Valuing employee share options - August 2004
In May 2004 the South African Institute of Chartered Accountants (SAICA) published new rules for the accounting of employee share options. This means that from 1 January 2005 charges will be made to the income statement and reserves will build up on the balance sheet in respect of employee share benefits granted to employees after 7 November 2002.

The new rules also require prior year comparatives and these will affect the opening balance of retained earnings for the first full year of disclosure. In order to comply with the standard companies will have to use appropriate modelling techniques to value share schemes, as well as make detailed disclosure of the methods and assumptions used.

But, while the application of fair value principles to share-based remuneration has been widely welcomed, the new standard presents some practical difficulties for companies, especially with regard to which modelling techniques to use. Many of the commonly used models such as the Black-Sch' and traditional Binomial model do not adequately provide for complexities such as lapsing of options through voluntary resignations, "irrational" human exercise and so on. What's more certain modelling techniques require explicit assumptions to be disclosed, for example, the share price's expected dividend yield, and this information could be highly sensitive.

It is important that companies get to grips with how the new rules will affect their profits and what the impact of different methods and assumptions on the likely future accounting charges will be. Companies need to start by looking at the anticipated expense and its impact on their income statements.

The application of the new standard to employee share benefits granted in 2003 and 2004 (or earlier for cash settled options) gives companies little opportunity to mitigate the impact of the new standard on the company's 2005 results.

Where, as is usually the case, there is no market price available the standard requires that "fair value" of employee share benefits must be calculated by a model which must allow for the reduction in value of the options due to non-transferability. For instance, employees' tendency to exercise share options earlier than their final allowable date must be taken into account and allowance must be made for "closed periods" during which options cannot be exercised.

According to Costa Economou, Actuary at Alexander Forbes Financial Services, it is vitally important that companies that have not already assessed the impact of the new standard on their accounts do so as soon as possible, as information for 2004 will need to be disclosed in the 2005 accounts.