The fair value of a equity instrument granted is determined as follows (IFRS 2.16-17):
- If market prices are available for the actual equity instruments granted – i.e. shares or share options with the same terms and conditions – then the estimate of fair value is based on these market prices. IFRS 2 Fair value of equity instruments granted
- If market prices are not available for the equity instruments granted, then the fair value of equity instruments granted is estimated using a valuation technique.
IFRS 2 (IFRS 2.18, B2-B41) includes an appendix that provides guidance on measuring the fair value of shares and of share options. Because the methods of measuring these two types of share-based payments are different, it is important to determine the type of equity instrument granted (see Determination of the type of equity instrument granted).
The key difference between measuring the fair value of a share granted and the fair value of a share option granted is that the option holder benefits only from that part of the share price at the exercise date that exceeds the exercise price. IFRS 2 Fair value of equity instruments granted
Another common difference is that option holders are often not entitled to any dividends declared before the exercise of the option, whereas shareholders are usually entitled to them. This difference in dividend entitlement also affects the valuation. For detailed guidance on applying appropriate measurement methods, see Valuing unvested shares and Valuing share options below.
F estimates the fair value of a share option without dividend entitlement at 80 and the fair value of the dividend entitlement at 20.
Shares granted in a share-based payment are valued with reference to quoted share prices, if available. Quoted share prices are adjusted for terms and conditions that apply to the shares granted that do not apply to the publicly quoted shares, except when such terms and conditions (e.g. vesting conditions) are excluded from the fair value measurement under IFRS 2.
Under IFRS 2, the per-instrument value of share-based payments is not adjusted for service and non-market performance conditions but is adjusted for market conditions and non-vesting conditions. Service and non-market performance conditions are considered in estimating the number of awards that are expected to vest (see Recognition of equity-settled share-based payment transactions with employees).
If an entity’s shares are not quoted publicly, then valuation techniques are used to estimate the fair value of the shares granted (IFRS 2.B2). Valuation techniques usually focus on valuing the entity as a whole as a starting point and are grouped into three general types of approaches: the income approach, the cost or assets approach and the market approach.
The techniques include market multiples, enterprise value/earnings before interest, taxes, depreciation and amortisation (EV/EBITDA) multiples, the discounted cash flow (DCF) method etc. A detailed description of the techniques for valuing entities is beyond the scope of this appendix.
Examples of terms and conditions that may lead to adjustments to a current share price include awards in which a holder is not entitled to dividends declared on the shares during the vesting period, and awards in which a share is subject to post-vesting restrictions that limit the holder’s ability to transfer the share after they have earned the award (IFRS 2.B3).
When an unvested share is granted to an employee, and the employee is not entitled to receive dividends on the share during the vesting period, the price of the share should be adjusted for the expected dividends forgone.
The value of an unvested share that is not entitled to receive dividends during the vesting period can be estimated using a Black-Scholes-Merton (BSM) model with a term equal to the vesting period and a very small but greater than zero exercise price; a zero exercise price cannot be used because the BSM includes the exercise price in a denominator so the use of a zero exercise price value would cause the model to report an error.
Sometimes shares issued in share-based payment transactions do not have voting rights. When such instruments are valued with reference to the value of shares with similar economic rights (e.g. rights to dividends or rights in the case of a winding up) but which have voting rights, an adjustment may be required for the lack of voting rights of the instruments.
There are not well-established rules or methods to value voting rights in these circumstances. One consideration may be whether the comparable shares used for valuation purposes reflect a controlling or non-controlling interest value. In the case of the latter, the voting rights may have a limited incremental value effect. This issue is also relevant for valuing shares without voting rights underlying share options.
For example, Company P, a publicly traded company, issues non-voting shares to employees with similar economic rights to publicly traded shares that have voting rights. The publicly traded share price reflects trades for small ownership interests in P. Although such shares may have voting rights, their ability to influence P is limited. As a result, the publicly traded price may not attribute significant value to the voting rights.
One approach to measuring the value effect of voting rights is to compare the share prices of dual classes of shares in public entities that have similar economic rights. For example, some entities have two classes of publicly traded shares, one of which has more votes per share than the other. The price differential between such classes may provide an indication of the value of voting rights, assuming economic rights are similar.
Share options give the holder the right to buy the underlying shares at a set price, called the ‘exercise price’, over or at the end of an agreed period. If the share price exceeds the option’s exercise price when the option is exercised, then the holder of the option profits by the amount of the excess of the share price over the exercise price.
Benefit is derived from the right under the option to buy a share for less than its value. The holder’s cost is the exercise price, whereas the value is the share price. It is not necessary for the holder to sell the share for this profit to exist. Sale only results in realisation of the profit.
Because an option holder’s profit increases as the underlying share price increases, share options are used to incentivise employees to contribute to an increase in the price of the underlying shares.
Employee options are typically call options, which give holders the right but not the obligation to buy shares. However, other types of options are also traded in markets. For example, put options give holders the right to sell the underlying shares at an agreed price for a set period.
Given that holders of put options profit when share prices fall below the exercise price, such options are not viewed as aligning the interests of employees and shareholders. All references in this section to ‘share options’ are to employee call options.
Share options granted by entities often cannot be valued with reference to market prices (IFRS 2.B4). Many entities, even those whose shares are quoted publicly, do not have options traded on their shares.
Options that trade on recognised exchanges such as the Chicago Board Options Exchange are created by market participants and are not issued by entities directly.
Even when there are exchange-traded options on an entity’s shares for which prices are available, the terms and conditions of these options are generally different from the terms and conditions of options issued by entities in share-based payments and, as a result, the prices of such traded options cannot be used directly to value share options issued in a share-based payment.
For example, the contractual lives of traded options are generally significantly shorter than the expected terms of share-based payments. In the absence of market prices, valuation techniques are used to value share options.
The value of a share option at exercise is relatively straightforward. If the exercise price is below the share price, then the value of the option is equal to the share price less the exercise price. However, if the exercise price is above the market price, then the option has no value.
In these circumstances, an employee wishing to buy shares would be expected to buy shares in the open market rather than exercising the option. Exercising the option would cause a loss because the holder would be acquiring an item for more than its market price.
The ability of an option holder to avoid a loss by not exercising the option (i.e. the option expires unexercised) highlights a feature of options – i.e. the option holder has the right but not the obligation to buy the shares. Therefore, the value of an option at exercise is the greater of zero or the share price less the exercise price.
The following table illustrates the value of an option at expiry under various share price scenarios.
Assume that an employee holds an option to buy shares in Company C at 10. At expiry, this right will have value if it allows the employee to buy shares at a price below that prevailing in the market. IFRS 2 Fair value of equity instruments granted
Notes IFRS 2 Fair value of equity instruments granted
The ‘pay-off’ of an option is the value of the option for a given underlying share price. A ‘pay-off function’ describes the formula to calculate the pay-off. For example, on a plain vanilla – i.e. standard – call option, the pay-off formula is the greater of the share price less the exercise price or zero.
More complex pay-off functions can be created. For example, when an entity wishes to place a cap on the maximum that an employee could earn from an award, the pay-off formula would be the greater of the share price less the exercise price, up to a maximum amount of the cap, or zero. IFRS 2 Fair value of equity instruments granted
The pay-off or value of an option at exercise is relatively straightforward because the share price is known. However, before exercise the future share price at the exercise date is not known, which makes the valuation of an option more complex. IFRS 2 Fair value of equity instruments granted
Option valuation models use mathematical techniques to identify a range of possible future share prices at the exercise date. From these possible future share prices, the option’s pay-off can be calculated. IFRS 2 Fair value of equity instruments granted
The fair value of an option at its grant date is estimated by calculating the present value of the possible future intrinsic values, which are estimated using a probability-weighted outcome technique (hereafter referred to as ‘probability-weighted values’). IFRS 2 Fair value of equity instruments granted
An option has two primary components of value: intrinsic value and time value. Time value is the difference between the total value of an option and its intrinsic value and can be viewed as having two components: minimum value and volatility value. IFRS 2 Fair value of equity instruments granted
As stated previously, intrinsic value can be calculated easily on any given date, but option pricing models are needed to estimate the overall value of an option, including its time value. These terms are described further as follows. IFRS 2 Fair value of equity instruments granted
Option pricing models, which are discussed in more detail in A2.100, use six key assumptions, as discussed below.
Assumptions IFRS 2 Fair value of equity instruments granted
There are a number of assumptions or inputs that are used in option pricing models. IFRS 2 Fair value of equity instruments granted
These assumptions and their relationship to an option’s value are as follows and are discussed over the next few pages (IFRS 2.B6 IFRS 2.B6).
The expected term of an option is the length of the period over which the option is expected to be unexercised. Expected term is the contractual life of an option adjusted to reflect early exercise of the option by employees – i.e. employees exercising an option before the end of its contractual term.
In general, the longer an option’s expected term, the higher is the value of the option. However, there are circumstances in which it will be optimal for an option holder to exercise an option earlier – e.g. because there are large dividends being paid on the underlying shares, so that a shorter term is better. Expected term is discussed in detail below.
Each of these assumptions is discussed in detail below. In general, expected volatility and expected term are often the assumptions with the greatest potential subjectivity.
The table below shows the different option values that result from changing an option’s expected term and expected volatility assumptions, assuming a share price and exercise price of 100, a risk-free rate of 5 percent and a dividend yield of 0 percent. IFRS 2 Fair value of equity instruments granted
A graph of this table shows that option values are not a linear function of expected term (IFRS 2.B20). This means that the value of an option with a two-year term is not twice the value of an option with a one-year term. IFRS 2 Fair value of equity instruments granted
As a result, calculating an option’s value based on the average date at which all employees are expected to exercise their options may be less accurate than stratifying employees into different groups based on similarity of early exercise behaviour and separately valuing the options received by each such group.
Effect on option value of varying the expected term for a specified volatility
See also selecting inputs to option pricing models IFRS 2 Fair value of equity instruments granted
No track record of market price
In many situations, a market price for equity instruments (e.g. share options) will not exist. This is because equity instruments issued to employees often have terms and conditions (e.g. vesting conditions) different from those instruments traded in the market and therefore a valuation technique is used (IFRS 2.B4, B26-B30).
A valuation technique requires the estimation of a number of variables, including the expected future volatility of the entity. If no equity instruments of the entity are traded, then an implied volatility should be calculated – e.g. based on actual experience of similar entities that have traded equity instruments. IFRS 2 Fair value of equity instruments granted
An entity, even one without a historical track record (e.g. a newly listed entity), should not estimate its expected volatility at zero.
In rare cases, an entity may be unable to estimate, at grant date, expected volatility and therefore the fair value of the equity instruments cannot be measured; in such rare cases use of the intrinsic value may be required (see Recognition of equity-settled share-based payment transactions with employees). IFRS 2 Fair value of equity instruments granted
Considering market and non-vesting conditions
In determining the grant-date fair value of the equity instruments granted, the impact of any market and non-vesting conditions is taken into account – i.e. they result in downward adjustments compared with the fair value without these conditions (see above) (IFRS 2.19-21A).
Although incorporating the impact of market conditions into the fair value may not usually be too difficult, because a market condition is by definition linked to the share price, in general the more difficult area is the determination of the value adjustment for non-vesting conditions. IFRS 2 Fair value of equity instruments granted
Non-vesting conditions can be based on non-controllable factors. Some of these can be quantified because there is market-based data on trend and volatility; for example, non-vesting conditions linked to a commodity price or an inflation factor (see Selecting inputs to option pricing models).
Non-vesting conditions can also arise when the performance assessment period for a non-market based performance measure (e.g. EBITDA or EPS) exceeds the required service period. In these cases, the entity will need to determine an appropriate method for incorporating the condition when determining the fair value of the award.
EPS target treated as a non-vesting condition
Company C issues shares to employees, subject to a three-year service condition and the achievement of growth in EPS of 30% by the end of the service period.
The share-based payment arrangement further contains a good leaver clause according to which any employees leaving the company because they are eligible for retirement before the end of the service condition are treated as if they had met the service condition. However, vesting is still subject to the achievement of the EPS target.
For those employees who will reach retirement age before the end of three years (‘good leavers’) the EPS target represents a non-vesting condition because the performance assessment period for the EPS target extends beyond the required service period (the period up to when the employee becomes eligible for retirement).
Because the EPS target represents a non-vesting condition, it is taken into account when measuring the fair value of the award at grant date.
C’s share price at grant date is 10 per share and no dividends are expected to be paid by the company before the end of the service period. Management has assessed that the probability of achieving the EPS target is 70%.
Company A incorporates the EPS target into the measurement of the grant-date fair value by choosing to adjust the share price on grant date by the probability of the EPS target not being achieved (30%). Therefore, the grant-date fair value of the award for the employees who are eligible for retirement is 7.
This amount is recognised immediately for those who are eligible to retire at grant date, and over the employees’ requisite service period for those who will become eligible to retire before the end of the three-year stated service period. For good leavers, there is no reversal of compensation cost if the EPS target is not achieved because the condition is a non-vesting condition.
Conversely, for the employees who will not become eligible to retire before the end of the explicit service period, the award is an equity-classified award that vests on the achievement of a performance condition.
As such, for these employees the grant-date fair value of the award is 10 and compensation cost will be recognised if the performance target is probable of achievement; however, the recognised compensation cost would be reversed for these employees if the performance target fails to be achieved.
Non-vesting conditions that employee can choose to meet
Common examples of non-vesting conditions that the employee can choose to meet are non-compete agreements, transfer restrictions after vesting, savings conditions or a requirement to hold shares (IFRS 2.B3, IG15A.Ex9A, BC171B, IU 11-06). IFRS 2 Fair value of equity instruments granted
Post-vesting restrictions are included in the grant-date measurement of fair value to the extent that the restrictions affect the price that a knowledgeable, willing market participant would pay for that share. The standard’s guidance on valuation notes that post-vesting transfer restrictions may have little, if any, effect on fair value when the shares are traded actively in a deep and liquid market.
Post-vesting transfer restriction
Company C has granted shares to employees subject to a one-year service condition. After the service period, employees are entitled unconditionally to the shares. However, under the arrangement they are not allowed to sell the shares for a further five-year period.
The five-year restriction on the sale of the shares is a post-vesting restriction, which is a non-vesting condition (see Chapter 5.4), and is taken into account by C in measuring the grant-date fair value. IFRS 2 Fair value of equity instruments granted
The IFRS Interpretations Committee discussed the fair value measurement of post-vesting transfer restrictions and noted that it is not appropriate to determine the fair value of equity instruments issued only to employees and subject to post-vesting restrictions, based on an approach that looks solely or primarily to an actual or synthetic market consisting only of transactions between an entity and its employees and in which prices, for example, reflect an employee’s personal borrowing rate (IFRS 2.B3, B10, BC168, IU 11-06).
This is because the objective of IFRS 2 is to estimate the fair value of an equity instrument and not the value from the employee’s perspective. The Committee also noted that factors that affect only the employee’s specific perspective on the value of the equity instruments are not relevant to estimating the price that would be set by a knowledgeable, willing market participant. Therefore, hypothetical transactions with actual or potential market participants willing to invest in restricted shares should be considered.
The effect on the grant-date fair value of other non-vesting conditions that the employee can choose to meet – e.g. savings conditions or a requirement to hold shares – is difficult to estimate because it relies on the ability of the entity to forecast employee behaviour. Entities may not have gathered such information historically and, in any case, past practice may not be a reliable indication of future behaviour; therefore, judgement is required. For a discussion of non-vesting conditions, see A2.50.
Non-vesting conditions that entity can choose to meet
An example of a non-vesting condition that the entity can choose to meet is the continuation of the plan by the employer. Applying the general requirements for non-vesting conditions would require the entity to estimate the probability that it would not continue with the plan and adjust the grant-date fair value accordingly (IFRS 2.IG24).
As an exception to the general requirement to reflect the expected outcome of non-vesting conditions in the measurement of grant-date fair value, the entity is prohibited from considering the possibility of not continuing the plan in the estimate of the grant-date fair value. IFRS 2 Fair value of equity instruments granted
The treatment of expected dividends in measuring the fair value of the equity instruments depends on whether the employees are entitled to dividends (IFRS 2.B31).
If the employees are not entitled to dividends declared during the vesting period, then the grant-date fair value of these equity instruments is reduced by the present value of dividends expected to be paid during this period compared with the fair value of equity instruments that are entitled to dividends (IFRS 2.B34).
If the employees are entitled to dividends declared during the vesting period, then in general the accounting treatment depends on whether the dividends are forfeitable – i.e. whether dividends have to be paid back if vesting conditions are not met (IFRS 2.B32).
Cost measurement and recognition for forfeitable dividend rights
In general, forfeitable dividends should be treated as dividend entitlements during the vesting period.
If the vesting conditions are not met, then any true-up of the share-based payment would recognise the profit or loss effect of the forfeiture of the dividend automatically because the dividend entitlements are reflected in the grant-date fair value of the award (for a discussion of when a true-up applies, see Recognition of equity-settled share-based payment transactions with employees).
Cost measurement and recognition for non-forfeitable dividend rights
In general, two approaches are acceptable in accounting for non-forfeitable dividends (IFRS 2.B31-B36).
One approach is to treat non-forfeitable dividends as a dividend entitlement during the vesting period when determining the grant-date fair value of the share-based payment. The value of the dividend right is reflected in the grant-date fair value of the share-based payment, and therefore increases the cost of the share-based payment. If the share-based payment does not vest, then in general the total amount previously recognised as a share-based payment cost should be split into: IFRS 2 Fair value of equity instruments granted
- the value for the non-forfeitable dividends; and IFRS 2 Fair value of equity instruments granted
- the balance of the share-based payment. IFRS 2 Fair value of equity instruments granted
In general, only the balance of the share-based payment cost – i.e. the amount excluding the non-forfeitable dividends – would be subject to true-up for failure to satisfy vesting conditions to reflect the benefit retained by the employee. IFRS 2 Fair value of equity instruments granted
The other approach is to view non-forfeitable dividends as a payment for services with vesting conditions different from the vesting conditions of the underlying share-based payment.
Under this approach, the dividend rights would be considered to be a benefit – e.g. under IAS 19 if the services are employee services – rather than a share-based payment because dividend amounts are unlikely to be based on the price (or value) of the entity’s equity instruments.
Accordingly, the grant-date fair value of the share-based payment would be lower than under the approach above.
Generally, dividends are considered to be part of the measurement of the grant-date fair value, which supports the first approach discussed above – i.e. to treat dividend entitlements as part of the share-based payment.
However, in some circumstances there may be evidence that the share component of the transaction is merely a mechanism to deliver the dividend payments (see 3.5.30). In fact patterns in which the dividend payment is the primary consideration, the second approach above, which accounts separately for dividends, might be more relevant.
In general, when the dividend rights are treated as dividend entitlements regardless of whether the dividends are forfeitable or non-forfeitable, dividends declared during the vesting period should be accounted for in accordance with the requirements of other standards – i.e. as a distribution.
Therefore, neither the declaration nor the payment of the dividends results in additional cost directly, because in general the recognition of cost for the grant of dividend rights should be considered separately, as discussed above (see Dividends, below). In particular under the first approach in Dividends, below, if the dividend amounts are retained even if the vesting conditions are not met, then in general no adjustment of the dividend accounting is necessary because the portion of the share-based payment cost related to the non-forfeitable dividend would not be trued up.
In relation to a grant of shares, in general dividends that are declared during the vesting period but not paid until vesting should also be charged to equity and recognised as a liability when they are declared. For a discussion of the accounting for dividends declared in relation to a share purchase funded through a loan and accounted for as a grant of share options, see Share purchases funded trough loans.
In general, if the share-based payment, and therefore forfeitable dividends thereon, are forfeited because of failure to satisfy a vesting condition, then the return of dividends or reduction in dividend payable should be accounted for as a transaction with a shareholder – i.e. the return should be recognised directly in equity as an adjustment of previously recognised dividends.
On 1 January Year 1, Company F grants one share option to an employee, subject to a four-year service condition. F expects the employee to remain employed until vesting date.
During the vesting period, the employee is entitled to receive dividends equal to dividends declared on common shares. The employee is required to return the dividends received if the service condition is not met.
The employee leaves in April Year 2.
The dividends declared and paid on a common share are as follows.
The accounting is as follows.
F accounts for the transaction as follows.