This month top tutor Tom Clendon explains all you need to know about share based cash flow.
When employees are granted share options in their employer’s company do these have to be expensed to profit? My understanding is that the company has not, and will not, have a cash outflow in respect of this transaction.
In short, yes and yes! While you are correct that the granting of options to employees does not result in a cash outflow for the company, nevertheless they must be expensed to profit.
Let me explain.
It is wages
Options are granted to staff as part of their remuneration package. If the share price has risen when they come to exercise the options, then the employee makes a profit. Options therefore act as an incentive for the staff to work harder so the business is more successful, so the share price goes up and they get a bonus!
A failure to recognise part of an employee’s remuneration would mean staff costs being understated and profit overstated.
A transaction of value
While there is no cash flow to measure the cost of the option and hence the expense, these types of options will certainly have a value. This value is subjective, so has to be determined by an actuary.
But it has a value, and one that can be measured reliably.
The financial statements need to be complete
A failure to record the issue of the options and the expense of wages would mean the financial statements would be incomplete. If financial statements are incomplete, then they cannot be a faithful representation. If they are not a faithful representation, then the financial statements will not be useful.
It is not without precedence
Charging an expense to profit without any cash outflow underpinning the transaction is not without precedence. Whilst depreciation is a noncash expense, the purchase consideration used to buy property plant and equipment is normally cash. However, in the majority of cases business combinations only involve a share for share exchange. This means that the impairment loss on goodwill is another expense charged against profit where the expense is not underpinned by a cash outflow.
Just to reiterate that issue of share options to employees does not involve a cash outflow for the company.
During the vesting period there is a charge to profit to represent the expense.
The other entry is to equity to reflect that the option is an equity instrument. Dr PL exp and Cr Equity (Other Components of Equity). No cash flow there at all.
But if at the end of the vesting period the options are exercised by the employee, then the company receives cash from the employee and issues shares to them. Dr Cash and Cr Equity (Share Capital). No cash outflow there – in fact, the company has a cash inflow!
• Tom Clendon is an ACCA SBR online lecturer and podcaster. See www.tomclendon.co.uk or WhatsApp 07725 350793 (+44 7725 350793)