Are You Overstating Your AASB 2 Share-Based Payment Expense?

The Hidden Pitfall of Using Black-Scholes for TSR-Hurdled Securities

In the world of executive compensation, share-based payments are a common and powerful tool. However, when it comes to accounting for these payments under AASB 2, many companies might be unknowingly overstating their expenses. The culprit? The use of the Black-Scholes model for valuing options with Total Shareholder Return (TSR) performance hurdles.

The AASB 2 Requirement

AASB 2 (paragraph 21) mandates that when share-based payments are subject to a TSR performance hurdle, the likelihood of meeting this vesting condition must be factored into the fair value estimation of the securities. This is where the Black-Scholes model falls short.

Why Black-Scholes Falls Short

The Black-Scholes model, while well-known and widely used, wasn’t designed to handle complex performance conditions like TSR hurdles. It essentially ignores these conditions, leading to an overstatement of the share-based payment expense.

A Practical Example

Let’s consider a typical scenario:

• An executive is granted 100,000 options
• Exercise price: $20 (matching the grant-date share price)
• Vesting period: 3 years
• Vesting condition: XYZ’s TSR benchmarked against S&P/ASX300 constituents

Vesting Criteria:

• TSR below 50th percentile: No vesting
• TSR at 50th percentile: 50% vesting
• TSR between 50th and 75th percentiles: Linear increase from 50% to 100%

TSR at or above 75th percentile: 100% vesting

The Overstatement in Numbers

Why the Overstatement Occurs

1. Black-Scholes Limitation: It only considers the likelihood of the share price exceeding the option exercise price at vesting. It doesn’t consider the extent to which the TSR hurdle will be satisfied.
2. Ignoring Vesting Conditions: Black-Scholes assumes all options will vest, ignoring the possibility that some or all might not due to the TSR condition.
3. Exercise Price Impact: As the exercise price decreases, the overstatement of the share-based payment expense becomes more pronounced. This is particularly significant for performance rights (effectively options with zero exercise price).

The Monte Carlo Alternative

The Monte Carlo valuation method can accurately factor in the TSR performance hurdles, providing a more accurate (and lower) valuation of share-based payments.

Key Takeaways

1. Black-Scholes is not designed to value share-based payments that are subject to TSR performance hurdles.
2. Using Black-Scholes for TSR-hurdled securities can significantly overstate share-based payment expenses.
3. The overstatement is particularly severe for performance rights (up to 43% in our example).
4. Monte Carlo valuation provides a more accurate valuation for TSR-hurdled securities and better complies with AASB 2’s requirement to incorporate performance hurdles into the valuation.

Implications for Companies

Given that AASB 2 (paragraph 23) doesn’t allow subsequent adjustments if TSR-hurdled securities don’t vest, it’s crucial to accurately estimate the fair value at the grant date. Overstating these expenses can have significant impacts on financial reporting and potentially mislead stakeholders.

In conclusion, while Black-Scholes remains a valuable tool in some scenarios, companies dealing with TSR-hurdled share-based payments should strongly consider adopting more sophisticated valuation methods like Monte Carlo simulations to ensure accurate financial reporting and compliance with AASB 2.