Concepts, Rules, and Examples

International accounting standards (IAS) have dealt only with presentation and disclosure requirements relating to stockholders' equity and have yet to address the accounting for the various components of stockholders' equity. There are numerous complex accounting issues relating to the various components of stockholders' equity, some of which have been and others which are still being tackled by the national standard-setting bodies. The absence of any international accounting standard dealing with the accounting treatment of equity transactions is an impediment to uniform and appropriate accounting by international conglomerates, multinational corporations, and other companies that comply with IAS.

Because of the absence of any promulgated international accounting standards on this highly complex and important area, this chapter makes extensive use of the guidance that exists under US GAAP. While this is obviously not binding on practice under IAS, to the extent that those other rules meaningfully deal with the economic substance of various transactions involving stockholders' equity, IAS accounting decisions could usefully be informed by them.

Presentation and Disclosure Requirements under IAS

Stockholders' equity also includes reserves such as statutory or legal reserves, general reserves and contingency reserves, and revaluation surplus. IAS 1 categorizes stockholders' interests in three broad subdivisions: issued capital, reserves, and accumulated profits or losses. This newly revised standard also sets forth requirements for disclosures about the details of share capital for corporations and the various capital accounts of other types of enterprises.

Disclosures relating to share capital.

1. The number or amount of shares authorized, issued, and outstanding. It is required that a company disclose information relating to the number of shares authorized, issued, and outstanding. Each of these has a different connotation. Authorized share capital is the maximum number of shares that a company is permitted to issue, according to its articles of association or its charter or bylaws (these being given different names in different countries). The number of shares issued and outstanding could vary, based on the fact that a company could have acquired its own shares and is holding them as treasury stock (discussed below under reacquired shares).

2. Capital not yet paid in. In an initial public offering (IPO), subscribers may be asked initially to pay in only a portion of the par value, with the balance due in installments, which are known as calls. Thus, it is likely that on the date of the balance sheet, a certain portion of the share capital is not yet paid in. For instance, while the gross amount of the stock subscription increases capital, if the due date of the last and final call falls on February 7, 2003, following the accounting year-end of December 31, 2002, the amount of capital not yet paid in should be shown as a deduction from stockholders' equity. In this manner, only the net amount (of capital) received up to the date of the balance sheet will be properly included in net stockholders' equity. IAS 1 requires that a distinction be made between shares that have been issued and fully paid, on the one hand, and those that have been issued but not fully paid, on the other hand. The number of shares outstanding at the beginning and at the end of each period presented must also be reconciled.

3. Par value per share. This is also generally referred to as legal value or face value per share. The par value of shares is specified in the corporate charter or bylaws and referred to in other documents, such as the share application and prospectus. Par value is the smallest unit of share capital that can be acquired unless the prospectus permits fractional shares (which is very unusual for commercial enterprises). In certain countries, including the United States, it is also permitted for corporations to issue no-par stock (i.e., stock that is not given any par value). In such cases, again depending on local corporation laws, sometimes a stated value is determined by the board of directors, which is then accorded effectively the same treatment as par value. IAS 1 requires disclosure of par values or of the fact that the shares were issued without par values.

   Traditionally, companies often issued shares at par value in cases where shares are issued immediately on incorporation or soon thereafter. However, when a well-established company with a proven track record issues shares, it may issue new shares at a premium. As a practical matter, par values have had a much diminished importance as corporation laws have been modernized in many jurisdictions, and often the par values will be trivial, such as $1 or even $0.01 per share. In such cases, issuance prices even at inception of a new corporation will be substantially above par value.

4. Movements in share capital accounts during the year. This information is usually disclosed in the footnotes to the financial statements, generally in a statement format, although in some circumstances merely described in a narrative in the footnotes. This statement, referred to as the Statement of Changes in Stockholders' Equity, highlights the changes during the year in the various components of stockholders' equity. It also serves the purpose of reconciling the beginning and the ending balances of stockholders' equity, as shown in the balance sheet. Under the provisions of IAS 1, enterprises must now present either a statement showing the changes in all the equity accounts (including issued capital, reserves and accumulated profit or loss), or a statement reporting changes in equity other than those arising from transactions with, or distributions to, owners.

5. Rights, preferences, and restrictions with respect to the distribution of dividends and to the repayment of capital. When there is more than one class of share capital with varying rights, adequate disclosure of the rights, preferences, and restrictions attached to each such class of share capital will enhance understandability of the information provided by the financial statements.

6. Cumulative preference dividends in arrears. If a company does not pay dividends on the preference shares for a certain number of years, it is required by statute (corporate law worldwide requires this) to make up these arrears in later years, if the shares have a cumulative feature. These dividends have to be paid before any dividends are paid on other equity shares. Although practice varies, most preference shares are cumulative in nature; preference shares that do not have this feature are called noncumulative preference shares.

7. Reacquired shares. Shares that are reacquired by a company are referred to as treasury stock. In those jurisdictions where the corporate or company law of the country permits the repurchase of shares, such shares, on acquisition by the company or its consolidated subsidiary, become legally available for reissue or resale without further authorization. Shares outstanding refers to shares other than those held as treasury stock. Treasury stock does not reduce the number of shares issued but affects the number of shares outstanding. It is to be noted that certain countries prohibit companies from purchasing their own shares, since to do so is considered as a reduction of share capital that can be achieved only with the express consent of the shareholders in an extraordinary general meeting and then only under certain conditions.

   In the United Kingdom, traditionally companies were prohibited from purchasing their own shares. However, the UK Companies Act of 1981 relaxed this prohibition by allowing this practice, subject of course to certain conditions. Even in the United States, for that matter, not all states recognize treasury stock, and in those states the reacquired shares are to be treated as having been retired. Normally, treasury stock is shown as a reduction of stockholders' equity. Under very rare circumstances it may be presented as an asset, and shown on the asset side of the balance sheet, provided that adequate disclosure is made of this. Accounting for treasury stock is discussed in further detail in the latter part of this chapter.

   In SIC 16, the Standing Interpretations Committee has restated the principle that an entity's own shares, when reacquired, are to be reported as deductions from equity and not as assets in the balance sheet. The acquisition transaction should be reported in the statement of changes in equity. When later resold, any difference between acquisition cost and ultimate proceeds represents a change in equity, and is therefore not to be considered a gain or loss to be included in the income statement. According to the interpretation, the reductions in equity may be either shown explicitly in the balance sheet's equity section as a contra account, or reported in the notes thereto. These rules are entirely consistent with widespread practice and the requirements of other national accounting standards.

   Another interpretation, SIC 17, addresses the commonly asked question of how to account for costs incurred in connection either with share issuances or with share reacquisitions (i.e., treasury share transactions). The interpretation holds that, consistent with existing practice, such costs are to be associated with the related capital transaction and accounted for on a consistent basis. Thus, these costs are to be accounted for as reductions of equity if the corresponding transaction was a share issuance, or as increases in the contra equity account when incurred in connection with share reacquisitions. Relevant costs are limited to incremental costs directly associated with the transactions. If the issuance involves a compound instrument as discussed by IAS 32, the issuance costs should be associated with the liability and equity components, respectively, using a rational and consistent basis of allocation.

8. Shares reserved for future issuance under options and sales contracts, including the terms and amounts. Companies issue stock options that grant the holder of these options rights to a specified number of shares at a certain price. A good example of a stock option is an option granted under an employee stock ownership plan (ESOP). Stock options are an increasingly popular means of employee remuneration, and usually top management is offered such noncash perquisites as part of its remuneration package. If a company has shares reserved for future issuance under option plans or sales contracts, it is necessary to disclose the number of shares, including terms and amounts, so reserved.

   An interpretation of the Standing Interpretations Committee (SIC 5) deals with situations in which enterprise obligations are to be settled in cash or in equity securities, depending on the outcome of contingencies not under the issuer's control. In general, these should be classed as liabilities, in accordance with the guidance in IAS 32, unless it is judged to be a remote possibility, at the time of issuance, that a settlement with cash or another financial asset will be required. In the latter case, classification as equity will be prescribed.

   The accounting for stock options is dealt with later in this chapter and presents many intriguing and complex issues, most of which the accounting profession has already addressed. However, by looking at the number of technically complex issues in this area, the impression may be had that the profession is still unable to come to grips fully with this topic. Under US GAAP, for example, a number of pronouncements have been issued on accounting for the cost to ESOP plans, but the most recent of these, issued in 1993, is not mandatorily applicable to shares held as of that date; instead, employers may continue to use the prior accounting methods for shares purchased prior to that time. Significant changes in the authoritative literature have recently been promulgated on the matter of accounting for stock-based compensation (options, appreciation rights, etc.). These changes are also discussed later in this chapter.

Disclosures relating to other equity.

1. Capital paid in excess of par value. This is the amount received on the issuance of shares that is the excess over the par value. It is called additional paid-in capital in the United States, while in some other countries, including the United Kingdom it is referred to as "share premium."

2. Revaluation reserve. When a company carries property, plant, and equipment at other than historical costs, as is permitted by IAS 16 (i.e., it does not follow the benchmark treatment, but instead, follows the allowed alternative treatment, and revalues property, plant, and equipment to fair value), the difference between the historical costs (net of accumulated depreciation) and the fair values is credited to the revaluation reserve. Under IAS 40, certain investments other than those in debt or equity securities can also be carried at revalued amounts. Thus, a revaluation reserve could arise not only from revaluations of property, plant, and equipment, but even from other investment property.

   The standard requires that movements of this reserve during the period (year) be disclosed, which is usually done in the footnotes. Also, restrictions as to any distributions of this reserve to shareholders should be disclosed.

3. Reserves. Reserves include capital as well as revenue reserves. Also, statutory reserves and voluntary reserves are included under this category. Finally, special reserves, including contingency reserves, are included herein.

   Statutory reserves (or legal reserves, as they are called in some jurisdictions) are created based on the requirements of the law or the statute under which the company is incorporated. For instance, most corporate statutes in Middle Eastern countries require that companies set aside 10% of their net income for the year as a "statutory reserve," with such appropriations to continue until the balance in this reserve account equals 50% of the company's equity capital.

   Sometimes a company's articles, charter, or bylaws may require that each year the company set aside a certain percentage of its net profit (income) by way of a contingency or general reserve. Unlike statutory or legal reserves, contingency reserves are based on the provisions of corporate bylaws. Apparently, the rationale behind creation of such reserves is to make the company strong by requiring that each year a stipulated percentage of profits be plowed back into equity instead of being distributed to shareholders.

   The standard requires that movements during the period (year) in these reserves be disclosed, along with the nature and purpose of each reserve presented within owners' equity.

4. Retained earnings. By definition, retained earnings represents a corporation's accumulated profits (losses) less any distributions that have been made therefrom. However, based on provisions contained in the international accounting standards, other adjustments are also made to the amount of retained earnings. IAS 8 requires the following to be shown as adjustments to retained earnings:

   1. Under the benchmark treatment, correction of fundamental errors that relate to prior periods should be reported by adjusting the opening balance of retained earnings. Comparative information should be restated, unless it is impracticable to do so.

   2. Under the benchmark treatment, the resulting adjustment from a change in accounting policy that is to be applied retrospectively should be reported as an adjustment to the opening balance of retained earnings. Comparative information should be restated unless it is impracticable to do so.

When dividends have been proposed but not formally approved, and hence when such intended dividends have not yet become reportable as a liability of the enterprise, disclosure is required by IAS 1. Dividends declared after the balance sheet date, but prior to the issuance of the financial statements, must be disclosed but cannot be formally recognized via a charge against retained earnings (as was sometimes done in the past). Also, the amount of any cumulative preference dividends not recognized as charges against accumulated profits must be disclosed, whether parenthetically or in the footnotes.

Classification between Liabilities and Equity

IAS 32 requires that the issuer of a financial instrument should classify the instrument, or its components, as a liability or as equity, according to the substance of the contractual arrangement on initial recognition. The crux of the issue is the differentiation between a financial liability and an equity instrument.

The standard defines a financial liability as a contractual obligation

1. To deliver cash or another financial asset to another enterprise, or

2. To exchange financial instruments with another enterprise under conditions that are potentially unfavorable.

An equity instrument, on the other hand, has been defined by the standard as any contract that evidences a residual interest in the assets of an enterprise after deducting all its liabilities.

Compound financial instruments.

Increasingly, it is not uncommon for corporations to issue financial instruments that have attributes of both equity and liabilities. IAS 32 stipulates that an enterprise that issues such financial instruments, which are technically known as compound instruments, should classify the component parts of the financial instrument separately as equity or liability as appropriate. (For a detailed discussion on financial instruments, refer to Chapters 5 and 10.)

Accounting for Share-Based Payments

At present, there is little guidance under IAS as to the accounting to be applied to the increasingly common situation where companies use their own shares as a means of compensating executives, other employees, and outside providers of services (vendors, etc.) as an alternative or supplement to cash payments. While the issuance of shares (or the granting of options to acquire shares) in exchange for services from outside providers (or in exchange for property, as when shares are used to purchase plant and equipment) clearly requires recordation at fair value, the matter of executive or employee option and share issuances remains unsettled.

This has proven to be a very contentious issue in those instances when attempts to address the accounting considerations have been made, principally in the US. In the past, the financial statement preparer community has vehemently resisted the imposition of requirements that would attach a cost to such payments. When the US standard setter attempted to impose such a requirement in the mid-1990s, a well orchestrated campaign opposing it, including threatened federal legislation to prohibit implementation, convinced the FASB to settle for a mere disclosure requirement. FASB was so chastened by this experience that, until fall 2002, it was adamantly opposed to reconsideration of its rule, even in the face of IASB's announcement that it would undertake a project to imposed expense recognition of share-based payments.

The confidence-shattering series of revelations of corporate malfeasance and financial reporting frauds in the US in the 2001–2002 period has changed the landscape significantly, making it possible to reexamine the need for improved accounting standards in a number of areas, including executive compensation. In the US, FASB has reluctantly undertaken a project to address this. While IASB had already announced its intention to pursue its project, the heightened public awareness probably adds to IASB's resolve and increases the likelihood that the effort will be productive.

IASB has already given some indications that there will be important results from this project. Despite the increasing use of share-based payment, there is no IFRS (or IAS) on how to account for these transactions, and concerns have accordingly been raised about this lack of authoritative guidance. IOSCO (the organization of securities regulators), among others, has stated that the IASC (IASB's predecessor) should consider the accounting treatment of share-based payments. According to IASB, the use of share-based payment arrangements has increased significantly in Europe in recent years, so that recently European standard-setting bodies have begun working on this issue and have even issued proposals on it (which call for expense recognition). Clearly, there is a sense of urgency driving the IASB to address this matter.

For example, in July 2000 G4+1 issued a discussion paper, Accounting for Share-Based Payment. Also, a draft accounting standard, Accounting for Share Option Plans and Similar Compensation Arrangements, was published by the German Accounting Standards Committee in June 2001. A discussion paper, The Accounting Treatment of Share-Based Payment, was issued by the Danish Institute of State Authorized Public Accountants (FSR) in April 2000. All of these documents essentially conclude that fair value measures need to be applied to stock-based compensation arrangements. Even the FASB's ill-fated SFAS 123 stated a conclusion that financial statements would be more relevant and representationally faithful if the estimated fair value of employee stock options were to be included in determining an entity's net income, consistent with the accounting for all other forms of compensation (although this was made optional and not required, due to strongly voiced opposition)

IASB has considered the experience of those national standard setters which have attempted to impose appropriate standards on the accounting for share-based payments. Inevitably, their constituents have argued that (among other things) they would be competitively disadvantaged if the national standard setter were to introduce changes in isolation from other standard-setting bodies. This only serves to underscore the necessity for dealing with this topic at the international level.

This is not to suggest that development of a workable fair value approach to accounting for share-based compensation payments will be anything other than difficult. There are a number of legitimate concerns about the recognition and measurement of share-based payment transactions. Some of these relate to the selection of an appropriate option pricing model, identification of the salient measurement date (the date at which the fair value of the shares or options is estimated), the method of accrual of expense over the performance period, and the appropriate treatments of lapsed options, options that are repriced or otherwise modified, employee share plans with cash alternatives and share appreciation rights.

In July 2001, the IASB agreed to add a project on share-based payment to its agenda. In September 2001, the IASB decided to invite comments on the July 2000 IASC/G4+1 discussion paper. Also that month, IASB considered whether share-based payment transactions, involving the purchase of goods or services with payment made in shares or options, should be recognized in the financial statements, resulting in the recognition of an expense in the income statement when those goods or services are consumed (or when the attributed amount does not continue to form part of a recognizable asset). The tentative conclusion was that, in principle, these transactions should be recognized in the financial statements, subject to the discussion of measurement and other issues.

There is general agreement that in the absence of an observable market price, an option pricing model will need to be used to estimate the fair value of share options, although which particular model should be used was not addressed. There may be a need to stipulate the manner in which option pricing models are to be adjusted to incorporate features common to employee share options and options issued by unlisted companies. There was also consideration of the relationship between measurement date and the reporting entity model (entity approach versus proprietary approach) and the distinction between liabilities and equity.

Yet another issue that has been given some consideration is whether recognition of an expense for share-based payments is consistent with the definition of an expense in the conceptual frameworks used by standard setters, in particular, the IASB Framework.

By March 2002, the IASB had considered a project plan that has the objective of publishing an Exposure Draft of an IFRS by the end of 2002. Based on a presumption that the use of an option pricing model will be stipulated, IASB concluded that a reporting entity should be required to disclose the model used and the inputs to that model (including expected volatility, expected dividends, and the risk-free interest rate). In addition to expected volatility, the entity should disclose historical volatility and an explanation of the differences between historical and expected volatility. The ultimate standard issued should explain how to determine the risk-free interest rate and the entity should disclose how the risk-free interest rate was determined.

The IASB has tentatively concluded, with respect to options granted that cannot be exercised during the vesting period, if the entity uses an option pricing model that values European options (which can only be exercised on their expiration dates), such as the BlackScholes model, no adjustment is required for the inability to exercise during the vesting period because the model already assumes that the options cannot be exercised during the holding period. If, on the other hand, the entity uses an option pricing model that values American options (which are exercisable at any time until expiration), such as a binomial model, the application of the model should take account of the inability to exercise during the vesting period.

The IASB also concluded that expected life, not contracted life, should be used in the option pricing model, to take account of the effect of nontransferability. Guidance will have to be given on when it might be necessary to adjust the option pricing model for the possible capital structure effects associated with issuing new shares upon the exercise of the options.

The IASB also considered vesting conditions (based upon the assumption that the standard will require the use of a fair value measurement method, with fair value estimated at grant date). The tentative conclusion was that the treatment of vesting conditions should be consistent with the objective of accounting for the services received, as consideration for the issue of shares or options. It is attempting to develop an example of an approach that would incorporate the existence of vesting conditions into the grant date valuation, with that valuation applied to the services received. Under this approach, an expense would be recognized for services received and consumed during each accounting period, and that expense would not be subsequently reversed in a future accounting period even if the shares or options granted were subsequently forfeited due to failure to meet vesting conditions. This approach will differ from that under the US standard, SFAS 123 (which may also be revised, now that FASB has agreed to revisit this matter).

The appropriate date at which to measure share-based payment transactions has also been the subject of IASN attention. It has tentatively agreed that, when the measurement of a share-based payment transaction is based upon the fair value of the shares or options issued (or to be issued), fair value should be estimated at grant date.

In May 2002, IASB discussed application and measurement issues relating to employee share purchase plans, share-based payment transactions with parties other than employees, repricing of options (and other changes in terms and conditions), and unlisted and newly listed companies. It tentatively concluded that there should be no exemption from the IFRS for employee share purchase plans. Furthermore, the measurement principles applying to all share-based payment transactions would be to measure transactions in which goods or services are received as consideration for the issue of equity instruments at the fair value of the goods or services received, or the fair value of the equity instruments issued (or to be issued), whichever is more readily determinable. For transactions measured at the fair value of the equity instruments issued (or to be issued), fair values should be estimated at grant date. For transactions with parties other than employees, there would be a rebuttable presumption that the fair value of the goods or services received is more readily determinable. For transactions with employees, there would be a rebuttable presumption that the fair value of the equity instruments issued (or to be issued) is more readily determinable.

There was also agreement reached that repricing of options (and other changes in terms and conditions), whether before or after vesting date, should be accounted for by recognizing additional remuneration expense based upon the incremental value given on repricing (i.e., the difference between the fair value of the repriced option and that of the original option, both estimated as at the date of repricing).

IASB contemplated permitting the use of the minimum value model by unlisted entities that are unable to estimate reliably the fair value of the goods or services received. However, it later decided that there will be no exceptions to the use of the fair value approach. Newly listed companies will not be permitted to use the minimum value method, however, and the standard will have to give guidance on estimating the expected volatility of newly listed and unlisted entities.

Valuation of the rights to options or shares granted will need to take into account all types of vesting conditions, including service conditions and performance conditions. That is, the grant date valuation should be reduced to allow for the possibility of forfeiture because of failure to satisfy vesting conditions. The resulting valuation then would be applied to the services received. The entity should be required to disclose the assumptions made in determining the grant date valuation with regard to the possibility of forfeiture, and the entity also should be required to disclose information on actual forfeitures compared with expected forfeitures estimated at grant date.

There will be no gain recognized for options that lapse at the end of the exercise period. Therefore, no accounting entry is required (apart from possibly a movement within equity, i.e., a transfer from one part of equity to another if the options previously were disclosed separately).

With regard to the accounting to be prescribed for share appreciation rights (SAR) settled in cash, there was agreement that a liability should be accrued over the vesting period, when services are provided by the employees (or other parties); the liability should be measured at fair value; and there should be separate disclosure, either on the face of the income statement or in the notes, of that portion of the expense recognized during each accounting period that is attributable to changes in the estimated fair value of the liability between grant date and settlement date.

As to share plans with cash alternatives, IASB tentatively agreed that for share plans where the employee has the choice of settlement, the compound financial instrument should be separated into its debt and equity components; the fair value of the compound instrument should be estimated at grant date, by first estimating the fair value of the liability component, then estimating the fair value of the equity component—while taking into account that the employee must forfeit the cash alternative to receive the option—and then assuming the two component values; and both components should be recognized over the vesting period, in the same manner as other forms of share-based payment, except that the debt component should be remeasured to fair value at each balance sheet date, while the equity component should not be remeasured.

At settlement, any difference between the amount of the liability component previously recognized and the amount of cash paid or the fair value of the liability component at the date it is surrendered should be accounted for as an adjustment to the transaction amount, that is, as an adjustment to the expense.

If the employee chooses the cash alternative, the cash payment will settle the liability in full. The amount of the equity component (if any) that was recognized previously should remain in equity, as it represents the equity component of the compound instrument that has been surrendered by the employee. If the employee does not elect to receive the cash alternative, the amount of the liability component of the compound instrument that previously was recognized as a liability should be transferred directly to equity.

Separate disclosures will be mandated, either on the face of the income statement or in the notes, of that portion of the expense recognized during each accounting period that is attributable to changes in the estimated fair value of the liability between grant date and settlement date.

For share plans that give the entity the choice of paying cash or issuing equity instruments, the tentative conclusion is that, if a liability exists (for example, the choice is not a substantive choice or a constructive obligation to settle in cash exists), the same accounting treatment as for cash-settled SAR should be applied. If no liability exists, the transaction should be accounted for in the same manner as other forms of equity-settled share-based payment transactions. If the entity elects to settle in cash rather than issue equity instruments, the cash payment should be debited to equity as the repurchase of an equity interest, with limited exceptions. If the entity elects to settle by issuing equity instruments, no accounting entry is required, (other than a movement within equity, if the various types of equity interests are disclosed separately), except as noted below.

If the entity chooses the settlement alternative with the higher fair value, as estimated at the date of settlement, additional remuneration expense should be recognized for the excess value given, that is, the difference between the cash paid or fair value of the equity instruments issued and the fair value of the equity instruments that otherwise would have been issued (or the amount of cash that otherwise would have been paid). Similarly, for share plans that allow the entity to pay cash to employees rather than issue shares upon the exercise of share options, the cash payment should be treated as the repurchase of an equity instrument and debited to equity. However, if the cash paid exceeds the gain that the employee would realize on exercise of the option, additional remuneration expense should be recognized for that excess cash paid. (All of these decisions are only tentative and subject to change as the deliberations continue.)

The IASB also tentatively agreed that equity instruments transferred directly from shareholders to employees, or to other parties who have provided goods or services to the entity, should be accounted for as share-based payment transactions, unless the transfer clearly is for a purpose other than compensation for goods or services supplied to the entity.