1.1 Background

Most share-based payment transactions undertaken by entities are awards of shares and options as remuneration to employees, in particular senior management and directors. One advantage of shares and options as remuneration is that they need not entail any cash cost to the entity. If an executive is entitled under a bonus scheme to a free share, the entity can satisfy this award simply by printing another share certificate, which the executive can sell, so that the cash cost of the award is effectively borne by shareholders rather than by the entity itself. However, this very advantage was the source of controversy surrounding share-based remuneration.

Investors became increasingly concerned that share-based remuneration was resulting in a significant cost to them, through dilution of their existing shareholdings. As a result, there emerged an increasing consensus among investors that awards of shares and share options should be recognised as a cost in the financial statements.

Accounting for share-based payment transactions is addressed in Section 26 – Share-based Payment. However, many of the requirements of Section 26 are virtually impossible to interpret without recourse to IFRS 2 – Share-based Payment – from which many of the requirements and definitions of Section 26 were ultimately derived.

The IASB published IFRS 2 in February 2004. There have been three subsequent sets of amendments to IFRS 2 as well as a number of clarifications through the IASB's Annual Improvements process. The most recent amendments to IFRS 2 were published in June 2016 and were mandatory for accounting periods beginning on or after 1 January 2018 for entities applying IFRS. These June 2016 amendments have not been incorporated into FRS 102 but are referred to, where relevant, in the discussions of IFRS 2 in this chapter.

1.2 Scope of Chapter 23 and referencing convention

This chapter generally discusses the requirements of Section 26 for entities applying FRS 102 in accounting periods beginning on or after 1 January 2019. It is based on the March 2018 version of FRS 102 which includes the amendments in 2017. Section 26 has had incremental improvements and clarifications made to it as a result of the Amendments to FRS 102 Triennial review 2017 – Incremental improvements and clarifications (Triennial review 2017), with retrospective effect. The March 2018 version of FRS 102 is referred to as ‘FRS 102’ throughout this chapter.

As noted at 1.1 above, the requirements of Section 26 are virtually impossible to interpret without recourse to IFRS 2, which contains extensive application and implementation guidance. Without this guidance, the practical application of the requirements of Section 26 is difficult and we therefore draw on the guidance in IFRS 2 as part of the explanation in this chapter, applying the hierarchy on selecting accounting policies as set out in Section 10 – Accounting Policies, Estimates and Errors (see Chapter 9 at 3.2).

The application of Section 26 – and IFRS 2 – to a variety of practical situations is unclear. Whilst this chapter addresses some of the complexities, other areas of discussion are beyond the scope of this publication. EY International GAAP 2019 includes a more detailed analysis in certain areas, as indicated later in this chapter.

1.3 Overview of accounting approach

The overall approach to accounting for share-based payment transactions is complex, in part because it is something of a hybrid. Essentially the total cost (i.e. measurement) of an award is calculated by determining whether the award is a liability or an equity instrument, using criteria somewhat different from those used in accounting for financial instruments but then applying measurement principles based on those generally applicable to financial liabilities or equity instruments. However the periodic allocation (i.e. recognition) of the cost¹ is determined using something closer to a straight-line accruals methodology, which would not generally be used for financial instruments.

This inevitably has the result that, depending on its legal form, a transaction of equal value to the recipient can result in several different potential charges in profit or loss. Moreover, many of the requirements are rules derived from the ‘anti-avoidance’ approach of IFRS 2. This means that an expense often has to be recorded for transactions that either have no ultimate value to the counterparty or to which, in some cases, the counterparty actually has no entitlement at all.

2.1 Scope

2.2 Recognition

2.3 Measurement of equity-settled share-based payment transactions

2.4 Cash-settled share-based payment transactions

Until the publication of an amendment to IFRS 2 in June 2016, the treatment of service and non-market performance conditions in determining the fair value of a cash-settled share-based payment transaction was unclear. The amendment clarified that the approach should be similar to that for equity-settled share-based payment transactions rather than the probability of such conditions being reflected directly in measuring the fair value of the liability. In the absence of a similar clarification to the wording of paragraph 14 of Section 26, we believe that either interpretation remains valid for cash-settled arrangements under FRS 102 (see 10.3.2.C below).

2.5 Share-based payment transactions with cash alternatives

2.6 Group plans

2.7 Government-mandated plans

2.8 Plans with net settlement for tax withholding obligations

The June 2016 amendment to IFRS 2 introduced an exception for transactions with a net settlement feature for tax withholding obligations. Following application of the amendment, awards meeting the exception criteria will be accounted for in their entirety as equity-settled rather than being separated into an equity-settled element and a cash-settled element. There is no comparable exception for entities applying FRS 102. See 15.3 below.

2.9 Disclosures

The disclosure requirements of Section 26 are generally derived from, but less extensive than, those of IFRS 2. However, Section 26 has three specific requirements that are not found in IFRS 2:

• if a valuation methodology is used to determine the fair value of equity-settled awards, the entity is required to disclose both the method and reason for choosing it;
• for cash-settled share-based payment transactions, an entity is required to disclose how the liability was measured; and
• where the alternative accounting treatment is adopted for group plans, disclosure of this fact is required together with the basis of allocation.

More generally, unlike IFRS, FRS 102 includes exemptions from disclosure for certain entities.

The disclosure requirements are discussed at 14 below.

2.10 First-time adoption

The first-time adoption provisions of FRS 102 are set out in Section 35 – Transition to this FRS. The specific requirements relating to share-based payments are discussed at 17 below. Unlike IFRS 1 – First-time Adoption of International Financial Reporting Standards, Section 35 does not specify the accounting treatment of an award that was granted prior to transition but subsequently modified.

3.1 Definitions

The following definitions from Appendix I: Glossary to FRS 102 are relevant to the scope of Section 26.

The definition of a share-based payment transaction was revised as part of the Triennial review 2017 and is now consistent with IFRS 2.

It will be seen from these definitions that FRS 102 applies not only to awards of shares and share options but also to awards of cash (or other assets) of a value equivalent to the value, or a movement in the value, of a particular number of shares.

3.2 Transactions within the scope of Section 26

Subject to the exceptions noted at 3.3 below, Section 26 must be applied to all share-based payment transactions, including:

1. equity-settled share-based payment transactions (discussed at 5 to 9 below);
2. cash-settled share-based payment transactions (discussed at 10 below); and
3. transactions where either the entity or the supplier of goods or services can choose whether the transaction is to be equity-settled or cash-settled (discussed at 11 below). [FRS 102.26.1].

Whilst the boundaries between these types of transaction are reasonably self-explanatory, there may be transactions – as discussed in more detail at 10 and 11 below – that an entity may intuitively regard as equity-settled which are in fact required to be treated as cash-settled.

Although the majority of share-based payment transactions are with employees, the scope of Section 26 is not restricted to employee transactions. For example, if an external supplier of goods or services, including another group entity, is paid in shares or share options, or cash of equivalent value, Section 26 must be applied.

A share-based payment transaction as defined in FRS 102 (see 3.1 above) requires goods or services to be received or acquired, but FRS 102 does not define ‘goods’ or give any additional guidance as to what might be included within such a term. IFRS 2 includes the following within its scope and it seems appropriate to use this guidance for the purposes of Section 26:

• inventories;
• consumables;
• property, plant and equipment (PP&E);
• intangibles; and
• other non-financial assets. [IFRS 2.5].

It will be seen that ‘goods’ do not include financial assets, which raises some further issues (see 3.3.6 below).

Although not always explicitly stated, the scope of Section 26 extends to:

• certain transactions by other group entities and by shareholders of group entities (see 3.2.1 below);
• transactions with employee benefit trusts (‘EBTs’) and similar vehicles (see 3.2.2 below);
• certain transactions where the identifiable consideration received appears to be less than the consideration given (see 3.2.3 below); and
• ‘all employee’ share plans (see 3.2.4 below).

Section 26 is silent on certain other transactions or arrangements, including vested transactions (see 3.2.5 below), where it is unclear whether the transactions or arrangements fall within the scope of the share-based payment accounting requirements.

In the absence of specific guidance in FRS 102 we suggest that entities follow the requirements of IFRS 2, or general practice that has evolved through the application of IFRS 2, as set out in the sections below.

3.2.1 Transactions by other group entities and shareholders

The definition of ‘share-based payment transaction’ (see 3.1 above) and additional requirements in paragraph 1A of Section 26 have the effect that the scope of Section 26 is not restricted to transactions where the reporting entity acquires goods or services in exchange for providing its own equity instruments (or cash or other assets based on the cost or value of those equity instruments). Within a group of companies it is common for one member of the group (typically the parent) to have the obligation to settle a share-based payment transaction in which services are provided to another member of the group (typically a subsidiary). This transaction is within the scope of Section 26 for the entity receiving the services (even though it is not a direct party to the arrangement between its parent and its employee), the entity settling the transaction and the group as a whole.

Accordingly, Section 26 requires an entity to account for a transaction in which it either:

• receives goods or services when another entity in the same group (or shareholder of any group entity) has the obligation to settle the share-based payment transaction; or
• has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services

unless the transaction is clearly for a purpose other than payment for goods or services supplied to the entity receiving them. [FRS 102.26.1A].

Moreover, the definition of ‘equity-settled share-based payment transaction’ (see 3.1 above) has the effect that the analysis of the transaction as equity-settled or cash-settled (and its accounting treatment) may differ when viewed from the perspective of the entity receiving the goods or services, the entity settling the transaction and the group as a whole depending on whether or not an entity is required to settle the award and whether that settlement is in its own equity instruments.

The Triennial review 2017 clarified that an entity settling a share-based payment transaction is required to account for that transaction as a cash-settled share-based payment transaction when:

• another group entity is receiving the goods and services; and
• the award is not settled with the equity instruments of the settling entity. [FRS 102.26.2A].

3.2.1.A Scenarios illustrating scope requirements for group entities

In this section we consider seven scenarios, all based on the simple structure in Figure 23.1. These scenarios are by no means exhaustive, but cover the situations most commonly seen in practice.

It should be noted that the scenarios below are based on the scope requirements of Section 26 as set out at 3.2.1 above and do not reflect the additional exemption for members of group schemes. This exemption allows the group expense to be allocated between members of the group on a reasonable basis rather than requiring each group entity to recognise and measure its expense in accordance with the general requirements of Section 26. [FRS 102.26.16]. The exemption and the accounting treatment of group share schemes generally are discussed in more detail at 13 below.

The scenarios assume that:

• the shareholder is not a group entity; and
• the subsidiary is directly owned by the parent company (see also 13.2.1 below in relation to intermediate parent companies).

 

Scenario	Who grants the award?	Which entity receives the goods or services?	Who settles the award?	On which entity's shares is the award based?	Award settled in shares or cash?
1	Parent	Subsidiary	Parent	Parent	Shares
2	Shareholder	Subsidiary	Shareholder	Parent	Shares
3	Subsidiary	Subsidiary	Subsidiary	Parent	Shares
4	Subsidiary	Subsidiary	Subsidiary	Subsidiary	Shares
5	Parent	Subsidiary	Parent	Subsidiary	Shares
6	Parent	Subsidiary	Parent	Parent	Cash
7	Shareholder	Subsidiary	Shareholder	Parent	Cash

Scenario 1

Parent awards equity shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Parent settles the award with the employees of Subsidiary.

1. Consolidated financial statements of Parent

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent group] … receives goods or services … in a share-based payment arrangement …’. A share-based payment arrangement includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … equity instruments … of the entity …’.

   The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of the group.

2. Separate financial statements of Parent

   Parent does not receive the goods or services but it does have the obligation to settle. This is within the scope of paragraph 1A(b) of Section 26 as Parent ‘has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services’. The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of Parent. [FRS 102.26.2A].

3. Subsidiary

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement …’. A ‘share-based payment arrangement’ includes ‘an agreement between … another group entity [i.e. Parent] … and another party (including an employee) that entitles the other party to receive … equity instruments of … another group entity’.

   The transaction is classified as an equity-settled transaction because Subsidiary ‘has no obligation to settle the transaction with the supplier’.

   Even if Subsidiary is not a party to the agreement with its employees, it nevertheless records a cost for this transaction. In effect, the accounting treatment is representing that Subsidiary has received a capital contribution from Parent, which Subsidiary has then ‘spent’ on employee remuneration. This treatment is often referred to as ‘push-down’ accounting – the idea being that a transaction undertaken by one group entity (in this case, Parent) for the benefit of another group entity (in this case, Subsidiary) is ‘pushed down’ into the financial statements of the beneficiary entity.

Scenario 2

Shareholder awards equity shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Shareholder settles the award with the employees of Subsidiary.

1. Consolidated financial statements of Parent

   Paragraph 1A of Section 26 refers to awards settled by a shareholder of a group entity on behalf of the entity receiving the goods or services.

   The transaction is classified as an equity-settled transaction, because the Parent group ‘receives goods or services but has no obligation to settle the transaction with [the] supplier’.

2. Separate financial statements of Parent

   Scenario 2 is not within the scope of Section 26 for the separate financial statements of Parent because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.

3. Subsidiary

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement …’. A ‘share-based payment arrangement’ includes ‘an agreement between … another group entity [i.e. Parent] … and another party (including an employee) that entitles the other party to receive … equity instruments of … another group entity’.

   The transaction is classified as an equity-settled transaction because Subsidiary ‘has no obligation to settle the transaction with the supplier’.

Scenario 3

Subsidiary awards equity shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Subsidiary settles the award with its employees.

1. Consolidated financial statements of Parent

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent group] … receives goods or services … in a share-based payment arrangement …’. A share-based payment arrangement includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … equity instruments … of the entity …’

   The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of Parent. [FRS 102.26.2A].

2. Separate financial statements of Parent

   Scenario 3 is not within the scope of Section 26 for the separate financial statements of Parent because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.

3. Subsidiary

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement …’. A ‘share-based payment arrangement’ includes ‘an agreement between … another group entity [i.e. Parent] … and another party (including an employee) that entitles the other party to receive … equity instruments of … another group entity’.

   The transaction is classified as a cash-settled transaction because Subsidiary has the obligation to settle the award with equity instruments issued by Parent – i.e. a financial asset in Subsidiary's separate financial statements – rather than with Subsidiary's own equity instruments.

   However, for the approach in this Scenario to apply, it must be the case that Subsidiary grants the award as a principal rather than acting as agent for Parent. If Subsidiary appears to be granting an award but is really doing so only on the instructions of Parent, as will generally be the case for UK companies, then the approach in Scenario 1 above is more likely to apply. This is discussed in more detail at 13.2-5-B below.

Scenario 4

Subsidiary awards equity shares in Subsidiary to employees of Subsidiary in exchange for services to Subsidiary. Subsidiary settles the award with the employees of Subsidiary.

1. Consolidated financial statements of Parent

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent group] … receives goods or services … in a share-based payment arrangement’. A share-based payment arrangement includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … equity instruments … of the entity …’.

   In the consolidated financial statements of Parent, shares of Subsidiary not held by Parent are a non-controlling interest.

   Separate financial statements of Parent

   Scenario 4 is not within the scope of Section 26 for the separate financial statements of Parent because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.

2. Subsidiary

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement’. A share-based payment arrangement includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … equity instruments … of the entity …’.

   The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of Subsidiary.

Scenario 5

Parent awards equity shares in Subsidiary to employees of Subsidiary in exchange for services to Subsidiary. Parent settles the award with the employees of Subsidiary.

1. Consolidated financial statements of Parent

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent group] … receives goods or services … in a share-based payment arrangement’. A share-based payment arrangement includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … equity instruments of the entity …’.

   The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of the group. In the consolidated financial statements of Parent, shares of Subsidiary not held by Parent are a non-controlling interest.

2. Separate financial statements of Parent

   Parent does not receive the goods or services but it does have the obligation to settle. This is within the scope of paragraph 1A(b) of Section 26 as Parent ‘has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services’. The transaction is classified as a cash-settled transaction as Parent is settling the award not in its own equity instrument but in an equity instrument issued by a subsidiary and held by Parent – i.e. a financial asset in Parent's separate financial statements. [FRS 102.26.2A].

3. Subsidiary

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement’. A ‘share-based payment arrangement’ includes ‘an agreement between … another group entity [i.e. Parent] … and another party (including an employee) that entitles the other party to receive equity instruments of the entity…’.

   The transaction is classified as an equity-settled transaction, because Subsidiary ‘has no obligation to settle the transaction with the supplier’.

Scenario 6

Parent awards cash based on the value of shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Parent settles the award with the employees of Subsidiary.

1. Consolidated financial statements of Parent

   Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent group] … receives goods or services … in a share-based payment arrangement’. A ‘share-based payment arrangement’ includes ‘an agreement between the entity … and another party (including an employee) that entitles the other party to receive … cash … of the entity … based on the price (or value) of equity instruments … of the entity …’.

   The transaction is classified as a cash-settled transaction, because it is settled in cash of the group.

2. Separate financial statements of Parent

   Parent does not receive the goods or services but it does have the obligation to settle. This is within the scope of paragraph 1A(b) of Section 26 as Parent ‘has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services’. The transaction is classified as a cash-settled transaction, because it is settled not in an equity instrument issued by Parent, but in cash based on the value of shares in Parent.

3. Subsidiary

   When the drafting of the definition of a ‘share-based payment transaction’ is examined closely, it is not absolutely clear that this arrangement is within the scope of Section 26 for Subsidiary. In order to be a share-based payment transaction (and therefore in the scope of Section 26) for the reporting entity, a transaction must also be a share-based payment arrangement. A share-based payment arrangement is defined as one in which the counterparty receives (our emphasis added):

   • cash or other assets of the entity; or
   • equity of the entity or any other group entity.
4. As drafted, the definition has the effect that a transaction settled in equity is in the scope of Section 26 for a reporting entity, whether the equity used to settle the transaction is the entity's own equity or that of another group entity. Where a transaction is settled in cash, however, the definition has the effect that a transaction is in the scope of Section 26 for a reporting entity only when that entity's own cash (or other assets) is used in settlement, and not when another group entity settles the transaction.

When read with the general scope requirements in paragraphs 1 and 1A, we believe that the apparent omissions from the definition of ‘share-based payment transaction’ should be regarded as minor drafting errors and that the transaction should be classified as an equity-settled transaction by Subsidiary, because Subsidiary ‘receives goods or services but has no obligation to settle the transaction with the supplier’.

Scenario 7

Shareholder awards cash based on the value of shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Shareholder settles the award with the employees of Subsidiary.

This transaction is within the scope of paragraph 1A of Section 26 for the consolidated financial statements of Parent and for the separate financial Subsidiary as it is a transaction where the shareholder has an obligation to settle on behalf of the entity receiving the goods or services. However, it does not strictly meet the definitions in Appendix I. As noted at Scenario 6 above, the definitions of ‘share-based payment transaction’ and ‘cash-settled share-based payment transaction’ as drafted do not explicitly address any arrangement that is settled in cash by a party other than the reporting entity.

Nevertheless, we believe that the transaction should be treated as being within the scope of Section 26 for the consolidated financial statements of Parent and the separate financial statements of Subsidiary and the transaction accounted for as equity-settled.

3.3 Transactions not within the scope of Section 26

Section 26 simply states that share-based transactions that are clearly for a purpose other than payment to the entity for goods or services are not within its scope. [FRS 102.26.1A]. It does not include any more specific examples of transactions that are outside the scope of its requirements. IFRS 2 includes some specific scope exemptions and we imagine that similar exemptions are intended to apply in the application of Section 26. The following transactions are outside the scope of IFRS 2:

• transactions with shareholders as a whole and with shareholders in their capacity as such (see 3.3.1 below);
• transfers of assets in certain group restructuring arrangements (see 3.3.2 below);
• business combinations (see 3.3.3 below);
• combinations of businesses under common control and the contribution of a business to form a joint venture (see 3.3.4 below); and
• transactions in the scope of IAS 32 – Financial Instruments: Presentation – and IAS 39 – Financial Instruments: Recognition and Measurement – or IFRS 9 – Financial Instruments – or Section 22 (see 3.3.5 below). In addition, the scope exemptions in IFRS 2 combined with those in IAS 32 and IAS 39 (or IFRS 9) appear to have the effect that there is no specific guidance in IFRS for accounting for certain types of investments when acquired in return for shares (see 3.3.6 below).

However, as noted at 3.2.4 above, there is no exemption for share schemes aimed mainly at lower- and middle-ranking employees, referred to in different jurisdictions by terms such as ‘all-employee share schemes’, ‘employee share purchase plans’ and ‘broad-based plans’.

3.4 Some practical applications of the scope requirements

This section addresses the application of the scope requirements of Section 26 to a number of situations frequently encountered in practice. The situations are not specifically addressed in Section 26 but the following sections draw on the requirements of Section 26 together with related guidance in IFRS 2 and our experience of the practical application of IFRS 2:

• remuneration in non-equity shares and arrangements with put rights over equity shares (see 3.4.1 below);
• an increase in the counterparty's ownership interest with no change in the number of shares held (see 3.4.2 below);
• awards for which the counterparty has paid ‘fair value’ (see 3.4.3 below);
• a cash bonus which depends on share price performance (see 3.4.4 below);
• cash-settled awards based on an entity's ‘enterprise value’ or other formula (see 3.4.5 below); and
• holding own shares to satisfy or ‘hedge’ awards (see 3.4.6 below).

The following aspects of the scope requirements are covered elsewhere in this chapter:

• employment taxes on share-based payment transactions (see 15 below); and
• instruments such as limited recourse loans that sometimes fall within the scope of the share-based payment, rather than financial instruments, requirements because of the link both to the entity's equity instruments and to goods or services received in exchange (see 16.2 below).

4.1 Vesting and vesting conditions

Under Section 26, the point at which a cost is recognised for goods or services depends on the concept of ‘vesting’.

A share-based payment to a counterparty is said to vest when it becomes an entitlement of the counterparty. The term is further defined as follows:

‘Under a share-based payment arrangement, a counterparty's right to receive cash, other assets or equity instruments of the entity vests when the counterparty's entitlement is no longer conditional on the satisfaction of any vesting conditions.’ [FRS 102 Appendix I].

This definition refers only to equity instruments of the entity and omits any reference to equity instruments of other group entities. This appears to be a drafting oversight given that the scope of Section 26 and the definitions of equity- and cash-settled share-based payment transactions in Appendix I to FRS 102 all refer to the equity instruments of the entity and other group entities.

The definition above refers to ‘vesting conditions’. Prior to the Triennial review 2017 this term was not defined in FRS 102. However, the standard now defines the term and is consistent with IFRS 2. Vesting conditions are defined as ‘conditions that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. Vesting conditions are either service conditions or performance conditions.’ [FRS 102 Appendix I].

The definition of vesting conditions emphasises the receipt of services by the entity. The recognition principles in FRS 102 using this approach set out the differing accounting treatments, discussed further below, depending on whether the share-based payment transaction includes a service condition. A service condition is, ‘a 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 service during the vesting period, it has failed to satisfy the condition. A service condition does not require a performance target to be met.’ [FRS 102 Appendix I].

The absence of a service requirement means that an award will vest, or be deemed to vest, immediately as there is no service to be rendered before the counterparty becomes unconditionally entitled to the award. This concept of immediate vesting is reinforced by the fact that FRS 102 requires an entity to presume, in the absence of evidence to the contrary, that services rendered by the counterparty (for example, an employee) as consideration for the share-based payments have already been received. Where there is immediate vesting, the entity is required to recognise the services received, i.e. the cost of the award, in full on the grant date of the award with a corresponding credit to equity or liabilities. [FRS 102.26.5].

If, as will generally be the case for employee awards, the share-based payments do not vest until the counterparty completes a specified period of service, the entity should presume that the services to be rendered by the counterparty as consideration for those share-based payments will be received in the future, during the vesting period, i.e. the period over which the services are being rendered in order for the award to vest. The entity is required to account for those services as they are rendered by the counterparty during the vesting period, with a corresponding increase in equity or liabilities. [FRS 102.26.6]. For example, if an employee is granted a share option with a service condition of remaining in employment with an entity for three years, the award vests three years after the date of grant. Accordingly, if the employee is still employed by the entity the cost of the award will be recognised over that three-year period.

As mentioned above, the vesting of awards might also be conditional on performance conditions which require both the counterparty to complete a specified period of service and specified performance targets to be met. Following the amendment to FRS 102 from the Triennial review 2017, the standard includes the following definition of a ‘performance condition’ consistent with IFRS 2:

‘A vesting condition that requires:

1. the counterparty to complete a specified period of service (i.e. a service condition); the service requirement can be explicit or implicit; and
2. specified performance target(s) to be met while the counterparty is rendering the service required in (a).

The period of achieving the performance target(s):

1. shall not extend beyond the end of the service period; and
2. may start before the service period on the condition that the commencement date of the performance target is not substantially before the commencement of the service period;

A performance target is defined by reference to:

1. the entity's own operations (or activities) or the operations or activities of another entity in the same group (i.e. a non-market condition); or
2. the price (or value) of the entity's equity instruments or the equity instruments of another entity in the same group (including shares and share options) (i.e. a market condition).

A performance target might relate either to the performance of the entity as a whole or to some part of the entity (or part of the group), such as a division or an individual employee.' [FRS 102 Appendix I].

Examples of performance conditions are a specified increase in the entity's profit over a specified period of time (a non-market condition – see 7.2 below) or a specified increase in the entity's share price (a market condition – see 7.3 below). [FRS 102.26.9]. As discussed more fully at 4.2 below, performance conditions refer to performance by an employee (such as a personal sales target) or performance by the entity (or part of the entity), rather than an external performance indicator, such as a general stock market index.

Thus a condition that an award vests if, in three years' time, earnings per share have increased by 10% and the employee is still in employment, is a performance condition. If, however, the award becomes unconditional in three years' time if earnings per share have increased by 10%, irrespective of whether the employee is still in employment, that condition is not a performance condition, but a ‘non-vesting’ condition because there is no associated service requirement (see 4.2 below).

In addition to the general discussion above and in the remainder this section, specific considerations relating to awards that vest on a flotation or change of control (or similar exit event) are addressed at 16.4 below.

4.2 Non-vesting conditions (conditions that are neither service conditions nor performance conditions)

Some share-based payment transactions are dependent on the satisfaction of conditions that are neither service conditions nor performance conditions. For example, an employee might be given the right to 100 shares in three years' time, subject only to the employee not working in competition with the reporting entity during that time. An undertaking not to work for another entity does not include a requirement for the counterparty to complete a specified period of service with the entity – the employee could sit on a beach for three years and still be entitled to collect the award. Accordingly, such a condition is not regarded as a vesting condition for the purposes of Section 26, but is instead referred to as a ‘condition that is not a vesting condition’. [FRS 102.26.9]. Alternatively IFRS 2 refers to such a condition as a ‘non-vesting condition’. Throughout this chapter we will refer to a ‘condition that is not a vesting condition’ as a ‘non-vesting condition’ (see 2.3.1 above).

Section 26 introduces the concept of a non-vesting condition when discussing the measurement of equity-settled awards, providing an example of a condition when an employee contributes to a saving plan as a condition that is not vesting condition, but does not otherwise define the term. [FRS 102.26.9]. Given the similarities of approach to recognition and measurement in IFRS 2 and Section 26, we presume that the concept of a non-vesting condition under FRS 102 is intended to be the same as that under IFRS 2 and this is the approach adopted in this chapter. The accounting impact of non-vesting conditions is discussed in detail at 7.4 below.

Although IFRS 2 contains a little more explanation about non-vesting conditions than is found in FRS 102, it does not explicitly define a ‘non-vesting condition’ but uses the term to describe a condition that is neither a service condition nor a performance condition. However, the concept of the ‘non-vesting’ condition is not entirely clear and the identification of such conditions is not always straightforward. This has sometimes resulted in differing views on the appropriate classification of certain types of condition depending on whether or not they were considered to be measures of the entity's performance or its activities and hence performance vesting conditions.

As noted at 4.1 above, FRS 102 and IFRS 2 define a vesting condition as a condition that determines whether the entity receives the services that entitle the counterparty to receive payment in equity or cash. Performance conditions are those that require the counterparty to complete a specified period of service and specified performance targets to be met (such as a specified increase in the entity's profit over a specified period of time).

The Basis for Conclusions to IFRS 2 adds that the feature that distinguishes a performance condition from a non-vesting condition is that the former has an explicit or implicit service requirement and the latter does not. [IFRS 2.BC171A].

In issuing its Annual Improvements to IFRSs 2010-2012 Cycle in December 2013 the IASB considered whether a definition of ‘non-vesting condition’ was needed. It decided that ‘the creation of a stand-alone definition … would not be the best alternative for providing clarity on this issue’. [IFRS 2.BC364]. Instead, it sought to provide further clarification in the Basis for Conclusions to IFRS 2, as follows:

‘…the Board observed that the concept of a non-vesting condition can be inferred from paragraphs BC170-BC184 of IFRS 2, which clarify the definition of vesting conditions. In accordance with this guidance it can be inferred that a non-vesting condition is any condition that does not determine whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity under a share-based payment arrangement. In other words, a non-vesting condition is any condition that is not a vesting condition.’ [IFRS 2.BC364].

For a condition to be a performance vesting condition, it is not sufficient for the condition to be specific to the performance of the entity. There must also be an explicit or implied service condition that extends to the end of the performance period. For example, a condition that requires the entity's profit before tax or its share price to reach a minimum level, but without any requirement for the employee to remain in employment throughout the performance period, is not a performance condition, but a non-vesting condition.

Specific examples of non-vesting conditions given by IFRS 2 include:

• a requirement to make monthly savings during the vesting period;
• a requirement for a commodity index to reach a minimum level;
• restrictions on the transfer of vested equity instruments; or
• an agreement not to work for a competitor after the award has vested – a ‘non-compete’ agreement. [IFRS 2.BC171B, IG24].

The IASB has also clarified that a condition related to a share market index target (rather than to the specific performance of the entity's own shares) is a non-vesting condition because a share market index reflects not only the performance of an entity but also that of other entities outside the group. Even where an entity's share price makes up a substantial part of the share market index, the IASB confirmed that this would still be a non-vesting condition because it reflects the performance of other, non-group, entities. [IFRS 2.BC354-358].

Thus, whilst conditions that are not related to the performance of the entity are always, by their nature, non-vesting conditions, conditions that relate to the performance of the entity may or may not be non-vesting conditions depending on whether there is also a requirement for the counterparty to render service.

As noted at 4.1 above, FRS 102 and IFRS 2 define a performance condition. The definition clarifies the extent to which the period of achieving the performance target(s) needs to coincide with the service period and states that this performance period:

1. shall not extend beyond the end of the service period; and
2. may start before the service period on the condition that the commencement date of the performance target is not substantially before the commencement of the service period.

There clearly remains an element of judgement in the interpretation of ‘substantially’ as used in the definition.

There is further discussion of the accounting treatment of non-vesting conditions at 7.4 below.

4.3 Vesting period

As noted at 4.1 above, the vesting period is the period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied. This is not the same as the exercise period or the life of the option, as illustrated by Example 23.1 below.

It is also important to distinguish between vesting conditions and other restrictions on the exercise of options and / or trading in shares, as illustrated by Example 23.2 below.

The accounting implications of vesting conditions, non-vesting conditions and vesting periods for equity-settled transactions are discussed at 5 to 8 below and for cash-settled transactions at 10 below.

5.1 Summary of accounting treatment

The provisions relating to accounting for equity-settled transactions are complex, even when supplemented by additional guidance as is found in the appendices and implementation guidance to IFRS 2. As noted at 1.2 above, FRS 102 does not replicate this guidance and so we have referred to IFRS 2 to supplement the requirements of FRS 102.

The key points can be summarised as follows.

1. All equity-settled transactions are measured at fair value. However, transactions with employees are measured using a ‘grant date model’ (i.e. the transaction is recorded at the fair value of the equity instrument at the date when it is originally granted), whereas transactions with non-employees are normally measured using a ‘service date model’ (i.e. the transaction is recorded at the fair value of the goods or services received at the date they are received). As noted at 4 above, all transactions, however measured, are recognised using a ‘service date model’ (see 6 below).
2. Where an award is made subject to future fulfilment of conditions, a ‘market condition’ (i.e. one related to the market price (or value) of the entity's equity instruments) or a ‘non-vesting condition’ (i.e. one that is neither a service condition nor a performance condition) is taken into account in determining the fair value of the award. However, the effect of conditions other than market and non-vesting conditions is ignored in determining the fair value of the award (see 4 above and 7 below).
3. Where an award is made subject to future fulfilment of service or performance vesting conditions, its cost is recognised over the period during which the service condition is fulfilled (see 4 above and 7 below). The corresponding credit entry is recorded within equity (see 5.2 below).
4. Until an equity instrument has vested (i.e. the entitlement to it is no longer conditional on future service) any amounts recorded are in effect contingent and will be adjusted if more or fewer awards vest than were originally anticipated to do so. However, an equity instrument awarded subject to a market condition or a non-vesting condition is considered to vest irrespective of whether or not that market or non-vesting condition is fulfilled, provided that all other vesting conditions are satisfied (see 7 below).
5. No adjustments are made, either before or after vesting, to reflect the fact that an award has no value to the employee or other counterparty e.g. in the case of a share option, because the option exercise price is above the current market price of the share (see 7.1.1 and 7.1.3 below).
6. If an equity instrument is cancelled, whether by the entity or the counterparty (see (g) below) before vesting, any amount remaining to be expensed is charged in full at that point (see 8.4 below). If an equity instrument is modified before vesting (e.g. in the case of a share option, by changing the performance conditions or the exercise price), the financial statements must continue to show a cost for at least the fair value of the original instrument, as measured at the original grant date, together with any excess of the fair value of the modified instrument over that of the original instrument, as measured at the date of modification (see 8.3 below).
7. Where an award lapses during the vesting period due to a failure by the counterparty to satisfy a non-vesting condition within the counterparty's control, or a failure by the entity to satisfy a non-vesting condition within the entity's control, the lapse of the award is accounted for as if it were a cancellation (see (f) above and 7.4.3 below).
8. In determining the cost of an equity-settled transaction, whether the entity satisfies its obligations under the transaction with a fresh issue of shares or by purchasing its own shares in the financial markets or from private company shareholders is completely irrelevant to the charge in profit or loss, although there is clearly a difference in the cash flows. Where own shares are purchased, they are accounted for as treasury shares (see 3.4.6 above).

The requirements summarised in (d) to (g) above can have the effect that an entity is required to record a cost for an award that is deemed to vest for accounting purposes but ultimately has no value to the counterparty because the award either does not vest or vests but is not exercised. These rather counter-intuitive requirements are in part ‘anti-abuse’ provisions to prevent entities from applying a ‘selective’ grant date model, whereby awards that increase in value after grant date remain measured at grant date while awards that decrease in value are remeasured. This is discussed further in the detailed analysis at 6 to 8 below.

5.2 The credit entry

As noted at (c) in the summary at 5.1 above, the basic accounting entry for an equity-settled share-based payment transaction is: [FRS 102.26.3]

• • Dr Profit or loss for the period (employee costs)
    • Cr Equity.

FRS 102 does not prescribe whether the credit should be to a separate reserve or, if the entity chooses to treat it as such, how it should be described. Under the Companies Act 2006, an entity is permitted to credit a separate ‘other reserve’ rather than the credit being allocated initially to the profit and loss reserve. The ‘other reserve’ is generally labelled as ‘shares to be issued’ or ‘share-based payment reserve’ with the share-based payment credit held within this reserve until the award vests (if an award of free shares), is exercised or lapses (an award of options). When such trigger events occur, it will be appropriate for the entity to make a transfer between reserves.

The FRS 102 credit is not taken to share capital and share premium as these are used to record the legal proceeds of a share issue.

Overall, there will be a net nil impact on equity arising from the FRS 102 accounting as the profit and loss expense is ultimately reflected in the profit and loss reserve and offset by the credit taken directly to equity. The impact on distributable profits of employee share schemes depends on whether or not the reporting entity is a public company. Whilst FRS 102 is not specifically addressed, the effect of the similar accounting requirements of IFRS 2 is discussed in Section 7 of TECH 02/17BL: Guidance on Realised and Distributable Profits under the Companies Act 2006 (TECH 02/17BL). [TECH 02/17BL.7].

Occasionally there will be a credit to profit or loss (see for instance Example 23.12 at 7.2.4 below) and a corresponding reduction in equity.

6.1 Cost of awards – overview

The general measurement rule in FRS 102 is that an entity must measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the fair value of the goods or services received cannot be estimated reliably, the entity must measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. [FRS 102.26.7].

‘Fair value’ is defined in Appendix I to FRS 102 as ‘the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction’. The definition goes on to make clear that, in the absence of more specific guidance within individual sections of FRS 102, the Appendix to Section 2 – Concepts and Pervasive Principles – should be used in determining fair value. Therefore, where the fair value of a share-based payment is based on the fair value of the goods or services, the Section 2 Appendix guidance should be used. Where the share-based payment is measured on the basis of the fair value of the equity instruments rather than the goods or services, Section 26 has its own specific rules in relation to determining the fair value which differ from the more general fair value measurement requirements of FRS 102 (see 6.5 below).

On their own, the general measurement principles of paragraph 7 of Section 26 might suggest that the reporting entity must determine in each case whether the fair value of the equity instruments granted or that of the goods or services received is more reliably determinable. However, paragraph 7 goes on to clarify that, in the case of transactions with employees and others providing similar services, the fair value of the equity instruments must always be used ‘because typically it is not possible to estimate reliably the fair value of the services received’ (see 6.2 below). [FRS 102.26.7].

Moreover, transactions with employees and others providing similar services are measured at the date of grant (see 6.2 below), whereas those with non-employees are measured at the date when the entity obtains the goods or the counterparty renders service (see 6.4 below). [FRS 102.26.8].

The overall position can be summarised by the following matrix.

One effect of a grant date measurement model is that, applied to a grant of share options that is eventually exercised, it ‘freezes’ the accounting cost at the (typically) lower fair value at the date of grant. This excludes from the post-grant financial statements the increased cost and volatility that would be associated with a model that constantly remeasured the award to fair value until exercise date.

The price to be paid in accounting terms for the grant date model is that, when an award falls in value after grant date, it continues to be recognised at its higher grant date value. It is therefore quite possible that, during a period of general economic downturn, financial statements will show significant costs for options granted in previous years, but which are currently worthless.

6.2.1 Who is an ‘employee’?

Given the difference between the accounting treatment of equity-settled transactions with employees and with non-employees, it is obviously important to understand what is meant by ‘employees and others providing similar services’. [FRS 102.26.7]. FRS 102 does not provide a definition but IFRS 2 defines ‘employees and others providing similar services’ as individuals who render personal services to the entity and either:

1. the individuals are regarded as employees for legal or tax purposes;
2. the individuals work for the entity under its direction in the same way as individuals who are regarded as employees for legal or tax purposes; or
3. the services rendered are similar to those rendered by employees.

The term encompasses all management personnel, i.e. those persons having authority and responsibility for planning, directing and controlling the activities of the entity, including non-executive directors. [IFRS 2 Appendix A].

The implication of (a) and (b) above is that it is not open to an entity to argue that an individual who is not an employee as a matter of law is therefore automatically a non-employee for the purposes of IFRS 2 and FRS 102.

The implication of (b) and (c) above is that, where a third party provides services pursuant to a share-based payment transaction that could be provided by an employee (e.g. where an external IT consultant works alongside an in-house IT team), that third party is treated as an employee rather than a non-employee for the purposes of IFRS 2 and FRS 102.

Conversely, however, where an entity engages a consultant to undertake work for which there is not an existing in-house function, the implication is that such an individual is not regarded as an employee. In other words, in our view, the reference in (c) to ‘services … similar to those rendered by employees’ is to services rendered by employees that the entity actually has, rather than to employees that the entity might have if it were to recruit them. Otherwise, the distinction in IFRS 2 and FRS 102 between employees and non-employees would have no effect, since it would always be open to an entity to argue that it could employ someone to undertake any task instead of engaging a contractor.

Exceptionally, there might be cases where the same individual is engaged in both capacities. For example, a director of the entity might also be a partner in a firm of lawyers and be engaged in that latter capacity to advise the entity on a particular issue. It might be more appropriate to regard payment for the legal services as made to a non-employee rather than to an employee.

6.2.2 Basis of measurement

As noted above, equity-settled transactions with employees must be measured by reference to the fair value of the equity instruments granted at ‘grant date’ (see 6.3 below). [FRS 102.26.8]. FRS 102 offers no explanation as to why this should be the case, but IFRS 2 asserts that this approach is necessary because shares, share options and other equity instruments are typically only part of a larger remuneration package, such that it would not be practicable to determine the value of the work performed in consideration for the cash element of the total package, the benefit-in-kind element, the share option element and so on. [IFRS 2.12].

In essence, this is really an anti-avoidance provision. The underlying concern is that, if an entity were able to value options by reference to the services provided for them, it might assert that the value of those services was zero, on the argument that its personnel are already so handsomely rewarded by the non-equity elements of their remuneration package (such as cash and health benefits), that no additional services are (or indeed could be) obtained by granting options.

6.3.1 Determination of grant date

The definition of ‘grant date’ in Appendix I to FRS 102 (see 6.3 above) emphasises that a grant occurs only when all the conditions are understood and agreed by the parties to the arrangement and any required approval process has been completed. This is reinforced by the implementation guidance accompanying the same definition in IFRS 2 which, in our view, should also be considered by an entity applying FRS 102.

For example, if an entity makes an award ‘in principle’ to an employee of options whose terms are subject to review or approval by a remuneration committee or the shareholders, ‘grant date’ is the later date when the necessary formalities have been completed. [FRS 102 Appendix I, IFRS 2.IG1-3].

The implementation guidance to IFRS 2 emphasises that the word ‘agree’ is ‘used in its usual sense, which means that there must be both an offer and an acceptance of that offer’. Therefore, there cannot be a grant unless an offer by one party has been accepted by the other party. The guidance notes that agreement will be explicit in some cases (e.g. if an agreement has to be signed), but in others it might be implicit, such as when an employee starts to deliver services for the award. [IFRS 2.IG2]. Determination of when the counterparty has agreed to an offer will often be an area of judgement that depends on the precise facts and circumstances of a particular situation.

The implementation guidance to IFRS 2 further notes that employees may begin rendering services in consideration for an award before it has been formally ratified. For example, a new employee might join an entity on 1 January and be granted options relating to performance for a period beginning on that date, but subject to formal approval by the remuneration committee at its next quarterly meeting on 15 March. In that case, the entity would typically begin expensing the award from 1 January based on a best estimate of its fair value, but would subsequently adjust that estimate so that the ultimate cost of the award was its actual fair value at 15 March (see 6.3.2 below). [IFRS 2.IG4]. This reference to formal approval could be construed as indicating that, in fact, FRS 102 and IFRS 2 require not merely that there is a mutual understanding of the award (which might well have been in existence since 1 January), but also that the entity has completed all processes necessary to make the award a legally binding agreement.

In practice, many situations are much less clear-cut than the examples given in the implementation guidance. Some of the practical interpretation issues are considered further below.

6.3.2 Communication of awards to employees and services in advance of grant date

As discussed at 6.3.1 above, the definition of grant date in FRS 102 together with the implementation guidance to IFRS 2 indicate that, in order for a grant to have been made, there must not merely be a mutual understanding of the terms – including the conditions attached to the award – but there must also be a legally enforceable arrangement. Thus, if an award requires board or shareholder approval for it to be legally binding on the reporting entity, it has not been granted until such approval has been given, even if the terms of the award are fully understood at an earlier date. However, if services are effectively being rendered for an award from a date earlier than the grant date as defined in IFRS 2, the cost of the award should be recognised over a period starting with that earlier date. [IFRS 2.IG4].

In some situations the employee will have a valid expectation of an award, and the entity will have a corresponding obligation, based on an earlier commitment by the entity. However, it might be the case that not all of the precise terms and conditions have been finalised. In our view, provided it is possible to estimate the fair value of the arrangement, an estimated cost for services should be recognised in advance of grant date in such cases as well as in those situations where formal approval does not take place until a later date.

The implications of this approach are illustrated in Example 23.3 below for a situation where formal approval of an award is delayed. It is important, however, to retain a sense of proportion in considering the overall impact on the financial statements. For example, in cases where the share price or value is not particularly volatile, whether the grant date is, say, 1 January or 1 April may not make a great difference to the valuation of the award, particularly when set beside the range of acceptable valuations resulting from the use of estimates in the valuation process.

Examples of situations where an employee might render service in advance of the formal grant date because the precise conditions of an award are outstanding are considered at 6.3.3 to 6.3.6 and at 16.4.1 below.

6.3.3 Exercise price or performance target dependent on a formula or future share price

Some share plans define the exercise price not in absolute terms, but as a factor of the share price. For example, the price might be expressed as:

• a percentage of the share price at exercise date; or
• a percentage of the lower of the share price at grant date and at exercise date.

The effect of this is that, although the actual exercise price is not known until the date of exercise, both the entity and the counterparty already have a shared understanding of how the price will be calculated and it is possible to estimate the outcome on an ongoing basis without the need for additional approval or inputs.

A similar approach might be applied in the setting of performance targets, i.e. they are set by reference to a formula rather than in absolute terms and so do not require further input by the entity or its shareholders.

In order for there to be a shared understanding and a grant date, the formula or method of determining the outcome needs to be sufficiently clear and objective to allow both the entity and the counterparty to make an estimate of the outcome of the award during the vesting period. Accordingly, in our view, grant date is the date on which the terms and conditions (including the formula for calculating the exercise price or performance target) are determined sufficiently clearly and agreed by the entity and the counterparty, subject to the matters discussed at 6.3.2 above.

6.3.4 Exercise price paid in shares (net settlement of award)

Some share awards allow the exercise price to be paid in shares. In practical terms, this means that the number of shares delivered to the counterparty will be the total ‘gross’ number of shares awarded less as many shares as have, at the date of exercise, a fair value equal to the exercise price.

In our view, this situation is analogous to that described at 6.3.3 above in that, whilst the absolute ‘net’ number of shares awarded will not be known until the date of exercise, the basis on which that ‘net’ number will be determined is established in advance. Accordingly, in our view, grant date is the date on which the terms and conditions (including the ability to surrender shares to a fair value equal to the exercise price) are determined and agreed by the entity and the counterparty, subject to the matters discussed at 6.3.2 above.

Such a scheme could be analysed as a share-settled share appreciation right (whereby the employee receives shares to the value of the excess of the value of the shares given over the exercise price), which is accounted for as an equity-settled award.

Awards settled in shares net of a cash amount to meet an employee's tax liability are considered further at 15.3 below.

6.3.5 Award of equity instruments to a fixed monetary value

Some entities may grant awards to employees of shares to a fixed value. For example, an entity might award as many shares as are worth £10,000, with the number of shares being calculated by reference to the share price as at the vesting date. The number of shares ultimately received will not be known until the vesting date. This begs the question of whether such an award can be regarded as having been granted until that date, on the argument that it is only then that the number of shares to be delivered – a key term of the award – is known, and therefore there cannot be a ‘shared understanding’ of the terms of the award until that later date.

In our view, however, this situation is analogous to those in 6.3.3 and 6.3.4 above in that, whilst the absolute number of shares awarded will not be known until the vesting date, the basis on which that number will be determined is established in advance in a manner sufficiently clear and objective as to allow an ongoing estimate by the entity and by the counterparty of the number of awards expected to vest. Accordingly, in our view, grant date is the date on which the terms and conditions are determined sufficiently clearly and agreed by the entity and the counterparty, subject to the matters discussed at 6.3.2 above.

FRS 102 does not address the valuation of such awards and IFRS 2 does not address it directly. Intuitively, it might seem obvious that an award which promises (subject to vesting conditions) shares to the value of £10,000 must have a grant date fair value of £10,000, adjusted for the time value of money, together with market conditions and non-vesting conditions. However, matters are not so clear-cut, as Example 23.4 illustrates:

Whilst there are hints in the Basis for Conclusions to IFRS 2 that the IASB thought that the two awards should be similarly valued, this treatment is not made explicitly clear.

Some argue that an award of shares to a given monetary amount contains a market condition, since the number of shares ultimately delivered (and therefore vesting) depends on the market price of the shares on the date of delivery. This allows the award to be valued at a fixed amount at grant date. We acknowledge that a literal reading of the definition of ‘market condition’ in FRS 102 and IFRS 2 supports this view, but question whether this can really have been intended. In our view, the essential feature of a share-based payment transaction subject to a market condition must be that the employee's ultimate entitlement to the award depends on the share price rather than the share price simply being used to determine the number of shares.

In our view, the principal question is whether the measurement of the transaction should be based on the overall award or on each share or share equivalent making up the award. In the absence of clear guidance as to the appropriate unit of account, entities may take a number of views on how to value awards of shares to a given value, but should adopt a consistent approach for all such awards.

6.3.6 Awards with multiple service and performance periods

Entities frequently make awards that cover more than one reporting period, but with different performance conditions for each period, rather than a single cumulative target for the whole vesting period. In such cases, the grant date may depend on the precision with which the terms of the award are communicated to employees, as illustrated by Example 23.5 below.

A variation on the above two scenarios which is seen quite frequently in practice is an award where the target is quantified for the first year and the targets for subsequent years depend on a formula-based increase in the year 1 target. The formula is set at the same time as the year 1 target. Whether the accounting treatment for scenario 1 above or scenario 2 above is the more appropriate in such a situation is, in our view, a matter of judgement depending on the precise terms of the arrangement (see 6.3.3 above).

6.3.7 Awards subject to modification by entity after original grant date

Some employee share awards are drafted in terms that give the entity discretion to modify the detailed terms of the scheme after grant date. Some have questioned whether this effectively means that the date originally determined as the ‘grant date’ is not in fact the grant date as defined in FRS 102, on the grounds that the entity's right to modify means that the terms are not in fact understood by both parties in advance.

In our view, this is very often not an appropriate analysis. If it were, it could mean that significant numbers of share-based awards to employees (including most in the UK) would be required to be measured at vesting date, which clearly is not intended under the grant date model in Section 26.

However, the assessment of whether or not an intervention by the entity after grant date constitutes a modification is often difficult. Some situations commonly encountered in practice are considered in the sections below.

6.3.8 ‘Good leaver’ arrangements

It is common for awards to contain a so-called ‘good leaver’ clause. A ‘good leaver’ clause is one which makes provision for an employee who leaves before the end of the full vesting period of an award nevertheless to receive some or all of the award on leaving (see 6.3.8.A below).

In other cases, the original terms of an award will either make no reference to ‘good leavers’ or will not be sufficiently specific to allow the accounting treatment on cessation of employment to be an automatic outcome of the original terms of the scheme. In such cases, and in situations where awards are made to leavers on a fully discretionary basis, the accounting approach differs from that required where the original terms are clear about ‘good leaver’ classification and entitlement (see 6.3.8.B below).

We refer throughout this section on ‘good leavers’ to an employee leaving employment, but similar considerations apply when an individual automatically becomes entitled to an award before the end of the original vesting period due to other reasons specified in the terms of the agreement, e.g. attaining a certain age or achieving a specified length of service, even if the individual remains in employment after the relevant date. In these situations, the date of full entitlement is the date on which any services – and therefore expense recognition – cease for the purposes of Section 26.

Arrangements for a good leaver to receive all, or part, of an award on leaving employment should be distinguished from a situation where an employee leaves with no award and where forfeiture accounting is likely to apply (see 8.4.1.A below).

6.3.9 Awards over a fixed pool of shares (including ‘last man standing’ arrangements)

An award over a fixed pool of shares is sometimes granted to a small group of, typically senior, employees. Such awards might involve an initial allocation of shares to each individual but also provide for the redistribution of each employee's shares to the other participants should any individual leave employment before the end of the vesting period. This is often referred to as a ‘last man standing’ arrangement.

The accounting requirements for such an arrangement are unclear and discussion of the various approaches seen in practice is beyond the scope of this publication. In the absence of specific guidance, several interpretations are possible and these are discussed in EY International GAAP 2019.

6.4.1 Effect of change of status from employee to non-employee (or vice versa)

Neither FRS 102 nor IFRS 2 gives specific guidance on how to account for an award when the status of the counterparty changes from employee to non-employee (or vice versa) but, in all other respects, the award remains unchanged. In our view, the accounting following the change of status will depend on the entity's assessment of whether or not the counterparty is performing the same or similar services before and after the change of status.

If it is concluded that the counterparty is providing the same or similar services before and after the change of status, the measurement approach remains unchanged. However, if the services provided are substantially different, the accounting following the change of status will be determined by the counterparty's new status.

A change of status is rare in practice. A detailed discussion is beyond the scope of this publication but the matter is addressed in EY International GAAP 2019.

7.1.1 The continuous estimation process of Section 26

The overall objective is that, at the end of the vesting period, the cumulative cost recognised in profit or loss (or, where applicable, included in the carrying amount of an asset), should represent the product of:

• the number of equity instruments that have vested, or would have vested, but for the failure to satisfy a market condition (see 7.3 below) or a non-vesting condition (see 7.4 below); and
• the fair value (excluding the effect of any non-market vesting conditions, but including the effect of any market conditions or non-vesting conditions) of those equity instruments at the date of grant.

It is essential to appreciate that the ‘grant date’ measurement model in FRS 102 seeks to capture the value of the contingent right to shares promised at grant date, to the extent that the promise becomes (or is deemed to become – see 7.1.2 below) an entitlement of the counterparty, rather than the value of any shares finally delivered. Therefore, if an option vests, but is not exercised because it would not be in the counterparty's economic interest to do so, FRS 102 still recognises a cost for the award.

In order to achieve this outcome, FRS 102 requires the following process to be applied:

1. at grant date, the fair value of the award (excluding the effect of any service and non-market performance vesting conditions, but including the effect of any market conditions or non-vesting conditions (conditions that are not vesting conditions)) is determined;
2. at each subsequent reporting date until vesting, the entity calculates a best estimate of the cumulative charge to profit or loss at that date, being the product of:
   1. the grant date fair value of the award determined in (a) above;
   2. the current best estimate of the number of awards that will vest (see 7.1.2 below); and
   3. the expired portion of the vesting period;
3. the charge (or credit) to profit or loss for the period is the cumulative amount calculated in (b) above less the amounts already charged in previous periods. There is a corresponding credit (or debit) to equity; [FRS 102.26.3-9]
4. once the awards have vested, no further accounting adjustments are made to the cost of the award, except in respect of certain modifications to the award – see 8 below; and
5. if a vested award is not exercised, an entity may (but need not) make a transfer between reserves – see 7.1.3 below.

The overall effect of this process is that a cost is recognised for every award that is granted, except when it is forfeited for failure to meet a vesting condition (see 7.1.2 below). [FRS 102.26.9].

It is stated above, service conditions and non-market performance vesting conditions are not taken into account in determining the fair value of an equity-settled share-based payment transaction. This approach was clarified in the Triennial review 2017 in paragraph 9 of Section 26 which requires market conditions and conditions that are not vesting conditions being reflected in the fair value of awards and other vesting conditions being taken into account in estimating the number of awards expected finally to vest.

7.1.2 Vesting and forfeiture

In normal English usage, and in many share scheme documents, an award is described as ‘vested’ when all the conditions needed to earn it have been met, and as ‘forfeited’ where it lapses before vesting because one or more of the conditions has not been met.

IFRS 2 uses the term ‘forfeiture’ in a much more restricted sense to refer to an award that does not vest in IFRS 2 terms. FRS 102 takes a similar approach although it does not specifically refer to ‘forfeiture’ of an award. Essentially the approach is as follows:

• where an award is subject only to vesting conditions other than market conditions, failure to satisfy any one of the conditions is treated as a forfeiture (and any cumulative expense recognised to date is reversed);
• where an award is subject to both
  • vesting conditions other than market conditions, and
  • market conditions and/or non-vesting conditions,

  failure to satisfy any one of the vesting conditions other than market conditions is treated as a forfeiture. Otherwise (i.e. where all the vesting conditions other than market conditions are satisfied), the award is deemed to vest even if the market conditions and/or non-vesting conditions have not been satisfied; and

• where an award is subject only to non-vesting conditions, it is always deemed to vest.

Where an award has been modified (see 8.3 below) so that different vesting conditions apply to the original and modified elements of an award, forfeiture will not apply to the original award if the service and non-market performance conditions attached to that element have been met. This will be the case even if the service and non-market performance conditions attached to the modified award have not been met and so the modified award is considered to have been forfeited (resulting in the reversal of any incremental expense relating to the modification). Examples 23.24 and Examples 23.25 at 8.3 below illustrate this point.

As a result of the interaction of the various types of condition, the reference in the summary at 7.1.1 above to the ‘best estimate of the number of awards that will vest’ really means the best estimate of the number of awards for which it is expected that all non-market vesting conditions will be met.

In practice, however, it is not always clear how that best estimate is to be determined, and in particular what future events may and may not be factored into the estimate. This is discussed further at 7.2 to 7.4 and 8.6 below.

7.1.3 Accounting after vesting

FRS 102 does not address specifically the treatment of share-based payment transactions once they have vested but it seems appropriate to adopt the approach required by IFRS 2.

Once an equity-settled transaction has vested (or, in the case of a transaction subject to one or more market or non-vesting conditions, has been treated as vested – see 7.1.2 above), no further accounting entries are made to reverse the cost already charged, even if the instruments that are the subject of the transaction are subsequently forfeited or, in the case of options, are not exercised. However, the entity may make a transfer between different components of equity. [IFRS 2.23]. For example, an entity's accounting policy might be to credit all amounts recorded for share-based transactions to a separate reserve such as ‘Shares to be issued’. Where an award lapses after vesting, it would then be appropriate to transfer an amount equivalent to the cumulative cost for the lapsed award from ‘Shares to be issued’ to another component of equity, usually the profit and loss reserve.

This prohibition against ‘truing up’ (i.e. reversing the cost of vested awards that lapse) is controversial, since it has the effect that a cost is still recognised for options that are never exercised, typically because they are ‘underwater’ (i.e. the current share price is lower than the option exercise price), so that it is not in the holder's interest to exercise the option.

7.2.1 Awards with service conditions

Most share-based payment transactions with employees are subject to explicit or implied service conditions. Examples 23.8 and Examples 23.9 below illustrate the application of the allocation principles discussed at 7.1 above to awards subject only to service conditions which are based on the implementation guidance to IFRS 2. [IFRS 2.IG11].

7.3.1 What is a ‘market condition’?

The Glossary to FRS 102 defines the term ‘market vesting condition’, whereas paragraph 9 of Section 26 refers to ‘market conditions’ and ‘market vesting conditions’ which sets out the principles of measuring an equity-settled share-based payment. We believe that the terms are synonymous and from here on we will refer to the condition as a market condition. A market condition is defined as ‘a condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price of the entity's equity instruments, such as attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving a specified target that is based on the market price of the entity's equity instruments relative to an index of market prices of equity instruments of other entities’. [FRS 102 Appendix I]. In order for a market condition to be treated as a performance vesting condition rather than as a non-vesting condition, there must also be an implicit or explicit service condition (see 4.2 above).

The ‘intrinsic value’ of a share option is defined as ‘the difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares’. [FRS 102 Appendix I]. In other words, an option to acquire for £8 a share with a fair value of £10 has an intrinsic value of £2. A performance condition based on the share price and one based on the intrinsic value of the option are effectively the same, since the values of each will obviously move in parallel.

Section 26 includes a specified increase in the entity's share price as an example of a market condition. [FRS 102.26.9]. A market condition often seen in practice, although more common in a listed entity and not specifically mentioned in FRS 102, is a condition based on total shareholder return (TSR). TSR is a measure of the increase or decrease in a given sum invested in an entity over a period on the assumption that all dividends received in the period had been used to purchase further shares in the entity. The market price of the entity's shares is an input to the calculation.

However, a condition linked to a purely internal financial performance measure such as profit or earnings per share is not a market condition. Such measures will affect the share price or value, but are not directly linked to it, and hence are not market conditions.

A condition linked solely to a general market index is not a market condition, but a non-vesting condition (see 4.2 above and 7.4 below), because the reporting entity's own share price is not relevant to the satisfaction of the condition.

However, if the condition were that the entity's own share price had to outperform a general index of shares, that condition would be a market condition because the reporting entity's own share price is then relevant to the satisfaction of the condition.

7.3.2 Summary of accounting treatment

The key feature of the accounting treatment of an equity-settled transaction subject to a market condition is that the market condition is taken into account in valuing the award at the date of grant, ‘with no subsequent adjustment to the estimated fair value, irrespective of the outcome of the market condition or condition that is not a vesting condition, provided that all other vesting conditions are satisfied’. [FRS 102.26.9(b)]. In other words, an award is treated as vesting irrespective of whether the market condition is satisfied, provided that all other service and non-market performance vesting conditions are satisfied. The requirements relating to market conditions can have rather controversial consequences, as illustrated by Example 23.14.

Therefore, an award is sometimes treated as vesting (and a cost is recognised for that award) when it does not actually vest in the natural sense of the word. See also Example 23.16 at 7.3.4 below.

This treatment is clearly significantly different from that for transactions involving a non-market vesting condition, where no cost would be recognised where the conditions were not met. As discussed at 7.2 above, the methodology prescribed for transactions with a vesting condition other than a market condition is to determine the fair value of the option ignoring the condition and then to multiply that fair value by the estimated (and ultimately the actual) number of awards expected to vest based on the likelihood of that non-market vesting condition being met.

In any event, it appears that it may be possible to soften the impact of the rules for market conditions relatively easily by introducing a non-market vesting condition closely correlated to the market condition. For instance, the option in Example 23.14 above could be modified so that exercise was dependent not only upon the £7 target share price and continuous employment, but also on a target growth in earnings per share. Whilst there would not be a perfect correlation between earnings per share and the share price, it would be expected that they would move roughly in parallel, particularly if the entity has historically had a fairly consistent price/earnings ratio. Thus, if the share price target were not met, it would be highly likely that the earnings per share target would not be met either. This would allow the entity to show no cumulative cost for the option, since only one (i.e. not all) of the non-market related vesting conditions would have been met.

Similarly, entities in sectors where the share price is closely related to net asset value (e.g. property companies and investment trusts) could incorporate a net asset value target as a non-market performance condition that would be highly likely to be satisfied only if the market condition was satisfied.

The matrices below illustrate the interaction of market conditions and vesting conditions other than market conditions. Matrix 1 summarises the possible outcomes for an award with the following two vesting conditions:

• the employee remaining in service for three years (service condition); and
• the entity's share price increasing by 10% over the vesting period (share price target).

It will be seen that, to all intents and purposes, the ‘Share price target (market condition) met?’ column is redundant, as this is not relevant to whether or not the award is treated as vesting for accounting purposes. The effect of this is that the entity would recognise an expense for outcome 2, even though no awards truly vest.

Matrix 2 summarises the possible outcomes for an award with the same conditions as in Matrix 1, plus a requirement for earnings per share to grow by a general inflation index plus 10% over the period (‘EPS target’).

Again it will be seen that, to all intents and purposes, the ‘Share price target (market condition) met?’ column is redundant, as this is not relevant to whether or not the award is treated as vesting. The effect of this is that the entity would recognise an expense for outcome 2, even though no awards truly vest. However, no expense would be recognised for outcome 4, which is, except for the introduction of the EPS target, equivalent to outcome 2 in Matrix 1, for which an expense is recognised. This illustrates that the introduction of a non-market vesting condition closely related to a market condition may mitigate the impact of the accounting requirements.

Examples of the application of the accounting treatment for transactions involving market conditions are given at 7.3.3 and 7.3.4 below.

7.3.3 Transactions with market conditions and known vesting periods

Following on from the discussion at 7.3.2 above, the accounting for these transactions is essentially the same as that for transactions without market conditions but with a known vesting period (including ‘graded’ vesting – see 7.2.2 above), except that adjustments are made to reflect the changing probability of the achievement of the non-market vesting conditions only, as illustrated by Example 23.15 below (based partly on IG Example 5 in the implementation guidance to IFRS 2). [FRS 102.26.9].

7.3.4 Transactions with variable vesting periods due to market conditions

Where a transaction has a variable vesting period due to a market condition, a best estimate of the most likely vesting period will have been used in determining the fair value of the transaction at the date of grant. IFRS 2 requires the expense for that transaction to be recognised over an estimated expected vesting period consistent with the assumptions used in the valuation, without any subsequent revision. [IFRS 2.15(b), IG14]. FRS 102 does not specify the accounting treatment in this situation but it seems consistent with the general requirement in paragraph 9 of Section 26 that there should be ‘no subsequent adjustment to the estimated fair value, irrespective of the outcome of the market condition’ to adopt a similar approach to that required by IFRS 2.

This may mean, for example, that if the actual vesting period for an employee share option award turns out to be longer than that anticipated for the purposes of the initial valuation, a cost is nevertheless recorded in respect of all employees who reach the end of the anticipated vesting period, even if they do not reach the end of the actual vesting period, as shown by Example 23.16 below, which is based on IG Example 6 in the implementation guidance in IFRS 2.

IFRS 2 does not specifically address the converse situation, namely where the award actually vests before the end of the anticipated vesting period. In our view, where this occurs, any expense not yet recognised at the point of vesting should be immediately accelerated. We consider that this treatment is most consistent with the overall requirement of IFRS 2 – and FRS 102 – to recognise an expense for share-based payment transactions ‘as the services are received’. [IFRS 2.7, FRS 102.26.3]. It is difficult to regard any services being received for an award after it has vested.

Moreover, the prohibition in paragraph 15 of IFRS 2 on adjusting the vesting period as originally determined refers to ‘the estimate of the expected vesting period’. In our view, the acceleration of vesting that we propose is not the revision of an estimated period, but the substitution of a known vesting period for an estimate.

Suppose in Example 23.16 above, the award had in fact vested at the end of year 4. We believe that the expense for such an award should be allocated as follows:

7.3.5 Transactions with multiple outcomes depending on market conditions

In practice, it is very common for an award subject to market conditions to give varying levels of reward that increase depending on the extent to which a ‘base line’ market performance target has been exceeded. Such an award is illustrated in Example 23.17 below.

It can be seen that the (perhaps somewhat counterintuitive) impact of this is that an equity-settled share-based payment where the number of shares increases in line with increases in the entity's share price may nevertheless have a fixed grant date value irrespective of the number of shares finally awarded.

7.3.6 Transactions with independent market conditions, non-market vesting conditions or non-vesting conditions

7.3.7 Awards based on the market value of a subsidiary or business unit

Awards with a market condition are frequently based on the market value of the (typically quoted) equity instruments of the parent entity. However, some entities implement share-based remuneration schemes which aim to reward employees by reference to the market value of the equity of the business unit for which they work. The detail of such schemes varies, but the general effect is typically as follows:

• at grant date, the employee is allocated a (real or notional) holding in the equity of the employing subsidiary, the market value of which is measured at grant date; and
• the employee is granted an award of as many shares of the listed parent as have a value, at a specified future date (often at, or shortly after, the end of the vesting period but sometimes at a later date), equal to the increase over the vesting period in the market value of the employee's holding in the equity of the employing subsidiary.

Some take the view that such a scheme contains a market condition, since it depends on the fair value of the subsidiary's shares, with the result that the grant date fair value per share:

• reflects this market condition (see 7.3.2 above); and
• is fixed, irrespective of how many parent company shares are finally issued, since the entity has effectively issued a market-based award with multiple outcomes based on the market value of the equity of a subsidiary (see 7.3.5 above).

In our view, however, the required accounting treatment of such schemes is not as straightforward as suggested by this analysis. A fundamental issue is whether any award dependent on the change in value of the equity of an unquoted entity contains a market condition at all. A market condition is defined (see 7.3.1 above) as one dependent on the ‘market price’ of the entity's equity. Prima facie, if there is no market, there is no market price.

Notwithstanding the absence of a market, some argue that there are generally accepted valuation techniques for unquoted equities which can yield a fair value as a surrogate for market value. The difficulty with that argument, in our view, is that the definition of ‘market condition’ refers to ‘market price’ and not to ‘fair value’. The latter term is, of course, used extensively elsewhere in Section 26 (and in IFRS 2), which suggests that the two terms were not considered to be interchangeable. This concern is reinforced by that fact that, in the ‘valuation hierarchy’ for the measurement of share awards in paragraph 10 of Section 26, a quoted market price is given as the preferred (but not the only) method of arriving at fair value (see 9 below).

An entity implementing such an award must therefore make an assessment, in any particular situation, of whether the basis on which the subsidiary equity is valued truly yields a market price (or value) or merely a fair value according to a hypothetical valuation model.

Furthermore, in order for there to be a market condition there needs to be a specified performance target. It is not always clear in such situations that there is such a target if the various outcomes depend on an exchange of shares regardless of the level of market price or value achieved by the subsidiary.

If it is considered that there is no market condition within the arrangement and there is simply an exchange of shares – in effect, using one entity's shares as the currency for the other – then the arrangement might nonetheless be viewed as containing a non-vesting condition (similar to when an arrangement depends on the performance of an index for example (see 4.2 above and 7.4 below)). Like a market condition, a non-vesting condition would be taken into account in determining the fair value of the award and would result in a fixed grant date fair value irrespective of the number of shares finally delivered.

7.4.1 Awards with no conditions other than non-vesting conditions

Any award that has only non-vesting conditions (e.g. an option award to an employee that may be exercised on a trade sale or IPO of the entity, irrespective of whether the employee is still in employment at that time) must be expensed in full at grant date. This is discussed further at 4.2 above and at 16.4 below, and illustrated in Example 23.6 at 7.1 above.

7.4.2 Awards with non-vesting conditions and variable vesting periods

Neither FRS 102 nor IFRS 2 explicitly addresses the determination of the vesting period for an award with a non-vesting condition but a variable vesting period (e.g. an award which delivers 100 shares when the price of gold reaches a given level, but without limit as to when that level must be achieved, so long as the employee is still in employment when the target is reached). However, given the close similarity between the required treatment for awards with non-vesting conditions and that for awards with market conditions, we believe that entities should follow the guidance for awards with market conditions and variable vesting periods (see 7.3.4 above).

7.4.3 Failure to meet non-vesting conditions

As noted above, the accounting under IFRS 2 – and, in the absence of specific guidance, FRS 102 – for non-vesting conditions sometimes differs from that for market conditions in the timing of the recognition of expense if the non-vesting condition is not satisfied. The treatment depends on the nature of the non-vesting condition, as follows:

• if a non-vesting condition within the control of the counterparty (e.g. making monthly savings in an SAYE scheme) is not satisfied during the vesting period, the failure to satisfy the condition is treated as a cancellation (see 8.4 below), with immediate recognition of any expense for the award not previously recognised; [IFRS 2.28A, IG24]
• if a non-vesting condition within the control of the entity (e.g. continuing to operate the scheme) is not satisfied during the vesting period, the failure to satisfy the condition is treated as a cancellation (see 8.4 below), with immediate recognition of any expense for the award not previously recognised; [IFRS 2.28A, IG24] but
• if a non-vesting condition within the control of neither the counterparty nor the entity (e.g. a financial market index reaching a minimum level) is not satisfied, there is no change to the accounting and the expense continues to be recognised over the vesting period, unless the award is otherwise treated as forfeited by IFRS 2. [IFRS 2.BC237A, IG24]. In our view, the reference to the vesting period would include any deemed vesting period calculated as described in 7.4.2 above.

If an award is forfeited due to a failure to satisfy a non-vesting condition after the end of the vesting period (e.g. a requirement for an employee not to work for a competitor for a two year period after vesting), no adjustment is made to the expense previously recognised, consistent with the general provisions for accounting for awards in the post-vesting period (see 7.1.3 above). This would be the case even if shares previously issued to the employee were required to be returned to the entity.

8.3.1 Modifications that increase the value of an award

8.3.2 Modifications that decrease the value of an award

This type of modification does not occur very often, as the effect would be somewhat demotivating and, in some cases, contrary to local labour regulations. However, there have been occasional examples of an award being made more onerous – usually in response to criticism by shareholders that the original terms were insufficiently demanding.

The general requirement of FRS 102 and of IFRS 2 (as outlined at 8.3 above) is that, where an award is made more onerous (and therefore less valuable), the financial statements must still recognise the cost of the original award. This rule is in part an anti-avoidance measure since, without it, an entity could reverse the cost of an out-of-the-money award by modifying it so that it was unlikely to vest (for example, by adding unattainable non-market performance conditions) rather than cancelling the award and triggering an acceleration of expense as at 8.4 below.

8.3.3 Modifications with altered vesting period

Where an award is modified so that its value increases, FRS 102 and IFRS 2 require the entity to continue to recognise an expense for the grant date fair value of the unmodified award over its original vesting period, even where the vesting period of the modified award is longer (see 8.3.1 above). This appears to have the effect that an expense may be recognised for awards that do not actually vest, as illustrated by Example 23.25 (which is based on Example 23.20 above).

It may seem strange that a cost is being recognised for the original award in respect of the 25 employees who leave during year 4, who are never entitled to anything. However, in our view, this is consistent with:

• the overall requirement of FRS 102 and IFRS 2 that the minimum cost of a modified award should be the cost that would have been recognised if the award had not been modified; and
• IG Example 8 in IFRS 2 (the substance of which is reproduced in Example 23.24 above) where an expense is clearly required to be recognised to the extent that the original performance conditions would have been met if the award had not been modified.

Moreover, as Examples 23.24 and 23.25 illustrate, the rule in FRS 102 and IFRS 2 requiring recognition of a minimum expense for a modified award (i.e. as if the original award had remained in place) applies irrespective of whether the effect of the modification is that an award becomes less valuable to the employee (as in Example 23.24) or more valuable to the employee (as in Example 23.25).

Where a modified vesting period is shorter than the original vesting period, all of the expense relating to both the original and modified elements of the award should, in our view, be recognised by the end of the modified vesting period as no services will be rendered beyond that date.

8.3.4 Modifications that reduce the number of equity instruments granted but maintain or increase the value of an award (‘value for value’ exchanges and ‘give and take’ modifications)

As discussed at 8.3-2-B above, IFRS 2 requires cancellation accounting to be applied to a reduction in the number of equity instruments when a modification reduces both the number of equity instruments granted and the total fair value of the award. [IFRS 2 Appendix B.44(b)]. FRS 102 is silent on the accounting treatment of such arrangements and we therefore suggest that entities follow the IFRS 2 requirements. The IFRS 2 approach is consistent with the fact that part of the award has been removed without compensation to the employee. However, a modification of this kind is rarely seen in practice because of the demotivating effect and, in some jurisdictions, a requirement to pay compensation to the counterparty. An entity is more likely to modify an award so that the overall fair value remains the same, or increases, even if the number of equity instruments is reduced. These types of modification, sometimes known as ‘value for value’ exchanges or ‘give and take’ modifications, are considered below.

Where an entity reduces the number of equity instruments but also makes other changes so that the total fair value of the modified award remains the same as, or exceeds, that of the original award as at the modification date, it is unclear whether the unit of account for accounting purposes should be an individual equity instrument or the award as a whole. Examples 23.26 and 23.27 below illustrate the two situations and the two approaches.

Given the lack of clarity, we believe that an entity may make an accounting policy choice as to whether it considers the unit of account to be an individual equity instrument or an award as a whole. Further detail on the arguments underpinning each of the two approaches is given in EY International GAAP 2019 but is beyond the scope of this publication.

Once made, the accounting policy choice should be applied consistently to all modifications that reduce the number of equity instruments but maintain or increase the overall fair value of an award. Whatever the policy choice, the entity will still need to determine whether or not the amendments to the arrangement are such that it is appropriate to account for the changes as a modification rather than as a completely new award (see 8.4.2 and 8.4.4 below).

8.3.5 Modification of award from equity-settled to cash-settled (and vice versa)

Occasionally an award that was equity-settled when originally granted is modified so as to become cash-settled, or an originally cash-settled award is modified so as to become equity-settled. FRS 102 provides no explicit guidance on such modifications. IFRS 2 provides no explicit guidance on modifications from equity-settled to cash-settled but the June 2016 amendment clarified IFRS 2 to provide more specific guidance on modifications of awards from cash-settled to equity-settled. In the absence of specific guidance in FRS 102 we believe that it is possible to arrive at a reasonable approach by analogy to the provisions of IFRS 2 in respect of:

• the modification of equity-settled awards during the vesting period (see 8.3 above);
• the addition of a cash-settlement alternative to an equity-settled award after grant date (as illustrated in IG Example 9 in the implementation guidance to IFRS 2);
• the settlement of equity-settled awards in cash (see 8.4 below); and
• the settlement in equity of awards where the entity has a choice of settlement, but which have been accounted for as cash-settled during the vesting period (see 11.1.1.A below).

A detailed discussion of this topic is beyond the scope of this publication but the subject is addressed more fully in EY International GAAP 2019.

8.4.1 Distinction between cancellation and forfeiture

The provisions of IFRS 2 apply when an award of equity instruments is cancelled or settled ‘other than a grant cancelled by forfeiture when the vesting conditions are not satisfied’. [IFRS 2.28]. The significance of this is that the terms of many share-based awards provide that they are, or can be, ‘cancelled’, in a legal sense, on forfeiture. IFRS 2 is clarifying that, where an award is forfeited (within the meaning of that term in IFRS 2 – see 7.1.2 above), the entity should apply the accounting treatment for a forfeiture (i.e. reversal of expense previously recognised), even if the award is legally cancelled as a consequence of the forfeiture. FRS 102 does not have such an explicit distinction but we presume that a similar treatment is intended.

8.4.2 Distinction between cancellation and modification

One general issue raised by the approach to modification and cancellation in FRS 102 and IFRS 2 is where the boundary lies between ‘modification’ of an award in the entity's favour and outright cancellation of the award. As a matter of legal form, the difference is obvious. However, if an entity were to modify an award in such a way that there was no realistic chance of it ever vesting (for example, by introducing a requirement that the share price increase 1,000,000 times by vesting date), some might argue that this amounts to a de facto cancellation of the award. The significance of the distinction is that, whereas the cost of a ‘modified’ award continues to be recognised on a periodic basis over the vesting period (see 8.3 above), the remaining cost of a cancelled award is recognised immediately.

8.4.3 Calculation of the expense on cancellation

The basic accounting treatment for a cancellation and settlement is illustrated in Example 23.28 below.

Example 23.28 illustrates the basic calculation of the required cancellation ‘charge’. In more complex situations, however, the amount of the ‘charge’ may not be so clear-cut, due to an ambiguity in the drafting of paragraph 28(a) of IFRS 2 and paragraph 13 of Section 26, which state that an entity:

‘shall account for the cancellation or settlement … as an acceleration of vesting, and therefore shall recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period.’ [FRS 102.26.13, IFRS 2.28(a)].

There is something of a contradiction within this requirement as illustrated by Example 23.29.

In extreme cases, the entity's best estimate, as at the date of cancellation, might be that no awards are likely to vest. In this situation, no cancellation expense would be recognised. However, there would need to be evidence that this was not just a rather convenient assessment made as at the date of cancellation. Typically, the previous accounting periods would also have reflected a cumulative expense of zero on the assumption that the awards would never vest.

An effect of these requirements is that they create an accounting arbitrage between an award that is ‘out of the money’ but not cancelled (the cost of which continues to be spread over the remaining period to vesting) and one which is formally cancelled (the cost of which is recognised immediately). Entities might well prefer to opt for cancellation so as to create a ‘one-off’ charge to earnings rather than continue to show, particularly during difficult trading periods, significant periodic costs for options that no longer have any real value. However, such early cancellation of an award precludes any chance of the cost of the award being reversed through forfeiture during, or at the end of, the vesting period if the original vesting conditions are not met.

8.4.4 Replacement awards

FRS 102 contains no specific requirements or guidance in relation to replacement awards and so we consider it appropriate to draw on those in IFRS 2. The remainder of this section therefore reflects the IFRS 2 requirements. Whilst the requirements relating to accounting for replacement awards are generally clear under IFRS 2, there are nevertheless some issues of interpretation.

As set out at 8.4 above, a new award that meets the criteria in paragraph 28(c) of IFRS 2 to be treated as a replacement of a cancelled or settled award is accounted for as a modification of the original award and any incremental value arising from the granting of the replacement award is recognised over the vesting period of that replacement award. Where the criteria are not met, the new equity instruments are accounted for as a new grant (in addition to accounting for the cancellation or settlement of the original arrangement). The requirements are discussed in more detail below.

10.3.1 Basic accounting treatment

For a cash-settled share-based payment transaction, Section 26 requires an entity to measure the goods or services acquired and the corresponding liability incurred at the fair value of the liability. Until that liability is settled, the entity should remeasure the fair value at each reporting date and at the date of settlement. Any changes in fair value arising from this process of remeasurement should be recognised in profit or loss for the period. [FRS 102.26.14].

It is clear that the ultimate cost of a cash-settled transaction must be the actual cash paid to the counterparty, which will be the fair value at settlement date but the liability is recognised and measured as follows:

• at each reporting date between grant and settlement the fair value of the award is determined in accordance with the requirements of Section 26;
• during the vesting period, the liability recognised at each reporting date is the Section 26 fair value of the award at that date multiplied by the expired portion of the vesting period;
• from the end of the vesting period until settlement, the liability recognised is the full fair value of the liability at the reporting date.

Where the cost of services received in a cash-settled transaction is recognised in the carrying amount of an asset (e.g. inventory) in the entity's statement of financial position, the carrying amount of the asset should not be adjusted for changes in the fair value of the liability.

Although paragraph 14 of Section 26 refers to ‘fair value’ it provides no further guidance about how the fair value of a cash-settled share-based payment liability should be determined. Appendix I to FRS 102 includes a definition of ‘fair value’ as:

‘the amount for which … a liability [could be] settled … between knowledgeable, willing parties in an arm's length transaction. In the absence of any specific guidance provided in the relevant section of this FRS, the guidance in the Appendix to Section 2 – Concepts and Pervasive Principles – shall be used in determining fair value.’

The reference to ‘fair value’ in paragraph 14 is not highlighted as a defined term and so it is not clear whether the defined term in Appendix I to FRS 102 is intended to apply to liabilities for cash-settled share-based payments. Section 26 specifies how fair value should be determined for equity-settled share-based payment transactions (see 9.2 and 9.3 above) but contains no specific guidance for cash-settled share-based payment transactions. In our view, an acceptable approach would be to use the guidance in the Appendix to Section 2 but also to draw on IFRS 2 (using the GAAP hierarchy in Section 10) to provide some more practical guidance on the approach to be taken in fair valuing a cash-settled share-based payment transaction.

The Appendix to Section 2 indicates that an appropriate valuation technique should be used and that this might include an option pricing model. The use of a pricing model is consistent with the requirement in IFRS 2 that fair value be determined by applying an option pricing model, taking into account the terms and conditions on which the cash-settled transaction was granted, and the extent to which the employees have rendered service to date.

10.3.2 Application of the accounting treatment

The treatment required by Section 26 for cash-settled transactions is illustrated by Example 23.33 which is based on IG Example 12 in the implementation guidance to IFRS 2.

The entity will recognise the cost of this award as follows:

^* Liability at end of period + cash paid in period – liability at start of period

The accounting treatment for cash-settled transactions is therefore (despite some similarities in the methodology) significantly different from that for equity-settled transactions. An important practical issue is that, for a cash-settled transaction, the entity must determine the fair value at each reporting date rather than at grant date (and at the date of any subsequent modification or settlement) as would be the case for equity-settled transactions. As Example 23.33 shows, it is not necessary to determine the fair value of a cash-settled transaction at grant date in order to determine the share-based payment expense.

We discuss in more detail below the following aspects of the accounting treatment of cash-settled transactions:

• determining the vesting period (see 10.3.2.A below);
• periodic allocation of cost (see 10.3.2.B below);
• treatment of non-market vesting conditions (see 10.3.2.C below);
• treatment of market conditions and non-vesting conditions (see 10.3.2.D below); and
• treatment of modification, cancellation and settlement (see 10.3.2.E below).

11.1.1 Accounting at date of settlement for awards where there is a choice of equity- or cash-settlement

FRS 102 contains no guidance about how to account as at the date of settlement for an award that has been accounted for as cash-settled but which is settled in equity, or vice versa. We suggest the following approach based on the requirements of IFRS 2 or practice that has evolved in the application of that standard.

11.1.2 Change in classification of award after grant date

Neither FRS 102 nor IFRS 2 specifies whether a transaction where the entity has a choice of settlement in equity or cash should be assessed as equity-settled or cash-settled only at the inception of the transaction or whether this should also be assessed at each reporting date until the transaction is settled.

FRS 102 states that a transaction should be treated as equity-settled unless either criterion (a) or criterion (b) in paragraph 15A of Section 26 applies (see 11.1 above). As it is not specified that this assessment takes place only at inception of the award, in our view FRS 102 requires an ongoing assessment of the relevance of these criteria.

FRS 102 does not specify how to account for a change in classification resulting from a change in the entity's policy or intention. In our view, the most appropriate treatment is to account for such a change as if it were a modification of the manner of settlement of the award (see 10.4 above). Where the entity is able to choose the manner of settlement, the substance of the situation is the same as a decision to modify the manner of settlement of an award which does not already give the entity a choice. These situations are distinct from those where the manner of settlement depends on the outcome of a contingent event outside the entity's control (see 11.3 below).

11.1.3 Economic compulsion for cash settlement (including unlisted entity awards with a presumption of cash settlement)

Some awards may nominally give the reporting entity the choice of settling in cash or equity, while in practice giving rise to an economic compulsion to settle only in cash. In addition to the examples mentioned at 11.1 above, this will often be the case where an entity that is a subsidiary or owned by a small number of individuals, such as members of the same family, grants options to employees. In such cases there will normally be a very strong presumption that the entity will settle in cash in order to avoid diluting the existing owners' interests. Similarly, where the entity is not listed, there is little real benefit for an employee in receiving a share that cannot be realised except when another shareholder wishes to buy it or there is a change in ownership of the business as a whole.

In our view, such schemes are generally most appropriately accounted for as cash-settled schemes from inception. In any event, once the scheme has been operating for a while, it is likely that there will be a past practice of cash settlement such that the scheme is required to be treated as a liability under the general provisions of FRS 102 summarised above.

A similar conclusion is often reached even where the terms of the agreement do not appear to offer the entity a choice of settling the award in cash but it has established a constructive obligation or a past practice of so doing (see 10.2 above).

11.2.1 Transactions with settlement alternatives of different value

In many share-based payment transactions with a choice of settlement, the value of the share and cash alternatives is equal. The counterparty will have the choice between (say) 1,000 shares or the cash value of 1,000 shares. Under FRS 102, this transaction would be accounted for as a cash-settled transaction.

However, it is not uncommon, particularly in transactions with employees, for the equity-settlement alternative to have more value. For example, an employee might be able to choose at vesting between the cash value of 1,000 shares immediately or 2,000 shares (often subject to further conditions such as a minimum holding period, or a further service period). In such a situation, it will need to be decided whether the arrangement falls within paragraph 15C of Section 26 (see 11.2 above) leading to the entire arrangement being accounted for as an equity-settled transaction.

11.2.2 ‘Backstop’ cash settlement rights

Some schemes may provide cash settlement rights to the holder so as to cover more or less remote contingencies.

If the terms of the award provide the employee with a general right of cash-settlement, FRS 102 requires the award to be treated as cash-settled. This is the case even if the right of cash settlement is extremely unlikely to be exercised (e.g. because it would give rise to adverse tax consequences for the employee as compared with equity settlement). If, however, the right to cash-settlement is exercisable only in specific circumstances, a more detailed analysis may be required (see 11.3 below).

11.3.1 Approach 1 – Treat as cash-settled if contingency is outside entity's control

One approach might be to observe that the underlying principle that determines whether an award is accounted for as equity-settled or cash-settled appears to be whether the reporting entity can unilaterally avoid cash-settlement (see 11.1 and 11.2 above). Under this approach, any award where the counterparty has a right to cash-settlement is always treated as a liability, irrespective of the probability of cash-settlement, unless there is no commercial substance. By contrast, an award where the choice of settlement rests with the entity is accounted for as a liability only where the entity's own actions have effectively put it in a position where it has no real choice but to settle in cash.

Applying this approach, it is first of all necessary to consider whether the event that requires cash-settlement is one over which the entity has control. If the event, however unlikely, is outside the entity's control, then under this approach the award should be treated as cash-settled. However, if the event is within the entity's control, the award should be treated as cash-settled only if the entity has a liability by reference to the criteria summarised in 11.1 above.

Whilst, in our view, this is an acceptable accounting approach, it does not seem entirely satisfactory. For example, it is common for an equity-settled share-based payment award to contain a provision to the effect that, if the employee dies in service, the entity will pay to the employee's estate the fair value of the award in cash. The approach above would lead to the conclusion that the award must be classified as cash-settled, on the basis that it is beyond the entity's control whether or not an employee dies in service. This seems a somewhat far-fetched conclusion, and is moreover inconsistent with the accounting treatment that the entity would apply to any other death-in-service benefit.

11.3.2 Approach 2 – Treat as cash-settled if contingency is outside entity's control and probable

Under US GAAP,³ a cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee's control (such as an initial public offering) does not give rise to a liability until it becomes probable that that event will occur.

In our view, this approach based on the probability of a contingent event that is outside the control of both the counterparty and the entity is also acceptable in the absence of specific guidance in FRS 102 (and IFRS 2) and has frequently been used in practice by entities applying IFRS 2.

The impact of Approach 1 and Approach 2 can be illustrated by reference to an award that requires cash-settlement in the event of a change of control of the entity (see 11.3.3 below).

11.3.3 Application of Approach 1 and Approach 2 to awards requiring cash settlement on a change of control

It is not uncommon for the terms of an award to provide for compulsory cash-settlement by the entity if there is a change of control of the reporting entity. Such a provision ensures that there is no need for any separate negotiations to buy out all employee options, so as to avoid non-controlling (minority) interests arising in the acquired entity when equity-settled awards are settled after the change of control.

The determination of whether or not a change of control is within the control of the entity is beyond the scope of this publication.

If the facts and circumstances of a particular case indicate that a change of control is within the entity's control, the conclusion under either Approach 1 or Approach 2 above would be that the award should be treated as cash-settled only if the entity has a liability by reference to the criteria summarised at 11.1 above.

If, however, the change of control is not considered to be within the control of the reporting entity, the conclusion will vary depending on whether Approach 1 or Approach 2 is followed. Under Approach 1, an award requiring settlement in cash on a change of control outside the control of the entity would be treated as cash-settled, however unlikely the change of control may be. Under Approach 2 however, an award requiring settlement in cash on a change of control outside the control of the entity would be treated as cash-settled only if a change of control were probable.

A difficulty with Approach 2 is that it introduces rather bizarre inconsistencies in the accounting treatment for awards when the relative probability of their outcome is considered. As noted at 11.2.2 above, an award that gives the counterparty an absolute right to cash-settlement is accounted for as a liability, however unlikely it is that the counterparty will exercise that right (unless the cash settlement option is considered to have no commercial substance). Thus, under this approach, the entity could find itself in the situation where it treats:

• as a liability: an award with a unrestricted right to cash-settlement for the counterparty, where the probability of the counterparty exercising that right is less than 1%; but
• as equity: an award that requires cash settlement in the event of a change of control which is assessed as having a 49% probability of occurring.

In our view, an entity may adopt either of these accounting treatments, but should do so consistently and state its policy for accounting for such transactions if material.

It should be noted in the selection of an accounting policy that the IASB had discussions – but did not conclude – on whether an approach based on the ‘probable’ outcome, as set out here, should be applied under IFRS 2 or whether an approach based on the accounting treatment for a compound financial instrument should be used. Any further developments in this area could affect the availability of the alternative treatments in future. The detailed discussions are beyond the scope of this publication but are addressed in EY International GAAP 2019.

There is further discussion at 16.4 below of awards that vest or are exercisable on a flotation or change of control, including the question of whether a cash-settlement obligation rests with the entity itself or with other parties involved in the change of control (see 16.4.6 below).

11.3.4 Accounting for change in manner of settlement where award is contingent on future events outside the control of the entity and the counterparty

When, under Approach 2 above, the manner of settlement of an award changes solely as a consequence of a re-assessment of the probability of a contingent event, there is neither settlement of the award nor modification of its original terms. The terms of the award are such that there have been two potential outcomes, one equity-settled and one cash-settled, running in parallel since grant date. It is as if, in effect, the entity has simultaneously issued two awards, only one of which will vest.

At each reporting date the entity should assess which outcome is more likely and account for the award on an equity- or cash-settled basis accordingly. In our view, any adjustments arising from a switch between the cumulative amount for the cash-settled award and the cumulative amount for the equity-settled award should be taken to profit or loss in the current period. This is similar to the approach for an award with multiple independent vesting conditions (see 7.3.6 above).

When applying an approach where the two outcomes have both been part of the arrangement from grant date, an entity measures the fair value of the equity-settled award only at the original grant date and there is no remeasurement of the equity-settled award on reassessment of the settlement method. As the cash-settled award would be remeasured on an ongoing basis, a switch in the manner of settlement during the period until the shares vest or the award is settled in cash could give rise to significant volatility in the cumulative expense. At the date of vesting or settlement, however, the cumulative expense will equate to either the grant date fair value of the equity-settled approach or the settlement value of the cash-settled approach depending on whether or not the contingent event has happened.

The situation discussed in this section (i.e. an arrangement with two potential outcomes from grant date because the manner of settlement is not within the control of either the entity or the counterparty) is not the same as an award where the manner of settlement is entirely within the entity's control. Where the entity has such control and therefore a choice of settlement, a change in the manner of settlement is treated as a modification with a potential catch-up adjustment through equity (see 10.4 above).

13.2.1 Background

From a financial reporting perspective, it is generally necessary to consider the accounting treatment in:

• the group's consolidated financial statements;
• the parent's separate financial statements; and
• the employing subsidiary's financial statements.

We make the assumption throughout this section on group share schemes that the subsidiary is directly owned by the parent company. In practice, there will often be one or more intermediate holding companies between the ultimate parent and the subsidiary. The intermediate parent company generally will not be the entity granting the award, receiving the goods or services or responsible for settling the award. Therefore, under Section 26, we believe that there is no requirement for the intermediate company to account for the award in its separate financial statements.

The accounting entries to be made in the various financial statements will broadly vary according to:

• whether the award is satisfied using shares already held or a fresh issue of shares;
• whether any charge is made to the employing subsidiary for the cost of awards to its employees;
• whether an EBT is involved. The accounting treatment of transactions undertaken with and by EBTs is discussed in more detail at 13.3 below; and
• the tax consequences of the award. For the purposes of the discussion and illustrative examples below, tax effects are ignored. A more general discussion of the tax effects of share-based payment transactions may be found at 15 below.

The sections below largely discuss the application of the basic requirements of Section 26 to share-based payment transactions within a group of entities. However, in addition to the application of those requirements, Section 26 allows an alternative treatment based on the allocation of a group share-based payment expense to group entities on a reasonable basis (see 13.2.3.A below).

13.2.2 Scope of Section 26 for group share schemes

By virtue of the definition of a ‘share-based payment transaction’ (see 3.1 and 3.2.1 above), a group share-based payment transaction is in the scope of Section 26 for:

• the consolidated financial statements of the group (the accounting for which follows the general principles set out in 4 to 11 above);
• the separate or individual financial statements of the entity in the group that receives goods or services (see 13.2.3 below); and
• the separate or individual financial statements of the entity in the group (if different from that receiving the goods or services) that settles the transaction with the counterparty. This entity will typically, but not necessarily, be the parent (see 13.2.4 below).

As discussed at 3 above, the scope paragraphs of Section 26, together with the definitions in Appendix I to FRS 102, indicate whether transactions are to be accounted for as equity-settled or as cash-settled in most group situations including:

• transactions settled in the equity of the entity, or in the equity of its parent (see 13.2.5 below); and
• cash-settled transactions settled by a group entity other than the entity receiving the goods or services (see 13.2.6 below).

At 3.2-1-A above, we consider seven scenarios commonly found in practice and outline the approach required by Section 26 in the consolidated and separate or individual financial statements of group entities depending on whether the award is settled in cash or shares and which entity grants the award, has the obligation to settle the award and receives the goods or services. These scenarios do not reflect the alternative treatment for group plans in Section 26 (see 13.2.3.A below).

It is common practice in a group share scheme to require each participating entity in the group to pay a charge, either to the parent or to an EBT, in respect of the cost of awards made under the scheme to employees of that entity. This is generally done either as part of the group's cash-management strategy, or in order to obtain tax relief under applicable local legislation. The amount charged could in principle be at the discretion of the group, but is often based on either the fair value of the award at grant date or the fair value at vesting, in the case of an award of free shares, or exercise, in the case of an award of options.

Neither FRS 102 nor IFRS 2 directly addresses the accounting treatment of such intragroup management charges and other recharge arrangements, which is discussed further at 13.2.7 below. [IFRS 2 Appendix B.46].

Worked examples illustrating how these various principles translate into accounting entries are given at 13.4 to 13.6 below.

13.2.3 Entity receiving goods or services

The entity in a group receiving goods or services in a share-based payment transaction determines whether the transaction should be accounted for as equity-settled or cash settled in its separate or individual financial statements. It does this by assessing the nature of the awards granted and its own rights and obligations.

The entity accounts for the transaction as equity-settled when either the awards granted are the entity's own equity instruments, or the entity has no obligation to settle the share-based payment transaction. Otherwise, the entity accounts for the transaction as cash-settled. Where the transaction is accounted for as equity-settled it is remeasured after grant date only to the extent permitted or required by Section 26 for equity-settled transactions generally, as discussed at 4 to 7 above.

A possible consequence of these requirements is that the amount recognised by the entity may differ from the amount recognised by the consolidated group or by another group entity settling the share-based payment transaction. This is discussed further at 13.6 below.

The cost recognised by the entity receiving goods or services is calculated according to the principles set out above unless the group applies the alternative treatment for group plans in Section 26 (see 13.2.3.A below). The cost under Section 26 is not adjusted for any intragroup recharging arrangements, the accounting for which is discussed at 13.2.7 below.

13.2.4 Entity settling the transaction

As noted at 3.2.1 above, Section 26 was clarified in the Triennial review 2017 by specifying the accounting treatment when the entity settling the transaction does not receive the goods or services. An entity settling a share-based payment transaction when another entity in the group receives the goods or services should recognise the transaction as an equity-settled share-based payment transaction only if it is settled in its own equity instruments, otherwise, the transaction is recognised as a cash-settled share-based payment transaction. [FRS 102.26.2A].

The above requirements relate only to the credit entry – the classification of the transaction as equity- or cash-settled, and its measurement. They do not specify the debit entry, which is therefore subject to the general requirement of IFRS 2 (and Section 26) that a share-based payment transaction should normally be treated as an expense, unless there is the basis for another treatment (see 4 above).

In our view, the settling entity is not always required to treat the transaction as an expense. Instead:

• Where the settling entity is a parent (direct or indirect) of the entity receiving the goods or services and is accounting for the transaction as equity-settled, it will generally account for the settlement of the award as an addition to the cost of its investment in the employing subsidiary (or of that holding company of the employing subsidiary which is the settling entity's directly-held subsidiary). It may then be necessary to review the carrying value of that investment to ensure that it is not impaired.
• Where the settling entity is a parent (direct or indirect) of the entity receiving the goods or services and is accounting for the transaction as cash-settled (whereas the subsidiary will be accounting for the transaction as equity-settled), in our view it has an accounting policy choice for the treatment of the remeasurement of the cash-settled liability. Either:
  • it accounts for the entire award as part of the contribution to the subsidiary and therefore as an addition to the cost of its investment in the employing subsidiary (or of that holding company of the employing subsidiary which is the settling entity's directly-held subsidiary); or
  • after the initial capitalisation of the grant date fair value of the liability, it remeasures the liability through profit or loss.

    Whichever policy is chosen, it may then be necessary to review the carrying value of the investment to ensure that it is not impaired.

• In other cases (i.e. where the settling entity is a subsidiary (direct or indirect) or fellow subsidiary of the entity receiving the goods or services), it should treat the settlement as a distribution, and charge it directly to equity. Whether or not such a settlement is a legal distribution is a matter of law.

We adopt the approach of full capitalisation by the parent entity in the worked examples set out at 13.4 to 13.6 below.

13.2.5 Transactions settled in equity of the entity or its parent

13.2.6 Cash-settled transactions not settled by the entity receiving goods or services

The scope section of Section 26 (see 3 above) considers arrangements in which the parent has an obligation to make cash payments to the employees of a subsidiary linked to the price of either:

• the subsidiary's equity instruments, or
• the parent's equity instruments.

In both cases, the subsidiary has no obligation to settle the transaction. Therefore, unless the alternative accounting rules are applied (see below), the subsidiary accounts for the transaction as equity-settled, recognising a corresponding credit in equity as a contribution from its parent. [FRS 102.26.1-1A].

The subsidiary subsequently remeasures the cost of the transaction only for any changes resulting from non-market vesting conditions not being met in accordance with the normal provisions of Section 26 discussed at 4 to 7 above. Section 26 does not specifically make the point – made in IFRS 2 – that this will differ from the measurement of the transaction as cash-settled in the consolidated financial statements of the group. [IFRS 2 Appendix B.56-57].

The parent has an obligation to settle the transaction in cash, paragraph 2A of Section 26 requires the parent to account for the transaction as cash-settled in both its consolidated and separate financial statements as the settling entity. [FRS 102.26.1, 2A].

The requirement for the subsidiary to measure the transaction as equity-settled is somewhat controversial. The essential rationale for requiring the subsidiary to record the cost of a share-based payment transaction settled by its parent is to reflect that the subsidiary is effectively receiving a capital contribution from its parent.

Using the alternative accounting treatment for group plans set out in Section 26 (see 13.2.3.A above), it appears that the subsidiary in this situation could base its expense either on an equity-settled calculation or on an allocation of the group cash-settled expense.

13.2.7 Intragroup recharges and management charges

As noted at 13.2.2 above, neither FRS 102 nor IFRS 2 deals specifically with the accounting treatment of intragroup recharges and management charges that may be levied on the subsidiary that receives goods or services, the consideration for which is equity or cash of another group entity.

The accounting requirements of FRS 102 for group share schemes derive from requirements in IFRS 2 which evolved, via an Interpretation, from an exposure draft (D17) published in 2005.⁴ In the absence of more specific guidance, we suggest that the treatment outlined below is applied to recharge arrangements in place between entities applying FRS 102. For entities applying the Companies Act 2006, the accounting treatment under D17 is also addressed in Section 7 of TECH 02/17BL. [TECH 02/17BL.7.53-56].

D17 proposed that any such payment made by a subsidiary should be charged directly to equity, on the basis that it represents a return of the capital contribution recorded as the credit to equity required by IFRS 2 (see 13.2.3 and 13.2.6 above) up to the amount of that contribution, and a distribution thereafter.

In our view, whilst IFRS 2 and FRS 102 as currently drafted clearly do not explicitly require this treatment, this is likely to be the more appropriate analysis for most cases where the amount of the recharge or management charge to a subsidiary is directly related to the value of the share-based payment transaction. Indeed, the only alternative, ‘mechanically’ speaking, would be to charge the relevant amount to profit or loss. This would result in a double charge (once for the FRS 102 charge, and again for the management charge or recharge) which we consider less appropriate in cases where the amounts are directly related. Accordingly, in the examples at 13.4 to 13.6 below, we apply the treatment originally proposed in D17 to any payments made by the subsidiary for participation in the group scheme.

Many intragroup recharge arrangements are based directly on the value of the underlying share-based payment – typically at grant date, vesting date or exercise date. In other cases, a more general management charge might be levied that reflects not just share-based payments but also a number of other arrangements or services provided to the subsidiary by the parent. Where there is a more general management charge of this kind, we believe that it is more appropriate for the subsidiary to recognise a double charge to profit or loss rather than debiting the management charge to equity as would be the case for a direct recharge.

IFRS 2 and FRS 102 also do not address how the parent should account for a recharge or management charge received. In our view, to the extent that the receipt represents a return of a capital contribution made to the subsidiary, the parent may choose whether to credit:

• the carrying amount of its investment in the subsidiary; or
• profit or loss (with a corresponding impairment review of the investment).

Even if part of the recharge received is credited to the carrying amount of the investment, any amount received in excess of the capital contribution previously debited to the investment in subsidiary should be accounted for as a distribution from the subsidiary and credited to the income statement of the parent. Where applicable, the illustrative examples at 13.4 to 13.6 below show the entire amount as a credit to the income statement of the parent rather than part of the recharge being treated as a credit to the parent's investment in its subsidiary.

A further issue that arises in practice is the timing of recognition of the recharge by the parties to the arrangement. In the absence of a contractual agreement, the treatment adopted might depend on the precise terms and whether there are contractual arrangements in place, but two approaches generally result in practice:

• to account for the recharge when it is actually levied or paid (which is consistent with accounting for a distribution); or
• to accrue the recharge over the life of the award or the recharge agreement even if, as is commonly the case, the actual recharge is only made at vesting or exercise date.

An entity should choose the more appropriate treatment for its particular circumstances. The first approach is often the more appropriate in a group context where recharge arrangements might be rather informal and therefore not binding until such time as a payment is made. It is also consistent with the overall recognition of the arrangement through equity. The second approach, which is likely to be the more appropriate approach when a liability is considered to exist in advance of the payment date, is closer in some aspects to the accounting treatment of a provision or financial liability but would reflect changes in the liability through equity rather than profit or loss and would build up the liability over the life of the award rather than recognising it in full when a present obligation has been identified.

Whichever accounting treatment is adopted, any adjustments to the amount to be recognised as a recharge, whether arising from a change in the Section 26 expense or other changes, should be recognised in the current period and previous periods should not be restated.

Where applicable, the examples at 13.4 to 13.6 below illustrate the first of the two treatments outlined above and recognise the recharge only when it becomes payable at the date of exercise.

13.3.1 Background

For some time entities have established trusts and similar arrangements for the benefit of employees. These are known by various names but, for the sake of convenience, in this section we will use the term ‘EBT’ (‘employee benefit trust’) to cover all such vehicles by whatever name they are actually known.

The commercial purposes of using such vehicles vary from employer to employer but may include the following:

• An EBT, in order to achieve its purpose, needs to hold shares that have either been issued to it by the entity or been bought by the EBT on the open market.
• In the case of longer-term benefits the use of an EBT may ‘ring fence’ the assets set aside for the benefit of employees in case of the insolvency of the entity.
• The use of an EBT may be necessary in order to achieve a favourable tax treatment for the entity or the employees, or both.

The detailed features of an EBT will again vary from entity to entity but typical features often include the following:

• The EBT provides a warehouse for the shares of the sponsoring entity, for example by acquiring and holding shares that are to be sold or transferred to employees in the future. The trustees may purchase the shares with finance provided by the sponsoring entity (by way of cash contributions or loans), or by a third-party bank loan, or by a combination of the two. Loans from the entity are usually interest-free. In other cases, the EBT may subscribe directly for shares issued by the sponsoring entity or acquire shares in the market.
• Where the EBT borrows from a third party, the sponsoring entity will usually guarantee the loan, i.e. it will be responsible for any shortfall if the EBT's assets are insufficient to meet its debt repayment obligations. The entity will also generally make regular contributions to the EBT to enable the EBT to meet its interest payments, i.e. to make good any shortfall between the dividend income of the EBT (if any) and the interest payable. As part of this arrangement the trustees may waive their right to dividends on the shares held by the EBT.
• Shares held by the EBT are distributed to employees through an employee share scheme. There are many different arrangements – these may include:
  • the purchase of shares by employees when exercising their share options under a share option scheme;
  • the purchase of shares by the trustees of an approved profit-sharing scheme for allocation to employees under the rules of the scheme; or
  • the transfer of shares to employees under some other incentive scheme.
• The trustees of an EBT may have a legal duty to act at all times in accordance with the interests of the beneficiaries under the EBT. However, most EBTs (particularly those established as a means of remunerating employees) are specifically designed so as to serve the purposes of the sponsoring entity, and to ensure that there will be minimal risk of any conflict arising between the duties of the trustees and the interest of the entity.

13.3.2 Accounting forEBTs

The requirement to treat an EBT as an extension of the entity is included in Section 9 (see Chapter 8 at 4.5). [FRS 102.9.35-37]. This treatment has the following broad consequences for the consolidated and separate financial statements of the reporting entity:

• Until such time as the entity's own shares held by the EBT vest unconditionally in employees any consideration paid for the shares should be deducted in arriving at shareholders' equity.
• Other assets and liabilities (including borrowings) of the EBT should be recognised as assets and liabilities in the financial statements of the sponsoring entity.
• No gain or loss should be recognised in profit or loss or other comprehensive income on the purchase, sale, issue or cancellation of the entity's own shares. Consideration paid or received for the purchase or sale of the entity's own shares in an EBT should be shown separately from other purchases and sales of the entity's own shares (‘true’ treasury shares held by the reporting entity) in the statement of changes in equity.
• Any dividend income arising on own shares should be excluded from profit or loss and deducted from the aggregate of dividends paid. In our view, the deduction should be disclosed if material.
• Finance costs and any administration expenses should be charged as they accrue and not as funding payments are made to the EBT.

The discussion above, and in the remainder of 13 below, focuses on arrangements where the EBT holds unallocated shares of the reporting entity and/or shares that have been allocated to employees in connection with share awards but where the awards have not yet vested. There will also be situations in practice in which an EBT reaches the stage where, or is designed so that, it only holds shares to which employees have full entitlement (i.e. the shares are fully vested). In this situation the shares are beneficially owned and controlled by the individual employees but might remain in trust for tax or other reasons in the period following vesting. Where an EBT does not hold any unvested shares and there are no other assets or liabilities in the EBT over which the entity continues to exercise control, there will be nothing left in the EBT to incorporate into the entity's financial statements by extension.

13.3.3 Illustrative Examples – awards satisfied by shares purchased by, or issued to, an EBT

The following Examples show the interaction of accounting for the EBT with the requirements of Section 26. Example 23.36 illustrates the treatment where an award is satisfied using shares previously purchased by the EBT. Example 23.37 illustrates the treatment where freshly issued shares are used.

1 This reflects the fact that the entity's resources have increased as a result of a transaction with an owner, which gives rise to no gain or loss and is therefore credited direct to equity.

2 It is necessary to transfer the cost of the shares ‘reissued’ by the EBT out of own shares, as the deduction for own shares would otherwise be overstated. The total cost of the pool of 400,000 shares immediately before vesting was £1,045,000 (£250,000 purchased on 1 January and £795,000 purchased on 1 September), representing an average cost per share of £2.6125. £2.6125 × 350,000 shares = £914,375.

† These amounts should all be accounted for in the profit and loss reserve or, until the awards are exercised, a separate reserve for share-based payments.

Example 23.36 illustrates the importance of keeping the accounting for the cost of the shares completely separate from that for the cost of the share-based payment award. In cash terms, ABC has made a ‘profit’ of £30,625, since it purchased 350,000 shares with a weighted average cost of £914,375 and issued them to the executives for £945,000. However, this ‘profit’ is accounted for entirely within equity, whereas a calculated expense of £52,500 is recognised in profit or loss.

1 This entry is required to reconcile the legal requirement to record an issue of shares with the fact that, in reality, there has been no increase in the resources of the reporting entity. All that has happened is that one member of the reporting group (the EBT) has transferred cash to another (the parent entity). In our view, this amount should not strictly be accounted for within any ‘Own shares reserve’ in equity, which should be restricted to shares acquired from third parties, although it is increasingly common in practice to see an entry in ‘own shares’ to reflect such a holding of shares by an EBT.

2 This reflects the fact that the entity's resources have increased as a result of a transaction with an owner, which gives rise to no gain or loss and is therefore credited direct to equity.

† These amounts should all be accounted for in the profit and loss reserve (subject to note 1 above) or, until the awards are exercised, a separate reserve for share-based payments.

13.3.4 Financial statements of the EBT

The EBT may be required to prepare financial statements in accordance with requirements imposed by local law or by its own trust deed. The form and content of such financial statements are beyond the scope of this publication.

13.4.1 Consolidated financial statements

So far as the consolidated financial statements are concerned, the transactions to be accounted for are:

• the purchase of the shares by the EBT and their eventual transfer to the employee; and
• the cost of the award.

Transactions between H plc or S Limited and the EBT are ignored since the EBT is treated as an extension of H plc (see 13.3 above). The accounting entries required are set out below. As in other examples in this chapter, an entry to equity is not allocated to a specific reserve as this will vary between entities (although the most common for an entity complying with the Companies Act 2006 will be the profit and loss reserve or a separate ‘other reserve’ for share-based payments).

^* Total cost £3,000 (3000 options × £1) spread over 36 months. Charge for period to December 20x1 is 6/36 × £3,000 = £500, and so on. In practice, where options are granted to a group of individuals, or with variable performance criteria, the annual charge will be based on a continually revised cumulative charge (see further discussion at 7.1 to 7.4 above).

^†3,000 options at £1.50 each.

^‡ This reflects the fact that the overall effect of the transaction for the group in cash terms has been a ‘loss’ of £1,500 (£6,000 original cost of shares less £4,500 option proceeds received). However, under FRS 102 this is an equity transaction, not an expense.

^**£6,000 cost of own shares purchased on 1 January 20x2 now transferred to the employee. In practice, it is more likely that the appropriate amount to be transferred would be based on the weighted average price of shares held by the EBT at the date of exercise, as in Example 23.36 at 13.3.3 above. In such a case there would be a corresponding adjustment to the debit to equity marked with ‡ above.

13.4.2 Parent

13.4.3 Employing subsidiary

The employing subsidiary is required to account for the FRS 102 expense and the contribution to the EBT on exercise of the award. This gives rise to the accounting entries set out below. The entries to reflect the expense are required by FRS 102 (see 13.2.3 above). The treatment of the contribution to the EBT as a distribution is discussed at 13.2.7 above.

* Total cost £3,000 (3000 options × £1) spread over 36 months. Charge for period to December 20x1 is 6/36 × £3,000 = £500, and so on. In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 7.1 to 7.4 above).

† This should be treated as a reduction of whatever component of equity was credited with the £3,000 quasi-contribution from the parent in the accounting entries above.

13.5.1 Consolidated financial statements

The consolidated financial statements need to deal with:

• the charge required by FRS 102 in respect of the award; and
• the issue of shares.

Transactions between H plc or S Limited and the EBT are ignored since the EBT is treated as an extension of H plc (see 13.3 above). The accounting entries required are set out below. As in other examples in this chapter, an entry to equity is not allocated to a specific reserve as this will vary between entities (although the most common for an entity complying with the Companies Act 2006 will be the profit and loss reserve or a separate ‘other reserve’ for share-based payments).

* Total cost £3,000 (3000 options × £1) spread over 36 months. Charge for period to December 20x1 is 6/36 × £3,000 = £500, and so on. In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 7.1 to 7.4 above).

† From the point of view of the consolidated group, the issue of shares results in an increase in net assets of only £4,500 (i.e. the exercise price received from the employee), since the £6,000 contribution from the employing subsidiary to the EBT is an intragroup transaction. However, an entity applying the Companies Act 2006 is required to increase its share capital and share premium accounts by the £10,500 legal consideration for the issue of shares. The £6,000 consideration provided from within the group is effectively treated as a bonus issue.

13.5.2 Parent

13.5.3 Employing subsidiary

The employing subsidiary is required to account for the FRS 102 expense and the contribution to the EBT on exercise of the award. This gives rise to the accounting entries set out below. The entries to reflect the expense are required by FRS 102 (see 13.2.3 above). The treatment of the contribution to the EBT as a distribution is discussed at 13.2.7 above.

* Total cost £3,000 (3000 options × £1) spread over 36 months. Charge for period to December 20x1 6/36 × £3,000 = £500, and so on. In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 7.1 to 7.4 above).

† £3,000 of this payment should be treated as a reduction of whatever component of equity was credited with the £3,000 quasi-contribution from the parent in the accounting entries above. The remaining £3,000 would be treated as a distribution and deducted from any appropriate component of equity.

13.6.1 Consolidated financial statements

The group has entered into a cash-settled transaction which is accounted for using the methodology discussed at 10.3 above. This gives rise to the following accounting entries:

^* Charge for period to 31 December 20x1 is 6/36 × 3000 × £1.80 [reporting date fair value] = £900. Charge for year ended 31 December 20x2 is 18/36 × 3000 × £2.70 = £4,050 less £900 charged in 20x1 = £3,150 and so on (refer to Example 23.33 at 10.3.2 above). In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 10 above).

13.6.2 Parent company

The parent accounts for the share-based payment transaction under FRS 102 as a cash-settled transaction, since the parent settles the award by delivering cash to the employees of the subsidiary (see 13.2.4 above). However, as discussed at 13.2.4 above, instead of recording a cost, as in its consolidated financial statements, the parent records an increase in the carrying value of its investment in subsidiary. It might then be necessary to consider whether the ever-increasing investment in subsidiary is supportable or is in fact impaired. As this is a matter to be determined in the light of specific facts and circumstances, it is not considered in this example. Any impairment charge would be recorded in profit or loss.

This would result in the following accounting entries:

^* Increase in investment to 31 December 20x1 is 6/36 × 3000 × £1.80 [reporting date fair value] = £900. Increase for year ended 31 December 20x2 is 18/36 × 3000 × £2.70 = £4,050 less £900 charged in 20x1 = £3,150 and so on (refer to Example 23.33 at 10.3.2 above). In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 10 above).

Where the parent entity was also the employing entity (and therefore receiving goods or services), it would apply the same accounting treatment in its separate financial statements as in its consolidated financial statements (see 13.6.1 above).

13.6.3 Employing subsidiary

The employing subsidiary accounts for the transaction as equity-settled, since it receives services, but incurs no obligation to its employees (see 13.2.3 and 13.2.6 above). This gives rise to the following accounting entries:

^* Charge for period to 31 December 20x1 is 6/36 × 3000 × £1.50 [grant date fair value] = £750, and so on. In practice, where options were granted to a group of individuals, or with variable performance criteria, the annual charge would be based on a continually revised cumulative charge (see further discussion at 7.1 to 7.4 above).

The effect of this treatment is that, while the group ultimately records a cost of £10,500, the subsidiary records a cost of only £4,500.

However, there may be cases where the subsidiary records a higher cost than the group. This would happen if, for example:

• the award vests, but the share price has fallen since grant date, so that the value of the award at vesting (as reflected in the consolidated financial statements) is lower than the value at grant (as reflected in the subsidiary's financial statements); or
• the award does not actually vest because of a failure to meet a market condition and/or a non-vesting condition (so that the cost is nil in the consolidated financial statements) but is treated by FRS 102 as vesting in the subsidiary's financial statements, because it is accounted for as equity-settled (see 7.3 and 7.4 above).

14.2.1 Equity-settled arrangements

For equity-settled share-based payment arrangements, FRS 102 requires an entity to ‘disclose information about how it measured the fair value of goods or services received or the value of the equity instruments granted. If a valuation methodology was used, the entity shall disclose the method and the reason for choosing it’. [FRS 102.26.19].

Unlike IFRS 2, FRS 102 has no specific requirement to disclose the inputs to an option pricing model and other assumptions made in the determination of fair value.

The requirement in FRS 102 to disclose the reason for choosing the valuation methodology used is not found in IFRS 2 but is consistent with the fact that FRS 102 allows directors to select an appropriate method of valuation rather than requiring the use of an option-pricing model (as is the case in IFRS 2 when market price information is not available).

14.2.2 Cash-settled arrangements

FRS 102 includes a requirement to disclose information about how the liability for a cash-settled arrangement was measured but does not expand on this general requirement. [FRS 102.26.20]. There is no direct correlation between this requirement and the disclosure requirements of IFRS 2 as the latter do not specifically address the measurement of cash-settled arrangements. The FRS 102 requirement is therefore potentially more onerous.

14.2.3 Modification of share-based payment arrangements

Where share-based payment arrangements have been modified during the accounting period, FRS 102 requires an explanation of those modifications [FRS 102.26.21] although, unlike IFRS 2, there is no specific requirement to disclose the incremental fair value or information about how that incremental value was measured.

14.2.4 Group share-based payment arrangements

If the reporting entity is part of a group share-based payment arrangement and it measures its share-based payment expense on the basis of a reasonable allocation of the expense for the group (in accordance with paragraph 16 of Section 26 – see 13.2.3.A above), then disclosure is required of that fact and of the basis for the allocation. [FRS 102.26.22].

16.4.1 Grant date

Sometimes awards are structured so that they will vest on flotation, or so that they will vest on flotation subject to further approval at that time. For awards in the first category, grant date as defined in FRS 102 will be the date on which the award is first communicated to employees (subject to the normal requirements of Section 26 relating to a shared understanding, offer and acceptance, as discussed at 6.3 above). For awards in the second category, grant date will be at or around the date of flotation, when the required further approval is given.

This means that the cost of awards subject to final approval at flotation will generally be significantly higher than that of awards that do not require such approval. Moreover, as discussed further at 6.3 above, it may well be the case that employees begin rendering service for such awards before grant date (e.g. from the date on which the entity communicates its intention to make the award in principle). In that case, the entity would need to consider making an initial estimate of the value of the award for the purpose of recognising an expense from the date services have been provided, and continually re-assess that value up until the actual grant date. As with any award dependent on a non-market vesting condition, an expense would be recognised only to the extent that the award is considered likely to vest. The classification of a requirement to float as a non-market vesting condition is discussed further at 16.4.3 below.

16.4.2 Vesting period

Many awards that vest on flotation have a time limit – in other words, the award lapses if flotation has not occurred on or before a given future date. In principle, as discussed at 7.2.3 above, when an award has a variable vesting period due to a non-market performance condition, the reporting entity should make a best estimate of the likely vesting period at each reporting date and calculate the Section 26 charge on the basis of that best estimate.

In practice, the likely timing of a future flotation is notoriously difficult to assess months, let alone years, in advance. In such cases, it would generally be acceptable simply to recognise the cost over the full potential vesting period until there is real clarity that a shorter period may be more appropriate. However, in making the assessment of the likelihood of vesting, it is important to take the company's circumstances into account. The likelihood of an exit event in the short- to medium-term is perhaps greater for a company owned by private equity investors seeking a return on their investment than for a long-established family-owned company considering a flotation.

It is worth noting that once an exit event becomes likely, the Section 26 expense will in some cases need to be recognised over a shorter vesting period than was originally envisaged as the probability of the exit event occurring will form the basis at the reporting date of the estimate of the number of awards expected to vest (see also the discussion at 8.6 above).

16.4.3 Is flotation or sale a vesting condition or a non-vesting condition?

There was debate in the past about whether a requirement for a flotation or sale to occur in order for an award to vest was a vesting condition or a non-vesting condition. The argument for it being a non-vesting condition was that flotation or sale may occur irrespective of the performance of the entity. The counter-argument was essentially that the price achieved on flotation or sale, which typically affects the ultimate value of the award (see 16.4.4 below), reflects the performance of the entity and is therefore a non-market performance condition (provided there is an associated service condition).

On the basis of discussions on the interpretation of IFRS 2 by the IASB and the IFRS Interpretations Committee, it appears appropriate to treat a requirement to float or be sold as a performance vesting condition rather than as a non-vesting condition, provided there is also a service condition for the duration of the performance condition (see 4.2 above). If the service period is not at least as long as the duration of the flotation or sale condition, the condition will need to be accounted for as a non-vesting condition.

Even though the condition is deemed to relate to the entity's own operations and therefore generally classified as a performance condition, it will sometimes be concluded that fulfilment of the condition is outside the control of both the entity and the counterparty. The settlement of an award in equity or cash might depend on the outcome of the condition i.e. there might be either cash- or equity-settlement that is entirely contingent on the exit event. Such contingent arrangements are discussed at 11.3 above.

16.4.4 Awards requiring achievement of a minimum price on flotation or sale

Some awards with a condition contingent on flotation (or another similar event) vest only if a minimum price per share is achieved. For example, an entity might grant all its employees share options, the vesting of which is contingent upon a flotation or sale of the shares at a price of at least £5 per share within five years, and the employee still being in employment at the time of the flotation or sale.

Taken alone, the requirement for a flotation or sale to occur is a non-market performance condition (see further below and at 16.4.3 above). However, if a minimum market price has to be achieved, the question arises as to whether, in addition to the service requirement, such an award comprises:

• a single market performance condition (i.e. float or sell within five years at a share price of at least £5); or
• two conditions:
  • a market performance condition (share price at time of flotation or sale of at least £5); and
  • a non-market performance condition (flotation or sale achieved within five years).

The significance of this is the issue discussed at 7.3 above, namely that an expense must always be recognised for all awards with a market condition, if all the non-market vesting conditions are satisfied, even if the market condition is not. In either case, however, there is a market condition which needs to be factored into the valuation of the award.

If the view is that ‘flotation or sale at £5 within five years’ is a single market condition, the entity will recognise an expense for the award for all employees still in service at the end of the five year period, since the sole non-market vesting condition (i.e. service) will have been met. Note that this assumes that the full five-year period is considered the most likely vesting period at grant date (see 16.4.2 above).

If, on the other hand, the view is that ‘flotation or sale within five years’ and ‘flotation or sale share price £5’ are two separate conditions, and no flotation or sale occurs, no expense will be recognised since the performance element of the non-market vesting condition (i.e. ‘flotation or sale within five years’) has not been satisfied. However, even on this second analysis, if a sale or flotation is achieved at a price less than £5, an expense must be recognised, even though the award does not truly vest, since the non-market condition (i.e. ‘flotation or sale within five years’ with its associated service requirement) will have been met.

In our view, the appropriate analysis is to regard ‘flotation or sale within five years’ and ‘flotation or sale share price £5’ as two separate conditions.

The example above assumes that there is a service condition equal in duration to the other condition attached to the award and hence the analysis above only considers vesting conditions. If the fact pattern were such that there was no service condition, or a service condition that was of a shorter duration than the other conditions, then those conditions would need to be treated as non-vesting conditions rather than as performance vesting conditions.

16.4.5 Awards ‘purchased for fair value’

As noted at 3.4.3 above, entities that are contemplating a flotation or trade sale may invite employees to subscribe for shares (often a special class of share) for a relatively nominal amount. In the event of a flotation or trade sale occurring, these shares may be sold or will be redeemable at a substantial premium. It is often argued that the initial subscription price paid represents the fair value of the share at the time, given the inherent high uncertainty as to whether a flotation or trade sale will in fact occur.

The premium paid on the shares in the event of a flotation or trade sale will typically be calculated in part by reference to the price achieved. The question therefore arises as to whether such awards fall within the scope of Section 26. It might be argued for example that, as the employee paid full fair value for the award at issue, there has been no share-based payment and, accordingly, the award is not within the scope of Section 26.

In our view, in order to determine whether the arrangement falls within the scope of Section 26, it is necessary to consider whether the award has features that would not be expected in ‘normal’ equity transactions – in particular, a requirement for the holder of the shares to remain in employment until flotation or sale and/or individual buyback arrangements. If this is the case, regardless of the amount subscribed, the terms suggest that the shares are being awarded in connection with, and in return for, employee services and hence that the award is within the scope of Section 26. This may mean that, even if the award has no material fair value once the subscription price has been taken into account (and therefore gives rise to no FRS 102 expense), it may be necessary to make the disclosures required by Section 26.

Moreover, even if the amount paid by the employees can be demonstrated to be fair value for tax or other purposes, that amount would not necessarily meet the valuation requirements of Section 26. Specifically, a ‘true’ fair value would take into account non-market vesting conditions (such as a requirement for the employee to remain in employment until flotation or a trade sale occurs). However, a valuation for Section 26 purposes would not take such conditions into account (see 6.5 and 7.2.1 above) and would therefore typically be higher than the ‘true’ fair value.

If the arrangement relates to a special class of share rather than ordinary equity shares, the underlying shares might well be classified under FRS 102 as a liability rather than as equity. However, if the redemption amount is linked to the flotation price of the ‘real’ equity, the arrangement will be a cash-settled share-based payment transaction under Section 26 (see 3.4.1 above).

It is common in such situations for the cost of satisfying any obligations to the holders of the special shares to be borne by shareholders rather than by the entity itself. This raises a number of further issues, which are discussed at 3.2.1 above and at 16.4.6 below.

16.4.6 ‘Drag along’ and ‘tag along’ rights

An award might be structured to allow management of an entity to acquire a special class of equity at fair value (as in 16.4.5 above), but (in contrast to 16.4.5 above) with no redemption right on an exit event. However, rights are given:

• to any buyer of the ‘normal’ equity also to buy the special shares (sometimes called a ‘drag along’ right);
• to a holder of the special shares to require any buyer of the ‘normal’ equity also to buy the special shares (sometimes called a ‘tag along’ right).

Such schemes are particularly found in entities where the ‘normal’ equity is held by a provider of venture capital, which will generally be looking for an exit in the medium term.

It may well be that, under the scheme, the entity itself is required to facilitate the operation of the drag along or tag along rights, which may involve the entity collecting the proceeds from the buyer and passing them on to the holder of the special shares.

This raises the issue of whether such an arrangement is equity-settled or cash-settled. The fact that, in certain circumstances, the entity is required to deliver cash to the holder of a share suggests that the arrangement is an award requiring cash settlement in specific circumstances, the treatment of which is discussed at 11.3 above.

However, if the terms of the award are such that the entity is obliged to pass on cash to the holder of the share only if, and to the extent that, proceeds are received from an external buyer, in our view the arrangement may be economically no different to the ‘broker settlement’ arrangements typically entered into by listed entities.

Under such broker settlement arrangements, the entity may either sell employees' shares in the market on the employees' behalf or, more likely, arrange for a third party broker to do so. A sale of shares on behalf of an employee is undertaken by the entity as agent and does not give rise to an increase in equity and an expense, although a share-based payment expense will be recognised for the award of shares. Such an arrangement does not of itself create a cash-settled award, provided that the entity has not created any obligation to the employees. If, however, the entity has either created an expectation among employees that it will step in to make good any lack of depth in the market, or has indeed itself contracted to repurchase the shares in question, it may well mean that analysis as a cash-settled scheme is more appropriate. However, as the entity may enter into much the same transaction with a broker whether it is selling shares on its own behalf or on behalf of its employees, the challenge is for the entity to be able to demonstrate the true economic nature of the transaction.

Following on from the approach to broker settlement arrangements outlined above, an arrangement where the employees' shares are being sold to an external buyer could be regarded as equity-settled because the entity's only involvement as a principal is in the initial delivery of shares to employees. However, consideration must be given to all the factors that could suggest that the scheme is more appropriately regarded as cash-settled.

In making such an assessment, care needs to be taken to ensure that the precise facts of an arrangement are considered. For example, a transaction where the entity has some discretion over the amount of proceeds attributable to each class of shareholder might indicate that it is inappropriate to treat the entity simply as an agent in the cash payment arrangement. It might also be relevant to consider the extent to which, under relevant local law, the proceeds received can be ‘ring fenced’ so as not to be available to settle other liabilities of the entity.

It is also the case that arrangements that result in employees obtaining similar amounts of cash can be interpreted very differently under Section 26 depending on how the arrangement is structured and whether, for example:

• the entity is required to pay its employees cash on an exit (having perhaps held shares itself via a trust and those shares having been subject to ‘drag along’ rights); or
• the employees themselves have held the right to equity shares on a restricted basis with vesting – and ‘drag along’ rights – taking effect on a change of control and the employees receiving cash for their shares.

The appropriate accounting treatment in such cases requires a significant amount of judgement based on the precise facts and circumstances.