Fair value employee share options in IFRS 2

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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Option valuation models

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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Employee share purchase plans

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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Example Disclosure financial instruments

Example Disclosure financial instruments

The guidance for this example disclosure financial instruments is found here.

7 Financial assets and financial liabilities

This note provides information about the group’s financial instruments, including:

  • an overview of all financial instruments held by the group
  • specific information about each type of financial instrument
  • accounting policies
  • information about determining the fair value of the instruments, including judgements and estimation uncertainty involved.

The group holds the following financial instruments: [IFRS 7.8]

Amounts in CU’000

Notes

2020

2019

Financial assets

Financial assets at amortised cost

– Trade receivables

7(a)

15,662

8,220

– Other financial assets at amortised cost

7(b)

4,598

3,471

– Cash and cash equivalents

7(e)

55,083

30,299

Financial assets at fair value through other comprehensive income (FVOCI)

7(c)

6,782

7,148

Financial assets at fair value through profit or loss (FVPL)

7(d)

13,690

11,895

Derivative financial instruments

– Used for hedging

12(a)

2,162

2,129

97,975

63,162

Example Disclosure financial instruments

Financial liabilities

Liabilities at amortised cost

– Trade and other payables1

7(f)

13,700

10,281

– Borrowings

7(g)

97,515

84,595

– Lease liabilities

8(b)

11,501

11,291

Derivative financial instruments

– Used for hedging

12(a)

766

777

Held for trading at FVPL

12(a)

610

621

124,092

107,565

The group’s exposure to various risks associated with the financial instruments is discussed in note 12. The maximum exposure to credit risk at the end of the reporting period is the carrying amount of each class of financial assets mentioned above. [IFRS 7.36(a), IFRS 7.31, IFRS 7.34(c)]

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Change in ownership in a subsidiary – IFRS 10 Best complete read

Change in ownership in a subsidiary

Accounting for a subsequent change in ownership in a subsidiary, i.e. a change in the parent’s ownership interest in a subsidiary may result from a purchase or sale of shares by the parent or from transactions between the subsidiary and non-controlling interests.

This narrative discusses the accounting for changes in ownership interests that:

Change in ownership in a subsidiary that do not result in loss of control

Non-controlling interests (NCI) in a subsidiary are presented as a separate component of equity in the consolidated statement of financial position. Consequently, changes in a parent’s ownership interest in a subsidiary that do not result in loss of control are accounted for as equity transactions.

Parent’s accounting treatment:

When the NCI in a subsidiary changes but the same parent retains control: (IFRS 10.23, IFRS 10.B96)

  • no gain or loss is recognised when the parent sells shares (so increasing NCI)
  • a parent’s purchase of additional shares in the subsidiary (so reducing NCI) does not result in additional goodwill or other adjustments to the initial accounting for the business combination
  • in both situations, the carrying amount of the parent’s equity and NCI’s share of equity is adjusted to reflect changes in their relative ownership interest in the subsidiary. Any difference between the amount of NCI adjustment and the fair value of the consideration received or paid is recognised in equity, attributed to the parent [IFRS 10.B96]
  • the parent should also take the following into consideration:
    • the allocated amounts of accumulated OCI (including cumulative exchange differences relating to foreign operations) are adjusted to reflect the changed ownership interests of the parent and the NCI. The re-attribution of accumulated OCI is similarly treated as an equity transaction (ie a transfer between the parent and the NCI)
    • for a partial disposal of a subsidiary with foreign operations, the parent must re-attribute the proportionate share of cumulative exchange differences recognised in OCI to NCI in that foreign operation [IAS 21.48C]
    • IFRS 10 has no specific guidance for costs directly related to changes in ownership interests. In our view, costs that are incremental should be deducted from equity (consistent with IAS 32’s rules on other types of transaction in the entity’s own equity).

Examples

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Convertible instruments in EPS calculations – 2 good to read

Convertible instruments in EPS calculations

Convertible instruments are instruments other than stand-alone options that by their terms may be converted in whole or in part into the ordinary shares of an entity, such as convertible bonds or convertible preference shares.

This narrative builds on the basic principles introduced in EPS or earnings per share, and sets out the specific basic and diluted EPS implications of the following types of instrument(s).

If these instruments fall in the scope of IAS 32 Financial Instruments: Presentation, then they can contain a derivative recognised at fair value through profit or loss, a financial liability and/or equity components, depending on their terms. For example, a bond with an embedded option to convert it into ordinary shares of the issuer is a compound instrument, containing a financial liability and an equity component, if the conversion option is classified as equity. [IAS 32.26–32]

Although this is less common, a convertible instrument may fall in the scope of IFRS 2 Share-based Payment if it is issued in exchange for goods or services. In this case, the convertible instrument is generally regarded as a share-based payment with a choice of settlement. If the entity has the settlement choice, then the instrument is classified as either equity-settled or cash-settled, depending on whether the entity has a present obligation to settle in cash. If the holder has the settlement choice, then the instrument is classified as a compound instrument. [IFRS 2.34–43]

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Written put options and forwards for EPS calculations

Written put options and forwards

Written puts and forwards, as discussed in this narrative, are those that may require an entity to purchase its ordinary shares. Typically, these instruments are in the scope of IAS 32 Financial Instruments: Presentation.

This narrative builds on the basic principles introduced in EPS or earnings per share, and sets out the specific basic and diluted EPS implications of the following types of instrument(s).

Under IAS 32, a written put or forward that contains an obligation for an entity to purchase its own ordinary shares in cash or other financial assets generally gives rise to a financial liability for the present value of the redemption amount. Subsequent to initial recognition, the liability is measured in accordance with IFRS 9 Financial instruments. [IAS 32.23]

This narrative covers written put options over an entity’s own shares. For additional considerations about written put options over NCI in the consolidated financial statements of the parent entity, see Written puts over NCI.

EPS implications

Generally, in general shares that are subject to written puts or forwards are not regarded as outstanding in basic EPS but do impact diluted EPS. Understanding the accounting for these instruments is also relevant, because it determines whether their assumed conversion would have a consequential effect on profit or loss.

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Preference shares in EPS Calculations

Preference shares in EPS Calculations

Preference shares may in accordance with IAS 32 Financial Instruments: Presentation be classified as a whole or by their component parts into a financial liability and/or an equity instrument, depending on their terms. They may be convertible into ordinary shares.

This narrative builds on the basic principles introduced in EPS or earnings per share, and sets out the specific basic and diluted EPS implications of the following types of instrument(s).

An entity needs to consider whether equity-classified preference shares are a class of ordinary shares. If the entity has more than one class of ordinary shares, then it is required to present EPS for each class. Ordinary shares of the same ‘class’ are those shares that have the same right to receive dividends or otherwise share in the profit for the period. Additional considerations for classes of ordinary shares are set out below in classes of ordinary shares. [IAS 33.5–6]

EPS implications

Generally, how preference shares are dealt with in EPS depends on their accounting classification as liabilities or equity instruments, and whether they are convertible into ordinary shares.

Preference shares in EPS Calculations

Potential impact on basic EPS

Potential impact on diluted EPS

The numerator might or might not be affected and the denominator is not affected.

The numerator and the denominator might or might not be affected.

Preference shares that are wholly classified as liabilities under IAS 32 are not ordinary shares. The returns to the holders of these shares – e.g. post-tax amounts of preference dividends – have generally been recognised in profit or loss and therefore no further adjustment to the numerator is necessary. [IAS 33.13]

For preference shares that are wholly or partly classified as equity instruments under IAS 32, the numerator is adjusted for any returns to the holders of these shares, which include the post-tax amounts of preference dividends and any differences arising on settlement. For additional considerations and examples of adjustments for equity-classified preference shares in basic EPS. [IAS 33.12]

In addition, separate disclosure of EPS amounts is required for equity-classified preference shares that form a separate class of ordinary shares. [IAS 33.66]

Preference shares that are convertible into ordinary shares, other than those that are mandatorily convertible, are POSs (see Convertible instruments).

For equity-classified convertible preference shares, the potential adjustment:

  • to the numerator includes the returns to the holders of these shares adjusted in the calculation of basic EPS (see left); and
  • to the denominator is based on the additional ordinary shares resulting from the assumed conversion.

Conversion is assumed to have occurred at the beginning of the period (or, if later, the date of issuance of the convertible preference shares).

For liability-classified convertible preference shares, the potential adjustment:

  • to the numerator includes the post-tax amount of any dividends and other consequential changes in income or expense that would result from the assumed conversion; and
  • to the denominator is based on the additional ordinary shares resulting from the assumed conversion.

Conversion is assumed to have occurred at the beginning of the period (or, if later, the date of issuance of the convertible preference shares). For an example of adjustments for convertible instruments containing a liability component, see contracts settled in shares or cash.

Dilutive or anti-dilutive?

Generally, a convertible preference share is anti-dilutive whenever the amount of the dividend on such shares declared in or accumulated for the current period and any other required adjustment to the numerator per ordinary share obtainable on conversion exceeds basic EPS from continuing operations. [IAS 33.50]

Classes of ordinary shares

If an entity has more classes of ordinary shares, then EPS is disclosed for each class of ordinary shares that has a different right to share in the profit for the period. Therefore, for an entity that applies IAS 33, it is important to identify which of the instruments in issue are ordinary shares and to determine if there is more than one class of ordinary shares. (IAS 33.66)

IAS 33 defines an ‘ordinary share’ as ‘an equity instrument that is subordinate to all other classes of equity instruments’. It also explains that ordinary shares participate in profit for the period only after other types of shares such as preference shares have participated, and that ordinary shares of the same class are those shares that have the same right to receive dividends or otherwise share in the profit for the period. (IAS 33.5–6)

If an entity has shares with different rights, then it considers whether all of the shares are in fact ordinary shares. Consider the following contrasting examples.

Case – Two classes of ordinary shares

Company X has two classes of shares, A and B. The holders of class B shares are entitled to dividends equal to 50% of any dividends declared on the class A shares, but the shares are otherwise identical to class A shares. Both classes are subordinate to all other classes of equity instruments with respect to participation in profit.

In this case, X concludes that both class A and class B shares are ordinary shares despite the difference in entitlement to dividends. Disclosure of separate EPS amounts is therefore required for both class A and class B ordinary shares.

In general, an entity is not required to present separate EPS information for participating preference shares that are not considered to be a separate class of ordinary shares.

Case – Participating preference shares that are not ordinary shares

Company C has two classes of shares, X and Y. Shareholders of class X are entitled to a fixed dividend per share and have the right to participate in any additional dividends declared. The class Y shareholders participate equally with class X shareholders with respect to the additional dividends only.

In this example, C concludes that class X shares are not considered to be ordinary, because the fixed entitlement creates a preference over the class Y shares, and the class Y shareholders are subordinate to the class X shareholders. This is even if both classes participate equally in the residual assets of C on dissolution.

The class Y shares are the only class of ordinary shares, and therefore the only class of shares for which disclosure of EPS information is required. However, the participating rights of each class of these shares should be considered in determining earnings attributable to ordinary shareholders.

In general, puttable instruments that qualify for equity classification instead of financial liability classification under IAS 32 Financial Instruments: Presentation are not ordinary shares for the purposes of IAS 33. We believe that it is not appropriate to apply by analogy the limited scope exemption under IAS 32 for EPS calculation purposes. (IAS 32.16A–16F)

The EPS presentation is not required for, or as a result of the existence of, such instruments. However, when determining the earnings that are attributable to the ordinary shareholders, the terms of these instruments should be evaluated to determine if they are participating instruments.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

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Preference shares in EPS Calculations

EPS Calculation – IAS 33 Best complete read

EPS Calculation

Here is full example of an EPS Calculation. This narrative builds on the basic principles introduced in the narrative EPS, and sets out the specific basic and diluted EPS calculation rules as per IAS 33 Earnings per share.

Case

Company P earns a consolidated net profit of 4,600,000 during the year ended 31 December Year 1 and 5,600,000 during the year ended 31 December Year 2. The total number of ordinary shares outstanding on 1 January Year 1 is 3,000,000.

Various POSs are issued before 1 January Year 1 and during the years ended 31 December Year 1 and Year 2. During this period, the outstanding number of ordinary shares also changes.

The statement of changes in equity below summarises only the actual movements in the outstanding number of ordinary shares, followed by detailed information about such movements and POSs outstanding during the periods.

EPS Calculation

Details of the instruments and ordinary share transactions during Year 1 and Year 2

1. Convertible preference shares

At 1 January Year 1, P has 500,000 outstanding convertible preference shares. Dividends on these shares are discretionary and non-cumulative. Each preference share is convertible into two ordinary shares at the holder’s option.

The preference shares are classified as equity in P’s financial statements.

On 15 October Year 1, a dividend of 1.20 per preference share is declared. The dividend is paid in cash on 15 December Year 1. Preference dividends are not tax-deductible.

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Stock dividends in IAS 33 EPS Calculations

Stock dividends

Stock dividends are dividends paid to the ordinary shareholders of an entity in the form of additional ordinary shares rather than in cash. They may also be referred to as ‘scrip dividends’, or ‘share dividends’, and they may or may not have a cash alternative. IAS 33 EPS Calculations

This narrative builds on the basic principles introduced in the narrative EPS, and sets out the specific basic and diluted EPS implications of the following types of instrument(s). IAS 33 EPS Calculations

EPS implications

Generally, how stock dividends are dealt with in EPS depends on whether the investor has a cash alternative.

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