In our blog, we regularly inform you about the tax implications of employee stock and option plans (ESOP). This time, we will address the question of how to properly report these employee plans according to Czech accounting standards for reporting entities following Decree No. 500/2002 Coll., as amended.
Let us first summarise the basic types of ESOP:
Within these programmes, employees receive actual shares or stock, or the right (option) to purchase them, either completely free or at a discounted price. The plan serves as an additional reward for the employee’s work, i.e., it is essentially a form of bonus to the salary. The goal is also to retain employees through this incentive. The relevant shares/stock/options can belong either to the company employing the individual or to other companies within the group (usually the parent company).
Within this programme, employees are paid monetary amounts, but the payout amount is determined by the value of shares/stock.
The essential characteristic of ESOP is their long-term nature, i.e. an employee usually acquires a title (right) only after several years and under certain conditions (achievement of set goals).
While in the IFRS accounting standards, the reporting of liabilities/debts and expenses from these plans is thoroughly addressed (IFRS 2 Share-based Payment), Czech accounting currently lacks any specific regulation, requiring the determination of appropriate accounting principles to be based more on general rules and the rules of the relevant programme.
The IFRS approach can be briefly summarised as reporting aligned with the purpose. It means that expenses attributable to ESOP (whether cash payments or payments in shares/stock/options) must be reported as wage costs, as it is effectively remuneration for the employee’s work. The counterpart is either the reporting of a financial liability or a “reserve” in equity, which is intended for the subsequent increase of share capital or to cover the issuance of treasury shares that have been held by the company until now. If the employee receives shares of the parent company, this fact must also be reflected as wage costs in the accounts of the company employing the individual.
The key question for reporting ESOP in Czech accounting is whether the company employing the relevant individual will be exposed to any actual costs, i.e. whether it will have to expend any funds to fulfil obligations arising from the programme. If no funds are expended, then it is very difficult to report costs in Czech accounting.
1. Programmes where the employee physically receives a company’s shares or stock to be issued
This is the most complex situation because the company does not incur a debt that would require expenditure or funds for its settlement. Therefore, it is not possible to account for a reserve or a liability. The definition of a reserve pursuant to Section 26 (3) of the Accounting Act is not fulfilled: “Reserves are intended to cover liabilities or costs, whose nature is clearly defined and where, as of the balance sheet date, it is either probable or certain that they will occur, but their amount or timing is uncertain. As of the balance sheet date, the reserve must represent the best estimate of costs that are likely to occur, or in the case of liabilities, the amount needed for settlement”.
The IFRS approach under which the costs of this programme are recognised against equity cannot be applied either. Czech accounting regulations do not allow such formation of equity.
Typically, these programmes are reflected in accounting only at the moment of settlement when shares are issued, and a negative share premium arises if they are issued for free or at a value lower than their nominal value.
Similarly, this is the case with options. According to the definition in Czech accounting standard CAS 110 Derivatives, an option to sell treasury shares, which will be settled by delivering treasury shares, is not considered a derivative.
2. Programmes where the employee physically receives shares of another company (parent company)
If the company has the obligation to first purchase the shares of the parent company and then transfer them to the employee, it should establish a reserve for this obligation. The same approach is followed if, although the shares are not directly purchased, the costs incurred by the parent company are invoiced to it. The amount of the reserve will depend, among other things, on the current market price of the parent company’s shares. The Accounting Act (see above) requires the reserve to be established at the level of the best estimate of costs likely to occur. The complete adoption of the IFRS 2 approach, where the liability to the employee is gradually established over the duration of the programme, is highly debatable, as Czech accounting legislation assumes that the liability for other reserves is established in its full expected amount all at once. Nevertheless, gradual formation over time can be at least partially simulated by considering the probability of payout.
For these programmes, it is also necessary to thoroughly analyse the setup and exclude the possibility that it is a derivative.
3. Programmes settled in cash
For programmes settled in cash, the company should establish a reserve over time. The process of creating the reserve is similar to programme 1 stated above. Therefore, it is necessary to set an appropriate method in advance to evaluate:
Only after the evaluation of the programme, i.e., at the moment when the employee has fulfilled the conditions of the programme (duration and goals), can the liability be accounted for against wage costs.
Similar to the programmes stated in point 2, it is also necessary to thoroughly analyse their setup and exclude the possibility that it is a derivative. If the programme is a derivative instrument (particularly in the case of options), it is necessary to account for these options at their fair value.
Although accounting for ESOP is not specifically regulated in Czech accounting legislation, these employee programmes cannot be ignored over time and accounted for only at the point of settlement. This is particularly true for programmes settled in cash. Full adoption of the IFRS approach can also be questionable. Therefore, we recommend addressing this issue in a timely manner with an auditor and, if it is a significant item, describing in the financial statements both the method of reporting and valuation of any reserve, as well as any uncertainties regarding the determination of its amount.
Be aware that some programmes may, according to Czech accounting, represent a derivative instrument, which must always be valued at fair value in the income statement (in the case of ESOP, it cannot inherently be a hedging instrument).
Programmes can also offer variability in selection, i.e., the employee or the company can choose the form of performance (in cash or shares), it is then a “compound instrument”, and it is necessary to be even more prudent when setting the correct accounting policy that will comply with Czech accounting legislation.
Unfortunately, the expected new interpretation by the National Accounting Council on employee benefits (NI-75) will probably not help with reporting ESOP, as employee share and option plans have been excluded from the interpretation proposal.
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