New Standards for Reporting Equity-based Compensation and Their Effect on Financial Statements

After extensive deliberations involving industry, regulators and academia, new accounting treatment for expensing employee stock bonuses goes into effect on January 1, 2008. For Taiwan's financial accounting standards, this is one of the most significant breakthroughs in recent years: Apart from aligning those standards with international accounting norms (i.e., IFRS), the expression of financial statements will more clearly segregate the expenses companies incur in the course of operations from earnings that can be appropriated for the investing public, thereby avoiding unreasonable distributions of after-tax earnings to employees. This effectively gives a boost to corporate governance and strengthens companies' management of business expenses. That said, however, it is certain also to have an extremely large impact on companies' pre-tax net profit, so when corporate managements plan to award employees stock or other equity products, they must consider the impact the associated expense will have on earnings.

In order to regulate the accounting treatment of the equity products in question, Taiwan's Accounting Research and Development Foundation (ARDF) issued Statement of Financial Accounting Standards (SFAS) No. 39, Share-based Payment. Where a corporation's shareholders transfer equity products they own in the corporation or its affiliated companies, as consideration to providers of goods or services, the associated cost of the consideration falls within the scope of the standard and should be expensed. SFAS 39 primarily governs the accounting treatment of share-based payment transactions settled in equity instruments (for example, employee stock options), share-based transactions settled in cash (such as stock appreciation rights), or hybrid financial instruments for which either of these two settlement methods may be chosen.

The impact of the new standard can be divided essentially into two parts: First, adjusting compensation expenses using market values as of the closing dates of various financial statements, bringing the expenses recognized closer to their fair market value; and second, recognizing compensation expenses according to the vesting period and conditions related to employee-provided services, so that expenses tally more closely with the company's operating conditions. The following paragraphs outline the effects on financial statements in 2008 and beyond.

Recently, the main objective of all new accounting standards or amendments to existing ones, including SFAS 35 on asset impairment, SFAS 34 and 36 on financial instruments, and SFAS 39 on equity instrument payments, has been to replace historical costs, used in past financial statements but widely criticized, with market values as of financial statement closing dates, which are obtainable from open markets. Hence, paragraph 12 of SFAS 39 explains that fair values for goods and services acquired, and equity instruments granted, should be used for measuring and making accounting entries of such transactions; and paragraph 50 of the standard says that if an enterprise is unable to reliably estimate on the measurement date the fair market values of the equity instruments it has granted, it must first make accounting entries based on the market prices at the time of measurement, and subsequently recognize gains and losses due to changes in market prices. The principal aim is to make the expense ultimately disclosed for the equity instruments correspond to the company's market price, so that the cost of the company's equity instruments is suitably expressed.

In addition, paragraphs 11 and 36 of SFAS 39 provide that a corporation's share-based payment transactions must be recognized at the time that the goods or services are acquired. That is, employee compensation expenses recognized by a company should be matched against the corresponding revenue generated, but the standard divides recognition of employee compensation into either one-time recognition or phased recognition. If equity instruments are paid out when the vesting conditions are already met, then the associated compensation charge must be recognized on a one-time basis. If, on the other hand, there are vesting conditions that must be met within the vesting period, before the equity instruments may be paid out, then the compensation charge must be amortized over the years in question. As a result, the effect of compensation expenses on a company's pre-tax earnings depends ultimately on how management designs the vesting period and vesting conditions.

SFAS 39, by regulating the accounting treatment of a company's equity-based compensation and making it part of expenses, helps accomplish corporate governance goals. Moreover equity instrument payments are divided into equity-settled transactions, cash-settled transactions and hybrid transactions in which either settlement method may be chosen. Apart from recognizing the compensation expenses in these transactions, the corresponding transactions items are divided into shareholder equity, liabilities, or a combination of the two. In consequence, the choice of equity instrument type also influences a company's equity structure and financial ratios. For instance, if a company makes payments using cash-settled share-based transactions, the corresponding transaction items come under liabilities, which produces a relatively adverse effect on the company's liquidity ratio and debt ratio. Therefore, before companies pay out equity instruments, they should be aware of the effect on pre-tax earnings. At the same time, they should consider the interests of shareholders and creditors to make sure that employees, the investing public and creditors all come out winners.

Han Wu is a partner at PricewaterhouseCoopers Taiwan. Please send your comments and questions to: Han.Wu@tw.pwc.com