IFRS 2 Determination of type of equity instruments granted

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IFRS 2 Determination of type of equity instruments granted, the types are:

Employee share purchase plans

In an employee share purchase plan (ESPP), the employees are usually entitled to buy shares at a discounted price. The terms and conditions can vary significantly and some ESPPs include option features (IFRS 2 IG17). IFRS 2 Determination of type of equity instruments granted

In general, the predominant feature of the share-based payment arrangement determines the accounting for the entire fair value of the grant. That is, depending on the predominant features, a share purchase plan is either a true ESPP or an option plan. All of the terms and conditions of the arrangement should be considered when determining the type of equity instruments granted and judgement is required. The determination is important because the measurement and some aspects of the accounting for each are different (see below).

Options are characterised by the right, but not the obligation, to buy a share at a fixed price. An option has a value (i.e. the option premium), because the option holder has the benefit of any future gains and has none of the risks of loss beyond any option premium paid. The value of an option is determined in part by its duration and by the expected volatility of the share price during the term of the option. In our view, the principal characteristic of an ESPP is the right to buy shares at a discount to current market prices.

ESPPs that grant short-term fixed purchase prices do not have significant option characteristics because they do not allow the grant holder to benefit from volatility. ESPPs that provide a longer-term option to buy shares at a specified price are, in substance, option plans, and should be accounted for as such (IFRS 2 B4-B41).

Examples of other option features that may be found in ESPPs are (IFRS 2 IG17):

  • ESPPs with look-back features, whereby the employees are able to buy shares at a discount, and choose whether the discount is applied to the entity’s share price at the date of the grant or its share price at the date of purchase; IFRS 2 Determination of type of equity instruments granted granted
  • ESPPs in which the employees are allowed to decide after a significant period of time whether to participate in the plan; and
  • ESPPs in which employees are permitted to cancel their participation before or at the end of a specified period and obtain a refund of any amounts paid into the plan.

In all of these examples, the employees are protected from a decline in the value of the equity instrument. The implementation guidance to IFRS 2 indicates that the option features in these ESPP examples mean that they are, in effect, share option plans.

Exhibit – Share purchase plan at fixed price for longer period IFRS 2 Determination of type of equity instruments granted

Employees of Company B are entitled to buy shares at a fixed price from the date of communication of the plan until two years later.

Whether the predominant feature in this agreement is the option feature requires judgement based on all of the terms and conditions of the plan. In the absence of other indicators, this agreement is effectively an option and should be accounted for as an option plan and not as an ESPP. This is because the employees have no obligation to buy the shares, but only the right.

If the share price falls below the fixed exercise price, then the employees would not buy any shares. Therefore, the employees are protected from a decline in the value of the shares.

The classification as a ‘true’ ESPP or as an option plan affects:

  • the determination of grant date; IFRS 2 Determination of type of equity instruments granted granted
  • the number of instruments to account for; and IFRS 2 Determination of type of equity instruments granted granted
  • the measurement of the grant-date fair value. IFRS 2 Determination of type of equity instruments granted

Exhibit – Impact of classification as true ESPP or as option plan

On 1 January Year 1, Company T grants a right to its employees to buy shares at a 20% discount from its share price. This grant is made to 1,000 of its employees and 700 employees buy shares.

If the substance of the offer is an ESPP, then grant date is the date when the employees accept the offer and recognition is based on the number of employees that accept the offer (i.e. 700).

Conversely, if the substance of the offer is an option grant, then grant date is not dependent on the explicit acceptance by the employees and is therefore achieved on 1 January Year 1. Recognition is based on the options granted to the 1,000 employees, assuming that the award vests and not on the 700 employees that exercise their options.

Share purchases funded through loans IFRS 2 Determination of type of equity instruments granted granted

The determination of whether a share purchase plan is in substance an option plan is affected when the employee receives a loan from the entity to fund the purchase of the shares. All of the terms and conditions should be analysed when determining the type of equity instruments granted. A share purchase funded through loans provided by or guaranteed by the granting entity may indicate that an ESPP is in substance an option plan. IFRS 2 Determination of type of equity instruments granted granted

If a share-based payment that is funded through a loan contains a put option feature over the shares such that it removes any risk for the employee of share price decreases while all rewards above the market rate of interest are retained, then this plan is, in substance, an option that should be accounted for as such. For an illustration of such a share-based payment, see the exhibit – Share purchase funded through loan: Net settlement, below. It is difficult to support recognition of shares and the loan as outstanding when the shares were paid for by a loan from the issuer to the buyer. IFRS 2 Determination of type of equity instruments granted

If the substance of a share purchase arrangement is an option, then neither the shares nor the loan are outstanding until either the options are exercised by paying the exercise price for the shares – i.e. by repaying the loan – or the options expire. Accordingly, until exercise of the options, the shares ‘issued’ to employees are treated as treasury shares and no financial asset for the loan receivable from the employees is recognised until this time. IFRS 2 Determination of type of equity instruments granted granted

Consider the following example of a share-based payment that is structured as a share purchase arrangement.

Exhibit – Share purchase funded through loan: Net settlement

An employee receives a right to and buys shares immediately and, at the same time, receives a loan for the amount of the exercise price. The loan accrues interest at a market rate. The employee receives a right to settle the loan in full by tendering the shares bought. IFRS 2 Determination of type of equity instruments granted

In this example, the put option feature over the shares removes any risk for the employee of share price decreases while all rewards above the market rate of interest are retained. This plan is considered, in substance, an option and the transaction should be accounted for as such. IFRS 2 Determination of type of equity instruments granted granted

Exhibit – Share purchase funded through loan: Gross settlement

Now the loan and interest are settled in full in cash but the employee has the right to put the shares back to the entity at the original purchase price plus interest at a market interest rate, provided that the cash is used to settle the loan and interest. That is, compared with a right to settle by tendering shares, there is an equal and opposite cash outflow from the entity to the employee and a subsequent cash inflow to the entity from the employee when the employee chooses not to ‘exercise’ the option.

The key conclusion is the same as before – i.e. there is an option feature because the employee is protected from share price decreases by being able to sell back the shares at the original purchase price, while all rewards above the market rate of interest are retained if the employee chooses to ‘exercise’ the option by settling the loan and not selling back the shares.

Determining assets to which entity has recourse for loan repayment

In assessing whether shares paid for by a loan from the issuer are in substance a grant of options, an entity should consider whether it has full recourse to the employees in respect of the balance of the loan. For example, if the share price falls below the outstanding balance of the loan, then does the entity have recourse to the personal assets of the employee, and will it pursue collection of the full loan balance? IFRS 2 Determination of type of equity instruments

In our view, it is appropriate to account for the transaction as the issue of shares and a financial asset for the loan receivable only when it can be demonstrated clearly that the entity has and will pursue full recourse to the employee in respect of the loan. IFRS 2 Determination of type of equity instruments granted

Whether the entity has full recourse to the employee in respect of the loan should be assessed based on all of the terms and conditions of the arrangement. For the loan to be considered full recourse, it should be documented as a full recourse loan and there should not be evidence that would indicate otherwise – e.g. a past history of the entity waiving all or a portion of similar loans.

The following are examples of indicators that may support the conclusion that a loan is full recourse. IFRS 2 Determination of type of equity instruments

  • The loan is reported by the entity to a credit agency in the same manner as commercial loans. IFRS 2 Determination of type of equity instruments granted
  • The entity requests financial information from the employees to assess their ability to repay the loans.
  • The entity has an ongoing process for monitoring the collectability of the loan. IFRS 2 Determination of type of equity instruments granted
  • If applicable, the entity has a past history of collection in full of other employee loans (e.g. housing loans).

Exhibit – Share purchase funded through loan with retrospective partial waiver – Full-recourse loan

Company W issues shares to its employees at the market price on the date of issue and the purchases are funded through a loan provided by W to its employees. W has recourse to all of the employees’ assets and not just the shares bought with the loan. If W achieves a two-year cumulative EPS growth target of 15%, then 25% of the loan balance will be waived – i.e. the share purchase price will be reduced retrospectively by 25%. IFRS 2 Determination of type of equity instruments granted

W has the intent and ability to pursue full collection of the outstanding loan balance and a past practice of collecting loans from employees.

In this example, the arrangement is an issue of shares and a financial asset (e.g. the loan is full recourse and therefore the arrangement is not in substance an option grant but rather should be treated as a share purchase). The employees may earn a discount to the share price subject to the achievement of a non-market performance condition – i.e. a waiver of 25% of the share price if a cumulative EPS target is met.

The potential retrospective adjustment to the share purchase price is a share-based payment and not an employee benefit under IAS 19 Employee Benefits because the payment is based on the share price. This is consistent with the example in IFRS 2 of a reduction in the exercise price of an option as a result of achieving a non-market performance condition – i.e. the shares ultimately can be bought by the employees at a discount from the purchase price specified originally.

Because the employees receive equity instruments (i.e. shares that may be bought at a discount) and do not receive a payment based on the price (or value) of the entity’s shares or other equity instruments, the share-based payment should be classified as equity-settled. IFRS 2 Determination of type of equity instruments granted

Exhibit – Share purchase funded through loan with retrospective partial waiver – Non-recourse loan

Company X issues shares to its employees at the market price on the date of issue. The fact pattern is the same as in the previous exhibit, except that X does not have the ability to pursue full collection of the outstanding loan balance. Instead, X only has the ability to require the employees to tender back the shares if either the share-based payment does not vest (i.e. the loan is not reduced or the employees leave) or the share-based payment vests but the employees choose not to settle the reduced loan balance on vesting.

In this example, the grant should not be classified as a share purchase plan, but as an option plan. IFRS 2 Determination of type of equity instruments granted

This is because X does not have full recourse to the outstanding loan balance. If, for example, the performance target is not met and the share price has fallen compared with the date of purchase, then the employees only need to tender back the shares to X and the outstanding loan balance is waived. The employees are protected from any downside risk, because they received the shares and just tender them back without any payment made. This is in substance the same as not exercising a share option.

As a result, X should not recognise either the loan or the shares as outstanding. IFRS 2 Determination of type of equity instruments granted

See the following two exhibits for an illustration of the accounting for this type of arrangement. IFRS 2 Determination of type of equity instruments granted

Exhibit 1 – Accounting for Share purchase funded through loan: Fixed interest, no dividends

On 1 January Year 1, Company B grants one of its employees a right to buy a share, subject to a three-year service condition; the share purchase is funded through a loan to the employee. The loan amount equals the share price of 100 at grant date. The employee signs the loan note and takes legal ownership of the share but the share is not delivered to the employee; it is held under control of the entity (i.e. the employee cannot sell the share). IFRS 2 Determination of type of equity instruments granted

The loan bears a fixed interest rate of 5% per annum (not compounded), to be paid at the maturity date of the loan, which is the vesting date. The employee is not entitled to receive dividends declared during the vesting period. No dividends are expected to be paid, and none are actually paid during the vesting period.

At the end of the service period, the employee can choose: IFRS 2 Determination of type of equity instruments granted

  • to repay the loan including interest, in which case the share will be delivered to the employee; or IFRS 2 Determination of type of equity instruments granted
  • not to repay the loan, in which case the share is returned to the entity. IFRS 2 Determination of type of equity instruments granted

B applies an option pricing model and estimates the grant-date fair value of the option at 13.50. The exercise price assumed in the model is 115, being the loan amount of 100 plus three years’ interest at 5 per annum. B expects the employee to provide the requisite service, which they do. IFRS 2 Determination of type of equity instruments granted

B accounts for the transaction as follows. IFRS 2 Determination of type of equity instruments granted

IFRS 2 Determination of type of equity instruments granted

Scenario B illustrates that the cumulative share-based payment expense previously recognised is not adjusted. IFRS 2 Determination of type of equity instruments granted

Exhibit 2 – Accounting for Share purchase funded through loan: Fixed interest and dividends

Following the previous accounting exhibit, now that the employee is entitled to dividends declared during the service period. If the employee leaves before vesting date or the option is not exercised by repaying the loan amount including interest, then the employee will lose the entitlement to those dividends.

Dividends are expected to be 5 each year from Year 1 to Year 3. Dividends declared are not paid to the employee, but used to repay part of the loan amount.

At the end of the service period, the employee can choose: IFRS 2 Determination of type of equity instruments granted

  • to repay the loan (including interest) less any dividends declared during the service period, in which case the share will be delivered to the employee; or
  • not to repay the loan (including interest) less any dividends declared during the service period, in which case the share is returned to the entity and the dividends declared will not be paid to the employee. IFRS 2 Determination of type of equity instruments granted

B applies an option pricing model and estimates the grant-date fair value of the option at 21. The value of the option has increased compared with the value in the previous exhibit from 13.50 to 21 because of the dividend entitlement. For a discussion of how dividend protection features are taken into account in option pricing models, see Selecting inputs to option pricing models. B expects the employee to provide the requisite service, which they do. IFRS 2  Determination of type of equity instruments

The actual dividends declared are 4 in Year 1, 5 in Year 2 and 7 in Year 3, for a total amount of 16. IFRS 2 Determination of type of equity instruments granted

For simplicity, this example assumes that dividends declared do not reduce the loan amount for the purpose of calculating interest on the loan, and the dividends themselves are not interest-bearing for the employee. IFRS 2 Determination of type of equity instruments granted

B accounts for the transaction as follows. IFRS 2 Determination of type of equity instruments granted

IFRS 2 Determination of type of equity instruments granted

If the structure is viewed as a share purchase, then the financial asset should be accounted for separately from the share-based payment and should be recognised and measured in accordance with the financial instruments standards. Under those standards, the initial and subsequent measurement of the financial asset should reflect the likelihood of the employee receiving a discount as a result of the achievement of the non-market performance condition. IFRS 2 Determination of type of equity instruments granted

If the loan issued to the employee does not bear interest at a market rate, then in our view the low-interest loan is a benefit conveyed to the employee that could be accounted for under IFRS 2. In some cases, such a loan is available only for financing share purchases, which suggests that the loan is an integral part of the share-based payment arrangement and therefore it should be accounted for under IFRS 2. IFRS 2 Determination of type of equity instruments granted

However, it might also be appropriate to account for the discount as an employee benefit separately from the share-based payment, particularly if similar loans are available for other purposes.

In other arrangements, a share purchase by employees may be funded only partially through a loan from the entity – e.g. the entity issues a loan to employees for 70 percent of the market price of its shares and the employee is required to pay in cash the remaining 30 percent of the purchase price. The entity has recourse only to the shares and the employees receive a right to settle the loan by tendering the shares bought, either directly or via a right to put the shares back to the entity.

If the market price of the shares is less than the amount of the loan when the shares are to be tendered to the entity, then the entity receives the shares as settlement of the loan in full – i.e. the entity accepts the risk that its share price will decrease by greater than 30 percent. If the cash payment by the employee represents substantially all of the reasonably possible losses – based on the expected volatility of the shares – then in our view the fact that the loan has recourse only to the shares does not preclude accounting for the transaction as the issuance of shares and a financial asset. IFRS 2 Determination of type of equity instruments granted

This is because, subsequent to the date of issuance, the employee is not only able to benefit from increases in the entity’s share price, but is also at risk for substantially all of the reasonably possible decreases in the share price. IFRS 2 Determination of type of equity instruments granted

Exhibit – Share purchase partially funded through loan

Company P issues shares to its employees at the market price on the date of issue. P issues a loan to employees at an amount equal to 70% of the total market price of the shares issued; the employees are required to pay in cash the remaining 30% of the purchase price. The entity has recourse only to the shares and the employees receive a right to settle the loan by tendering the shares bought either directly or via a right to put the shares back to the entity. IFRS 2 Determination of type of equity instruments granted

If the market price of the shares is less than the amount of the loan when the shares are to be tendered to the entity, then the entity receives the shares as settlement of the loan in full – i.e. the entity accepts the risk that its share price will decrease by greater than 30%. IFRS 2 Determination of type of equity instruments granted

If the cash payment by the employees represents substantially all of the reasonably possible loss based on the expected volatility of the shares – i.e. the expected volatility is less than 30% – then the fact that the loan is recourse only to the shares does not preclude accounting for the transaction as the issuance of shares and a financial asset.

Accounting for interest and dividends in a grant of share options

As a consequence of treating a share purchase funded through a limited recourse loan as an option, an issue arises about how to account for the share purchase, the loan issue, any interest on the loan and any dividends on the shares. IFRS 2 Determination of type of equity instruments granted

The share purchase, loan issue, interest and dividends should be accounted for in accordance with the substance of the arrangement. If the share purchase funded through a non-full recourse loan is in substance a share option, then neither the loan nor the shares should be recognised as outstanding and the repayment of the loan by the employee should be treated as the payment of the exercise price. IFRS 2 Determination of type of equity instruments granted

Consequently, interest is not accrued over the vesting period but should be recognised only as part of the exercise price when it is received. Interest therefore decreases the grant-date fair value of the option due to an increased exercise price. The right to receive dividends should also be taken into account in estimating the grant-date fair value of the option – i.e. any entitlement increases the grant-date fair value compared with an option without dividend entitlement. IFRS 2 Determination of type of equity instruments granted

However, forfeitable dividends declared but not paid out before exercise of the option should be recognised only when the loan amount, reduced for the dividends, becomes a recognised receivable on exercise. This is because the obligation to pay the dividends only reduces the unrecognised receivable due from the employee, rather than being a liability in its own right; this treatment is different from dividends declared on unvested shares. IFRS 2 Determination of type of equity instruments granted

The entity should choose an accounting policy, to be applied consistently, of either recognising the dividends by netting the amount with the proceeds from the exercise price or by recognising a separate distribution in equity. IFRS 2 Determination of type of equity instruments granted

Exhibit – Share purchase funded through loan: Fixed interest, no dividends

On 1 January Year 1, Company B grants one of its employees a right to buy a share, subject to a three-year service condition; the share purchase is funded through a loan to the employee. The loan amount equals the share price of 100 at grant date. The employee signs the loan note and takes legal ownership of the share but the share is not delivered to the employee; it is held under control of the entity (i.e. the employee cannot sell the share).

The loan bears a fixed interest rate of 5% per annum (not compounded), to be paid at the maturity date of the loan, which is the vesting date. The employee is not entitled to receive dividends declared during the vesting period. No dividends are expected to be paid, and none are actually paid during the vesting period.

At the end of the service period, the employee can choose:

  • to repay the loan including interest, in which case the share will be delivered to the employee; or
  • not to repay the loan, in which case the share is returned to the entity.

B applies an option pricing model and estimates the grant-date fair value of the option at 13.50. The exercise price assumed in the model is 115, being the loan amount of 100 plus three years’ interest at 5 per annum. B expects the employee to provide the requisite service, which they do.

B accounts for the transaction as follows.

Scenario B illustrates that the cumulative share-based payment expense previously recognised is not adjusted.

Exhibit – Share purchase funded through loan: Fixed interest and dividends

Assume the same facts as in Example 6.5.8, except that the employee is entitled to dividends declared during the service period. If the employee leaves before vesting date or the option is not exercised by repaying the loan amount including interest, then the employee will lose the entitlement to those dividends.

Dividends are expected to be 5 each year from Year 1 to Year 3. Dividends declared are not paid to the employee, but used to repay part of the loan amount.

At the end of the service period, the employee can choose:

  • to repay the loan (including interest) less any dividends declared during the service period, in which case the share will be delivered to the employee; or
  • not to repay the loan (including interest) less any dividends declared during the service period, in which case the share is returned to the entity and the dividends declared will not be paid to the employee.

B applies an option pricing model and estimates the grant-date fair value of the option at 21. The value of the option has increased compared with the value in Example 6.5.8 from 13.50 to 21 because of the dividend entitlement. For a discussion of how dividend protection features are taken into account in option pricing models, see A2.50. B expects the employee to provide the requisite service, which they do.

The actual dividends declared are 4 in Year 1, 5 in Year 2 and 7 in Year 3, for a total amount of 16.

For simplicity, this example assumes that dividends declared do not reduce the loan amount for the purpose of calculating interest on the loan, and the dividends themselves are not interest-bearing for the employee.

B accounts for the transaction as follows.

Free shares

In some share-based payments, employees are entitled to shares for no cash consideration; however, the grant is conditional on the fulfilment of vesting conditions. If the holders of such shares have the same rights as holders of shares not subject to a vesting condition, then the value of the shares granted is equal to the value of vested shares. However, if the holders of such shares are not entitled to dividends during the vesting period, then the measurement of grant-date fair value reflects the fact that expected future dividends will not be received by employees.

The existence of market conditions and non-vesting conditions further reduces the grant-date fair value used for equity-settled share-based payments, regardless of whether they are shares or options.

See also: IFRS Community

IFRS 2 Determination of type of equity instruments granted granted

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