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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Disclosure non-financial assets and liabilities example

Disclosure non-financial assets and liabilities example

The guidance for this disclosure example is provided here.

8 Non-financial assets and liabilities

This note provides information about the group’s non-financial assets and liabilities, including:

  • specific information about each type of non-financial asset and non-financial liability
    • property, plant and equipment (note 8(a))
    • leases (note 8(b))
    • investment properties (note 8(c))
    • intangible assets (note 8(d))
    • deferred tax balances (note 8(e))
    • inventories (note 8(f))
    • other assets, including assets classified as held for sale (note 8(g))
    • employee benefit obligations (note 8(h))
    • provisions (note 8(i))
  • accounting policies
  • information about determining the fair value of the assets and liabilities, including judgements and estimation uncertainty involved (note 8(j)).

8(a) Property, plant and equipment

Amounts in CU’000

Freehold land

Buildings

Furniture, fittings and equipment

Machinery and vehicles

Assets under construction

Total

At 1 January 2019

Cost or fair value

11,350

28,050

27,510

70,860

137,770

Accumulated depreciation

-7,600

-37,025

-44,625

Net carrying amount

11,350

28,050

19,910

33,835

93,145

Movements in 2019

Exchange differences

-43

-150

-193

Revaluation surplus

2,700

3,140

5,840

Additions

2,874

1,490

2,940

4,198

3,100

14,602

Assets classified as held for sale and other disposals

-424

-525

-2,215

3,164

Depreciation charge

-1,540

-2,030

-4,580

8,150

Closing net carrying amount

16,500

31,140

20,252

31,088

3,100

102,080

At 31 December 2019

Cost or fair value

16,500

31,140

29,882

72,693

3,100

153,315

Accumulated depreciation

-9,630

-41,605

-51,235

Net carrying amount

16,500

31,140

20,252

31,088

3,100

102,080

Movements in 2020

Exchange differences

-230

-570

-800

Revaluation surplus

3,320

3,923

7,243

Acquisition of subsidiary

800

3,400

1,890

5,720

11,810

Additions

2,500

2,682

5,313

11,972

3,450

25,917

Assets classified as held for sale and other disposals

-550

-5,985

-1,680

-8,215

Transfers

950

2,150

-3,100

Depreciation charge

-1,750

-2,340

-4,380

-8,470

Impairment loss (ii)

-465

-30

-180

-675

Closing net carrying amount

22,570

38,930

19,820

44,120

3,450

128,890

At 31 December 2020

Cost or fair value

22,570

38,930

31,790

90,285

3,450

187,025

Accumulated depreciation

-11,970

-46,165

-58,135

Net carrying amount

22,570

38,930

19,820

44,120

3,450

128,890

(i) Non-current assets pledged as security

Refer to note 24 for information on non-current assets pledged as security by the group.

(ii) Impairment loss and compensation

The impairment loss relates to assets that were damaged by a fire – refer to note 4(b) for details. The whole amount was recognised as administrative expense in profit or loss, as there was no amount included in the asset revaluation surplus relating to the relevant assets. [IAS 36.130(a)]

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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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Contingencies – Best and complete 2 read

Contingencies

Contingencies are an interesting subject in accounting because for example within IAS 37 the term ‘contingent’ is used for liabilities and assets that are not recognised because their existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

So contingencies may exists as to the recognition or disclosure of assets and liabilities, but also for contingent consideration in IFRS 3 Business combinations, contingent settlement provisions included in financial instruments (arising on liquidation or in puttable instruments) and/or contingently issuable shares in IAS 33 Earnings per share, just to name a few.

Recognition criteria for provisions and contingent liabilities

Provisions can be distinguished from other liabilities (e.g. trade payables and accruals) due to the uncertainty concerning the timing or amount of the future expenditure required in settlement.

In a general sense, all provisions are contingent because they are uncertain in timing or amount. However, within IAS 37 the term ‘contingent’ is used for liabilities and assets that are not recognised because their existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

IAS 37.14 requires a provision be recognised when all of the following apply:

  • an entity has a present obligation (legal or constructive) as a result of a past event
  • it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation
  • a reliable estimate can be made of the amount of the obligation

Provisions are measured at the best estimate of the expenditure required to settle the present obligation at the reporting period:

  • including any considerations for risks and uncertainties
  • including time value of money (if material)
  • including future events when there is sufficient objective evidence that they will occur
  • excluding gains from the expected disposal of assets

Provisions are to be reviewed at the end of each reporting period and adjusted to reflect the current best estimate.

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Venture capital valuation method

Venture capital valuation method

With the estimation challenges that analysts face in valuing young companies, it should come as no surprise that they look for solutions that seem to, at least on the surface, offer them a way out. Many of these solutions, though, are the source of the valuation errors we see in young company valuations. In this section, we will look at the most common manifestations of what we view as the dark side in young company valuations, and how they play out in the venture capital valuation method.

  1. Top line and bottom line, no detail: It is difficult to estimate the details on cash flow and reinvestment for young companies. Consequently, many valuations of young companies focus on the top line (revenues) and the bottom line (earnings, and usually equity earnings), with little or no attention paid to either the intermediate items (that separate earnings from revenues) or the reinvestment requirements (that separate earnings from cash flows)
  2. Focus on the short term, rather than the long term: The uncertainty we feel about the estimates that we make for young companies become greater as we go further out in time. Many analysts use this as a rationale for cutting short the estimation period, using only three to five years of forecasts in the valuation. “It is too difficult to forecast out beyond that point in time” is the justification that they offer for this short time horizon.
  3. Mixing relative with intrinsic valuation: To deal with the inability to estimate cash flows beyond short time periods, analysts who value young companies use relative valuation as a crutch. Thus, the value at then end of the forecast period (three to five years) is often estimated by applying an exit multiple to the expected revenues or earnings in that year and the value of that multiple is itself estimated by looking at what publicly traded companies in the business trade at right now.
  4. Discount rate as the vehicle for all uncertainty: The risks associated with investing in a young company include not only the traditional factors – earnings volatility and sensitivity to macroeconomic conditions, for example – but also the likelihood that the firm will not survive to make a run at commercial success. When valuing private businesses, analysts often hike up discount rates to reflect all of the concerns that they have about the firm, including the likelihood that the firm will not make it.
  5. Ad hoc and arbitrary adjustments for differences in equity claims: As we noted in the last section, equity claims in young businesses can have different rights when it comes to cash flow and control and have varying degrees of illiquidity. When asked to make judgments on the value of prior claims on cash flows, superior control rights or lack of liquidity, many analysts use rules of thumb that are either arbitrary or based upon dubious statistical samples.

All five of these practices come into play in the most common approach used to value young firms, which is the venture capital approach. This approach has four steps to it:

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Cash flow forecasting

A Basic Guide to Cash Flow Forecasting

Nobody wants their business to fail. Although it’s impossible to predict the future with 100% accuracy, a cash flow forecast is a tool that will help you prepare for different possible scenarios in the future.

In a nutshell, cash flow forecasting involves estimating how much cash will be coming in and out of your business within a certain period and gives you a clearer picture of your business’ financial health

What is Cash Flow Forecasting?

Cash flow forecasting is the process of estimating how much cash you’ll have and ensuring you have a sufficient amount to meet your obligations. By focusing on the revenue you expect to generate and the expenses you need to pay, cash flow forecasting can help you better manage your working capital and plan for various positive or difficult scenarios.

A cash flow forecast is composed of three key elements: beginning cash balance, cash inflows (e.g., cash sales, receivables collections), and cash outflows (e.g., expenses for utilities, rent, loan payments, payroll).

Building Out Cash Flow Scenario Models

It’s always good to create best case, worst-case and moderate financial scenarios. Through cash flow forecasting, you’ll Cash flow forecastingbe able to see the impact of these three scenarios and implement the suitable course of action. You can use the models to predict what needs to happen especially during difficult and uncertain times.

In situations where variables shift quickly such as during a recession, it is highly recommended to review and update your cash flow forecasts regularly on a monthly or even weekly basis. By monitoring your cash flow forecast closely, you’ll be able to identify warning signs such as declining revenue or increasing expenses.

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IFRS 15 Customers unexercised rights and breakage

IFRS 15 Customers unexercised rights and breakage

INTRO An entity may receive a non-refundable prepayment from a customer that gives the customer the right to receive goods or services in the future. Common examples include gift cards, vouchers and non-refundable tickets. Typically, some customers do not exercise their right – this is referred to as ‘breakage’.

An entity recognises a prepayment received from a customer as a contract liability and recognises revenue when the promised goods or services are transferred in the future. However, a portion of the contract liability recognised may relate to contractual rights that the entity does not expect to be exercised – i.e. a breakage amount. [IFRS 15.B44–B45]

The timing of revenue recognition related to breakage depends on whether the entity expects to be entitled to a breakage amount – i.e. if it is highly probable that recognising breakage will not result in a significant reversal of the cumulative revenue recognised. [IFRS 15.B46]

Customers unexercised rights

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