Share-based payment

In share-based payment transactions, an entity receives goods or services from a counterparty and grants equity instruments (equity-settled share-based payment transactions) or incurs a liability to deliver cash or other assets for amounts that are based on the price (or value) of equity instruments (cash-settled share-based payment transactions) as consideration.

The following transactions are not in the scope of IFRS 2:

  • transactions with counterparties acting as shareholders rather than as suppliers of goods or services;
  • transactions in which a share-based payment is made in exchange for control of a business; and
  • transactions in which contracts to acquire non-financial items in exchange for a share-based payment are in the scope of the financial instruments standards.

A ‘counterparty’ can be an employee or any other party.

An ‘equity instrument’ is a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Under the financial instruments standards, some instruments issued in the legal form of shares may be classified as liabilities. Some potential share-based payment arrangements require payments based on the change in the price of an instrument that evidences a residual interest in an entity, but which would be classified as a liability under the financial instruments standards.

The term ‘equity instrument’ is defined in IFRS 2 without reference to IAS 32, and it appears that classification under IAS 32 is not relevant. For example, IFRS 2 includes as an illustration of a cash-settled share-based payment a grant of puttable or redeemable shares or options over them. Such instruments would generally be classified as financial liabilities under IAS 32. Under IFRS 2, payment based on the value of a puttable or redeemable share is a cash-settled share-based payment.Share-based payment

Goods or services received in a share-based payment transaction are measured at fair value.

Goods are recognised when they are obtained and services are recognised over the period over which they are received.

Classification of share-based payment transactions

Share-based payment transactions are classified based on whether the entity’s obligation is to deliver its own equity instruments (equity-settled) or cash or other assets (cash-settled). An intention or requirement to buy own equity instruments in order to settle a share-based payment does not affect classification.

Awards requiring settlement in a variable number of equity instruments to a specified value are classified as equity-settled.

Grants of equity instruments that are redeemable mandatorily or at the counterparty’s option are classified as cash-settled, without consideration of intent or probability. Grants of equity instruments that are redeemable at the entity’s option are classified based on the entity’s intent and past practice of settling in shares or cash.

Classification of conditions

Share-based payment transactions, in particular those with employees, are often conditional on the achievement of conditions. IFRS 2 distinguishes between vesting conditions and non-vesting conditions as follows.

– Vesting condition

A condition that determines whether an entity receives services that entitle condition the counterparty to receive cash, other assets or equity instruments of the entity. A vesting condition is either a service condition or a performance condition. Share-based payment

Service condition

Performance condition

Vesting condition that requires the counterparty to complete a specified period of service during which services are provided to the entity.

If the counterparty, regardless of the reason, ceases to provide services during the vesting period, then it has failed to satisfy the condition.

The service requirement can be explicit or implicit.

Share-based payment Share-based payment Share-based payment Share-based payment Share-based payment Share-based payment Share-based payment Share-based payment

Vesting condition that requires the counterparty to complete a specified period of service and specified performance target(s) to be met while services are rendered.

A performance target can be one of the following conditions.

  • Market condition: If it is based on the price (or value) of the entity’s equity instruments e.g. achieving a certain share price target.

  • Non-market performance condition: If it is based on the entity’s operations or activities – e.g. achieving a certain profit target.

– Non-vesting condition

A condition other than a vesting condition that determines whether a counterparty receives the share-based payment – e.g. counterparty’s choice of participation in a share purchase programme by paying monthly contributions.

Equity-settled share-based payments with employeesShare-based payment

Equity-settled share-based payment transactions with employees require indirect measurement and each equity instrument granted is measured on its grant date.

The impacts of any market conditions and non-vesting conditions are reflected in the grant-date fair value of each equity instrument. Any service or non-market performance condition is not reflected in the grant-date fair value of the share-based payment. Instead, an estimate is made of the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied.

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The product of this estimate – i.e. grant-date fair value per equity instrument multiplied by the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied – is the estimate of the total share-based payment cost.

This cost is recognised over the vesting period, with a corresponding entry in equity. The cost is recognised as an expense or capitalised as an asset if the general asset-recognition criteria in IFRS are met. If the payment is not subject to a service condition, then it is recognised immediately.

Subsequent to initial recognition and measurement, the estimate of the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied is revised during the vesting period. The cumulative amount recognised at each reporting date is based on the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied.

Ultimately, the share-based payment cost is based on the number of equity instruments for which these conditions are satisfied. No adjustments are made in respect of market conditions – i.e. neither the number of instruments nor the grant-date fair value is adjusted if the outcome of the market condition differs from the initial estimate.

Subsequent to initial recognition and measurement, the manner of adjustment for non-vesting conditions depends on whether there is choice within the condition. Failure to satisfy the following conditions results in accelerated recognition of unrecognised cost:

  • non-vesting conditions that the counterparty can choose to meet: e.g. paying contributions towards the purchase (or exercise) price on a monthly basis, or complying with transfer restrictions; and
  • non-vesting conditions that the entity can choose to meet: e.g. continuing the plan.

A non-vesting condition that neither the entity nor the counterparty can choose to meet (e.g. a target based on a commodity index) has no impact on the accounting if it is not met – i.e. there is neither a reversal of the previously recognised cost nor an acceleration of recognition.

Cash-settled share-based payments with employees

Cash-settled share-based payment transactions are measured initially at the fair value of the liability and are recognised as an expense or capitalised as an asset if the general asset recognition criteria in IFRS are met.

If the payment is subject to a vesting condition, then the amounts are recognised over the vesting period. At each reporting date until settlement date, the recognised liability is remeasured at fair value with changes recognised in profit or loss.

Remeasurements during the vesting period are only recognised to the extent that services have been received – e.g. on a time-proportionate basis. If the payment is not subject to a vesting condition, then it is recognised immediately.

Employee transactions with a choice of settlement

Some share-based payment transactions provide one party with the choice of settlement in cash or in equity instruments. If the entity has the choice of settlement, then the transaction is classified as an equity-settled or a cash-settled share-based payment transaction, depending on whether the entity has a present obligation to settle in cash.

A ‘present obligation to settle in cash’ exists, for example, if the entity has a past practice or a stated policy of settling in cash. If the counterparty has the choice of settlement, then the entity has granted a compound instrument comprising a debt component and an equity component.

Modifications and cancellations of employee transactions

Modifications of an equity-settled share-based payment arrangement are accounted for only if they are beneficial. If the fair value of the equity instruments granted has increased as a result of a modification to their terms and conditions, then the incremental fair value at the date of modification is recognised in addition to the grant-date fair value. Modifications that are not beneficial to the counterparty do not affect the amount of the share-based payment cost recognised. However, reductions in the number of equity instruments granted are accounted for as cancellations.

Cancellations by the entity or by the counterparty are treated as an acceleration of vesting, requiring any unamortised compensation cost to be recognised immediately. If an entity grants new equity instruments to replace cancelled equity instruments, then this cancellation and replacement may be accounted for in the same way as a modification.

Group share-based payments

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 transaction from the perspective of both the receiving and the settling entities.

In a group share-based payment transaction in which the parent grants a share-based payment to the employees of its subsidiary, the share-based payment is recognised in the consolidated financial statements of the parent, in the separate financial statements of the parent and in the financial statements of the subsidiary.

Recharge arrangements do not affect the classification of the share-based payment arrangement, but may be accounted for by analogy to share-based payments.

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Share-based payments with non-employees

Equity-settled share-based payment transactions with non-employees are generally measured at the fair value of the goods or services received (direct measurement), rather than at the fair value of the equity instruments granted at the time when the goods or services are received.

If in rare cases the fair value of the goods or services received cannot be measured reliably, then the goods or services received are measured with reference to the fair value of the equity instruments granted (indirect measurement).

Replacement awards in a business combination

IFRS 3 provides guidance about the accounting for replacements of awards held by the acquiree’s employees (acquiree awards) in a business combination when the acquirer:

  • is obliged to issue share-based payment replacement awards (replacement awards); or
  • chooses to replace awards that expire as a result of the business combination.

To the extent that the replacement awards relate to past service, they are included in the consideration transferred; to the extent that they require future service, they are not part of the consideration transferred and instead are treated as post-combination remuneration cost. If they relate to both past and future service, then the market-based measure of the replacement awards is allocated between consideration transferred and post-combination cost.

IFRS 3 also includes guidance for equity-settled acquiree awards that the acquirer chooses not to replace (unreplaced awards). Such unreplaced awards are part of the non-controlling interests in the acquiree at the date of acquisition.

Other application issues

The interaction between IFRS 2 and other standards can be difficult. The interaction with some of those standards – e.g. IFRS 3 – is addressed in IFRS 2. However, there are some other standards that are not addressed specifically in IFRS 2 but which raise questions on the interaction with IFRS 2. These include IAS 12 Income Taxes, IAS 33 Earnings per Share and IAS 10 Events after the Reporting Period. The issue of whether hedge accounting can be applied is also a common question.

An example

Assume that the expected number of options to be exercised is 2,000,000, that the exercise price is $1.25, and that the fair value of each option is $0.30. The vesting period is three years. Assuming that the estimate of 2,000,000 does not change, then the accounting for each of the three years would be as follows:Share-based payment

Debit Remuneration Expense $200,000
Credit Issued Capital (Options)    $200,000

Note that the number of options might change on a year-by-year basis (depending on staff departures etc.), in which case the numerical amount of the entry could be different each year. If the options are exercised (all at once is assumed here), we would have: Share-based Payment

Debit Bank  $2,500,000
Debit Issued Capital (Options) $600,000
Credit Issued Capital   $3,100,000

If the options expire worthless at the end of the exercise period (all having previously vested), the entry would be:

Debit Issued Capital (Options)  $600,000
Credit Retained Earnings   $600,000

In other cases the options may vest (for example, and employee satisfies the service performance criterion), but the options remain unexercised at the end of their life (for example the share price at that point in time is below the exercise price). At the end of the exercise period, the amount sitting in Shareholders’ Funds under the heading Issued Capital (Options) would need to be eliminated. This amount should be transferred back into Retained Earnings, but not through the Income Statement.

In summary, the past expense of $600,000 in the above example would stand, without an offsetting income line when the options expire worthless1. Share-based Payment

Where the options are exercised, the company would receive cash. As well, the amount credited to Issued Capital (Options) would now be transferred into Issued Capital. A simple example of these procedures is shown in the example below. Note that once the options are exercised the look of the Balance Sheet would be the same regardless whether the options had not been accounted for at all during their life (the “do nothing” alternative) or had been expensed during the vesting period.

The only difference would be within Shareholders’ Funds. Under the IFRS-2 provisions there would have been an expense recognised each year and hence Retained Earnings would be less by $600,000 in this example. However Issued Capital would be more, also by $600,000. Share-based Payment

Fair value of employee share options Share-based Payment

The value of an option depends on six variables – the share price at the time, the exercise price, interest rates, time to run to expiry, the volatility of the returns on the underlying shares, and dividends expected to be paid during the life of the options. There are other factors that make the valuation more complex. The major one is that typically employee share options do not vest for a period of time, and then can be exercised at any time after service vesting, subject to any remaining performance hurdles being satisfied, and also subject to any insider trading provisions that may exist.

Hence, employee share options are a mixture of European and American options (if they were traded on an exchange they would be known as Bermudan options). If the performance hurdles are market based (as in the Pumpkin Patch case) this, too, needs to be factored into the valuation.

With traded options there is a simple rule – don’t exercise call options on non-dividend paying shares early. But while options on markets can be traded, employee share options lack liquidity. Liquidity is valuable, and the only (easy) way in which the managers can create liquidity is to exercise their rights and then sell the shares.

So early exercise is common, perhaps motivated by the desire of the employees to diversify their wealth. Effectively they will be allocating some of the monetary wealth away from where their human capital is allocated. And this raises another issue – the employees may be assigning a value to the options that is less than the cost of the options to the company, creating a deadweight loss.

All this suggests that valuing employee options is difficult and there is some considerable uncertainty in the final numbers. However, they are likely to be a substantially better esShare-based paymenttimate than the estimate of expense used currently, which is zero. Further, the uncertainty is probably no greater than with other items that we take for granted – like the useful life of an asset for depreciation purposes.

Most valuers will use some form of binomial option pricing model to determine “fair value”, and the binomial model can cope with most of the complexity that has been described above. Share-based Payment

Some will use the Black-Scholes-Merton option pricing model and use expected life (not total life) of the option in the formula. Share-based Payment

The more complicated the option, the more likely a binomial solution will be needed. From the company’s perspective, this will not come for free – firms will need to employ a financial expert to determine the initial fair value, every time the firm grants new options. Of course, it is acknowledged that firms do need to know what options are worth if they are part of a remuneration package, so it can be argued that the net incremental cost of having to “book” the amount into the accounting system is quite low. Share-based Payment

Apart from market-based performance hurdles that have to be incorporated into the valuation, the major estimation problems center around the measurement of the volatility of share price returns. Take the case of Pumpkin Patch. Clearly, the initial valuation of the options would have to be done before the shares start trading, so the volatility of the share returns in that company cannot be observed. Instead about all one can do is use volatility measures of shares of companies in the same industry, which are listed. Unfortunately, as a practical matter, different estimates of volatility can have a major impact on the option’s value, and this gets worse the longer the term of the option.

Plenty of articles are still being published on this issue, and the US Securities and Exchange Commission has recently published a 64-page Bulletin outlining alternative valuation methodologies that might be applied2. One very recent working paper suggested that we think about employee share options as 90-day options that get renewed every 90 days until they are exercised, which if the employee leaves and the options have vested, will normally be no more than 90 days after departure.

The amount to be expensed each quarter would be based on the difference between the value of the option and its intrinsic value. The authors argue that this reduces difficulty with parameter estimation during this short window3. Share-based Payment

Share-based Payment

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