Introduction

​Performance rights are a common and effective way for companies to incentivise their employees. They allow companies to remunerate employees with non-cash compensation (thus are attractive ideas for startups) but also align the employee with the goals of the company. Many companies will include performance rights as part of their LTI plan for these reasons. In this article, I am going to discuss what non-market-based performance rights are, how to recognise and value these rights in connection with AASB 2, and run through some practical considerations to illustrate.

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What are non-market-based performance rights?

Performance rights are derivative instruments that allow an employee to be issued shares when certain performance criteria are fulfilled. For the purposes of this article, I will divide these rights into three main categories, based on the accounting treatment under AASB 2: 

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• Service-based, which vest based on an employee serving out a fixed number of years of employment;

• Market-based, which vest based on external criteria, typically share price or VWAP;

• Non-market-based, which vest on internal criteria and the subject of this article.

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Non-market-based performance rights will typically be tied to things such as revenue goals, customer retention or operational milestones. Being tied to internal goals presents challenges to us as accountants as we cannot use gold standard methodologies for valuation, such as Black-Scholes or GBM. Instead, we need to carefully examine internal and external sources of information to assist us.

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Valuation and measurement

For the most part, non-market-based rights function similarly to other share-based payments. As per AASB 2, they:

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• Are measured at fair value at grant date, typically meaning share price for a listed entity (p10)

• Are expensed over their vesting period (p15)

• Are equity-settled, meaning there will be no revaluation of the fair value of the rights (p19)

• Are transferred to retained earnings or another equity account if forfeited (p23)​

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​However, there is one key difference between non-market rights and service/market-based rights, as per p19:

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'Vesting conditions, other than market conditions, shall not be taken into account when estimating the fair value of the shares or share options at the measurement date. Instead, vesting conditions, other than market conditions, shall be taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount so that, ultimately, the amount recognised for goods or services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest.'

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As part of our initial recognition, and subsequently at balance date, we must determine the probability of the performance right being granted and apply that to the initial fair value to determine the number of rights to expense out. Although this won't change our initial overall valuation, there is an added administrative burden here. When accounting for these rights, not only do we need to adjust our working file to account for increased/decreased expensing, we also need to examine the inputs for these rights and adjust as necessary.

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Like many aspects of accounting, we can follow a simple two-step approach to coming up with the value of an asset, liability or right:

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• Determine fair value, usually share price

• Modify this by the probability of occurrence (refer to the Conceptual Framework for specific classes - assets for instance differ from liabilities)

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Note: for assets/liabilities, we also need to account for discounting, however this is not applicable to share-based payments under p19.

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Below I will present my methodology to determining the quantity and valuation of non-market-based performance rights.

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General methodology

We can apply the above logic with a few modifications when it comes to valuing non-market-based performance rights. The crux of our calculations will be working out the key drivers behind the non-market-based conditions, the various probabilities associated and their respective effect on the condition. Please note the methodology below and any future worked examples assume a Monte Carlo-based model. As an aside, Monte Carlo / simulation-based models are typically used for valuations with multiple interacting pieces, and are considered the gold standard for more complex models in accounting. Additionally, having a basic understand of statistics is useful when working with more advanced models, and will serve an accountant well when it comes to forecasting and preparing more complex stochastic models.

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Step 1:

Calculate fair value of the rights, typically using share price based on grant date. For grant date, we refer to the definition in Appendix A:

'The date at which the entity and another party (including an employee) agree to a share-based payment arrangement, being when the entity and the counterparty have a shared understanding of the terms and conditions of the arrangement. At grant date the entity confers on the counterparty the right to cash, other assets, or equity instruments of the entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained.'

​This could be the date of a contract signed, an announcement to the market or shareholder approval in the case of director rights.

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Step 2:

Determine key drivers behind the non-market-based conditions as well as the probabilities associated and their respective effect on the conditions. For instance, if our non-market condition is customer churn, one potential impact is company pricing changes. 

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Based on historical data, we might determine that the company raises prices 50% of the time each year. Additionally, when prices are increased, churn increases by 2% per year. When prices are kept steady, there is no effect on churn. This step is very important as we need to pull together relevant internal information as well as review external information. We also need to be able to retrieve this information at future periods to adjust the number of rights in our calculation.

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Step 3:

Prepare our valuation model, typically in Excel or Python. This article will present a contrived example with references to Excel calculations however Python is perfectly capable of running the same model. Python has the benefit of being able to run many more simulations than Excel in very quick time (typically performance rights valuations using Monte Carlo simulations require at least 10,000 simulations.) However, Python is not common knowledge for accountants and will make the audit process more difficult as auditors will need to familiarise themselves with programming language.

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Typically, a good model will be tabular and include the number of simulations, a random number generated in a cell, and subsequent cells that use this random number to determine the outcome. Note: for discrete possibilities, a simple RAND() formula is recommended; however it is common for models to assume a normal distribution, so it is good for one to familiarise themselves with NORM.S.INV. For our contrived model, we will assume discrete possibilities, however for sales-based conditions, it might be prudent to assume normal distributions.

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Step 4:

Calculate how many simulations achieve the target as a proportion of total simulations. A simple way to do this is to add a checker column in Excel and COUNTIFS the number of 1s (1 being allocated to a success) as a proportion of total simulations (COUNTA.)

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Step 5:

​Multiply this probability by the number of shares and the fair value at grant date. This will form our total value of the rights. Subsequently, we will re-assess the probability at balance date and update the number of rights and hence the amount expensed in the period. However, as noted above, we do not revisit the fair value of the rights - what we determine on grant date will be the value of our equity.

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We can now prepare our working file to calculate the share-based payment expense for the period for these rights. Again, these will be the same as other options and rights as per p8:

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Dr SBP Expense (PL)

Cr Reserves (BS)​

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Closing thoughts

​Non-market-based performance rights present additional challenges to accountants, both in determining the quantity of rights to account for as well as the rigorous information-gathering required. As with all things, it is important to be familiar with standard, in this case AASB 2, to determine the correct accounting methodology. Additionally, all accountants should have a strong command of Excel and, in my opinion, a basic understanding of Python if they encounter performance rights often.​

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For business owners, performance rights are a powerful way to align your employees with the company and spare your cash reserves. However, one must consider the effects of dilution as well as any compliance requirements (such as shareholder approval and compliance with EIS requirements.)

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Koldun Consulting has assisted with both the accounting process for non-market-based performance rights as well as assisting design LTI policies to incentivise employees. If you are a business owner and need assistance with performance rights or remuneration plans, please don't hesitate to reach out to koldunconsulting@protonmail.com.

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