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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Transfer pricing – IAS 12 Best complete read

Transfer pricing
 for
transactions between related parties

A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an inter-company transaction. Although inter-company transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for preparation of individual tax returns each entity (or a tax consolidation unit of more than one entity in the group in one and the same tax jurisdiction) prepares stand-alone (or a tax consolidation unit) tax returns.

See also:

IAS 24 Related parties narrative IFRS 15 Revenue narrative IAS 12 Income tax narrative

Transfer prices directly affect the allocation of group-wide taxable income across national tax jurisdictions. Hence, a group’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.

Arm’s length transaction principle

Most OECD countries rely upon the OECD TP Guidelines for Multinational Enterprises and Tax Administrations, that were originally released in 1995 and subsequently updated in 2017 (OECD TP Guidelines). The OECD TP Guidelines reaffirmed the OECD’s commitment to the arm’s length transaction principle.

In fact, the arm’s length transaction principle is considered “the closest approximation of the workings of the open market in cases where goods and services are transferred between associated enterprises.” The arm’s length principle implies that transfer prices between related parties should be set as though the entities were operating at arm’s length (i.e. were independent enterprises).

The application of the arm’s length transaction principle is generally based on a comparison of all the relevant conditions in a controlled transaction with the conditions in an uncontrolled transaction (i.e. a transaction between independent enterprises).

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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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Definition of provision – IAS 37 Complete easy read

Definition of provision

The definition of provision is key to IAS 37. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. In the past, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results they believe that their various stakeholder may want.

As part of the attempt of IASB to further restrict this type of earnings management within IFRSs, IASB adopted an update of IAS 37 in April 2001 originating from September 1998. IAS 37 was further updated for Onerous contracts – Costs of fulfilling a contract in May 2020.

IAS 37: ‘Onerous Contracts – Cost of Fulfilling a Contract’

lAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the entity’s obligations exceed the economic benefits to be received under that contract. Unavoidable costs are the lower of the net cost of exiting the contract and the costs to fulfil the contract. The amendment clarifies the meaning of ‘costs to fulfil a contract’.

The amendment explains that the direct cost of fulfilling a contract comprises:

  • the incremental costs of fulfilling that contract (for example, direct labour and materials); and
  • an allocation of other costs that relate directly to fulfilling contracts (for example, an allocation ofthe depreciation charge for an item of PP&E used to fulfil the contract).

The amendment also clarifies that, before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets used in fulfilling the contract, rather than on assets dedicated to that contract.

The amendment could result in the recognition of more onerous contract provisions, because previously some entities only included incremental costs in the costs to fulfil a contract.

The key definition of provision

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11 Best fair value measurements under IFRS 13

11 Best fair value measurements under IFRS 13

Several IFRS standards provide guidance regarding the scope and application of the fair value option for assets and liabilities. Here they are from 1 to 11…….

1 Investments in associates and joint ventures

Investments held by venture capital organizations and the like are exempt from IAS 28’s requirements only when they are measured at fair value through profit or loss (FVPL) in accordance with IFRS 9. Changes in the fair value (FV) of such investments are recognized in profit or loss in the period of change.

The IASB acknowledged that FV information is often readily available in venture capital organizations and entities in similar industries, even for start-up and non-listed entities, as the methods and basis for fair value measurement are well established. The IASB also confirmed that the reference to well-established practice is to emphasize that the exemption applies generally to those investments for which fair value is readily available.

2 Intangible assets

Subsequent to initial recognition of intangible assets, an entity may adopt either the cost model or the revaluation model as its accounting policy. The policy should be applied to the whole of a class of intangible assets and not merely to individual assets within a class11 Best fair value measurements under IFRS 13, unless there is no active market for an individual asset.

The revaluation model may only be adopted if the intangible assets are traded in an active market; hence it is not frequently used. Further, the revaluation model may not be applied to intangible assets that have not previously been recognized as assets. For example, over the years an entity might have accumulated for nominal consideration a number of licenses of a kind that are traded on an active market. 11 Best fair value measurements under IFRS 13

The entity may not have recognized an intangible asset as the licenses were individually immaterial when acquired. If market prices for such licenses significantly increased, the value of the licenses held by the entity would substantially increase. In this case, the entity would be prohibited by IAS 38 from applying the revaluation model to the licenses, because they were not previously recognized as an asset.

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Excellent Study IFRS 9 Eligible Hedged items

IFRS 9 Eligible Hedged items

the insured items of business risk exposures

Although the popular definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

Every entity is exposed to business risks from its daily operations. Many of those risks have an impact on the cash flows or the value of assets and liabilities, and therefore, ultimately affect profit or loss. In order to manage these risk exposures, companies often enter into derivative contracts (or, less commonly, other financial instruments) to hedge them. Hedging can, therefore, be seen as a risk management activity in order to change an entity’s risk profile.

The idea of hedge accounting is to reduce (insure) this mismatch by changing either the measurement or (in the case of certain firm commitments) FRS 9 Eligible Hedged itemsrecognition of the hedged exposure, or the accounting for the hedging instrument.

The definition of a Hedged item

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that

  1. exposes the entity to risk of changes in fair value or future cash flows and
  2. is designated as being hedged

The hedge item can be:

Only assets, liabilities, firm commitments and forecast transactions with an external party qualify for hedge accounting. As an exception, a hedge of the foreign currency risk of an intragroup monetary item qualifies for hedge accounting if that foreign currency risk affects consolidated profit or loss. In addition, the foreign currency risk of a highly probable forecast intragroup transaction would also qualify as a hedged item if that transaction affects consolidated profit or loss. These requirements are unchanged from IAS 39.

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