Granting share options costs the company nothing in cash, and that is exactly why the accounting surprises people. Under both FRS 102 and IFRS 2, an option granted to an employee is remuneration, measured at its fair value at the grant date and charged to profit over the period the employee earns it — so a company that paid nothing reports a cost, often a large one, in the year it issues options.
The principle: equity-settled awards
Share-based payment accounting starts from a simple idea. The company received services from employees and paid for them with equity instruments. The services have a cost, and the cost is measured by reference to what was given up — the fair value of the options at the date they were granted.
Three features follow from that, and each catches finance teams out:
- The grant-date fair value is fixed. It is not remeasured as the share price moves. An option granted when the shares were worth £1 carries the same charge whether they end up at £5 or 20p;
- The charge is spread over the vesting period. Options vesting evenly over four years produce four years of cost, not one;
- The double entry does not touch cash or liabilities. The debit goes to profit and loss as an employee cost; the credit goes to equity. Net assets are unchanged, and the charge reduces distributable reserves, which matters for a company planning dividends.
Vesting conditions decide the arithmetic
How conditions are treated is the technical heart of the standard, and getting it wrong misstates the charge for years.
Service conditions and non-market performance conditions — staying three years, hitting a profit target — are not reflected in the grant-date fair value. Instead, the company estimates how many options will actually vest and trues that estimate up each period. If half the cohort leaves, the cumulative charge for their options is reversed. If a profit target is missed and the options lapse, the charge reverses entirely.
Market conditions — a share price target, or total shareholder return against an index — are treated the opposite way. They are built into the grant-date fair value through the valuation model, and are not subsequently trued up. If the market condition is never met and the options lapse worthless, the charge stays in the accounts. Companies find this counter-intuitive: a cost recognised for an award nobody ever received.
Measuring fair value in a private company
Listed companies use option pricing models — Black-Scholes for simple awards, binomial or Monte Carlo models where the terms are path-dependent — with inputs for share price, exercise price, expected life, volatility, dividends and the risk-free rate.
Private companies have the same requirement and a harder problem, because two inputs do not exist observably: the share price and the volatility. In practice the share price comes from a valuation — the one prepared for an EMI agreement with HMRC is the natural starting point, though the purposes differ — and volatility is estimated from listed comparators in the same sector. Both assumptions should be documented at the time, because an auditor will ask and a reconstruction three years later is unconvincing.
FRS 102 offers some relief in how the requirement is applied to small entities, but it does not remove the charge. "We're a startup, we don't do share-based payment accounting" is a position that survives until the first audit, the first diligence exercise, or the first time a lender looks at the reported loss.
The tax mismatch
The accounting charge and the corporation tax deduction are different numbers arising at different times, and confusing them is common.
The accounting charge is spread from grant to vesting and is based on grant-date fair value. The statutory corporation tax deduction, by contrast, generally arises when the option is exercised, and is measured by the difference between the market value of the shares at that point and what the employee paid — which for a successful company is a far larger figure than the accounting charge, and lands in a single year.
The accounting charge itself is disallowed in the tax computation. Deferred tax may need recognising in the meantime where a future deduction is expected, measured on the intrinsic value at the reporting date — the one place where the share price movement does re-enter the accounts.
Disclosure and practical discipline
The accounts must describe the arrangements, the number and weighted average exercise price of options outstanding, granted, exercised, lapsed and expired in the period, the valuation method and its significant inputs, and the total expense recognised. Preparing that from a spreadsheet maintained by whoever last remembered is how errors enter the accounts.
The discipline worth adopting is a single option register — grant date, holder, number, exercise price, vesting terms, valuation inputs and status — maintained as grants happen rather than reconstructed at the year end. It serves the accounting charge, the tax deduction, the ERS annual return and the eventual cap table in a funding round, all from one source.
Acumon handles share-based payment accounting and the valuations behind it through financial reporting and valuation work, alongside the scheme design covered by our employment tax team. If options were granted in a prior year and never accounted for, the correction is a prior period adjustment — better made deliberately than found.