leads to different effects on the net assets, financial position and results of operations. Although the offsetting entry to personnel expenses must be allocated to equity for an equity settlement as per IFRS 2.7, a provision must be recognized for a cash settlement as per IFRS 2.30. This has an effect, inter alia, on the level of the equity ratio. Furthermore, the different settlement forms (equity-settled vs. cash-settled) have an impact on company cash flow. Both shall be discussed by way of example below.

Cash Flow

If one analyzes a stock option program which is equity-settled and financed by way of a capital increase, the exercising of an option will result in the issuance of new stock. To receive that stock, the employees pay the exercise price to the company. The proceeds from employees thereby have a positive effect on the company's cash flow. Since the costs of employee compensation are passed on to the current shareholders due to the dilutive effect of the newly issued shares, the company is not exposed to any outflow of funds. Thus a stock option plan financed by way of a capital increase results in an increase in the company's net cash flow.

Equity Ratio

If, in turn, one analyzes a cash-settled stock option program, the company has an obligation to pay to service subscription rights. In that context, these stock options must be recognized as liabilities in the balance sheet. The granting of such subscription rights therefore results in a double burden on the equity ratio for the term of the option plan. On the one hand, the personnel expenses recognized for the work performance reduce reported equity, although the recognition of a provision, on the other hand, increases total capital in relation to equity.

In practice, it has been increasingly observed that the corresponding effects of accounting rules laid down in IFRS 2 lead to surprises in financial performance indicators and balance sheet ratios. Before establishing a stock option program, a company should therefore always have a clear idea of how this will impact control-related balance sheet ratios; that is, anticipate the effects of accounting in principle and, likewise, accounting with respect to amount (in terms of the actuarial determination of the fair value of a stock option).

Author: Dr. Christoph Lippert, Manager, christophlippert@kpmg.com

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