Incentivization vs. Market Price Risk:

Skills shortages, the war for talent, and retention strategies—amidst the buzzword jungle of today’s dynamic working world, companies face the challenge of retaining highly qualified employees in the long run in an increasingly competitive environment and ensuring their alignment with corporate objectives. For boards of directors, the German Corporate Governance Code and the Stock Corporation Act explicitly require the implementation of long-term and sustainable remuneration systems.

A widely used solution for incentivizing employees and meeting regulatory requirements is share-based compensation programs. The core element of these programs is linking remuneration to the development of company value or share price, as well as the achievement of other corporate goals. Depending on the structure and accounting treatment, these programs can lead to significant fluctuations in results above EBIT, which may only be mitigated through appropriate hedging strategies.

Share-based payments under IFRS 2 are a form of compensation where companies grant beneficiaries, as part of their remuneration, either actual equity instruments (shares) of the company (equity-settlement) or a special payment based on the value of equity instruments (cash-settlement). This additional compensation component must be recognized either as a liability (cash-settlement) or as an increase in equity (equity-settlement) and is accrued over the typically multi-year vesting period. The services received are generally recognized as personnel expenses, as they cannot be capitalized.

In addition to the settlement type, further design parameters such as lock-up periods or additional exercise conditions can be used to specifically increase motivation. If the program is too complex or lacks a clear link to corporate objectives, there is a risk that the desired positive effects on employee behavior will not materialize. The plan design must also ensure that the value of the granted instruments correlates with an increasing company value.

The settlement type has a significant impact on the effect of share-based payments on results. Cash-settled programs are popular in practice due to their greater flexibility, but compared to granting actual equity instruments, they generally result in greater fluctuations in results.

While the fair value of an equity-settlement is determined only at the grant date and remains constant thereafter, a cash-settlement requires continuous re-measurement of fair value at each reporting date. As a result, companies are exposed to the risk of fluctuating share prices throughout the entire term.

Beyond the motivational aspects of optimal program design, another relevant factor arises. The required re-measurement of the liability in the case of cash-settlement creates a payment obligation of uncertain amount. 

As with foreign exchange, interest rate, or commodity price risks, it is advisable to consider the share price risk resulting from share-based payments from a risk management perspective. To manage the impact on results, it is therefore economically sensible for companies to hedge potential payouts against corresponding fluctuations using suitable hedging instruments such as equity forwards, swaps, or options.

However, to achieve matching results between the underlying transaction and the hedging instrument, it is necessary to assess – due to the strict special accounting requirements of IFRS 2 regarding the recognition and allocation of personnel expenses – whether such economic hedging relationships can also be appropriately reflected in the accounts. Since the effects of share-based payments cannot easily be synchronize with the accounting for standalone derivatives, accumulating hedged positions at the hedge rate is generally only possible through the application of cash flow hedge accounting under IFRS 9.

For designation in cash flow hedge accounting, it must first be assessed whether the expected cash outflow from the grant of the share-based payment transaction qualifies as a hedged item under IFRS 9. This concerns a planned transaction whose amount is uncertain due to share price fluctuations and vesting conditions. If beneficiaries do not meet predefined performance conditions, or if employment ends during the vesting period, this can result in partial or total forfeiture of the payment claim, depending on the specific program design. Therefore, the probability of occurrence of the hedged transaction is particularly important when hedging share-based payments. Only if this probability can be demonstrated to be at least 90% does the hedged transaction qualify as a hedged item under IFRS 9.

Furthermore, the effectiveness of the hedging relationship must be continuously demonstrated from designation until its scheduled end. In addition to standard requirements such as the absence of dominant credit risk and a hedge ratio derived from the actual quantities of hedged risk and contracted hedging instruments, special challenges arise when hedging share-based payments to also demonstrate the required economic relationship.

The company must be able to demonstrate with sufficient certainty that changes in the value of the hedging instruments and the payment obligation from cash-settled share-based payments offset each other.  In addition to a qualitative assessment of matching parameters using the critical terms match method, a quantitative determination of retrospective ineffectiveness, for example using the dollar-offset method, is also required. In practice, for reasons of simplification and cost, certain features of the underlying transaction—such as settlement at average rates or price caps—are often omitted when designing the hedging instruments, resulting in regular differences between the valuation-relevant parameters of the underlying and hedging transactions. Additional features, such as the exchange of dividends and interest over the hedge term, may also be agreed for the hedging instruments. All such differences between the underlying and hedging transactions inevitably affect the effectiveness of the hedging relationship and lead to significant ineffectiveness that must be recognized in profit or loss.

Finally, for accounting purposes, the modified grant date method from IFRS 2 for cash-settled share-based payments must be aligned with the hedging result. Valuation effects of the hedging instrument assessed as effective are initially recognized in the cash flow hedge reserve within equity and, in line with the effect of the underlying transaction, reclassified to profit or loss. At each reporting date, the amount of personnel expense accrued from the cash settlement is offset by a corresponding profit or loss recognition of changes in the value of the hedging instrument. Effective changes in value of the hedging instrument that exceed this amount remain in the cash flow hedge reserve until later periods.

You can count on us for support and advice on implementing hedging strategies for existing or new share-based payment programs. Our team will show you the accounting effects and the requirements for applying cash flow hedge accounting for your specific program.

Source: KPMG Corporate Treasury News, Edition 155, June 2025
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Jan-Philipp Wallis, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Carolin Höynck, Assistant Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG