Hedging strategies for stock option plans

Hedging strategies for stock option plans

Stock option plans (SOPs) are used widely as a tool to control and incentivise top management.

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Stock option plans (SOPs) are used widely as a tool to control and incentivise top management. We have therefore taken the opportunity to explore this topic from a number of angles in a series of current articles (see also "Challenges handling share based payments" by Thomas Baureis). Public perception and the extensive note disclosures required by IFRS have also made it important to present such plans on the balance sheet and recognise them in earnings. This topic is examined more closely below.

To keep a cap on the personnel expenses arising from SOPs, some companies are starting to use forward stock transactions to hedge the probable number of shares eligible individuals are authorised to buy against stock price fluctuations.

However, the impact of these forward transactions on the income statement can normally only be synchronised with the SOP result if hedge accounting is applied. Without hedge accounting, the fair value of the instruments used to hedge claims arising in future periods must be presented in full in the results.

The combination of economic hedging and hedge accounting allows SOP liabilities to be saved up continually

 

Moreover, if hedge accounting is not applied, it is not possible to net the profit contributions made by forward stock transactions against those arising from the valuation of share based payments in the IFRS income statement. On the other hand, the combination of economic hedging and hedge accounting allows SOP liabilities to be saved up continually via personnel expenses. Taking this action merely helps an entity manage risks and optimize results, but does not affect the power of SOPs as incentivisation tools.

The core elements needed to designate a forward stock transaction as a hedging relationship and share based payment as the hedged item in a cash flow hedge are briefly outlined below. Please note that, irrespective of the points raised below, other requirements and conditions for the designation of hedge accounting (e.g. IAS 39.88) remain valid and applicable.

This requirement is rooted in the rules that govern hedge accounting

Hedge accounting is possible only if the stock option plan is a cash settled plan rather than an equity settled plan. This requirement is rooted in the rules that govern hedge accounting: If share based payment were made in the entity's own shares (equity), the hedged item would not be recognised in profit or loss. This, however, is one of the preconditions for a cash flow hedge. There are also certain instruments which cannot be used to substantiate the hedging relationship.

Holding treasury shares would hedge the impact of stock price volatility on the claims arising from SOPs, but is not recognised as a hedging instrument for the purposes of hedge accounting. In practice, therefore, liquid forward stock transactions that are settled net are frequently used as hedges.

In a cash flow hedge, the hedged item is the expected cash flow from a given commitment. This cash flow depends both on the current stock price and on the degree to which entitlements have been earned. The earning of entitlements in turn depends on the achievement of certain income targets, for example, or may be linked to the expiry of entitlements if the person concerned leaves the entity.

In the case of plans where the earning of entitlements also depends on additional factors, it is therefore necessary to prove that the grounds for the entitlement – i.e. the occurrence of the stock price risk – are highly probable. In relevant literature, "highly probable" is understood to mean a probability of occurrence in excess of 90%. As a rule, evidence can be provided by empirical measurements of other historic factors and by calculating a confidence interval (90th percentile).

Under certain circumstances, i.e. given a high hedge ratio, it may not be possible to designate all forward stock transactions as parts of an effective hedge relationship, as a high probability of occurrence cannot be asserted for every forward stock transaction that is exposed to stock price risks. The high probability of occurrence must also be tested repeatedly during the lifecycle of the hedge.

To measure the personnel expenses arising from remeasurement of the SOP entitlement (pursuant to IFRS 2) as independently of stock price changes as possible, it makes sense to adopt the layer approach, i.e. by formally specifying the initial accrual of cash flows as a condition.

The hedged risk covers the change in cash flows arising from changes in the price of stocks granted as options within the framework of the SOP. Part of the hedged item will thus be recognised in profit and loss pursuant to the provisions of IFRS 2 (by adjusting earned components of the entitlement in line with the current stock price) and part of it will not (due to those components of the entitlement that have not yet been earned). The hedges themselves will be recognised in profit and loss in the same amount as the components of the SOP that are recognised in profit and loss.

This is because, technically, those forward stock transactions that hedge the entitlements earned at the cut-off date are part of OCI. Remeasurement of the SOP liability leads to the reclassification of the OCI component as personnel expenses. At the same time, those forward stock transactions that hedge entitlements that have not yet been earned in future periods likewise constitute OCI. This component is not (yet) reclassified. The result is a personnel expense item that does not depend on ongoing changes in stock prices.

Where expenses are classified by function (using the function of expense method), IAS 1.104 requires the disclosure of additional information on the nature of certain expenses, such as personnel expenses. If the client were to apply the total cost method instead of the function of expense method, only those personnel expenses netted against the hedge result would be recognised in profit and loss.

 

IFRS 7.22 requires disclosures

No further disclosures pursuant to IAS 1.104 would then be required. However, IFRS 2.50f require disclosure of at least the total expenses arising from share based payments in cases where the goods or services received are not eligible for recognition and must therefore immediately be recognised as expenses. We believe that this requirement necessitates disclosure of expenses before netting against the hedge result.

IFRS 7.22 requires disclosures such as descriptions of each hedge type and of the hedged risks. Regarding the issues discussed in this article, the notes should disclose that the cash flows expected from the stock option plans are hedged against fluctuations in the stock price. For cash flow hedges, IFRS 7.23 requires disclosure of the amounts recognised in other comprehensive income in reporting period, as well as disclosure of amounts reclassified to the specified individual items in the income statement.

We would be happy to talk to you about what this complex hedging approach could look like for your entity. A safe path through the many and varied reporting requirements can be found for each of these topics.

Source: KPMG Corporate Treasury News, Edition 55, May 2016
Author: Felix Wacker-Kijewski, Manager, fwackerkijewski@kpmg.com

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