NZSA Best Practice

SUBMISSION BY

New Zealand Shareholders’ Association Inc

to

The Institute of Chartered Accountants of New Zealand

and

The International Accounting Standards Board

on

ED - 93 and ED 2 respectively

January 2003

FOREWARD

The Association was formed in May 2001 with the object of supporting and encouraging ethical management of listed companies for the benefit of all shareholders. This is an all-embracing sentence and other objectives support this desire. The education of our members and the public in the conduct of business and the interpretation of accounts is high on our agenda. Our rules and progress to date are documented on our website - www.nzshareholders.co.nz <http://www.nzshareholders.co.nz> - which we commend for your attention.

From the above you will appreciate we will always have the interests of investors uppermost in our actions. This point is particularly apposite when considering the comments in BC275 dealing with ‘users’ of accounts. Our membership is presently in excess of 400 and growing strongly.

It is our policy to publish all of our correspondence on our Website and accordingly this submission will also be so published.

Please note, in respect of employee share options which is the primary focus of our submission, that we are proposing a fundamentally different approach to assessing the cost of such options. We have not considered whether this approach would be also applicable to share warrants and other financial derivatives, but suspect that our proposals for assessing the cost of employee share options may have equal relevance for other similar derivatives.

New Zealand Shareholders’ Association Inc.

P O Box 6310
Wellesley Street
Auckland
New Zealand
Website: www.nzshareholders.co.nz
Tel: 64 9 309 5191

INTRODUCTION

We have been encouraged to present this submission because it incorporates proposed accounting practice on the treatment of employee share options. The importance of this topic will be realised when we point out that it was the first policy statement of our Association and was issued on 28 June 2001 titled "Share Options form Management".

Our organization is firmly of the view that the sooner International Standards of Accounting are followed by all countries the sooner investors in many places will be encouraged and feel confident to return to the equities market. We urge the International Accounting Standards Board to continue its role in seeking wide international acceptance for their Standards. Particularly we believe a wider understanding of the role and competence of the International Board in all countries would be helpful.

While we do not agree with the general thrust of the proposed standard as it relates to employee share options, we applaud the initiative taken by The Institute of Chartered Accountants of New Zealand in its acceptance of International Standards and of presenting, unchanged, this proposed standard. As stated earlier we welcome international consistency in the treatment of like transactions.

It occurs to us there is a need for both our Institute and the International Board to advise all concerned of the proposals that are in place to convince all countries to accept international standards. For example it seems likely that standard setting organizations in many countries may be disbanded and we are left to wonder how this valuable input will be substituted so that the International Board may continue with its work.

We were initially concerned that by introducing non-option transactions the document had been made increasingly difficult to understand. However, having read the commentary we are better able to understand the complexity of covering all situations.

The following pages include part only of the submission by The New Zealand Shareholders’ Association Inc on the exposure draft "ED-93 Share-based payment" issued by The Institute of Chartered Accountants of New Zealand. This exposure draft mirrors the draft "International Financial Reporting Standard IFRS X Share Based Payment" issued by the International Accounting Standards Board. .

SUBMISSION

Our submission is divided into three sections.

A. The Exposure Draft asks for comments on the various points sought by the FRSB.

B. In addition we have responded to the questions raised by the IASB.

C. We point out that we are, generally, in agreement with the draft International Reporting Standard so far as it concerns employee share options, and the need to recognise the cost of such arrangements to the ultimate owners of an enterprise that grants such options. The need to account for this form of reward on an annual basis must be successfully achieved in a simple and comprehensive manner that a reader of Financial Statements can understand, and must involve a minimum of subjective judgements.

We have not addressed the question of other related share based payments. It occurs to us that perhaps these are already covered by other standards. However any initial criticism is diluted after reading the commentary and noting that this aspect has been introduced with a minimum of complication. The important matter is that there is an annual charge to the financial performance statements covering options. Providing the costs of compliance are not excessive we believe investors will approve the principles involved.

A. FRSB QUERIES

1. We are in no doubt that the proposal is in the best interests of New Zealand.

2. We note that it has been the practice in the past to encourage the thought that where a particularly difficult problem exists, New Zealand is an exception as there are unique aspects that must be dealt with. We do not subscribe to this view. The relative speed of travel and communication these days, the range of trade and the ability of many more to enjoy the benefits of overseas travel all go to ensure that, however isolated we may be physically, we are closer to the rest of the world and our problems are no longer unique and do not call for different rules.

3. The relevance here seems unlikely to be a problem. We are ambivalent on this matter.

4. It occurs to us that there may be a problem if differential reporting is not allowed. We prefer to make no further comment on this matter.

5. It would seem not if summary information is disclosed rather than transactional information.

6. In so far as listed companies will, where relevant, already have made most of the calculations we see no particular reason for cost to become a consideration.

7. No comment.

Our comments that follow deal with share options only and thus any questions relating primarily to other transactions are not dealt with in our comment.

B. INTERNATIONAL ACCOUNTING STANDARDS BOARD QUESTIONS

Question 1
We consider there should be no exceptions for listed companies.

Question 2
It is clearly appropriate to measure the value of goods or services paid for with shares at the time that the services are performed or the goods are provided; if however the shares are vested immediately then payment has been made and if the services span a period end then prepayment issues arise. Options are not shares, see section C. Shares on the other hand have a value that can be measured and services also have a market value. In most service issues the value of the shares will be easier to determine and hence the cost to the enterprise is the value of shares issued rather than the "value" of the service. We do after all use Historical cost accounting as our measurement base. The entry is thus simple for the issue of shares, Dr Expense, Cr equity for the market value of the shares on the date issued. If market value cannot be ascertained then the value is that for which the directors would sign a fair value certificate at the date of issue.

Question 3.
It is inappropriate to value the service; it is more appropriate to value the share as that is the cost to the enterprise, or at least the opportunity cost to the enterprise which is a better approximation of cost than subjective assessments of value. After all the entity could issue shares for cash at market value and pay cash for the services.

Question 4.
The appropriate date for measuring cost is the date that agreement has been reached to issue a share. A share should be regarded no differently to cash; again we emphasis that a company could issue a share at market value for cash and settle its obligations in cash. Options however are not shares, see section C.

Question 5
As we understand the reasoning, the grant date is the date upon which certain obligations are created, contingent or otherwise, and therefore from the grant date until the closure of the arrangement either by lapse or by issue of shares a measurement issue will exist and will be required to be dealt with continuously over its term. To attempt to simplify the matter into a one off annual charge is as ridiculous as trying to do the same with complex financial derivatives, which clearly require continuous annual review until expiry.

Question 6
We disagree see above. Shares should be treated as a cash equivalent and the value of the share is the cost to the enterprise. Imagine the distortions that could occur if the value of the service was cranked up and then capitalised to an asset account, a massive increase in equity and assets that would result in no reference to actual cost.

Question 7
Yes, we agree, but note that we do not regard an option as a share, but rather a derivative that requires alternative treatment, see section C.

Regarding the FRSB comment, we are not sure which other New Zealand standard is applicable and therefore the relevance of this comment.

Question 8
If an enterprise proposes that a vesting period is one of the contingencies upon which equity or an option is granted, it should be assumed that the enterprise’s strategy works and that the vesting period will be satisfied. The cost should be recognised in full immediately and only reversed if the equity is cancelled or the options lapse on a case-by-case basis. However we do agree that if for example the vesting period is three years, then the cost should be spread over three years, i.e. there is an element of prepayment in recognising the total cost up front, again see section C.

Question 9
Unfortunately we can see no alternative other than the choice selected. However we comment that this is the least acceptable of the matters being considered. Of course this is only an issue if an employee or service provider provides a bundled service that the recipient then has to separate out between activities. It only affects reported profit if one of those activities is of a capital nature and does not go through the Revenue statement.

Question 10
We do not agree with this proposal. If, as has been suggested, the options are not exercised then, assuming we read the paragraph correctly, there will be an amount representing a provision included in current liabilities that will never be required. The provision should be released to equity once the options are not exercisable. See Section C.

Question 11
No, we believe that you have dismissed the alternative of the intrinsic value of the option too early, see section C. We disagree strongly with Para BC285.

Question 12
No, all arrangements should be assumed to run their contractual term until they are cancelled or lapse. The grant of an option is one transaction, and the exercise or lapse is another, the less subjective assumptions made the better.

Question 13
Comments in Question 12 are relevant here also, we disagree.

Question 14
If an option is extendable, then an issue exists until the end of any possible extension, a situation not dissimilar to a landlord’s position with tenant rights of renewal.

Question 15
See section C.

Question 16
We agree, that principle based standards are most appropriate, we do not however agree with the principle proposed in this particular standard.

Question 17
It is a fresh transaction and must be dealt with, to this extent only we agree.

Question 18
We find the FRSB comment more attractive. We see no justification why, in an option situation, a liability should be retained either in the form of a current or long-term liability, once the option has been cancelled, we therefore disagree.

Question 22
We have on occasions wondered at the reasoning behind the usual New Zealand pronouncement with new practice statements that comparative figures need not be provided in the first year. We hold the view that the inclusion of comparative figures, once the compliance date is set, is important for investors and applaud this change in attitude by the International Board. In practice the time delay in producing an initial exposure draft until the final statement is produced is lengthy and will usually give companies more than adequate warning of any change in procedures.

Question 25
We note that Advisory Groups and other experts have offered their assistance at various stages in the deliberations. We have not studied the original exposure draft but irrespective of this fact we consider it would be valuable for your readers to be aware of the names and experience of the persons making up these groups.

C. Case for an Intrinsic Value approach to determining the Cost of Employee Share Options.

Base Principles:

Accounting systems the world over are based on the Historical Cost model for assessing the value of assets and the reporting of liabilities and profits.

All accounting entries require judgements to be made and wherever possible such judgements should be objectively made and independently verifiable, the quality of Financial reports is inversely correlated to the level of subjective judgements that are required to be made in such reports preparation.

The only instruments that count as equity instruments are those instruments that have a direct claim over the net assets of an enterprise, its profits, or voting rights to determine the management and direction of an enterprise, or all of the above. Traditionally options have a more remote claim and are not therefore equity as such. An option to take up equity only becomes equity when it is so taken up, but clearly in some circumstances that can be immediate, eg takeovers etc.

In the context of Financial reporting, cost is the cash equivalent value of resources expended. In the case of shares the best measure for the cost of a transaction settled with shares is the cash opportunity loss of not issuing the shares for cash and settling the obligation with cash.

Period accounting gives rise to accounting issues of matching and consistency. When a cost extends over many periods matters of accruals and prepayments must be dealt with consistently to ensure a matching of revenue and costs. In developing Accounting Standards to deal with short term period accounting issues, long term economic real cost should not be compromised.

Objectives

Any standard developed to deal with share options to employees should ensure that the full economic cost of such arrangements is reported as a cost and dealt with through the financial statements over the term of such arrangements.

In breaking the economic cost into period on period charges to the enterprise, the level of subjective judgements required to be made must be kept to a minimum to ensure that non-Financial people can understand the adjustments to earning made in the Financial Statements.

What is the Economic Cost of a Share option?

The economic cost of a share option to the owners of an enterprise is the difference between the price at which a share could have been issued for cash, and the strike price paid under the option on the day the option is exercised and the share is issued.

For example if on day one there were 100 shares on issue with a total value of $1,000 (i.e. $10 per share) and the company’s employees were granted an option for 10 years over a further 100 shares at $20 per share, if in 10 years time the shares have a value of $100 per share and this is the price at which the company could issue 100 shares (note liquidity issues with such an amount relative to the existing issued stock), then the opportunity cost or the economic cost to the owners of the existing 100 shares is $80000. Spreading this cost over the 10 year period is the complex part, but no standard should result in a lesser or greater cost over the entire term than the total economic cost. ED 93 does not reference the cost reported over the term of an option arrangement back to economic cost and this is a flaw. If the options lapsed there is no economic cost, but ED93 would still record a cost in year one.

When should the cost get recorded, and when is it incurred?

No economic cost is incurred until the shares are issued and the option is exercised. The actual cost should not be recognised until that time. The journal entry upon the shares being issued should be:

Dr Cash for the strike price paid
Dr Cost (the balance)
Cr Equity for the market value of the shares issued at the date the shares are issued, the date of the option grant is not relevant at this point.

Spreading the cost?

Obviously to defer the cost until the year of exercise is ridiculous and defies all common sense in matching revenue and cost in each accounting period, so clearly the cost needs to be spread over the term of the option grant, but how? We do not know until the date of the share issue what the actual cost will be arising from the grant of options today with a long term. Clearly an amount needs to be calculated to match costs with Revenue and this journal is:

Dr Cost
Cr Provision (liability)

When the shares are issued the provision is reversed, as then the actual cost is known, which is not dissimilar to a base price adjustment under the Accrual rules for financial arrangements.

On what basis should the cost be spread?

To ensure the minimum of subjective judgements, the year-end provision should be calculated with reference to the difference between the market price of the shares and the strike price of the option as at the enterprises balance date. If the option gets repriced during the period, a charge will occur to the Revenue account. If an option lapses, earlier provisions will be reversed. If an option is extended no adjustment is required. During periods of strong share price movement higher charges will be made to the Revenue account, during periods of share price falls credits will hit the revenue account. Assuming markets are rational, if the share price is rising it should be because profits are increasing, so reducing profits is consistent with the matching principle, and conversely if profits are falling in line with share price performance, reducing the provision and increasing the profit is also consistent with the matching principle. Efficient market theory is however another contentious matter in our view, but should be assumed for the purposes of this standard, as clearly other methods that involve estimating the required rate of return on equity and the risk premium assume an efficient market also.

Such an approach would result in a small charge in the first year with the charge increasing over the term of the option as the share price rises. This of course is what the grant of options is supposed to encourage. As employees perform, and the business performs so too does the share price. Under ED 93 the cost is all reported up front and the revenue doesn’t come through until later, this approach defies the matching principle. Using "mark to market method" for assessing the accrued economic cost of long term options more closely matches the economic performance of the enterprise to its economic cost in our view.

What about non-Listed entities where market price cannot be readily ascertained?

For such entities the market price is the price at which the directors would approve the issue of shares for cash at balance date, and sign fair value certificates in support of such an issue.

How should contingent Options be dealt with?

If an option is not exercisable it should not be included in the provisioning process outlined above. The existence of such options should of course be fully disclosed in the notes to the Financial Statements.

If the restrictions relate only to time rather than to performance it should be assumed that the vesting conditions will be satisfied and the option fully exercisable at the end of the vesting period. If for example the vesting period is three years, the full provision should be made but in the first year 2/3^{rds of the provision should be charged to prepayments. If the person leaves before the vesting period is satisfied all provisions and prepayments should be reversed.}

^{If the restriction relates to performance, the performance should be assumed to have been achieved unless it has not absolutely been achieved in any reporting period. Often in such circumstances the options lapse.}

^Conclusion

^{We believe that a standard based on the intrinsic value of the option will better assess the cost to an enterprise of option arrangements.}

^{We believe that spreading the economic cost using a "Mark to Market" will better achieve a true match of cost and benefit.}

^{For New Zealand Shareholders’ Association Inc}

^{B R Sheppard B.Com, - CA. O J Saint CA.}

^{Chairman, - Executive Director - Research}

^{29 January 2003}