Virtual shares are a popular way to reward employees without giving them actual shares in the company. This arrangement offers various advantages for both employers and employees. This article discusses the accounting treatment of the granting of virtual shares in the financial statements.

Virtual shares give employees the right to a bonus that is based on the increase in value of the company’s underlying shares (so-called Share Appreciation Rights or SARs) or on a virtual dividend when a company makes a profit. In contrast to traditional share options, employees do not receive ownership or voting rights in the company when exercising their rights. This means that they benefit from the increase in value or share in the profit, without the risks associated with share ownership.

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Accounting treatment under the Dutch Reporting Guidelines

For a correct accounting treatment of virtual shares in the financial statements, it is essential to have a good understanding of the nature of the arrangement and the conditions attached to it. The first step is to determine which chapter of the Dutch Accounting Standards (Richtlijnen voor de jaarverslaggeving) applies.

Virtual dividend

In the case of a grant of a virtual dividend, where an employee obtains the right to receive a cash amount when the company makes a profit and certain predefined conditions have been met, this will qualify as a profit-sharing or bonus arrangement that falls within the scope of DAS 271 Employee Benefits. The company must recognise a virtual dividend as an expense in the profit and loss account and, insofar as it has not yet been paid, record it as a liability on the balance sheet in the period when the work for which this reward is granted is carried out.

It must be determined on the basis of the plan’s conditions whether an obligation to make payment has arisen on or before the balance sheet date and whether a reliable estimate of the obligation can be made.

Share Appreciation Rights

In the case of SARs, in contrast to a virtual dividend that depends on profit, there is a virtual share value that depends on the development of the value or price of the company’s underlying shares.If SARs are granted to employees in exchange for their work as an employee, they must be accounted for based on DAS 275 Share-based Payments. The remainder of this article further elaborates on this accounting treatment.

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Classification of share-based payments

Share-based payment arrangements can generally be divided into two categories:

1. Arrangements that are settled in equity instruments; and
2. Arrangements that are settled in cash.

SARs generally fall under the second category, because settlement usually takes place through a cash bonus payment. Care must be taken when there are multiple alternatives for settlement: if the company has the right, and not the obligation, to settle the arrangement in cash, it must be accounted for as an arrangement that is settled in equity instruments.
If, however, the company can be required to settle in cash, the arrangement must be accounted for as a cash-settled arrangement.

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Impact of classification on balance sheet treatment

The distinction between both types of arrangements determines the accounting treatment: for arrangements that are settled in equity instruments, the fair value of the consideration is recognised in equity, and for arrangements that are settled in cash, a liability is recognised on the balance sheet.This liability is classified as a provision because the amount and timing of settlement of the liability are uncertain.

It is important to realise that this provision does not fall within the scope of DAS 252 Provisions, contingent liabilities and contingent assets: the probability of settlement of the obligation, unlike with a regular provision, is not relevant for determining whether it must be recognised on the balance sheet, but only for determining the amount of the liability.

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Analysis of conditions attached to the granting of SARs

There can be a wide variety of conditions attached to a share-based payment. For a correct accounting treatment, it is essential to understand and carefully analyse these conditions.
DAS 275 distinguishes between two types of conditions:

• Market-related condition: a condition that relates to the price or value of the company’s shares. For SARs, unconditional vesting will generally take place upon an increase in company valuation above the predefined starting value.
• Performance-related condition: a condition that does not qualify as a market-related condition. Some performance-related conditions that are common in SARs include:
  • Continued employment: It is common that an employee must remain employed for a certain period in order to become unconditionally entitled to the SARs. This period is also referred to as the vesting period. Judgement may be required in determining when the vesting period begins: this is the moment when the employer and employee have a shared understanding of the conditions. This usually coincides with the signing by both parties of the grant of the virtual shares.
  • Financial targets: Unconditional vesting may depend on the achievement of certain financial targets. This may include conditions such as the company achieving a certain revenue or profit in a period, or a certain revenue or profit growth.
  • Occurrence of a transaction: Unconditional vesting may depend on a sale of the company or an initial public offering (IPO).

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Measurement of the liability and recognition of expenses

The essence of accounting for share-based payments is that the (personnel) costs are recognised when the employee's services are received. These costs therefore affect the company’s profit.The corresponding recognition of the liability must result in a provision that is measured at each balance sheet date at the fair value of the liability at that moment.

The liability is built up during the vesting period and the resulting costs are recognised in profit or loss in a linear fashion. Ultimately, the cumulative amount of the expense is based on the granted SARs that become unconditional, multiplied by the increase in company value compared to the starting value.

Impact of performance-related conditions

Determining the amount of the liability also requires management to make an estimate at each balance sheet date of the number of SARs expected to become unconditional. Care must be taken when there are multiple tranches within a SAR grant or multiple grants to the same employee, to determine the correct vesting period and, therefore, the correct pattern of build-up of the provision.
Depending on the performance-related conditions agreed upon, management will also need to make estimates of, for example:

• the probability that employees will remain employed until the end of the vesting period;
• the probability that certain revenue or profit (growth) targets will be achieved; and/or
• the probability that a transaction such as an acquisition or IPO will take place.
  These probabilities will therefore affect the recognition of the expenses in the profit and loss account and the amount of the liability on the balance sheet.

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Impact of market-related conditions

Furthermore, when determining the fair value of the liability, account must be taken of market-related conditions. For SARs, an estimate of the fair value of (the shares of) the company must therefore be made at each balance sheet date, in order to determine the increase in value compared to the starting value. This determines the estimate of the amount that will ultimately have to be paid to an employee upon exercise of a vested SAR.

Other considerations

Other considerations when determining the fair value of the liability include, for example, estimating the timing of its settlement, discounting those cash flows to the balance sheet date, and determining the corresponding discount rate.

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Considerations for micro and small entities

This article refers to DAS 275 from the Dutch Accounting Standards for medium-sized and large entities. This chapter does not directly apply to smaller companies that apply the Dutch Accounting Standards for micro and small entities. Chapter B14 Employee Benefits of those standards refers to DAS 275 for the accounting of share option schemes.

The generally accepted view in practice is that this provision should not be interpreted narrowly, meaning that it also applies to other forms of share-based payments such as SARs. Therefore, the same accounting requirements apply to micro and small entities as to medium-sized and large entities. The disclosure requirements for micro and small entities are, however, more limited, and Chapter B14 notes that the entity may consider including the additional disclosures mentioned elsewhere in the DAS bundle.

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Considerations for groups

DAS 275 contains an exemption that can be applied by subsidiaries within a group.If the share-based payment to the employees of a subsidiary is initiated or settled by the parent company, the subsidiary does not have to apply the requirements of DAS 275.In practice, this means an administrative relief for subsidiaries within a group if the granting of SARs is initiated or settled by the parent company.If the parent company is responsible for the settlement by paying employees of the subsidiaries, the provision for the entire group must be recognised on the parent company’s balance sheet.

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Considerations when applying IFRS

If a company prepares its financial statements based on the International Financial Reporting Standards (IFRS), the standard IFRS 2 Share-based Payments must be applied to share-based payments. Except for a few specific exceptions, the accounting treatment under IFRS 2 will be the same as under DAS 275. However, IFRS 2 provides more guidance on the application of the requirements.

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Conclusion

The correct accounting for a virtual share plan in the financial statements is, in many cases, not straightforward, particularly when a plan qualifies as a share-based payment plan. Depending on the vesting conditions, the specific circumstances or the group structure, and the required company valuation when accounting for SARs, it may therefore be advisable to seek advice from a specialist.