IFRS 2 Share-based Payment

Fair value employee share options in IFRS 2

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Fair value employee share options

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. 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.

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Classify Group share-based payments in IFRS 2

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Classify Group share-based payments

Classification principles

Once an entity has determined that a share-based payment transaction is in the scope of IFRS 2 (see Definition and scope), it then determines the classification of the transaction.

Classification of the share-based payment transaction depends on the nature of the award granted and whether the entity has an obligation to settle the transaction. If the entity has either an obligation to settle in its own equity instruments or no obligation to settle at all, then the transaction is accounted for as equity-settled.

A settling entity that is not a receiving entity classifies a share-based payment transaction as equity-settled if it settles in its own equity instruments; otherwise, it classifies the transaction as cash-settled. (IFRS 2.43A-43C)

A share-based payment transaction is classified from the perspective of each reporting entity rather than by making a single classification determination. In a typical group share-based payment transaction involving the parent and the subsidiary, separate classification assessments are made for a single transaction from the following three perspectives: (IFRS 2.43A, B45-B61)

Therefore, a single share-based payment transaction could be classified as equity-settled in the financial statements of a subsidiary that receives the services and cash-settled in the group’s consolidated financial statements, or vice versa.

Equity instruments of another group entity – Own equity instruments vs cash or other assets

It is important to consider the perspective of the reporting entity and whether it is the separate entity or a consolidated group that is reporting when there is an obligation to settle the transaction in equity instruments of another group entity. This is because classification can differ between the separate and consolidated financial statements (see Case – Equity instruments viewed from the perspective of separate and consolidated financial statements, the first example below) and can also differ between the various consolidated financial statements in a multiple-level group structure (see Case – Equity instruments viewed from different levels of consolidated financial statements). (IFRS 2.B50)

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Accounting for group share-based payment in IFRS 2

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Accounting for group share-based payment transactions

After determining the classification of the share-based payment in the financial statements of the reporting entity (see Classify Group share-based payments), the recognition and measurement of the share-based payment transaction follows the accounting requirements for equity-settled share-based payments (see Equity-settled share-based payments) or for cash-settled share-based payments (see Cash-settled share-based payments). (IFRS 2.43A)

Accounting for group share-based payment transactions

Consequences of different classification in different financial statements

The amounts recognised for a single transaction in the financial statements of the receiving entity and the settling Accounting for group share-based paymententity will usually differ if the classification of the transaction is different in the financial statements of the receiving entity and the settling entity, or different in the consolidated financial statements at different levels within the group. (IFRS 2.43A)

Equity-settled share-based payments involving employees are measured once at grant date and the number of instruments is adjusted only to reflect the number of instruments for which any service and non-market performance conditions are satisfied. Neither changes in the fair value of the equity instruments nor changes between the estimated and actual outcome of any market or non-vesting conditions affect the accounting (see Equity-settled share-based payments).

In contrast, the liability arising from a cash-settled share-based payment is adjusted to reflect changes in the fair value of the underlying equity instruments as well as in the estimated and actual outcome of vesting and non-vesting conditions, so that the liability is remeasured to equal the amount ultimately paid (see Cash-settled share-based payments).

Accounting by receiving entity with no obligation to settle

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Group share-based payments

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Group share-based payments

IFRS 2 applies not only to transactions involving an entity’s own shares but also to transactions involving the shares of another group entity (i.e. group share-based payments).

Overview

In a group share-based payment:

A share-based payment in which the receiving entity, the settling entity and the reference entity are in the same group from the perspective of the ultimate parent is a group share-based payment in the scope of IFRS 2 from the perspective of both the receiving and the settling entities.

A share-based payment that is settled by an external shareholder is also in the scope of IFRS 2 from the perspective of the receiving entity, as long as the reference entity is in the same group as the receiving entity.

A receiving entity without any obligation to settle the transaction classifies a share-based payment transaction as equity-settled.

A settling entity classifies a share-based payment transaction as equity-settled if it is obliged to settle in its own equity instruments, and otherwise as cash-settled.

The normal recognition and measurement requirements for equity-settled and cash-settled share-based payment transactions apply.

Recharge arrangements do not affect the classification of the share-based payment.

In our view, if the recharge is clearly linked to the share-based payment, then it should be accounted for separately from the share-based payment, but as an adjustment to the capital contribution recognised in respect of the share-based payment.

If the recharge is not clearly linked to the share-based payment, then it is also accounted for separately from the share-based payment, and the entity considers whether it is in the scope of another standard.

Introduction

A share-based payment transaction in a group context may involve more than one entity in delivering the benefit to the group employees providing services. For example, a parent may grant its own equity instruments to employees of its subsidiary. From the perspective of the parent’s consolidated financial statements, this transaction is a share-based payment in the scope of IFRS 2.

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Option valuation models

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Option valuation models

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 pay-off of an option can be calculated. These intrinsic values at exercise are then probability-weighted and discounted to their present value to estimate the fair value of the option at the grant date.

This narrative is part of the IFRS 2 series, look here.

Model selection

There are three main models used to value options:

  • closed-form models: e.g. the BSM model;
  • lattice models; and
  • simulation models: e.g. Monte Carlo models.

These models generally result in very similar values if the same assumptions are used. However, certain models may be more restrictive than others – e.g. in terms of the different pay-offs that can be considered or assumptions that can be incorporated.

For example, a BSM model incorporates early exercise behaviour by using an expected term assumption that is shorter than the contractual life, whereas a lattice model or Monte Carlo model can incorporate more complex early exercise behaviour.

Simple model explanation

The approach followed in, for example, a lattice model illustrates the principles used in an option valuation model in a simplified manner.

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Replacements of employee share-based payments

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Replacements of employee share-based payments

Sometimes a share-based payment is granted as a replacement for another share-based payment that is cancelled. In this case, the principles of modification accounting are applied. The basis for conclusions to IFRS 2 explains that the reason for permitting a cancellation and a new grant to be accounted for as a modification is that the Board could not see a difference between those two transactions and a re-pricing, being a change in the exercise price.

To apply modification accounting, the entity identifies the new equity instruments granted as a replacement for cancelled equity instruments on the date on which the new equity instruments are granted. (IFRS 2.28(c))

If the entity does not identify a new equity-settled plan as a replacement for a cancelled equity-settled plan, then the two plans are accounted for separately. For example, if a new equity-settled share-based payment is offered and an old equity-settled share-based payment is cancelled, but the new plan is not identified as a replacement plan for the cancelled plan, then the new grant is recognised at its grant-date fair value and the original grant is accounted for as a cancellation. (IFRS 2.28(c))

IFRS 2 specifies that identification of a new grant as a replacement award is required on the date of the new grant. However, the standard is silent on the question of whether the cancellation should also be on the same date as the new grant. Judgement is required to determine whether the facts and circumstances demonstrate that the arrangement is a modification if time has passed between the cancellation and the identification of a new grant.

When modification accounting is applied, the entity accounts for any incremental fair value in addition to the grant-date fair value of the original award. In the case of a replacement, the incremental fair value is the difference between the fair value of the replacement award and the net fair value of the cancelled award, both measured at the date on which the replacement award is issued.

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Cancellation of employee share-based payments

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Cancellation of employee share-based payments

Cancellations or settlements of equity instruments during the vesting period by the entity or by the counterparty are accounted for as accelerated vesting, and therefore the amount that would otherwise have been recognised for services received is recognised immediately. (IFRS 2.28(a), IG15A.Ex9)

Cancellation by employee

Cancellations by the employee can occur because the employee waives the share-based payment for their own reasons. In our experience, this does not occur often in practice (see case – Voluntary cancellation by employee below). Cancellations will occur more often as a consequence of the employee choosing not to meet a non-vesting condition that is part of the share-based payment arrangement (see case – Cancellation by employee due to failure to meet non-vesting condition below). Failure to meet such a non-vesting condition is treated as a cancellation. (IFRS 2.28A, BC237B)

Case – Voluntary cancellation by employee

On 1 January Year 1, Company B grants 1,000 share options to its CEO, subject to a three-year service condition. A share option has a grant-date fair value of 10. B expects the CEO to satisfy the service condition, which they do.

In Year 2, the CEO waives the entitlement to share options in difficult economic times.

B accounts for the transaction as follows.

Cancellation of employee share-based payments

The example illustrates that the principle of accelerated vesting applies even if the employee voluntarily cancels an unvested share-based payment.

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Modifications of employee share-based payment IFRS 2

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Modifications of employee share-based payment transactions

  • The accounting for a modification depends on whether the modification changes the classification of the arrangement and whether the changes are beneficial to the employee.
  • As a minimum, the original grant-date fair value of the equity instruments granted is recognised under modification accounting.
  • Modifications that increase the fair value of the grant result in recognition of the incremental fair value measured at the date of modification.
  • Modifications that increase the number of equity instruments granted result in recognition of the fair value of the additional equity instruments, measured at the date of modification.
  • Other beneficial modifications – e.g. changes to service conditions or non-market performance conditions – are taken into account in applying the modified grant-date method.
  • Modifications that are not beneficial for the employee do not affect the total share-based payment cost.
  • Cancellations by the employee or by the entity result in accelerated vesting.
  • Compensation payments made for cancellations by the employer are recognised as a repurchase of equity interests. To the extent that a compensation payment exceeds the fair value of the equity instruments granted at the repurchase date, it is recognised as an expense.
  • Replacement awards need to be identified as such by the employer at the date when the new award is granted.
  • Replacement awards are accounted for by applying the principles of modification accounting, rather than as a separate new award and cancellation of the unvested old award.

This narrative contains guidance on modifications of share-based payment transactions with employees. There are no specific requirements for cash-settled share-based payments that are modified or cancelled because cash-settled share-based payments are remeasured to the ultimate cash payment

The modification requirements also apply to share-based payment transactions with parties other than employees that are measured indirectly – i.e. with reference to the fair value of the equity instruments granted. In this case, any reference to grant date is read as a reference to the applicable measurement date under those transactions – i.e. the date when the goods or services are received.

As a basic principle, IFRS 2 requires an entity to recognise, as a minimum, the original grant-date fair value of the equity instruments granted unless those equity instruments do not vest because of failure to meet any service and non-market performance conditions under the original terms and conditions. (IFRS 2.27)

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Employee share purchase plans

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Employee share purchase plans

In an 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)

In my view, 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 my 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. I believe that 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;
  • 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.

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Determination of grant date in IFRS 2

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Determination of grant date

The determination of grant date is important because this is the date on which the fair value of equity instruments granted is measured. Usually, grant date is also the date on which recognition of the employee cost begins. However, this is not always the case (Service commencement date and grant date in Determination of the vesting period).

‘Grant date’ is the date at which the entity and the employee agree to a share-based payment arrangement, and requires that the entity and the employee have a shared understanding of the terms and conditions of the arrangement. (IFRS 2.A)

In order for the employer and the employee to ‘agree’ to a share-based payment transaction, there needs to be both an offer and an acceptance of that offer. (IFRS 2.IG2)

Approval and communication by the employer

If the agreement is subject to an approval process, then the grant date cannot be before the date on which that approval is obtained. If a grant is made subject to approval – e.g. by a board of directors – then the grant date is normally when that approval is obtained.

The arrangement also needs to be communicated to the employees to achieve grant date.

In a broad-based unilateral grant of a share-based payment, there is often a period of time between board approval and communication of the terms of the award to individual employees. In some entities, the terms and conditions of the awards are communicated to each employee by their direct supervisor. Because of the varying schedules of employees and employers, it is possible that different employees may be informed of their awards on different dates.

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