Overview IFRS 2 Determination of the vesting period
Employee service costs are recognised in profit or loss over the vesting period from the service commencement date until vesting date. The following topics are of importance in IFRS 2 Determination of the vesting period
Service commencement date and grant date
The ‘vesting period’ is the period during which all of the specified vesting conditions are to be satisfied in order for the employees to be entitled unconditionally to the equity instrument. Normally, this is the period between grant date and the vesting date (see IFRS 2 Definitions).
However, services are recognised when they are received and grant date may occur after the employees have begun rendering services. Grant date is a measurement date only. If grant date occurs after the service commencement date, then the entity estimates the grant-date fair value of the equity instruments for the purpose of recognising the services from the service commencement date until grant date. A possible method of estimating the fair value of the equity instruments is by assuming that grant date is at the reporting date. Once grant date has been established, the entity revises the earlier estimates so that the amounts recognised for services received are based on the grant-date fair value of the equity instruments. In our view, this revision should be treated as a change in estimate (derived from IFRS 2 IG4, IFRS 2 IG Ex1A and IFRS 2 IG Ex2).
Exhibit – Service commencement date before grant date
On 1 January Year 1, Company B sets up an arrangement in which the employees receive share options, subject to a four-year service condition. The total number of equity instruments granted will be determined objectively based on B’s profit in Year 1. The total number of options will be allocated to employees who started service on or before 1 January Year 1. Significant subjective factors are involved in determining the number of instruments allocated to each individual employee and B concludes that grant date should be postponed until the outcome of the subjective evaluations is known in April Year 2 – i.e. subsequent to the approval of the financial statements for the reporting period ending 31 December Year 1.
Because the subjective factors are determined only in April Year 2, grant date cannot be before this date. However, in this case there is a clearly defined performance period, commencing on 1 January Year 1, which indicates that the employees have begun rendering their services before grant date. Accordingly, B recognises the cost of the services received from the date on which service commences – i.e. 1 January Year 1. The estimate used in the Year 1 financial statements is based on an estimate of the fair value, assuming that grant date is 31 December Year 1. This estimate will be revised in April Year 2 when the fair value at grant date is determined.
Assume that B estimates on 31 December Year 1 that the grant-date fair value of an equity instrument granted will be 10 and the actual fair value on grant date of April Year 2 is 9. Based on preliminary profit figures, B further estimates at 31 December Year 1 that the total number of equity instruments granted will be 100, which is confirmed by the final profit figure. If all instruments are expected to and actually do vest, then the accounting is as follows.
In some situations, the equity instruments granted vest in instalments over the specified vesting period. Assuming that the only vesting condition is service from grant date to the vesting date of each tranche, each instalment is accounted for as a separate share-based payment. As a result, even though all grants are measured at the same grant date, there will be several fair values and the total cost recognised each year will be different because both the grant-date fair values and the vesting periods are different. In our experience, instalments are not always on a yearly basis, but can also be on a monthly or even daily basis, which creates significantly more data complexities (IFRS 2 IG11).
Application of the graded vesting method to grants that vest in instalments results in recognition of a higher proportion of cost in the early years of the overall plan. This is because Year 1 would bear the full cost for the instalment vesting in Year 1 and a proportion of the cost of the instalment vesting over the next number of years – e.g. 1/2 of the Year 2 instalment, 1/3 of the Year 3 instalment etc. This effect is sometimes referred to as ‘front-end loading’ and is illustrated below.
Exhibit – Graded vesting
On 1 January Year 1, Company C grants 100 share options to 100 employees, subject to a four-year service condition. At each year end, 25% of the equity instruments granted vests – i.e. an employee leaving in Year 2 earns the entitlement to 25 share options. Once the share options vest, they can be exercised in the following two months. The exercise price equals the share price at grant date.
The fair values of the equity instruments granted differ due to their different option terms and are estimated as follows.
Assuming that C expects all employees to remain employed with C and that they ultimately do, the cost recognised for each of the share-based payment tranches in each period is determined as follows.
Attribution to periods
When allocating the cost of share-based payment awards that require the achievement of both service and performance conditions, in our view no greater significance should generally be placed on either the service or the performance condition; and the share-based payment cost should be recognised on a straight-line basis over the vesting period. Similar to the observation that it is not generally possible to identify the services received in respect of the individual components of an employee’s remuneration package (e.g. services received in respect of healthcare benefits vs a company car vs share-based payment), it is very difficult to determine whether more services were received in respect of any given performance period as compared with the service period (IFRS 2 15, IFRS 2 BC38).
Exhibit – Straight-line attribution and different reference periods
Company S issues to its employees share options that vest on the achievement of an EPS target after one year. In addition, the employees are required to remain employed with S for another three years after the EPS target is achieved.
In general, S should recognise the share-based payment cost on a straight-line basis over the four-year period in the absence of compelling evidence that a different recognition pattern is appropriate.
Commonly, even if a grant is subject to a four-year service condition and a challenging one-year performance condition, both beginning at the same time, this is not sufficiently compelling evidence to apply a method other than the straight-line method over four years.
Exhibit – Straight-line attribution with challenging performance target
Company T issues to its employees a share-based payment that is subject to a four-year service condition and a one-year performance condition, both beginning at the same time. The performance condition is defined as an increase in revenue by 20% and revenues have not increased by more than 10% over the past five years.
Although the performance target is challenging, in general T should recognise the grant-date fair value over four years.
Variable vesting period
In some share-based payments, the length of the vesting period varies depending on when a performance condition is satisfied. In this case, the length of the expected vesting period needs to be estimated (IFRS 2 15(b)).
Market condition with variable vesting period
If the performance condition in such transactions is a market condition, then the length of the expected vesting period is estimated consistently with the assumptions used in estimating the grant-date fair value of the equity instruments granted. The length of the vesting period is not revised subsequently.
Exhibit – Market condition not met when expected
Company U issues a share-based payment subject to the employee remaining in service until the share price achieves a certain target price at any time within the next five years. If the market condition is not met by the end of Year 5, then the employee is not entitled to the payment. U estimates that the market condition will be met at the end of Year 3. At the end of Year 3, the market condition has not yet been met, but it may still be met in the future.
In this example, the grant-date fair value is recognised over three years.
Because the expected length of the vesting period is not revised if the performance condition is a market condition, the entire grant-date fair value of the equity instruments granted is recognised in Years 1 to 3, even though at the end of Year 3 the market condition is not met.
No adjustment is made if the employee leaves in Year 4 because the employee has already completed the expected vesting period of three years.
IFRS 2 does not provide guidance on the accounting for the reverse scenario – i.e. if the market condition is met earlier than expected. Following the exhibit above (Exhibit – Market condition not met when expected), if the market condition is met in Year 2, then in theory all of the expected services have been provided. Therefore, it could be argued that no cost should be recognised subsequent to that date, and instead that recognition should accelerate at that date. In our view, IFRS 2’s explicit prohibition of revising the length of the vesting period should prevail – i.e. cost should continue to be recognised in accordance with the original three-year estimate – even though the accelerated recognition would possibly better reflect the economics of the scenario.
Exhibit – Market condition met earlier then expected
Company V issues a share-based payment subject to the employee remaining in service until the share price achieves a certain target price at any time within the next five years. V estimates that the market condition will be met at the end of Year 3. At the end of Year 2, the market condition is already met.
Like in the exhibit above (Exhibit – Market condition not met when expected), the grant-date fair value is recognised over three years.
However, because the market condition is met in Year 2, in theory all of the expected services have been provided. However, in general, the expense should continue to be recognised in accordance with the original three-year estimate.
Non-market performance condition with variable vesting period
In contrast to a variable vesting period with a market condition, if the length of the vesting period is dependent on achieving a non-market performance condition, then the entity makes an estimate of the length of the expected vesting period at grant date based on the most likely outcome of the performance condition. Subsequently, the entity revises the estimate of the length of the vesting period until the actual outcome is known (IFRS 2 15(b), IFRS 2 IG Ex2).
If the arrangement is accounted for as a grant with a variable vesting period, then the entity estimates at grant date whether (a) the employees will complete the requisite service period and (b) the non-market performance condition will be satisfied. A common example of a non-market performance condition with a variable vesting period is a requirement for an exit event (e.g. IPO or sale) combined with a requirement that the employee be employed until the exit event occurs. The individual circumstances of each arrangement will have to be considered. The share-based payment cost is recognised if the exit event is more likely than not to be achieved; it is not necessary to be certain that the exit event will occur (IFRS 2 15, IFRS 2 20).
Exhibit – Non-market performance condition not met when expected
Company B grants 100 share options with a grant-date fair value of 6 to its CEO. The share-based payment is subject to the CEO remaining in service until C’s market share, according to quarterly external surveys, is reported as exceeding 30% for a quarter, provided that this is achieved within the next five years.
The share-based payment is exercisable on the sixth anniversary following grant date.
B estimates that the term of the share-based payment will be six years regardless of when the market share target is met. B estimates that the target will be met at the end of Year 3. In the early part of Year 3, it becomes clear that the target will not be met by the end of Year 3. B’s revised estimate is that it will be met in Year 5, which ultimately is achieved.
Modifying this example, if it turns out in Year 5 that the market share target is not met, then forfeiture accounting applies – i.e. all previously recognised expense is reversed – because achieving a market share target is a non-market performance condition.
Exhibit – Non-market performance condition met earlier then expected
Company C grants 100 share options with a grant-date fair value of 6 to its CEO. The share-based payment is subject to the CEO remaining in service until C’s market share has exceeded 30% at any time within the next five years. The entity estimates that it will be met at the end of Year 3. At the end of Year 2, the options vest because the market share is 32%.
When accounting for a share-based payment award that contains multiple vesting alternatives and vesting depends on the interaction of a service condition and a performance condition, an entity should determine which vesting alternative to account for based on its assessment of which vesting alternative is the most likely outcome. This is because under IFRS 2 an entity generally accounts for the most likely outcome.
For example, an award of options is granted with a performance condition and a service condition, but the vesting period automatically accelerates if the performance condition is met during the period of required service; the award vests at the end of the service period regardless of whether the performance condition is met. The options are exercisable at the same fixed date regardless of when they vest. Such an award contains two vesting alternatives:
- vesting alternative 1: the period from grant date until the date on which the service condition is met. This would occur if the non-market performance condition is not met before the service condition is met; and
- vesting alternative 2: the period from grant date until the date on which the performance condition is met before the date on which the service period is completed. This is because vesting is automatically accelerated if the non-market performance condition is satisfied before the service condition.
In this situation, if an entity’s initial assessment was that the most likely outcome was vesting alternative two, then it would estimate the expected vesting date for that vesting alternative. As long as the entity believes that the non-market performance condition will be met before the service condition, then it should base its accounting on its best estimate of the expected vesting period. If subsequent information indicates that the length of vesting alternative two differs from the previous estimate, then the length of the vesting period is revised and the entity adjusts the recognised share-based payment expense on a cumulative basis in the period in which the estimate is revised. See Variable vesting period above.
If an entity’s assessment of the most likely outcome changes, then in general the accounting should switch to the alternative vesting period. The share-based payment cost recognised in the period of the change in estimate would adjust the cumulative cost recognised to the amount that would have been recognised if the new estimate had always been used. See 6.8.30.
Exhibit – Non-market performance condition with variable vesting period
Company D grants 100 share options with a grant-date fair value of 6 to its CEO. The share-based payment is subject to the CEO remaining in service for four years. However, vesting automatically accelerates if there is an IPO during the four-year service period.
The entity’s assessment at the grant date is that there will be an IPO at the end of Year 2. At the end of Year 2, the entity’s assessment is that an IPO will take place at the end of Year 3. At the end of Year 3, the entity’s assessment is that the share options will vest at the end of the service period.