With 30 June signalling the end of financial year and the beginning of the reporting season, thoughts now turn to working out the value for share based payments made during the year to meet the requirements in AASB 2 Share Based Payment.
Through Value Logic’s experience, the valuation of most options and performance rights encounter common issues which can be resolved with some careful advice and analysis of the situation.
At Value Logic we provide efficient turnaround for option valuation and performance right valuation to help companies with preparation of their accounts and ensuring that the auditors have adequate time to sign off before reporting deadlines. We also consult with companies prior to establishing plans and issuing equity interests to ensure that there are no unforeseen valuation issues which may produce unexpected results at reporting time.
What type of interest has been issued?
To report the correct value for share based payments requires the correct valuation technique. Of course, which valuation technique is appropriate is dependent on what type of equity interest has been issued, and the terms and conditions attaching to that equity interest.
An option with no vesting or exercise conditions, and an underlying share that does not pay dividends might be valued using the Black-Scholes model. A similar option whose underlying share does pay dividends might be valued using a modified version of the Black-Scholes model, or a Binomial model.
Options or performance rights with vesting or exercise conditions that are linked to market conditions, e.g. Total Shareholder Return relative to the ASX 200, could be valued using a Monte-Carlo Simulation model.
Vesting or exercise conditions
Vesting or exercise conditions can only be taken into account to value options or performance rights if they are a market condition. Examples of market conditions include measuring a share’s Total Shareholder Return against the ASX 200, or requiring a specific share price in order for the equity interest to be exercised.
Vesting conditions such as a condition of continuing employment, or a requirement to achieve a certain net profit, are taken into account when working out the number of options which are estimated to vest, rather than the value of the option.
When is the grant date?
The date on which the equity interest is to be valued is defined in AASB 2 Share Based Payment as the grant date. This date is the date on which the terms and conditions of the equity interest are agreed upon between the employer and the employee. This date can be a later date where shareholder approval is required for the issue of the equity interest.
Getting the correct date is important as it determines the share price used in the valuation. Where there are significant fluctuations in the underlying share price, this can significantly influence the valuation that results.
The grant date also affects the period over which the option or performance rights vest, and hence the allocation of the expense to each financial period. This may have a significant impact on the expense that is required to be recognised in each given financial period.
Share price volatility
Along with the time to expiry, the volatility is the other biggest influence on the value of an option. As the volatility has such a big influence on the valuation, it is important that the correct volatility is used.
AASB 2 requires the use of the expected future volatility of the share price over the life of the option or performance right. As it is the volatility expected in the future, an expectation of future volatility must be derived. Where a share price’s volatility is not expected to vary from its historical average, the historical volatility may be used as a guide.
Some cases when past volatility is not sufficient as a measure include:
- low trading volumes
- changes in business structure for the entity
- changes in economic conditions and stock-market performance
- the company is unlisted.
The key factor is to understand all the circumstances and use best judgement as to when another company’s share price volatility or an index’s volatility might be a better proxy.
Don’t confuse accounting valuation requirements with tax valuation requirements
Commonly it is assumed that the valuation techniques and requirements of AASB 2 are the same requirements found in the Income Tax Assessment Act 1997.
One of the key differences is that the tax legislation requires the valuation to ignore any vesting or exercise conditions when valuing the equity interest.
As the regulations provide a valuation methodology that uses a highly concessional version of the Black-Scholes model, the tax valuations quite commonly turn out lower than the corresponding accounting valuation.
This highlights the importance of getting both valuations performed so that employees are adequately advised of their tax obligations.
While the use of a valuation model may seem relatively simple, the selection of the correct inputs is vital to obtaining a valuation that correctly measures the fair value of equity interests issued as Share Based Payments.
If you have any questions or require any valuations, contact Ian Wood at Value Logic for further assistance.