Stock Option Plans

An employee stock option plan (SOP) represents the right awarded to certain employees to purchase a number of common shares of the company at a pre-agreed exercise price, commonly subject to certain conditions. The exercise price is usually set at the market price of the underlying shares on the date of the award or an average of the stock price during a period up to the date of the award.

Stock Appreciation Rights

A stock appreciation rights (SAR) plan provides eligible employees of the company with the right to receive cash equal to the appreciation of the company's common shares over a pre-established strike price. Therefore, an SAR is a cash-settled SOP.

Share Plans

There are many kinds of share plan. In general, employees of the company either voluntarily buy shares of the company on advantageous terms, or are granted a number of shares for free.

The most common type of share plan, so-called “equity plus plan” or “leverage share savings plan”, is a voluntary plan that gives eligible employees the opportunity to purchase shares of the company at the stock price on the purchase date and generally to receive at no additional cost a number of shares for each share purchased, up to a maximum annual limit, after a certain vesting period of several years. Commonly, the free shares to be received are forfeitable in certain circumstances.

Another typical design of a share plan is the so-called “discounted purchase plan”, a voluntary plan that gives eligible employees the opportunity to purchase shares of the company at a discount to the stock price on the purchase date. Shares purchased under the share plan cannot be sold for a certain period from the time of purchase.

As mentioned earlier, there are all sorts of variations to the two previous designs. At the end of this chapter, share plan awarded by HSBC is covered, which in my view is remarkably complex.

Employee Stock Ownership Plans

An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to a trust for the benefit of the company's employees. This type of plan should not be confused with employee stock option plans, also called ESOPs, described earlier. The structures of trust ESOPs vary, but typically a trust is set up by the company to acquire shares in the company for the benefit of the employees. Therefore, in a trust ESOP, its beneficiaries do not hold the stock directly (i.e., beneficiaries do not actually buy shares). Instead, the company contributes its own shares to the trust, contributes cash to buy its own stock, or, quite commonly, the trust borrows money from the company to buy stock. The structure of the plan is designed to benefit from significant tax advantages for the company, the employees, and the sellers. Employees gradually vest in their accounts and receive their benefits when they leave the company (although there may be distributions prior to that).

Accounting Entries on Grant Date

On grant date, the fair value of the award is estimated. An important ingredient in this estimate is the fair value of the equity option embedded in the award (see Figure 10.3), which is determined using an option pricing model, typically the Black–Scholes model.

The model takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, its expected dividends and the risk-free interest rate over the expected life of the option. The expected life of the option is estimated using various behavioural assumptions, such as exercise patterns of similar plans.

Market vesting conditions and non-vesting conditions are taken into account when estimating the fair value of the equity option. Non-market vesting conditions and service conditions are not taken into account.

No accounting entries take place on grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award is calculated (see Figure 10.4). The expense is measured by adjusting the fair value of the equity option that was calculated on the grant date for the expected likelihood of meeting the non-market vesting and service conditions. For example, if there is an 80% chance of achieving the non-market vesting and service conditions, the number of options is adjusted by multiplying the equity option fair value by 80%. Consequently, the compensation expense takes into account the expected number of options that are expected to vest. One of the ingredients of this adjustment is the estimation of the forfeiture rate for service conditions. Based on historical employee turnover data, the company estimates the percentage of beneficiaries who will leave the company before the vesting period lapses.

The total compensation expense is evenly allocated over the expected life of the award. For example, suppose that a company reports its financial statements on an annual basis. If at the first reporting date the total compensation was estimated to be EUR 16 million and the vesting period of the award was 4 years, the yearly compensation expense to be recognised on this date would be EUR 4 million (=16 mn/4). The compensation expense allocated to the first year would be charged to the profit or loss statement and a corresponding increase in equity recognised.

IFRS 2 is not prescriptive on the accounting required for the credit to equity in respect of an SOP. Practice varies, depending on local regulatory requirements. One approach that is common in some jurisdictions is to credit a share-based payment reserve until the award has been settled and at a later stage to reclassify the amounts in that reserve to share capital (however, this may not be permitted in some jurisdictions) or other reserves. In other jurisdictions, the credit entry may be directly applied to retained earnings. In our example, the credit to equity was made to a share-based payment reserve (SOP reserve), as follows:

At each subsequent reporting date, the adjustment due to non-market and service vesting conditions was re-estimated. Using our previous example, suppose that the total compensation was revised upwards at the second yearly reporting date from EUR 16 million to EUR 20 million. The yearly compensation expense to be allocated over the 4-year vesting period would become EUR 5 million (=20 mn/4). The compensation expense allocated to the second yearly period would be as follows:

Required Actions on Grant Date

No actions take place on the grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award is calculated (see Figure 10.5). The expense is measured by fair valuing the embedded equity option and adjusting it for the likelihood of achievement of all the vesting (market, non-market and service) and non-vesting conditions.

The total compensation expense is evenly allocated over the expected life of the award. For example, suppose that a company reports its financial statements on an annual basis. If at the first reporting date the total compensation was estimated to be EUR 16 million and the expected life of the award is 4 years, the yearly compensation expense to be recognised on this date would be EUR 4 million (=16 mn/4). The compensation expense allocated to the first year would be charged to the profit or loss statement and a corresponding increase in liabilities recognised, as follows:

At each subsequent reporting date, the compensation expense was re-estimated. Using our previous example, suppose that the total compensation was revised upwards at the second yearly reporting date to EUR 20 million from EUR 16 million. The yearly compensation expense to be allocated over the 4-year expected life of the award became EUR 5 million (=20 mn/4). The compensation expense allocated to the second yearly period would be as follows:

Also on the second reporting date an adjustment was made to the previous compensation expense to take into account the revised total compensation figure. This adjustment brought the already recognised compensation expense in line with the new total compensation estimate. As the company already had recognised a EUR 4 million expense at the first yearly reporting date, it would need to make a EUR 1 million adjustment to bring it in line with the new EUR 5 million yearly compensation expense, as follows:

The accounting recognition at the subsequent reporting dates was similar to the recognition outlined for the second yearly reporting date. Therefore, on a cumulative basis, no amount is recognised if the equity instruments granted do not vest because of a failure to satisfy market and/or non-market vesting conditions.

Actions Required on Grant Date

On grant date, ABC estimated the fair value of the equity option, ignoring the non-market and service vesting conditions, but taking into account the non-vesting conditions (in this case there were no non-vesting conditions). Based on historical data, ABC estimated that on average the beneficiaries would exercise the fair value of the option at the end of the first 6 months of the exercise period (i.e., 3.5 years after the grant date). Thus, the best estimation of the expected life of the award was 3.5 years. The fair value of the equity option was calculated by pricing a call option on ABC stock with a strike of EUR 50.00 (i.e., at-the-money), an expiry of 3.5 years, a volatility equal to the implied volatility for such options on ABC stock, and a 2% expected dividend yield of ABC stock during its life. The option valuation also included the market vesting condition (the outperformance of the Euro Stoxx50 index), assuming a 60% correlation between ABC's stock price and the index. ABC used the Monte Carlo simulation method to estimate the fair value of this option, coming up with a fair value of EUR 21 million. Note that the fair value of the option did not include any estimates regarding the non-market and service conditions.

No accounting entries took place on grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date, the total compensation expense associated with the award was calculated (see Figure 10.8). The expense was measured by adjusting the equity option fair value (which was calculated on the grant date) for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest. Based on historical top employee turnover data, ABC estimated the percentage of the beneficiaries expected to leave the company before the vesting period lapsed. Also ABC estimated the likelihood of ABC's EBITDA achieving a 10% annual growth rate during the vesting period.

The total compensation (i.e., personnel) expense was evenly allocated over the 3-year vesting period of the award. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.

Notes:

(1) Calculated on grant date, and fixed during the life of the award

(2) Estimated at each reporting date

(3) Calculated as (1) × (2) = 21 mn × 70%

(4) Calculated as (3)/Number of accounting periods = 14.7 mn/3

(5) 4.9 mn – 5.6 mn

(6) (5.3 mn × 2) – (4.9 mn × 2)

On 31 December 20X1, ABC estimated the expected likelihood of meeting the non-market vesting conditions to be 80%. A EUR 16.8 million total compensation expense was calculated by multiplying the EUR 21 million equity option fair value by the 80% estimate. The compensation expense allocated to the first year was charged to profit or loss and a corresponding increase in equity recognised as follows (amounts in EUR million):

On 31 December 20X2, the expected likelihood of meeting the non-market and service vesting conditions was re-estimated to be 70%. A EUR 14.7 million total compensation expense was calculated by multiplying the EUR 21 million equity option fair value by the 70% estimate. The compensation expense allocated to the second year was charged to profit or loss and a corresponding increase in equity recognised as follows (amounts in EUR million):

Also on 31 December 20X2, a EUR 0.7 million adjustment to the compensation expense was implemented as the new annual expense was EUR 4.9 million while the personnel expense recognised on 31 December 20X1 was EUR 5.6 million. The adjustment was recorded as follows (amounts in EUR million):

Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):

Accounting Entries upon Exercised/Unexercised Expiry

Following each exercise and at maturity of the SOP, the balance of the SOP reserve was recycled to another account of the shareholders' equity section. There were two scenarios to consider: (i) all (or part of) the plan options expired unexercised; and (ii) all (or part of) the plan options were exercised.

In order to describe the accounting entries under the first scenario, suppose that under ABC's SOP all the beneficiaries behaved identically and that on the SOP's expiration date on 31 December 20X4 no beneficiaries exercised their options. On that date, the SOP reserve had a carrying amount of EUR 15.8 million. Therefore, a compensation expense of EUR 15.8 million was recognised during the SOP's vesting period. It would have been illogical to leave an amount on the SOP reserve related to an SOP that no longer existed. Therefore, the balance of the SOP reserve was reclassified to some other account(s) of the shareholders' equity section. In this example I use the “retained earnings” account, but depending on the legal jurisdiction of the entity another equity account could have been used (e.g., “share premium”). The accounting entries were the following (amounts in EUR million):

Under the second scenario, exercise of the SOP, there was also a transfer within the shareholders' equity section, but the accounts affected depended on the action taken by the company. Suppose that upon exercise of the SOP, the company could either (i) issue new shares or (ii) deliver treasury shares.

Suppose that the SOP was exercised simultaneously by all the beneficiaries at the end of the fourth year and that ABC issued 2 million new shares, with a nominal value of EUR 2 million. Upon exercise of the SOP the beneficiaries paid the EUR 100 million (=2 mn × 50.00) strike amount in exchange for the new shares. The accounting entries were the following (amounts in EUR million):

If the company delivered treasury shares instead, the accounting entries would be the following (amounts in EUR million), assuming that the treasury shares delivered were previously recognised at EUR 15 million:

Conclusions

If at the end of the vesting period, the non-market condition (i.e., a 10% growth in EBITDA) had not been achieved, a reversal of the SOP's personnel expense already recognised would have taken place. Thus, on a cumulative basis no amount of personnel expense would not be recognised if the equity instruments granted did not vest because of a failure to satisfy non-market vesting conditions or service conditions.

If the non-market vesting conditions and the service conditions were satisfied while an SOP's market and non-vesting conditions (in our case there were no non-vesting conditions) were met, the personnel expense would not be reversed, and the total expense would end up increasing shareholders' equity, even if the SOP expired unexercised. Thus, if an SOP has a market vesting condition or a non-vesting condition, the company might still recognise an expense even if that condition is not attained and the option does not vest.

From the grant date ABC knew the maximum amount of compensation expense that it could end up recognising in profit or loss. This maximum amount was the fair value of the equity option on grant date (i.e., EUR 21 million).

Actions Required on Grant Date

No actions and no accounting entries took place on the grant date.

Accounting Entries at Each Reporting Date during the Life of the Award

At each reporting date and at maturity, the total compensation expense associated with the award was calculated (see Figure 10.9) by estimating the fair value of the embedded equity option expense and adjusting it for the expected likelihood of meeting the non-market and service vesting conditions. Consequently, the compensation expense took into account the expected number of options that were expected to vest.

The total compensation (i.e., personnel) expense was evenly allocated over the 3-year vesting period. The following table shows the personnel expense at each reporting date, assuming that ABC reported its financial statements on an annual basis.

Notes:

(1) Calculated at each reporting date

(2) 26.0 mn × 70%

(3) Calculated as (2)/Number of accounting periods = 18.2 mn/3, assuming a 3-year vesting period

(4) 6.1 mn – 5.3 mn

(5) (7.3 mn × 2) – (6.1 mn × 2), assuming a 3-year expected life of the SAR

On 31 December 20X1, ABC estimated both (i) the fair value of the embedded equity option (EUR 20 million) and (ii) the expected likelihood of meeting the non-market and service vesting conditions (80%). A EUR 16 million total compensation expense was calculated by multiplying the EUR 20 million equity option fair value by the 80% estimate. The compensation expense allocated to the first year was charged to profit or loss and a corresponding increase in liabilities recognised as follows (amounts in EUR million):

Repeating the process executed on the previous reporting date, on 31 December 20X2 ABC estimated a EUR 18.2 million compensation expense. Of this expense, EUR 6.1 million was allocated to the second year, charged to profit or loss and to liabilities as follows (amounts in EUR million):

Also on 31 December 20X2, a EUR 0.8 million adjustment to the compensation expense was implemented as the new annual expense was EUR 6.1 million while the personnel expense recognised on 31 December 20X1 was EUR 5.3 million. The adjustment was recorded as follows (amounts in EUR million):

Following the same reasoning, and using the numbers in the table above, the accounting entries on 31 December 20X3 were the following (amounts in EUR million):

Accounting Entries upon Exercise/Unexercised Expiry

Suppose that no beneficiaries exercised their rights prior to the SAR's expiry date. Suppose further that at expiry, on 31 December 20X4, all the beneficiaries behaved identically. As a consequence, there were two scenarios to consider: (i) that all the SAR options expired unexercised; and (ii) that all the SAR options were exercised.

Under the first scenario, the SAR lapsed fully unexercised. Thus, the SAR's fair value was zero. At the previous reporting dates a total EUR 21.8 million compensation expense was recognised. Therefore, this compensation expense had to be reversed on 31 December 20X4. The accounting entries were the following (amounts in EUR million):

Under the second scenario, the SAR was fully exercised. Suppose that on 31 December 20X4 ABC's share price was EUR 68. The SAR's fair value was EUR 36 million (=2 mn × (68 – 50)). As ABC had already recognised a total EUR 21.8 million compensation expense, an additional EUR 14.2 million (=36 mn – 21.8 mn) expense was recognised as follows (amounts in EUR million):

Additionally, the EUR 36 million cash award payment to the beneficiaries was recognised as follows (amounts in EUR million):

Conclusions

At each reporting date ABC had to fair value the SAR award. This had several implications:

• ABC's profit or loss statement was exposed to a rising stock price, potentially increasing its volatility.
• Overall, ABC did not have to recognise a compensation expense were the SAR to expire worthless.
• On the grant date ABC did not know the maximum amount of compensation expense that could end up recognised in profit or loss. Similarly on the grant date, ABC did not know the amount of cash it would need to meet the SAR award.

Main Risks in an SOP

Under its SOP, ABC was not exposed to equity market risk. Remember that from an accounting perspective, the equity option embedded in the SOP award was estimated at grant date. During the expected life of the award, the equity option was not further fair valued. Only the expectations of meeting the non-market conditions were reassessed at each reporting date. Therefore, ABC's profit or loss statement was not exposed to changes in ABC's stock price or changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the Euro Stoxx 50 index). In other words, ABC's profit or loss was not exposed to equity risk. While ABC's profit or loss was exposed to non-market risk (i.e., a 10% average EBITDA growth), its hedge was unavailable in the market.

ABC's shareholders were exposed to dilution risk. If the SOP ended up being exercised, ABC needed to deliver shares to the beneficiaries. Probably these shares would be newly issued, increasing the number of shares outstanding, and thus diluting existing shareholders. Nonetheless, the dilution risk was limited as new shares would be issued at a pre-established fixed price (EUR 50.00 per share).

Main Risks in an SAR

ABC was exposed to equity market risk. Remember that, from an accounting perspective, under the SAR the equity option was fair valued at each reporting date. Therefore, ABC's profit or loss was exposed to changes in ABC's stock price and to changes in the likelihood of meeting the market conditions (i.e., ABC stock had to outperform the Euro Stoxx 50 index).

ABC's profit or loss was exposed as well to the achievement of a non-market condition (i.e., a 10% average EBITDA growth). However, hedging this risk was unavailable in the market.

ABC was also exposed to liquidity risk. Upon exercise, ABC needed to pay a cash amount to the beneficiaries. A large amount of cash may require ABC to use precious liquidity resources or/and to raise financing.

ABC was not exposed to dilution risk as upon exercise no shares were delivered to the beneficiaries.

Strengths of the Strategy

The strategy had the following strengths:

• If the plan options were fully exercised, ABC would effectively meet the settlement commitments under both plans.
• Ignoring the financing costs related to the treasury shares, this hedging alternative was cheaper than hedging with calls if the plans were fully exercised. If the stock options were exercised, ABC would have saved the call premium, which could be substantial.
• The initial acquisition of the shares could have a positive effect on ABC's stock price.
• The hedge was not revalued during the life of the plan. Thus, there is a parallel accounting treatment in equity of the SOP's embedded equity option and the treasury shares as none of them are revalued after the grant date.

Weaknesses of the Strategy

The strategy had the following drawbacks:

• The acquisition of treasury shares used liquidity resources from the company. ABC could have needed to raise financing to fund the own shares acquisition.
• The acquisition of treasury shares had a negative impact on ABC's debt-to-equity ratio. Treasury shares were deducted from equity, increasing ABC's leverage.
• The hedge was not revalued. This was a weakness only for the SAR award. The SAR award was revalued periodically while the hedge was not. As a result, ABC was not able to apply hedge accounting.
• At maturity of the plan the shares hedging unexercised options were no longer needed. ABC could sell the shares in the market at a price below the acquisition price (i.e., at a loss), permanently reducing equity.
• ABC did not receive the treasury shares dividends, as an entity cannot distribute dividends to its own shares.
• The acquisition of treasury shares could affect ABC's flexibility in managing its treasury shares. Legally there is a limit (e.g., 10%) on the maximum percentage of voting capital that companies can hold in their own shares. Buying a substantial amount of treasury shares could bring the company close to the legal limit, restricting potential acquisition of more shares.
• Although the shares acquired to hedge a plan in theory remained on ABC's balance sheet until expiration, there was a potential temptation to manage these shares like the rest of the treasury shares. Some companies dynamically manage their holdings of treasury shares to alleviate potential disruptions in its stock market trading. For example, a company may acquire treasury shares to provide liquidity when there is a large selling order in the market and sell them later when its stock shows excessive strength.

Hedging an SOP with an Equity Swap

Suppose that ABC hedged its SOP plan with an equity swap. The strategy was in a way similar to a combination of a financing and an acquisition of treasury shares. Suppose that ABC entered into a total return equity swap with the following terms:

• Trade date: 1 January 20X1 (the award grant date)
• Termination date: 31 December 20X4 (the award maturity date)
• Number of shares: 2 million (the SOP number of options)
• Shares: ABC's ordinary shares
• Initial price: EUR 50.00 (ABC's share price on trade date)
• Initial equity notional: EUR 100 million
• Equity amount receiver: ABC
• ABC could partially/totally early terminate the equity swap at any time from 1 January 20X3 to 31 December 20X4
• ABC paid quarterly Euribor 3M plus 150 bps on the equity notional amount
• ABC received 100% of the gross dividends distributed to the underlying shares
• Settlement: physical settlement only

The strategy was executed as follows:

1. ABC entered into the equity swap on the award grant date. No up-front premium was paid.
2. During the life of the equity swap, ABC paid the equity swap floating amount, Euribor plus 150 bps on the equity swap notional. The equity swap notional was initially EUR 100 million, and was adjusted to take into account partial early terminations of the swap.
3. During the life of the equity swap, ABC received any dividends distributed to the underlying shares.
4. Upon each exercise of the SOP, ABC would terminate a number of shares of the equity swap equivalent to the number of options exercised under the plan. For example, if 200,000 options were exercised by the SOP beneficiaries, ABC would terminate 200,000 shares of the equity swap. Under the equity swap, ABC paid EUR 10 million (=0.2 mn × 50) and received 200,000 of its own shares, which in turn were delivered to the beneficiaries in exchange for a EUR 10 million payment.
5. If at the end of the vesting period the non-market conditions were not achieved, ABC faced two main alternatives: either to maintain the equity swap until its maturity or to terminate it early and in full. In either case, under the equity swap ABC would end up buying 50 million own shares and paying EUR 100 million. ABC then would need to decide whether to hold the treasury shares for future share-based award or to sell them in the market.
6. If at expiry of the SOP there were options that remained unexercised, ABC would buy through the equity swap the remaining shares and pay EUR 50 per share. ABC then would need to decide what to do with the own shares: whether to hold them for future share-based plans or to sell them onto the market.

The equity swap was classified for accounting purposes as an equity instrument. The initial accounting entry under IFRS was to recognise a liability for an amount equal to the present value of the equity swap notional, with a debit to an equity account.

The equity swap was not fair valued during its life. As a result, the equity swap did not add volatility to ABC's profit or loss statement as both the plan (ignoring service conditions) and the equity swap did not require fair valuing after the grant date. However, a liability was recognised, increasing ABC's leverage metrics.

Hedging an SAR with an Equity Swap

Suppose that ABC hedged its SAR plan with an equity swap. The terms were identical to those of the equity swap traded to hedge the SOP, except its settlement terms. The equity swap hedging the SAR allowed for cash settlement only. Therefore, at each partial early termination and/or at maturity, ABC received, if its stock price was above EUR 50.00, an amount equal to

or paid, if its stock price was below EUR 50.00, an amount equal to

Figure 10.11 shows the equity swap settlement amount as a function of the final price at maturity (i.e., the volume-weighted average price on that date). It can be seen that if the final price was above EUR 50.00 and ignoring the SAR's service conditions, ABC perfectly hedged its commitment under the SAR. However, if the final price was below EUR 50.00, ABC lost a substantial amount.

The strategy was executed as follows:

1. ABC entered into the equity swap on the award grant date. No up-front premium was paid.
2. During the life of the equity swap, ABC paid the equity swap floating amount, Euribor plus 150 basis points on the equity swap notional. The equity swap notional was initially EUR 100 million, and was subsequently adjusted to take into account partial early terminations of the swap.
3. During the life of the equity swap, ABC received any dividends distributed to the underlying shares.
4. Upon exercise of the SAR, ABC terminated a number of shares of the equity swap equal to the number of options exercised under the plan. For example, if 200,000 options were exercised by the SAR beneficiaries, ABC would terminate 200,000 shares of the equity swap. Assuming that ABC's share price was EUR 60 at the time of the exercise, under the equity swap, ABC received a EUR 2 million (=0.2 mn × (60 – 50)) settlement amount. This amount was paid in turn to the SAR beneficiaries.
5. If at the end of the vesting period the non-market conditions were not achieved, ABC faced two main alternatives: either to maintain the equity swap or to terminate it early and in full. In order to avoid further exposure to ABC's stock price, ABC would probably terminate it early. ABC would either (i) receive the appreciation of the underlying shares above EUR 50, or (ii) pay the depreciation of the underlying shares below EUR 50.
6. If at expiry of the SAR there were options that remain unexercised, the equity swap would terminate. ABC would either (i) receive the appreciation of the remaining underlying shares above EUR 50, or (ii) pay the depreciation of the remaining underlying shares below EUR 50.

The equity swap was classified for accounting purposes as a derivative. It was unlikely that ABC could apply hedge accounting as the payoffs of the SAR (a call option) and the equity swap (a forward like) were very different when ABC's stock price was below EUR 50.00. Assuming that the equity swap was undesignated, it was fair valued through profit or loss at each reporting date. Remember that the SAR was also fair valued at each reporting date, but the change in fair value was allocated over the 3-year vesting period. Therefore:

• If ABC's share price were above 50.00, the change in fair value of the SAR and of the equity swap would be similar (ignoring the time value of the equity option underlying the SAR and the adjustments due to the service condition). However, an accounting mismatch would occur in profit or loss, as the whole change in fair value of the swap would be recognised in profit or loss while just one third of the change in fair value of the SAR would be recognised in profit or loss.
• If ABC's share price were below 50.00, the change in fair value of the equity swap would be rather different from that of the SAR. To make things worse, only one third of the change in fair value of the SAR would be recognised in profit or loss. As a result a substantial mismatch in profit or loss would result, potentially increasing the volatility of ABC's profit or loss.

In summary, hedging an SAR with an equity swap may cause substantial distortions in an entity's financial statements. In the next subsection I will discuss a friendlier variation on the equity swap.

Strengths of the Strategy

The strategy had the following strengths:

• If the plan options were exercised, ABC effectively met the settlement commitments under both awards.
• ABC was not using cash resources, in contrast to a hedge with treasury shares.
• Ignoring the financing costs related to the equity swap, this hedging alternative was cheaper than hedging with calls if the plans were exercised. If the award's options were exercised, ABC saved the call premium, which was substantial due to the medium-term life of the award.
• The bank counterparty to the equity swap needed to buy the underlying shares in the market at inception. This initial acquisition had a positive effect on ABC's stock price.
• Regarding the SOP, the hedge was not revalued during the life of the award. Thus, there was a similar accounting treatment in equity as neither the SOP's embedded equity option nor the equity swap were fair valued subsequent to their commencement.

Weaknesses of the Strategy

The strategy had the following drawbacks:

• If the plans were unexercised because ABC shares traded below EUR 50.00, ABC would end up with either unwanted treasury shares (in case of the SOP) or a loss (in case of the SAR).
• Regarding the SAR, if the shares traded below EUR 50.00, there could be a substantial increase in the volatility of ABC's profit or loss statement due to the accounting recognition mismatch in profit or loss between the equity swap and the SAR.
• Regarding the SOP, the equity swap had a negative effect on ABC's leverage metrics, for example on its debt-to-equity ratio. On the one hand, there was a liability recognised from inception. On the other hand, there was an equity entry that reduced the balance of the shareholders' equity section of ABC's balance sheet.
• The equity swap consumed credit lines with its counterparty, reducing its flexibility to deal with this party. If the equity swap was collateralised and the share price fell, ABC would need to post collateral to the equity swap counterparty.
• In some jurisdictions, an equity swap may be treated as treasury shares from a legal perspective. This treatment could affect ABC's flexibility in managing its treasury shares, as they were subject to a maximum legal limit.

Strengths of the Strategy

The strategy had the following strengths:

• If the plan options were exercised, ABC would have effectively met the settlement commitments under both plans.
• ABC was not exposed to a share price lower than the strike price.
• In the case of the SAR, the hedge eliminated the award's profit or loss impact due to changes in market conditions as ABC was able to apply hedge accounting.
• The accounting treatment of the hedge was similar to that of the awards, not creating accounting mismatches.
• The implementation of the hedge had a positive effect on ABC's stock price as the bank supplying the call options needed to acquire ABC shares in the market at inception to hedge its position under the calls.
• ABC could sell the options at the end of the vesting period if the non-market conditions were not achieved. The sale would effectively reduce the hedge cost.

Weaknesses of the Strategy

The strategy had the following drawbacks:

• ABC paid a substantial premium up-front, as the SOP/SAR had medium-term maturities, using liquidity resources from the company. Financing might need to be raised to fund the premium. However, the premium was considerably lower than the initial outflow incurred when hedging the awards with treasury shares.
• The acquisition of call had a negative impact on ABC's debt-to-equity ratio. The premium of the call options hedging the SOP was deducted from equity, increasing ABC's leverage. However, the effect on leverage was considerably lower than the effect when hedging the awards with treasury shares.