1.2.1 IFRS 2 research project

In May 2015, the IASB announced a research project into certain aspects of IFRS 2.⁵

The objectives of the project were:

• to identify whether it is IFRS 2 that is causing perceived complexity in accounting for share-based payment arrangements and, if it is, to identify the most common areas of complexity; and
• to analyse why IFRS 2 has attracted so many interpretation requests.

In November 2015 the IASB considered a staff report which included an analysis of application issues and their causes, an analysis of the two measurement models in IFRS 2 (equity-settled and cash-settled) and various approaches for moving the project forward.⁶ The staff report observed that, on the basis of research and outreach performed, the complexity of applying IFRS 2 in practice has two main causes: the complexity of share-based payment arrangements themselves and use of the grant date fair value measurement model.⁷

Following an update on feedback received by its staff since November 2015, the IASB decided in May 2016:

• not to perform any further research on this topic;
• that there is no need to seek feedback on that decision or on the staff's findings; and
• that there is no need to publish a formal research paper or discussion paper summarising the research performed as part of this project but the staff will consider how best to make the work performed visible and retrievable.⁸

The IASB published a summary of the research findings in October 2018, confirming the main sources of complexity in accounting for share-based payments, are as noted above: the variety and complexity of the terms and conditions of share-based payments and use of grant date fair value measurement. The project summary also comments on criticism of excessive disclosures in the standard.⁹

The IASB confirmed in the Project Summary, that the terms and conditions of share‑based payments are varied and complex and that this variety and complexity contribute significantly to complexity in accounting for transactions involving share-based payments. Subsequently, accounting standards cannot remove the complexity arising from the variety and complexity of terms and conditions of share-based payments.

In considering the complexity of the grant date fair value measurement model used for equity-settled share-based payments, the IASB confirmed in the Project Summary the application issues covered three areas:

• Difficulty in understanding why changes in share price do not affect the accounting for equity‑settled share-based payments: the research found that the treatment is consistent with the accounting for other obligations that must be settled by issuing equity instruments in payment; and reflects the fact that the value of services received is unlikely to change after the grant date.
• Complexity in classifying conditions of share‑based payments as vesting or non-vesting: the research found that reducing that complexity significantly would require fundamental changes that would negate the advantages of the grant-date fair value measurement model and could be inconsistent with the distinction made between liabilities and equity in accounting for other obligations that must be settled by issuing equity instruments in payment.
• The apparently counterintuitive results for some actions that change equity-settled share-based payments, for example continuing to recognise expense for cancelled share-based payments and not reversing expense for ‘negative’ modifications of share-based payments: the staff research confirmed that the Basis for Conclusions on IFRS 2 provides for the approach to these items.

In addressing the criticisms that IFRS 2 leads entities to disclose excessive information in their financial statements, the research findings reminded preparers that IAS 1 – Presentation of Financial Statements – provides appropriate flexibility in how entities can disclose information about share-based payments. Therefore, entities should exercise judgement in deciding which information is material and must be disclosed.

1.4.1 Classification differences between IFRS 2 and IAS 32/IFRS 9

As noted above, not only are there differences between the accounting treatment of liabilities or equity under IFRS 2 as compared with that under IAS 32 and IFRS 9, but the classification of a transaction as a liability or equity transaction under IFRS 2 may differ from that under IAS 32.

One of the most important differences between IAS 32 and IFRS 2 is that a transaction involving the delivery of equity instruments within the scope of IFRS 2 is always accounted for as an equity transaction, whereas a similar transaction within the scope of IAS 32 might well be classified as a liability if the number of shares to be delivered varies.

The IASB offers some (pragmatic rather than conceptual) explanation for these differences in the Basis for Conclusions to IFRS 2. First, it is argued that to apply IAS 32 to share option plans would mean that a variable share option plan (i.e. one where the number of shares varied according to performance) would give rise to a more volatile (and typically greater) cost than a fixed plan (i.e. one where the number of shares to be awarded is fixed from the start), even if the same number of shares was ultimately delivered under each plan, which would have ‘undesirable consequences’. [IFRS 2.BC109]. Second, it is argued that this is just one of several inconsistencies between IAS 32 and IFRS 2 to be addressed as part of the IASB's review of the definitions of liabilities and equity in the Conceptual Framework. [IFRS 2.BC110].

The revision of the Conceptual Framework in 2018 led to a minor consequential amendment to the footnote to the definition of an equity instrument in Appendix A to IFRS 2. It is the definition of a liability within the footnote that has been revised rather than the definition of an equity instrument (see 1.2 above). In paragraph BC384 of the Basis for Conclusions to IFRS 2, the Board notes that the 2018 Conceptual Framework did not address classification of financial instruments with characteristics of both liabilities and equity and that the consequential amendments did not amend the guidance on classification of financial instruments in IFRS 2. Therefore, it does not expect the amendment to the footnote in IFRS 2 to have a significant effect on the application of the standard.

The boundary between liabilities and equity will be further explored by the IASB in its research project on Financial Instruments with Characteristics of Equity.¹⁰ Until there are any further amendments resulting from this or other projects, there will continue to be differences between the accounting and classification treatment of liabilities and equity under IFRS 2, compared with that under IAS 32 and IFRS 9.

2.2.1 Definitions

The following definitions are relevant to the scope of IFRS 2. [IFRS 2 Appendix A].

A share-based payment arrangement is ‘an agreement between the entity (or another group entity or any shareholder of any group entity) and another party (including an employee) that entitles the other party to receive

1. cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity, or
2. equity instruments (including shares or share options) of the entity or another group entity,

provided the specified vesting conditions, if any, are met.’

A share-based payment transaction is ‘a transaction in which the entity

1. receives goods or services from the supplier of those goods or services (including an employee) in a share-based payment arrangement, or
2. incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services.’

An equity-settled share-based payment transaction is ‘a share-based payment transaction in which the entity

1. receives goods or services as consideration for its own equity instruments (including shares or share options), or
2. receives goods or services but has no obligation to settle the transaction with the supplier.’

A cash-settled share-based payment transaction is ‘a share-based payment transaction in which the entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity’.

A group entity in the four definitions above means any parent, subsidiary, or subsidiary of any parent, of the entity and is based on the definition of ‘group’ in Appendix A to IFRS 10 – Consolidated Financial Statements – as ‘a parent and its subsidiaries’. [IFRS 2.63A, BC22E].

An equity instrument is ‘a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’.

An equity instrument granted is ‘the right (conditional or unconditional) to an equity instrument of the entity conferred by the entity on another party, under a share-based payment arrangement’.

A share option is ‘a contract that gives the holder the right, but not the obligation, to subscribe to the entity's shares at a fixed or determinable price for a specified period of time’.

It will be seen from these definitions that IFRS 2 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. Such cash awards may arise in a number of situations. For example:

• an entity may wish to extend its share scheme to the employees of overseas subsidiaries in jurisdictions where it may be difficult, or even illegal, to trade in the entity's shares, or where delivering shares would not give the same tax benefits to employees as would apply in the parent's own jurisdiction; or
• the entity may not wish to dilute existing shareholdings by significant share awards to employees.

In such cases, the employees may instead be offered cash equivalent to the value of the shares that they would otherwise have obtained.

2.2.2 Transactions within the scope of IFRS 2

Subject to the exceptions noted at 2.2.3 below, IFRS 2 must be applied to all share-based payment transactions, including:

1. equity-settled share-based payment transactions (discussed at 4 to 8 below);
2. cash-settled share-based payment transactions (discussed at 9 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 10 below). [IFRS 2.2].

Whilst the boundaries between these types of transaction are reasonably self-explanatory, there may be transactions – as discussed in more detail at 9 and 10 below – that an entity may intuitively regard as equity-settled which are in fact required to be treated as cash-settled under IFRS 2.

Although IFRS 2 was primarily a response to concerns over share-based remuneration, its scope is not restricted to transactions with employees. For example, if an external supplier of goods or services, including another group entity, is paid in shares or share options, or cash (or other assets) of equivalent value, IFRS 2 must be applied. Goods include:

• inventories;
• consumables;
• property, plant and equipment;
• 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 2.2.3.F below).

The scope of IFRS 2 extends to:

• group share schemes and certain transactions with shareholders (see 2.2.2.A below);
• transactions with employee benefit trusts and similar vehicles (see 2.2.2.B below);
• transactions where the identifiable consideration received appears to be less than the consideration given (see 2.2.2.C below);
• ‘all employee’ share plans (see 2.2.2.D below); and
• vested transactions (see 2.2.2.E below).

2.2.2.A Group schemes and transactions with group shareholders: scope issues

The definitions of ‘share-based payment arrangement’ and ‘share-based payment transaction’ at 2.2.1 above have the effect that the scope of IFRS 2 is not restricted to transactions where the reporting entity acquires goods or services in exchange for 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 IFRS 2 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, IFRS 2 requires an entity to account for a transaction in which it either:

• receives goods or services when another entity in the same group (or a 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. [IFRS 2.3A].

Moreover, the definitions of ‘equity-settled share-based payment transaction’ and ‘cash-settled share-based payment transaction’ have 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. [IFRS 2.43A].

We consider below seven scenarios, based on the simple structure in Figure 34.1 below. These scenarios are by no means exhaustive, but cover the situations most commonly seen in practice.

The scenarios considered in this section do not consider recharge arrangements between group entities. The accounting treatment of group share schemes, including those with recharge arrangements, is discussed in more detail at 12 below.

The scenarios assume that:

• the shareholder is not a group entity; and
• the subsidiary is directly owned by the parent company (see 12.2.1 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. [IFRS 2.43B‑43C, B52(a), B53‑B54].

• 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.

  Separate financial statements of Parent

• Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent as a single entity] … incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services’.
• The transaction is classified as an equity-settled transaction because it is settled in an equity instrument of Parent.

  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. [IFRS 2.B48(b)].

• 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 … any shareholder … and another party (including an employee) that entitles the other party to receive … equity instruments (including shares or share options) of the entity…’.
• The transaction is classified as an equity-settled transaction, because the Parent group ‘has no obligation to settle the transaction with the supplier’.
• Separate financial statements of Parent
• Scenario 2 is not within the scope of IFRS 2 for the separate financial statements of Parent, because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.
• 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 … any shareholder of any group entity [i.e. Shareholder] … and another party (including an employee) that entitles the other party to receive equity instruments of … another group entity [i.e. Parent]’.
• The transaction is classified as an equity-settled transaction, because Subsidiary ‘has no obligation to settle the transaction with the supplier’.

IFRS 2 explicitly does not address the accounting treatment for such a transaction within the financial statements of a shareholder that is not a group entity. [IFRS 2.BC22G]. We discuss at 12.9 below the accounting treatment of such transactions in the financial statements of a shareholder that is an investor in a joint venture or associate.

Scenario 3

Subsidiary awards equity shares in Parent to employees of Subsidiary in exchange for services to Subsidiary. Subsidiary settles the award with the employees of Subsidiary. [IFRS 2.43B, B52(b), B55].

• 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 (including shares or share options) of the entity’.
• The transaction is classified as an equity-settled transaction, because the Parent group ‘receives goods or services as consideration for its own equity instruments (including shares or share options) …’.
• Separate financial statements of Parent
• Scenario 3 is not within the scope of IFRS 2 for the separate financial statements of Parent, because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.
• 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 … [a] group entity [i.e. Subsidiary] … and another party (including an employee) that entitles the other party to receive equity instruments of … another group entity [i.e. Parent]’.
• 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 as agent for Parent and Subsidiary has the obligation to settle. 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 in certain jurisdictions, then the approach in Scenario 1 above is more likely to apply. This is discussed in more detail at 12.2.5.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. [IFRS 2.43B, B49].

• 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, classified as equity (see Chapter 7 at 4).

  Separate financial statements of Parent

• Scenario 4 is not within the scope of IFRS 2 for the separate financial statements of Parent, because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.

  Subsidiary

• Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. Subsidiary] … receives goods or services … in a share-based payment arrangement’.
• 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. [IFRS 2.43B‑43C, B50].

• 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, classified as equity (see Chapter 7 at 4).
• Separate financial statements of Parent
• Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent as a single entity] … incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity [i.e. Subsidiary] receives those goods or services’. The transaction is a share-based payment arrangement for Subsidiary (see below) and the consolidated financial statements of Parent (see above).
• For Parent, the transaction is classified as a cash-settled transaction, because it is settled not in an equity instrument issued by Parent, but in an equity instrument issued by a subsidiary and held by Parent – i.e. a financial asset in Parent's separate financial statements.
• 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. [IFRS 2.43C, B56-B58].

• 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.
• Separate financial statements of Parent
• Under the definition of ‘share-based payment transaction’, ‘the entity [i.e. the Parent as a single entity] … incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity [i.e. Subsidiary] receives those goods or services’.
• The transaction is classified as a cash-settled transaction, because it is settled in cash of Parent.
• Subsidiary
• IFRS 2 contains detailed guidance for the accounting treatment of such transactions by the employing subsidiary (see 12 below), from which it may reasonably be inferred that the IASB intended them to be in the scope of IFRS 2 for the subsidiary.
• However, this is strictly not the case when the drafting of IFRS 2 is examined closely. In order to be a share-based payment transaction (and therefore in the scope of IFRS 2) 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):
  • equity of the entity or any other group entity, or
  • cash or other assets of the entity.
• As drafted, the definition has the effect that a transaction settled in equity is in the scope of IFRS 2 for a reporting entity, whether the equity used to settle 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 IFRS 2 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.
• However, given the guidance referred to above in IFRS 2 for the accounting treatment for the reporting entity of transactions settled in cash by another group entity, we believe that the exclusion of such transactions from the definition of ‘share-based payment arrangement’ should be disregarded as a drafting slip.
• The transaction is classified as an equity-settled transaction by Subsidiary, because Subsidiary ‘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.

For the reasons set out in Scenario 6 above, this transaction is not strictly in the scope of IFRS 2 as drafted either for the consolidated or separate financial statements of Parent or for the individual financial statements of Subsidiary. As noted in Scenario 6 above, the definition of ‘share-based payment arrangement’ as drafted excludes any arrangement that is settled in cash by a party other than the reporting entity. Moreover, whilst IFRS 2 gives detailed guidance that effectively appears to ‘over-ride’ the definition in respect of a transaction settled by another group entity (see Scenario 6 above), there is no such over-riding guidance in respect of a transaction settled in cash by a non-group shareholder. The transaction is not within the scope of IFRS 2 for the separate financial statements of Parent, because Parent (as a separate entity) receives no goods or services, nor does it settle the transaction.

Nevertheless, we believe that the transaction should be treated as within the scope of IFRS 2 for the consolidated financial statements of Parent and the individual financial statements of Subsidiary. One of the original objectives of the project that led to the issue of the June 2009 amendment to IFRS 2 was to address a concern that, as originally issued, IFRS 2 did not require an entity to account for a cash-settled share-based payment transaction settled by an external shareholder.

In addition to the accounting treatment under IFRS 2, the group entities in this Scenario would need to consider the requirements of IAS 24 – Related Party Disclosures – as any payments by a shareholder would potentially need to be disclosed (see Chapter 39).

2.2.3 Transactions not within the scope of IFRS 2

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 2.2.3.A below);
• transfers of assets in certain group restructuring arrangements (see 2.2.3.B below);
• business combinations (see 2.2.3.C below);
• combinations of businesses under common control and the contribution of a business to form a joint venture (see 2.2.3.D below); and
• transactions in the scope of IAS 32 and IFRS 9 (see 2.2.3.E below).

In addition, the scope exemptions in IFRS 2 combined with those in IAS 32 and IFRS 9 appear to have the effect that there is no specific guidance in IFRS for accounting for certain types of investment when acquired in return for shares (see 2.2.3.F below).

As noted at 2.2.2.D above, there is no exemption from IFRS 2 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’.

2.2.4 Some practical applications of the scope requirements

This section addresses the application of the scope requirements of IFRS 2 to a number of situations frequently encountered in practice:

• remuneration in non-equity shares and arrangements with put rights over equity shares (see 2.2.4.A below);
• the treatment in the consolidated accounts of the parent of an equity-settled award of a subsidiary with a put option against the parent (see 2.2.4.B below);
• an increase in the counterparty's ownership interest with no change in the number of shares held (see 2.2.4.C below);
• awards for which the counterparty has paid ‘fair value’ (see 2.2.4.D below);
• a cash bonus which depends on share price performance (see 2.2.4.E below);
• cash-settled awards based on an entity's ‘enterprise value’ or other formula (see 2.2.4.F below);
• awards with a foreign currency strike price (see 2.2.4.G below);
• holding own shares to satisfy or ‘hedge’ awards (see 2.2.4.H below);
• shares or warrants issued in connection with a loan or other financial liability (see 2.2.4.I below);
• options over puttable instruments classified as equity under the specific exception in IAS 32 in the absence of other equity instruments (see 2.2.4.J below); and
• special discounts to certain categories of investor on a share issue (see 2.2.4.K below).

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

• employment taxes on share-based payment transactions (see 14 below); and
• instruments such as limited recourse loans and convertible bonds that sometimes fall within the scope of IFRS 2 rather than IAS 32/IFRS 9 because of the link both to the entity's equity instruments and to goods or services received in exchange. Convertible bonds are discussed at 10.1.6 below and limited recourse loans at 15.2 below.

3.1.1 ‘Malus’ clauses and clawback conditions

Whether as a result of an entity's own decision or in response to regulatory requirements, an increasing number of share-based payment awards include conditions that mean that the awards will only vest if there is no breach of any ‘malus’ clause on the part of the employee and/or the entity. Often these or other provisions are put in place to allow an entity to claw back vested awards from employees should any wrongdoing or underperformance be identified.

The impact of such clauses on the accounting treatment required by IFRS 2 depends on the precise terms of a particular arrangement. Aspects of arrangements that entities will need to consider include the following:

• whether the terms are sufficiently clear at the inception of the arrangement that there can still be a grant in IFRS 2 terms (see 5.3 below for further discussion of the requirements relating to grant date);
• whether the malus clause relates only to the actions of the individual employee (so-called ‘at fault’ malus) and whether the relevant period for consideration of the condition is limited to the vesting period or extends over a longer period;
• whether the malus clause relates only to the overall performance of the entity (so-called ‘not at fault’ malus) and, again, the applicable period during which the clause may be invoked; and
• whether the associated clawback arrangements are clear or depend on further decisions by the entity at the time the relevant ‘malus’ clause is invoked.

Broadly, it is likely to be the case that there will be a grant at inception provided the terms of the malus and clawback arrangements are sufficiently clear for there to be a shared understanding of the arrangements by both parties.

If the employee's ultimate entitlement to an award depends on an ‘at fault’ malus clause not being invoked, this is generally likely to be taken into account as part of any service vesting condition. If the condition extends beyond the usual vesting date of the award and the employee breaches the condition after the end of the vesting period, the vested awards will be treated as a cancellation under IFRS 2 (but there would be no impact on the expense already recognised for a vested award).

Depending on the precise terms, the assessment of a ‘not at fault’ malus clause is likely to require greater judgement. To the extent that the entity's overall performance formed part of the conditions on which the award would vest, it seems appropriate to treat the condition as part of a performance vesting condition. To the extent that a ‘not at fault’ malus clause could result in the clawback of an award after the end of the vesting period, there would need to be an assessment of how the identified fault or wrongdoing interacted with the position of the entity as previously determined at the end of the vesting period. The fault might relate solely to a situation that should have prevented the original vesting of the award (for example, a restatement of accounts relating to the vesting period) or it might be a more general condition relating to the ongoing performance of the entity.

If the condition extended beyond the service period, the entity would need to consider whether the award had a non-vesting condition from inception (see 3.2 below). However, given the nature of the condition, in our view it would be unlikely that there would be a significant reduction, if any, in the fair value of the award as a consequence of the non-vesting condition.

3.2.1 Background

Some share-based payment transactions, particularly those with employees, require 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 ‘determine whether the entity receives … services’ – 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 IFRS 2, but is instead referred to as a ‘non-vesting condition’. The accounting treatment of non-vesting conditions is discussed in detail at 6.4 below.

IFRS 2 does not explicitly define a ‘non-vesting condition’ (see 3.2.2 below), but uses the term to describe a condition that is neither a service condition nor a performance condition. Sometimes the condition will be wholly within the control of the counterparty and unconnected with the delivery of services, such as a requirement to save (see below). However, the identification of such conditions is not always straightforward.

The concept of a ‘non-vesting condition’, like much of IFRS 2 itself, had its origins as an anti-avoidance measure. It arose from a debate on how to account for employee share option schemes linked to a savings contract. In some jurisdictions, options are awarded to an employee on condition that the employee works for a fixed minimum period and, during that period, makes regular contributions to a savings account, which is then used to exercise the option. The employee is entitled to withdraw from the savings contract before vesting, in which case the right to the award lapses.

Entities applying IFRS 2 as originally issued almost invariably treated an employee's obligation to save as a vesting condition. If the employee stopped saving this was treated as a failure to meet a vesting condition and accounted for as a forfeiture, with the reversal of any expense so far recorded (see 6.1 and 6.2 below).

Some saw in this a scope for abuse of the general principle of IFRS 2 that, if a share-based payment transaction is cancelled, any amount not yet expensed for it is immediately recognised in full (see 7.4 below). The concern was that, if such a plan were ‘out of the money’, the employer, rather than cancel the plan (and thereby trigger an acceleration of expense) would ‘encourage’ the employee to stop saving (and thereby create a reversal of any expense already charged).

The broad effect of the January 2008 amendment to IFRS 2 (see 1.2 above) was to remove this perceived anomaly from the standard.

However, following the publication of the January 2008 amendment, it became apparent that the concept of the ‘non-vesting’ condition was not clear. This 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 activities and hence performance vesting conditions.

The Interpretations Committee took a number of the above issues onto its agenda as part of a wider project on vesting and non-vesting conditions. Where the issues were not addressed through the IASB's Annual Improvements to IFRSs 2010‑2012 Cycle, there is further discussion at 3.4 below.

3.2.2 Defining a non-vesting condition

As noted at 3.1 above, IFRS 2 defines 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].

Although it is stated that the Basis for Conclusions does not form part of IFRS 2, the IASB nonetheless appears to rely on users of the standard referring to the Basis for Conclusions in order to ‘infer’ the definition of a non-vesting condition.

A performance metric may be a non-vesting condition rather than a vesting condition in certain circumstances. 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 (see 3.2.3 below). [IFRS 2.BC171B, IG24].

The IASB has also clarified in the Basis for Conclusions to IFRS 2 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.BC353-BC358].

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 3.1 above, the definition of a performance vesting condition was clarified and expanded in the IASB's Annual Improvements. The amended definition includes wording intended to clarify 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.

During the process of finalising the amended definition, the IASB moved away from a requirement for the duration of the performance condition to fall wholly within the period of the related service requirement. In response to comments on the draft version of the Annual Improvements, the Board decided to make a late adjustment to clarify that the start of the performance period may be before the start of the service period, provided that the commencement date of the performance target is not substantially before the commencement of the service period. As stated in the definition above, however, the performance period may not extend beyond the end of the service period.

It is interesting to note that, in the US, the EITF also considered the question of non-coterminous service and performance conditions but, unlike the IASB, reached the conclusion that a performance target that affects the vesting of a share-based payment and that could be achieved after the requisite service period is a performance condition and does not need to be reflected in the fair value of the award at grant date.¹³ This was on the premise that the original definition of a performance condition in ASC 718 – Compensation – Stock Compensation – requires only a specified period of service. Before finalising the amendments to IFRS 2, the IASB specifically reconfirmed its own decision against the background of the US decision.¹⁴ This is therefore an area of difference between IFRS and US GAAP.

The late adjustment by the IASB goes some way towards removing an issue that is extremely common in practice, particularly with awards made to employees under a single scheme but at various times. The IASB gives the example of an earnings per share target as one of the areas in which respondents to the draft definitions observed that there could be a problem in practice, noting that the measure of earnings per share growth set as a performance target could often be that between the most recently published financial statements at grant date and those before the vesting date. [IFRS 2.BC341]. However, notwithstanding the amended definition, 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 6.4 below.

3.2.3 Non-compete agreements

In some jurisdictions it is relatively common to have a non-compete clause in share-based payment arrangements so that if the counterparty starts to work for a competitor within a specified timescale, i.e. he breaches the non-compete provision, he is required to return the shares (or an equivalent amount of cash) to the entity. Generally, a non-compete provision is relevant once an individual has ceased employment with the entity and so no future service is expected to be provided to the entity. However, the non-compete provision is often found in share-based payment awards entered into while the individual is still an employee of the entity and when there is no current intention for employment to cease. There are two divergent views on how such non-compete arrangements should be accounted for under IFRS 2.

The Basis for Conclusions to IFRS 2 states that ‘a share-based payment vests when the counterparty's entitlement to it is no longer conditional on future service or performance conditions. Therefore, conditions such as non-compete provisions and transfer restrictions, which apply after the counterparty has become entitled to the share-based payment, are not vesting conditions.’ [IFRS 2.BC171B].

One view is that, under the current definitions in the standard, this means that all non-compete agreements should be treated as non-vesting conditions with the condition reflected in the grant date fair value. Another reading of paragraph BC171B is that in some situations such arrangements meet the definition of a vesting condition and this allows any IFRS 2 expense to be reversed should the condition not be met. This view is explained further below. The lack of clarity in the standard as currently drafted means that there is diversity in practice.

Those who take the view that a non-compete arrangement is not always a non-vesting condition read paragraph BC171B as distinguishing between non-compete clauses which apply after the counterparty has become entitled to an award (a non-vesting condition) and those that, by implication, apply before the counterparty has become entitled to an award (a vesting condition). Broadly, therefore, if an employee has been given shares at the start of a non-compete period he is entitled to them (a non-vesting condition), but if the shares are retained by the entity or held in escrow, the employee is not entitled to the shares until the end of the non-compete period (a vesting condition).

This view may be difficult to reconcile with IFRS 2 as currently drafted because:

• it requires the reference to ‘entitlement’ to an award to be read as including a contingent obligation to forfeit the share, which is not in accordance with the general approach of IFRS 2; and
• it requires the words ‘which apply after the counterparty has become entitled to the share-based payment’ to be read with an implied emphasis on the word ‘after’, so as to distinguish it from an implied (unstated) alternative scenario in which the conditions apply before the counterparty becomes entitled to the share-based payment. A more natural reading is to consider these words as describing all non-compete agreements and transfer restrictions.

The classification of a non-compete provision is a matter that had been referred to the Interpretations Committee and to the IASB (see 3.4 below).

5.2.1 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 for IFRS 2 to define what is meant by employees. In fact IFRS 2 strictly refers to ‘employees and others providing similar services’ [IFRS 2.11] who are defined 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.

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.

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 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.

Related questions of interpretation arise where an award is made to an employee of an associate or a joint venture (see 12.9 below).

The effect of a change of status from employee to non-employee (or vice versa) is addressed at 5.4.1 below.

5.2.2 Basis of measurement

As noted above, IFRS 2 requires equity-settled transactions with employees to be measured by reference to the fair value of the equity instruments granted at ‘grant date’ (see 5.3 below). [IFRS 2.11]. 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.

5.3.1 Determination of grant date

IFRS 2 and the accompanying implementation guidance emphasise 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. Thus, 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. [IFRS 2 Appendix A, 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].

The counterparty's agreement to an offer might be particularly difficult to determine when it is implicit rather than explicit. For example, if an award required both the rendering of service and a subscription payment (other than a minimal one) by the employee, it is likely that the employee's agreement, and hence the grant date of the award, would coincide with the payment date – provided this occurs shortly after the offer date. If, however, the employee had the choice at the offer date of deferring payment until a much later date and could therefore decide whether the entity's subsequent performance justified his payment, then it is more likely that grant date would be the date on which the services commenced. 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 the 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. [IFRS 2.IG4]. This reference to formal approval could be construed as indicating that, in fact, IFRS 2 requires 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. For example, if a remuneration committee has discretion over some aspects of an award and whether it vests, does that mean that there is not a shared understanding until the vesting date? Similarly, does the counterparty need to have full quantification of every aspect of an award (performance targets, exercise price, etc.) or would an understanding of the formula for calculating performance or price be sufficient?

Some of these practical interpretation issues are considered further in the sections below.

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

As discussed at 5.3.1 above, the implementation guidance to IFRS 2 indicates 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 as discussed further in the sections that follow – 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, for the purposes of IFRS 2 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. An estimate of the grant date fair value of the award is used (e.g. by estimating the fair value of the equity instruments at the end of the reporting period), for the purposes of recognising the services received during the period between service commencement date and grant 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.

In situations where the entity estimates at the reporting date the grant date fair value of an award for services received in advance of grant date, the estimate is revised at subsequent reporting periods until the date of grant has been established. Once grant date has been established the entity revises the earlier estimate so that the amounts recognised for services received in respect of the grant are ultimately based on the grant date fair value of the equity instruments awarded.

The implications of the paragraph IG4 requirement are illustrated in Example 34.3 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 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 model.

Examples of situations where an employee might render service in advance of the IFRS 2 grant date because the precise conditions of an award are outstanding are considered at 5.3.3 to 5.3.7 and at 15.1 and 15.4.1 below.

5.3.3 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 remuneration committee, for example.

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 5.3.2 above.

5.3.4 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 in 5.3.3 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 5.3.2 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 treated as an equity-settled award under IFRS 2.

Awards settled in shares net of a cash amount to meet an employee's tax obligation are considered further at 14.3 below.

5.3.5 Award of equity instruments to a fixed monetary value

Some entities may grant employees awards of shares to a fixed value. For example, an entity might award as many shares as are worth €100,000, 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 5.3.3 and 5.3.4 above. Although 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 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 5.3.2 above.

The measurement of such awards raises further issues of interpretation, which we discuss at 8.10 below.

5.3.6 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 of IFRS 2 for such an arrangement are unclear. In the absence of specific guidance, several interpretations are possible and we believe that an entity may make an accounting policy choice, provided that choice is applied consistently to all such arrangements.

The first approach is based on the view that the unit of account is all potential shares to be earned by the individual employee and that, from the outset, each employee has a full understanding of the terms and conditions of both the initial award and the reallocation arrangements. This means that there is a grant on day one with each individual's award being valued on the basis of:

• that employee's initial allocation of shares; plus
• an additional award with a non-vesting condition relating to the potential reallocation of other participants’ shares.

Under this approach, the departure of an employee will be accounted for as a forfeiture and any cost reversed as the service condition will not have been met (see 6.1.2 below), but the redistribution of that individual's shares to the other employees will have no accounting impact. This approach is likely to result in a total expense that is higher than the number of shares awarded multiplied by the grant date price per share.

The second approach, which we believe is consistent with US GAAP, also considers the individual employee's award to be the unit of account. Under this approach, there is an initial grant to all the employees and it is only these awards for which the fair value is measured at the date of the initial grant. Any subsequent reallocations of shares should be accounted for as a forfeiture of the original award and a completely new grant to the remaining employees, measured at the new grant date. This approach accounts only for the specific number of shares that have been allocated to the individual employee as at the end of each reporting period. No account is taken in this approach of shares that might be allocated to the individual employee in the future due to another employee's forfeiture, even though the reallocation formula is known to the individual employees at the initial grant date.

A third view, which takes a pragmatic approach in the light of the issues arising from the two approaches outlined above, is to account for the award on the basis of the total pool of shares granted rather than treating the individual employee as the unit of account. In our view this approach is likely to be materially acceptable for many arrangements where the pool of shares relates to the same small number of participants from the outset. Under this approach, the fair value of the total pool of shares is measured at the grant date (day one) with the non-vesting condition effectively ignored for valuation purposes. Subsequent forfeitures and reallocations would have no effect on the accounting.

There is a distinction between the ‘last man standing’ arrangement described above and a situation where an entity designates a fixed pool of shares to be used for awards to employees but where the allocation of leavers’ shares is discretionary rather than pre-determined. In this situation, the valuation of the initial award would not take account of any potential future reallocations. If an employee left employment during the vesting period, that individual's award would be accounted for as a forfeiture and any reallocation of that individual's shares would be accounted for as a new grant with the fair value determined at the new grant date (i.e. a similar accounting treatment to that in approach two above).

A further type of award relating to a fixed pool of shares is one where an entity makes an award over a fixed number or percentage of its shares to a particular section of its workforce, the final allocation of the pool being made to those employed at the vesting date. In such an arrangement, some employees will typically join and leave the scheme during the original vesting period which will lead to changes in each employee's allocation of shares. Although employees are aware of the existence, and some of the terms, of the arrangement at the outset, the fact that there is no objective formula (see 5.3.3 to 5.3.5 above) for determining the number of shares that each individual will ultimately receive means that there is no grant under IFRS 2 until the date of final allocation. However, because the employees render service under the arrangement in advance of the grant date – either from day one or from a later joining date – the entity should estimate the fair value of the award to each individual from the date services commence and subsequently update it at each reporting period. The fair value estimated is expensed over the full service period of the award with a final truing up of the expense to the fair value of the award at the eventual grant date (see 5.3.2 above).

This has the effect that, where an entity decides to set aside a bonus pool of a fixed amount of cash, say £1 million, with the allocation to individual employees to be made at a later date, there is a known fixed cost of £1 million. However, where an entity decides to set aside a bonus pool of a fixed number of shares, with the allocation to individual employees to be made at a later date, the final cost is not determined until the eventual grant date.

5.3.7 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 34.4 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 5.3.3 above).

5.3.8 Awards subject to modification by entity after original grant date

As noted at 5.3.1 above, 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 IFRS 2, 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 also mean that, in some jurisdictions, nearly all share-based awards to employees would be required to be measured at vesting date, which clearly was not the IASB's intention.

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. See also the discussion at 3.1.1 above relating to the clawback of awards.

5.3.9 ‘Good leaver’ arrangements

In some jurisdictions 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 employment before the end of the full vesting period of the award to receive some or all of the award on leaving (see 5.3.9.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 approach required by IFRS 2 differs from that required where the original terms are clear about ‘good leaver’ classification and entitlement (see 5.3.9.B below).

In some jurisdictions awards are structured in a way which allows the majority of participants, rather than just a few specified categories of ‘good leaver’, to retain all or part of an award if they leave employment during the vesting period (see 5.3.9.C 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 IFRS 2 purposes.

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 7.4.1.A below).

5.3.10 Special purpose acquisition companies (‘SPACs’)

IPOs and trade sales may be achieved through the medium of special purpose acquisition companies (‘SPACs’). The detailed features of SPACs may vary, but common features tend to be:

• The SPAC is established by a small number of founders, typically with expertise in selecting attractive targets for flotation or sale. The founder shares contain a term to the effect that, if a target is eventually identified and floated or sold, the holders of the founder shares will receive a greater proportion of any proceeds than other shareholders at the time of flotation.
• At a later date, other (non-founder) shareholders invest. This is frequently achieved by an IPO of the SPAC. It is typically the case that, if a specific target is not identified and agreed by a required majority of non-founder shareholders, within a finite timescale, the other (non-founder) shareholders will have their funds returned.
• The SPAC seeks a target which is then approved (or not, as the case may be) by the required majority of non-founder shareholders.

The three stages outlined above have given rise to three interpretations as to the grant date for IFRS 2 purposes.

The first view is that there is no shared understanding until the specific target is identified and agreed (the third stage above). Holders of this view argue that the substance of the founder shareholders’ interest is economically equivalent to an award of shares in any target finally approved. Therefore, until the target is finally approved, there is no clarity as to the nature and value of the award to the founder shareholders.

The second view is that a shared understanding occurs at the point at which the non-founder shareholders invest (i.e. the second stage above). Holders of this view argue that a share-based payment can only occur when there has been a transfer of value from the non-founder shareholders to the founder shareholders and this cannot occur until there are some non-founder shareholders in place. However, once those non-founder shareholders are in place, there is a shared understanding that – if a transaction is subsequently approved – there will be a benefit for founder shareholders.

The third view is that a shared understanding occurs on the issue of the founder shares (i.e. the first stage above). Holders of this view argue that at that point there is a shared understanding that there will be a benefit for founder shareholders if non-founder shareholders are subsequently introduced and a transaction is subsequently approved. The benefit for founder shareholders consists both in seeking further investors and in identifying a suitable target. The founder shareholders will be actively rendering service towards these goals from the outset.

The IFRS Interpretations Committee conducted some initial outreach research into how SPACs are treated in practice, but the question has not been formally discussed to date. Until such time as additional guidance is given, it seems that the diversity in practice outlined above will remain and entities should use judgement to determine an appropriate grant date based on the specific terms of the arrangement.

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

IFRS 2 does not give 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, as follows:

• For a change from non-employee to employee status, the expense for periods following the change should be measured as if the award had been granted at the date of change of status. This revised measurement only applies to the expense for the portion of the award that vests after the change of status and there is no effect on the expense recognised in prior periods.
• For a change from employee to non-employee status, the expense for periods following the change should be measured on the basis of the fair value of the counterparty's services as they are received – if this is reliably determinable. Otherwise, the fair value used is that of the equity instruments granted but measured at the date the services are received (see 5.4 above). There is no effect on the expense recognised in prior periods.

If the status of the counterparty changes and the terms of the award are modified in order to allow the award to continue to vest, the modification and change of status should be assessed in accordance with the general principles in IFRS 2 relating to the modification of awards (see 7.3 below).

5.5.1 Reload features

A ‘reload feature’ is a feature in a share option that provides for an automatic grant of additional share options (reload options) whenever the option holder exercises previously granted options using the entity's shares, rather than cash, to satisfy the exercise price. [IFRS 2 Appendix A]. IFRS 2 requires reload features to be ignored in the initial valuation of options that contain them. Instead any reload option should be treated as if it were a newly granted option when the reload conditions are satisfied. [IFRS 2.22]. This is discussed further at 8.9 below.

6.1.1 The continuous estimation process of IFRS 2

The overall objective of IFRS 2 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 6.3 below) or a non-vesting condition (see 6.4 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 IFRS 2 seeks to capture the value of the contingent right to shares promised at grant date, to the extent that that promise becomes (or is deemed by IFRS 2 to become – see 6.1.2 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, IFRS 2 still recognises a cost for the award.

In order to achieve this outcome, IFRS 2 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 performance conditions or non-vesting conditions) is determined;
2. (b) 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 6.1.2 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; [IFRS 2.19‑20]
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 7 below; and
5. if a vested award is not exercised, an entity may (but need not) make a transfer between components of equity – see 6.1.3 below.

The overall effect of this process is that a cost is recognised for every award that is granted, except when it is forfeited, as that term is defined in IFRS 2 (see 6.1.2 below). [IFRS 2.19].

6.1.2 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 mean an award that does not vest in IFRS 2 terms. This is a particularly complex aspect of IFRS 2, which is discussed in more detail at 6.2 to 6.4 below. Essentially:

• 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 by IFRS 2;
• 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 by IFRS 2. Otherwise (i.e. where all the vesting conditions other than market conditions are satisfied), the award is deemed to vest by IFRS 2 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 by IFRS 2.

Where an award has been modified (see 7.3 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 34.23 and 34.24 at 7.3 below illustrate this point.

As a result of the interaction of the various types of condition, the reference in the summary at 6.1.1 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 service and 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 6.2 to 6.4 and at 7.6 below.

6.1.3 Accounting after vesting

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 under IFRS 2 – see 6.1.2 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.

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. Some commentators have observed that an accounting standard that can result in an accounting cost for non-dilutive options does not meet the needs of those shareholders whose concerns about dilution were the catalyst for the share-based payment project in the first place (see 1.1 above).

The IASB counters such objections by pointing out that the treatment in IFRS 2 is perfectly consistent with that for other ‘contingent’ equity instruments, such as warrants, that ultimately result in no share ownership. Where an entity issues warrants for valuable consideration such as cash and those warrants lapse unexercised, the entity recognises no gain under IFRS. [IFRS 2.BC218‑221].

6.2.1 Awards with service conditions

Most share-based payment transactions with employees are subject to explicit or implied service conditions. Examples 34.7 and 34.8 below illustrate the application of the allocation principles discussed in 6.1 above to awards subject only to service conditions. [IFRS 2.IG11].

Note that in Example 34.8 above, the number of employees that leave during year 1 and year 2 is not directly relevant to the calculation of cumulative expense in those years, but would naturally be a factor taken into account by the entity in estimating the likely number of awards finally vesting.

6.2.2 Equity instruments vesting in instalments (‘graded’ vesting)

An entity may make share-based payments that vest in instalments (sometimes referred to as ‘graded’ vesting). For example, an entity might grant an employee 600 options, 100 of which vest if the employee remains in service for one year, a further 200 after two years and the final 300 after three years. In today's more mobile labour markets, such awards are often favoured over awards which vest only on an ‘all or nothing’ basis after an extended period.

IFRS 2 requires such an award to be treated as three separate awards, of 100, 200 and 300 options, on the grounds that the different vesting periods will mean that the three tranches of the award have different fair values. [IFRS 2.IG11]. This may well have the effect that compared to the expense for an award with a single ‘cliff’ vesting, the expense for an award vesting in instalments will be for a different amount in total and require accelerated recognition of the expense in earlier periods, as illustrated in Example 34.9 below.

Provided all conditions are clearly understood at the outset, the accounting treatment illustrated in Example 34.9 would apply even if the vesting of shares in each year also depended on a performance condition unique to that year (e.g. that profit in that year must reach a given minimum level), as opposed to a cumulative performance condition (e.g. that profit must have grown by a minimum amount by the end of year 1, 2 or 3). This is because all tranches of the arrangement have the same service commencement date and so for the awards that have a performance condition relating to year 2 or year 3 there is a service condition covering a longer period than the performance condition. In other words, an award that vests at the end of year 3 conditional on profitability in year 3 is also conditional on the employee providing service for three years from the date of grant in order to be eligible to receive the award. This is discussed further at 5.3.7 above.

A variant of Example 34.9, is one where a share-based payment transaction vests with employees in instalments and the service period is not at least as long as the duration of the non-market performance condition, for example, a flotation or sale condition. The flotation or sale condition will be treated as a non-vesting condition and be incorporated into the determination of fair value (see 3.2 above). In contrast, when the service condition is the same duration as the flotation and sale condition, that condition will be treated as non-market performance condition, see Example 34.66 at 15.4.3 below.

The accounting treatment illustrated in Example 34.9 is the only treatment for graded vesting permitted under IFRS 2 whether an arrangement just has a service condition or whether it has both service and performance conditions. This contrasts with US GAAP²¹ which permits, for awards with graded vesting where vesting depends solely on a service condition, a policy choice between the approach illustrated above and a straight-line recognition method.

6.2.3 Transactions with variable vesting periods due to non-market performance vesting conditions

An award may be made with a vesting period of variable length. For example, an award might be contingent upon achievement of a particular performance target (such as achieving a given level of cumulative earnings) within a given period, but vesting immediately once the target has been reached. Alternatively, an award might be contingent on levels of earnings growth over a period, but with vesting occurring more quickly if growth is achieved more quickly. Also some plans provide for ‘re-testing’, whereby an original target is set for achievement within a given vesting period, but if that target is not met, a new target and/or a different vesting period are substituted.

In such cases, the entity needs to estimate the length of the vesting period at grant date, based on the most likely outcome of the performance condition. Subsequently, it is necessary continuously to re-estimate not only the number of awards that will finally vest, but also the date of vesting, as shown by Example 34.10. [IFRS 2.15(b), IG12]. This contrasts with the treatment of awards with market conditions and variable vesting periods, where the initial estimate of the vesting period may not be revised (see 6.3.4 below).

It will be noted that in Example 34.10, which is based on IG Example 2 in the implementation guidance to IFRS 2, it is assumed that the entity will pay no dividends (to any shareholders) throughout the maximum possible three year vesting period. This has the effect that the fair value of the shares to be awarded is equivalent to their market value at the date of grant.

If dividends were expected to be paid during the vesting period, this would no longer be the case. Employees would be better off if they received shares after two years rather than three, since they would have a right to receive dividends from the end of year two. In practice, an entity is unlikely to suspend dividend payments in order to simplify the calculation of its share-based payment expense, and it is unfortunate that IG Example 2 is not more realistic. [IFRS 2 IG Example 2].

One solution might be to use the approach in IG Example 4 in the implementation guidance to IFRS 2 (the substance of which is reproduced as Example 34.12 at 6.2.5 below). That Example deals with an award whose exercise price is either CHF12 or CHF16, dependent upon various performance conditions. Because vesting conditions other than market conditions must be ignored in determining the value of an award, the approach is in effect to treat the award as the simultaneous grant of two awards, whose value, in that case, varies by reference to the different exercise prices. [IFRS 2 IG Example 4].

The same principle could be applied to an award of shares that vests at different times according to the performance conditions, by determining different fair values for the shares (in this case depending on whether they vest after one, two or three years). The cumulative charge during the vesting period would be based on a best estimate of which outcome will occur, and the final cumulative charge would be based on the grant date fair value of the actual outcome (which will require some acceleration of expense if the actual vesting period is shorter than the previously estimated vesting period).

Such an approach appears to be taking account of non-market vesting conditions in determining the fair value of an award, contrary to the basic principle of paragraph 19 of IFRS 2 (see 6.1.1 above). However, it is not the vesting conditions that are being taken into account per se, but the fact that the varying vesting periods will give rise to different lives for the award (which are required to be taken into account – see 7.2 and 8 below). That said, the impact of the time value of the different lives on the fair value of the award will, in many cases, be insignificant and it will therefore be a matter of judgement as to how precisely an entity switches from one fair value to another.

Economically speaking, the entity in Example 34.10 has made a single award, the true fair value of which must be a function of the weighted probabilities of the various outcomes occurring. However, under the accounting model for share-settled awards in IFRS 2, the probability of achieving non-market performance conditions is not taken into account in valuing an award. If this is required to be ignored, the only approach open is to proceed as in Example 34.10 above and treat the arrangement as if it consisted of the simultaneous grant of three awards.

Some might object that this methodology is not relevant to the award in Example 34.10 above, since it is an award of shares rather than, in the case of Example 34.12 (see 6.2.5 below), an award of options. However, an award of shares is no more than an award of options with an exercise price of zero. Moreover, the treatment outlined in the previous paragraph is broadly consistent with the rationale given by IFRS 2 for the treatment of an award vesting in instalments (see 6.2.2 above).

In Example 34.10 above, the vesting period, although not known, is at least one of a finite number of known possibilities. The vesting period for some awards, however, may be more open-ended, such as is frequently the case for an award that vests on a trade sale or flotation of the business. Such awards are discussed further at 15.4 below.

6.2.4 Transactions with variable number of equity instruments awarded depending on non-market performance vesting conditions

More common than awards with a variable vesting period are those where the number of equity instruments awarded varies, typically increasing to reflect the margin by which a particular minimum target is exceeded. In accounting for such awards, the entity must continuously revise its estimate of the number of shares to be awarded, as illustrated in Example 34.11 below (which is based on IG Example 3 in the implementation guidance to IFRS 2). [IFRS 2 IG Example 3].

This Example reinforces the point that, under the methodology in IFRS 2, it is quite possible for an equity-settled transaction to give rise to a credit to profit or loss for a particular period during the period to vesting.

6.2.5 Transactions with variable exercise price due to non-market performance vesting conditions

Another mechanism for delivering higher value to the recipient of a share award so as to reflect the margin by which a particular target is exceeded might be to vary the exercise price depending on performance. IFRS 2 requires such an award to be dealt with, in effect, as more than one award. The fair value of each award is determined, and the cost during the vesting period based on the best estimate of which award will actually vest, with the final cumulative charge being based on the actual outcome. [IFRS 2.IG12, IG Example 4].

This is illustrated in Example 34.12 below.

At first sight this may seem a rather surprising approach. In reality, is it not the case that the entity in Example 34.12 has made a single award, the fair value of which must lie between CHF12 and CHF16, as a function of the weighted probabilities of either outcome occurring? Economically speaking, this is indeed the case. However, under the accounting model for equity-settled share-based payments in IFRS 2, the probability of achieving non-market performance conditions is not taken into account in valuing an award. If this is required to be ignored, the only approach open is to proceed as above.

6.3.1 What is a ‘market condition’?

IFRS 2 defines a market condition as follows:

‘A performance condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price (or value) of the entity's equity instruments (or the equity instruments of another entity in the same group), such as:

1. attaining a specified share price or a specified amount of intrinsic value of a share option; or
2. achieving a specified target that is based on the market price (or value) of the entity's equity instruments (or the equity instruments of another entity in the same group) relative to an index of market prices of equity instruments of other entities.

A market condition requires the counterparty to complete a specified period of service (i.e. a service condition); the service requirement can be explicit or implicit.’ [IFRS 2 Appendix A].

A market condition is a type of performance condition and the above definition should be read together with the definition of a performance condition (see 3.1 above). If there is no service requirement, the condition will be a non-vesting condition rather than a performance vesting condition (see 3.2 above).

The ‘intrinsic value’ of a share option means ‘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’. [IFRS 2 Appendix A]. In other words, an option to pay $8 for 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.

An example of a market condition 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, but are not directly linked to it, and hence are not market conditions.

A condition linked to a general market index is a non-vesting condition rather than a market condition (see 3.2 above and 6.4 below). For example, suppose that an entity engaged in investment management and listed only in London grants options to an employee responsible for the Far East equities portfolio. The options have a condition linked to movements in a general index of shares of entities listed in Hong Kong, so as to compare the performance of the portfolio of investments for which the employee is responsible with that of the overall market in which they are traded. That condition would not be regarded as a market condition under IFRS 2, because even though it relates to the performance of a market, 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 of entities listed in Hong Kong, that condition would be a market condition because the reporting entity's own share price is then relevant to the satisfaction of the condition.

6.3.2 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, but then subsequently ignored, so that an award is treated as vesting irrespective of whether the market condition is satisfied, provided that all service and non-market performance vesting conditions are satisfied. [IFRS 2.21, IG13]. This can have rather controversial consequences, as illustrated by Example 34.13.

Therefore, IFRS 2 sometimes treats as vesting (and recognises a cost for) awards that do not actually vest in the natural sense of the word. See also Example 34.15 at 6.3.4 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. The Basis for Conclusions indicates that the IASB accepted this difference for two main reasons:

1. it was consistent with the approach in the US standard FAS 123 – Accounting for Stock-Based Compensation; and
2. in principle, the same approach should have been adopted for all performance conditions. However, whereas market conditions can be readily incorporated into the valuation of options, other conditions cannot. [IFRS 2.BC183‑184].

The methodology prescribed by IFRS 2 for transactions with a vesting condition other than a market condition is therefore 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 (see 6.2 above). It is interesting to note, however, that the January 2008 amendment to IFRS 2 (see 1.2 above) had the effect that certain conditions previously regarded as non-market vesting conditions (and therefore ‘impossible’ to incorporate in the determination of fair value) became non-vesting conditions (and therefore required to be incorporated in the determination of fair value).

One of the reasons for adoption of this approach under US GAAP (not referred to in the Basis for Conclusions in IFRS 2) was as an ‘anti-avoidance’ measure. The concern was that the introduction of certain market conditions could effectively allow for the reversal of the expense for ‘underwater’ options (i.e. those whose exercise price is higher than the share price such that it is not in the holder's interest to exercise the option) for which all significant vesting conditions had been satisfied, contrary to the general principle in US GAAP (and IFRS 2) that no revisions should be made to the expense for an already vested option.

For example, when the share price is £10 an entity could grant an employee an option, exercisable at £10, provided that a certain sales target had been met within one year. If the target were achieved, IFRS 2 would require an expense to be recognised even if the share price at the end of the year were only £8, so that the employee would not rationally exercise the option. If, however, the performance conditions were that (a) the sales target was achieved and (b) the share price was at least £10.01, the effect would be (absent specific provision for market conditions) that the entity could reverse any expense for ‘underwater’ options.

It appears that it may be possible to soften the impact of IFRS 2's 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 34.13 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 total shareholder return (‘TSR’) relative to that of a peer group being in the top 10% of its peer group at the end of the period (‘TSR target (market condition)’).

It will be seen that, to all intents and purposes, the ‘TSR target (market condition) met?’ column is redundant, as this market condition is not relevant to whether or not the award is treated as vesting by IFRS 2. 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 ‘TSR target (market condition) met?’ column is redundant, as this market condition is not relevant to whether or not the award is treated as vesting by IFRS 2. 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 IFRS 2.

Examples of the application of the accounting treatment for transactions involving market conditions are given in 6.3.3 to 6.3.5 below.

6.3.3 Transactions with market conditions and known vesting periods

The accounting for such transactions is essentially the same as that for transactions without market conditions but with a known vesting period (including ‘graded’ vesting – see 6.2.2 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 34.14 below. [IFRS 2.19‑21, IG13, IG Example 5].

6.3.4 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].

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 34.15 below, which is based on IG Example 6 in the implementation guidance in IFRS 2. [IFRS 2 IG Example 6].

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 to recognise an expense for share-based payment transactions ‘as the services are received’. [IFRS 2.7]. It is difficult to regard any services being received for an award after it has vested.

Moreover, the prohibition in 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 34.15 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:

6.3.5 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 met. Such an award is illustrated in Example 34.16 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.

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

6.3.7 Transactions with hybrid or interdependent market conditions and non-market vesting conditions

Awards may sometimes have a performance condition which depends simultaneously on a market element and a non-market element, sometimes known as ‘hybrid’ conditions. Examples of such conditions include:

• a particular price-earnings (PE) ratio (calculated by reference to share price, a market condition, and earnings, a non-market vesting condition); and
• a maximum level of discount of market capitalisation (a market condition) below net asset value (a non-market vesting condition).

Such awards are rather curious, in the sense that these ratios may remain fairly constant irrespective of the underlying performance of the entity, so that a performance condition based on them is arguably of limited motivational value.

In our view, in contrast to our suggested treatment of awards with independent market and non-market vesting conditions discussed at 6.3.6.A above, awards with interdependent market and non-market vesting conditions must be accounted for entirely as awards with market conditions. These awards contain at least one element that meets the definition of a market condition but which cannot be completely split from the non-market element for separate assessment. An indicator such as the PE ratio, or discount of market capitalisation below net asset value, is a market condition as defined since it is ‘related to the market price … of the entity's equity instruments’ (see 6.3.1 above).

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

Awards with a market condition are usually based on the market price or value of the (typically quoted) equity instruments of the parent entity. However, a group might consider the parent's share price to be a somewhat blunt instrument for measuring the performance of the employees of a particular subsidiary or business unit. Indeed, it is not difficult to imagine situations in which a particular subsidiary might perform well but the parent's share price might be dragged down by other factors, or conversely where the parent's share price might rise notwithstanding poor results for that subsidiary.

Accordingly, 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 6.3.2 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 6.3.5 above).

In our view, however, the treatment of such schemes under IFRS 2 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. IFRS 2 defines a market condition (see 6.3.1 above) as one dependent on the ‘market price (or value)’ of the entity's equity. Prima facie, if there is no market, there is no market price or value.

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 IASB refers in the definition of ‘market condition’ to ‘market price (or value)’ and not to ‘fair value’. The latter term is, of course, used extensively elsewhere in IFRS 2, which suggests that the IASB does not see the two terms as equivalent. This concern is reinforced by that fact that, even though it does not apply to the measurement of awards accounted for under IFRS 2, the ‘valuation hierarchy’ in IFRS 13 gives a quoted market price as the preferred (but not the only) method of arriving at fair value (see Chapter 14 at 16).

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 valuation model.

Furthermore, in order for there to be a market condition, as defined in IFRS 2, 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 3.2 above and 6.4 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.

6.4.1 Awards with no conditions other than non-vesting conditions

The effect of the treatment required by IFRS 2 is that 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 3.2 above and at 15.4 below, and illustrated in Example 34.5 at 6.1 above.

6.4.2 Awards with non-vesting conditions and variable vesting periods

IFRS 2 does not explicitly address 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 in the standard for awards with market conditions and variable vesting periods (see 6.3.4 above).

6.4.3 Failure to meet non-vesting conditions

As noted above, the accounting for non-vesting conditions sometimes differs from that for market conditions as regards 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 or holding a specified number of shares in a matching share arrangement) is not satisfied during the vesting period, the failure to satisfy the condition is treated as a cancellation (see 7.4 below), with immediate recognition of any expense for the award not previously recognised; [IFRS 2.28A, IG24, IG Example 9A]
• 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 7.4 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 6.4.2 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 of IFRS 2 for accounting for awards in the post-vesting period (see 6.1.3 above). This would be the case even if shares previously issued to the employee were required to be returned to the entity on forfeiture (see 3.1.1 and 3.2.3 above for further discussion of clawback arrangements and non-compete arrangements respectively).

7.3.1 Modifications that increase the value of an award

7.3.2 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 IFRS 2 (as outlined at 7.3 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 in 7.1 above.

7.3.3 Modifications with altered vesting period

As noted at 7.3.1 above, where an award is modified so that its value increases, IFRS 2 requires 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. This appears to have the effect that an expense may need to be recognised for awards that do not actually vest, as illustrated by Example 34.24 (which is based on Example 34.19 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 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 34.23 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 34.23 and 34.24 illustrate, the rule in 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 34.23) or more valuable to the employee (as in Example 34.24).

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 point. In this type of modification – as distinct from a change of estimate where there is a variable vesting period (see 6.2.3 above) – we believe that an entity has an accounting policy choice between retrospective and prospective adjustment of the vesting period as at the modification date. The overall expense recognised between grant date and vesting date will be the same in both cases, but there will be timing differences in the recognition of the expense, with retrospective accounting resulting in a higher expense as at the modification date itself.

7.3.4 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 7.3.2.B above, cancellation accounting has 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.B44(b)]. This 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 34.25 and 34.26 below illustrate the two situations and the two approaches.

In both Examples above, the first view is based on paragraph B44(b) of IFRS 2 which states that ‘if the modification reduces the number of equity instruments granted to an employee, that reduction shall be accounted for as a cancellation of that portion of the grant, in accordance with the requirements of paragraph 28’. This is perhaps further supported by paragraph B43(a) which, in providing guidance on accounting for a modification that increases the fair value of an equity instrument, appears only to refer to individual equity instruments when it states that ‘the incremental fair value granted’ in a modification is ‘the difference between the fair value of the modified equity instrument and that of the original equity instrument, both estimated as at the date of modification’. [IFRS 2.B43‑44].

The second view is based on the overriding requirement in paragraph 27 of IFRS 2 for the grant date fair value of the equity instruments to be recognised unless the awards do not vest due to a failure to meet a vesting condition (other than a market condition) that was specified at grant date. This requirement is applicable even if the award is modified after the grant date. The same paragraph also requires an entity to recognise the effect of modifications ‘that increase the total fair value of the share-based payment arrangement or are otherwise beneficial to the employee’. This reference to ‘total fair value’ supports the view that the total award is the unit of account and is reiterated in paragraphs B42 and B44 which provide guidance, respectively, for situations where the total fair value decreases or increases as a consequence of the modification of an award. Supporters of view 2 further consider that, in contrast to the cancellation accounting approach that is required in the very specific case where part of the award is, in effect, settled for no consideration (see 7.3.2.B above), a modification that reduces the number of equity instruments but maintains or increases the overall fair value of the award clearly provides the counterparty with a benefit. As a consequence, it is considered that no element of the grant date fair value should be accelerated as a cancellation expense. [IFRS 2.27, B42, B44].

Given the lack of clarity in IFRS 2, 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. However, once made, that 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. Whichever policy is chosen, the general requirements of IFRS 2 will still need to be applied in order to determine whether or not the amendments to the arrangement are such that it is appropriate to treat the changes as a modification (in IFRS 2 terms) rather than as a completely new award (see 7.4.2 and 7.4.4 below).

7.3.5 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. Such modifications are discussed at 9.4 below.

7.4.1 Distinction between cancellation and forfeiture

The provisions of IFRS 2 summarised at 7.4 above 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 6.1.2 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.

7.4.2 Distinction between cancellation and modification

One general issue raised by 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 7.3 above), the remaining cost of a cancelled award is recognised immediately.

7.4.3 Calculation of the expense on cancellation

The basic accounting treatment for a cancellation and settlement is illustrated in Example 34.27 below.

Example 34.27 illustrates the basic calculation of the cancellation ‘charge’ required by IFRS 2. 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 the standard, which reads as follows:

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

There is something of a contradiction within this requirement as illustrated by Example 34.28.

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 IFRS 2 expense of zero on the assumption that the awards would never vest.

An effect of these requirements is that IFRS 2 creates 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.

7.4.4 Replacement awards

The required accounting treatment of replacement awards, whilst generally clear, nevertheless raises some issues of interpretation. Most of this sub-section addresses the replacement of unvested awards but the treatment of vested awards is addressed at 7.4.4.C below.

As set out at 7.4 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.

8.2.1 Call options – overview

Before considering the features of employee share options that make their valuation particularly difficult, a general overview of call options may be useful.

Call options give the holder the right, but not the obligation, to buy the underlying shares at a specified price (the ‘exercise’ or ‘strike’ price) on, or before, a specified date. Share-based payments take the form of call options over the underlying shares.

Options are often referred to as American or European. American options can be exercised at any time up to the expiry date, whereas European options can be exercised only on the expiry date itself.

The terms of employee options commonly have features of both American and European options, in that there is a period, generally two or three years, during which the option cannot be exercised (i.e. the vesting period). At the end of this period, if the options vest, they can be exercised at any time up until the expiry date. This type of option is known as a Window American option or Bermudan option.

A grant of shares is equivalent to an option with an exercise price of zero and will be exercised regardless of the share price on the vesting date. Throughout the discussion below, any reference to share options therefore includes, to the extent applicable, share grants or zero strike price options. There is further discussion of grants of free shares at 8.7.1 below.

8.2.2 Call options – valuation

As noted in 8.1 above, option value consists of intrinsic value and time value. For a call option, intrinsic value is the greater of:

• the share price less the exercise price, and
• zero.

Figure 34.2 below sets out the intrinsic value (or payoff) for a call option with an exercise price of $5.00.

A call option is said to be ‘in-the-money’ when the share price is above the exercise price of the option and ‘out-of-the-money’ when the share price is less than the exercise price. An option is ‘at-the-money’ when the share price equals the exercise price of the option.

The time value of an option arises from the time remaining to expiry. As well as the share price and the exercise price, it is impacted by the volatility of the share price, time to expiry, dividend yield and the risk-free interest rate and the extent to which it is in- or out-of-the-money. For example, when the share price is significantly less than the exercise price, the option is said to be ‘deeply’ out-of-the-money. In this case, the fair value consists entirely of time value, which decreases the more the option is out-of-the-money.

The main inputs to the value of a simple option are:

• the exercise price of the option;
• the term of the option;
• the current market price of the underlying share;
• the expected future volatility of the price of the underlying share;
• the dividends expected to be paid on the shares during the life of the option (if any); and
• the risk-free interest rate(s) for the expected term of the option.

Their effect on each of the main components of the total value (intrinsic value and time value) is shown in Figure 34.3 below.

The effect of these inputs on the value of a call option can be summarised as follows:

* In most cases the time value of an option is positive. Whilst an American option always has positive or zero time value, a European option may have a zero or negative time value when there is a high dividend yield and the option is considerably in-the-money. In this case, as the time to expiry increases, a European call option will reduce in value (negative time value) and an American call option will stay constant in value (zero time value).

The factors to be considered in estimating the determinants of an option value in the context of IFRS 2 are considered in more detail at 8.5 below.

8.2.3 Factors specific to employee share options

In addition to the factors referred to in 8.2.2 above, employee share options are also affected by a number of specific factors that can affect their true economic value. These factors, not all of which are taken into account for IFRS 2 valuation purposes (see 8.4 and 8.5 below), include the following:

• non-transferability (see 8.2.3.A below);
• continued employment requirement (see 8.2.3.B below);
• vesting and non-vesting conditions (see 8.2.3.C below);
• periods during which holders cannot exercise their options – referred to in various jurisdictions as ‘close’, ‘restricted’ or ‘blackout’ periods (see 8.2.3.D below);
• limited ability to hedge option values (see 8.2.3.E below); and
• dilution effects (see 8.2.3.F below).

8.3.1 The Black-Scholes-Merton formula

The Black-Scholes-Merton methodology is commonly used for assessing the value of a freely-traded put or call option and allows for the incorporation of static dividends on shares. The assumptions underlying the Black-Scholes-Merton formula are as follows:

• the option can be exercised only on the expiry date (i.e. it is a European option);
• there are no taxes or transaction costs and no margin requirements;
• the volatility of the underlying asset is constant and is defined as the standard deviation of the continuously compounded rates of return on the share over a specified period;
• the risk-free interest rate is constant over time;
• short selling is permitted;
• there are no risk-free arbitrage opportunities;
• there are log normal returns (i.e. the continuously compounded rate of return is normally distributed); and
• security trading is continuous.

The main limitation of the Black-Scholes-Merton methodology is that it only calculates the option price at one point in time. It does not consider the steps along the way when there could be a possibility of early exercise of an American option (although as discussed at 8.4 below this can be partially mitigated by using an assumed expected term as an input to the calculation).

The Black-Scholes-Merton formula is an example of a closed-form model, which is a valuation model that uses an equation to produce an estimated fair value. The formula is as shown in Figure 34.4 below.

Whilst the Black-Scholes-Merton formula is complex, its application in practice is relatively easy. It can be programmed into a spreadsheet, and numerous programs and calculators exist that use it to calculate the fair value of an option. As a result, the formula is used widely by finance professionals to value a large variety of options. However, a number of the assumptions underlying the formula may be better suited to valuing short-term, exchange-traded share options rather than employee share options.

The attributes of employee share options that render the Black-Scholes-Merton formula less effective as a valuation technique include:

• Long term to expiry

• The formula assumes that volatility, interest rates and dividends are constant over the life of the option. While this may be appropriate when valuing short-term options, the assumption of constant values is less appropriate when valuing long-term options.

• Non-transferability and early exercise

• The formula assumes a fixed maturity/exercise date. While IFRS 2 provides for the use of an ‘expected term’ in place of the contractual life to reflect the possibility of early exercise resulting from the non-transferability of employee share options or other reasons (see 8.5 below), this may not adequately describe early exercise behaviour.

• Vesting conditions and non-vesting conditions

• The formula does not take into account any market-based vesting conditions or non-vesting conditions.

• Blackout periods

• As the formula assumes exercise on a fixed date, and does not allow earlier exercise, it does not take into consideration any blackout periods (see 8.2.3.D above).

In summary, application of the Black-Scholes-Merton formula is relatively simple, in part because many of the complicating factors associated with the valuation of employee share options cannot be incorporated into it directly and, therefore, must be derived outside of the formula (e.g. the input of an expected term).

IFRS 2 states that the Black-Scholes-Merton formula may not be appropriate for long-lived options which can be exercised before the end of their life and which are subject to variation in the various inputs to the model over the life of the option. However, IFRS 2 suggests that the Black-Scholes-Merton formula may give materially correct results for options with shorter lives and with a relatively short exercise period. [IFRS 2.B5].

The development of appropriate assumptions for use in the Black-Scholes-Merton formula is discussed at 8.5 below.

As noted above, the Black-Scholes-Merton formula is an example of a closed form model that is not generally appropriate for awards that include market performance conditions. However, in certain circumstances it may be possible to use closed form solutions other than the Black-Scholes-Merton formula to value options where, for example, the share price has to reach a specified level for the options to vest. These other solutions are beyond the scope of this chapter.

8.3.2 The binomial model

The binomial model is one of a subset of valuation models known as lattice models, which adopt a flexible, iterative approach to valuation that can capture the unique aspects of employee share options. A binomial model produces an estimated fair value based on the assumed changes in prices of a financial instrument over successive periods of time. In each time period, the model assumes that at least two price movements are possible. The lattice represents the evolution of the value of either a financial instrument or a market variable for the purpose of valuing a financial instrument.

The concepts that underpin lattice models and the Black-Scholes-Merton formula are the same, but the key difference between a lattice model and a closed-form model is that a lattice model is more flexible. The valuations obtained using the Black-Scholes-Merton formula and a lattice model will be very similar if the lattice model uses identical assumptions to the Black-Scholes-Merton calculation (e.g. constant volatility, constant dividend yields, constant risk-free rate, the same expected life). However, a lattice model can explicitly use dynamic assumptions regarding the term structure of volatility, dividend yields, and interest rates.

Further, a lattice model can incorporate assumptions about how the likelihood of early exercise of an employee share option may increase as the intrinsic value of that option increases, or how employees may have a high tendency to exercise options with significant intrinsic value shortly after vesting.

In addition, a lattice model can incorporate market conditions that may be part of the design of an option, such as a requirement that an option is only exercisable if the underlying share price reaches a certain level (sometimes referred to as ‘target share price’ awards). The Black-Scholes-Merton formula is not generally appropriate for awards that have a market-based performance condition because it cannot handle that additional complexity.

Most valuation specialists believe that lattice models, through their versatility, generally provide a more accurate estimate of the fair value of an employee share option with market performance conditions or with the possibility of early exercise than a value based on a closed-form Black-Scholes-Merton formula. As a general rule, the longer the term of the option and the higher the dividend yield, the larger the amount by which the binomial lattice model value may differ from the Black-Scholes-Merton formula value.

To implement the binomial model, a ‘tree’ is constructed the branches (or time steps) of which represent alternative future share price movements over the life of the option. In each time step over the life of the option, the share price has a certain probability of moving up or down by a certain percentage amount. It is important to emphasise the assumption, in these models, that the valuation occurs in a risk-neutral world, where investors are assumed to require no extra return on average for bearing risks and the expected return on all securities is the risk-free interest rate.

To illustrate how the binomial model is used, Example 34.33 below constructs a simple binomial lattice model with a few time steps. The valuation assumptions and principles will not differ in essence from those in a Black-Scholes-Merton valuation except that the binomial lattice model will allow for early exercise of the option. The relevant difference between the two models is the specification of a very small number of time steps, for illustrative purposes, in the binomial lattice model (see also 8.3.2.A below). We discuss below how the model can be augmented for a more complex set of assumptions.

One of the advantages of a lattice model is its ability to depict a large number of possible future paths of share prices over the life of the option. In Example 34.33 above, the specification of an interval of 12 months between nodes provides an inappropriately narrow description of future price paths. The shorter the interval of time between each node, the more accurate will be the description of future share price movements.

Additions which can be made to a binomial model (or any type of lattice model) include the use of assumptions that are not fixed over the life of the option. Binomial trees may allow for conditions dependent on price and/or time, but in general do not support price-path dependent conditions and modifications to volatility. This may affect the structure of a tree making it difficult to recombine. In such cases, additional recombination techniques should be implemented, possibly with the use of a trinomial tree (i.e. one with three possible outcomes at each node).

For the first three assumptions above, the varying assumptions simply replace the value in the fixed assumption model. For instance, in Example 34.33 above r = 0.05; in a time-dependent version this could be 0.045 at time 1, 0.048 at time 2 and so on, depending on the length of time from the valuation date to the individual nodes.

However, for a more complicated addition such as assumed withdrawal rates, the equation:

may be replaced with

where ‘g’ is the rate of employee departure, on the assumption that, on departure, the option is either forfeited or exercised. As with the other time- and price-dependent assumptions, the rate of departure could also be made time- or price-dependent (i.e. the rate of departure could be assumed to increase as the share price increases, or increase as time passes, and so forth).

8.3.2.A Lattice models – number of time steps

When performing a lattice valuation, a decision must be taken as to how many time steps to use in the valuation (i.e. how much time passes between each node). Generally, the greater the number of time steps, the more accurate the final value. However, as more time steps are added, the incremental increase in accuracy declines. To illustrate the increases in accuracy, consider the diagram below, which values the option in Example 34.33 above as a European option. In this case, the binomial model has not been enhanced to allow for early exercise (i.e. the ability to exercise prior to expiry).

Whilst the binomial model is very flexible and can deal with much more complex assumptions than the Black-Scholes-Merton formula, there are certain complexities it cannot handle, which can best be accomplished by Monte Carlo Simulation – see 8.3.3 below.

The development of appropriate assumptions for use in a binomial model is discussed at 8.5 below.

In addition to the binomial model, other lattice models such as trinomial models or finite difference algorithms may be used. Discussion of these models is beyond the scope of this chapter.

8.3.3 Monte Carlo Simulation

In order to value options with market-based performance targets where the market value of the entity's equity is an input to the determination of whether, or to what extent, an award has vested, the option methodology applied must be supplemented with techniques such as Monte Carlo Simulation.

TSR compares the return on a fixed sum invested in the entity to the return on the same amount invested in a peer group of entities. Typically, the entity is then ranked in the peer group and the number of share-based awards that vest depends on the ranking. For example, no award might vest for a low ranking, the full award might vest for a higher ranking, and a pro-rated level of award might vest for a median ranking.

The following table gives an example of a possible vesting pattern for such a scheme, with a peer group of 100 entities.

Figure 34.5 below summarises the Monte Carlo approach.

The valuation could be performed using either:

• a binomial valuation or the Black-Scholes-Merton formula, dependent on the results of the Monte Carlo Simulation; or
• the Monte Carlo Simulation on its own.

The framework for calculating future share prices uses essentially the same underlying assumptions as lie behind Black-Scholes-Merton and binomial models – namely a risk-neutral world and a log normal distribution of share prices.

For a given simulation, the risk-neutral returns of the entity and those of the peer group or index are projected until the performance target is achieved and the option vests. At this point, the option transforms into a ‘vanilla’ equity call option that may be valued using an option pricing model. This value is then discounted back to the grant date so as to give the value of the option for a single simulation.

When the performance target is not achieved and the option does not vest, a zero value is recorded. This process is repeated thousands or millions of times. The average option value obtained across all simulations provides an estimate of the value of the option, allowing for the impact of the performance target.

8.4.1 Non-transferability

As noted at 8.2.3.A above, employee options and other share-based awards are almost invariably non-transferable, except (in some cases) to the employee's estate in the event of death in service. Non-transferability often results in an option being exercised early (i.e. before the end of its contractual life), as this is the only way for the employee to realise its value in cash. Therefore, by imposing the restriction of non-transferability, the entity may cause the effective life of the option to be shorter than its contractual life, resulting in a loss of time value to the holder. [IFRS 2.BC153‑169].

One aspect of time value is the value of the right to defer payment of the exercise price until the end of the option term. When the option is exercised early because of non-transferability, the entity receives the exercise price much earlier than it otherwise would. Therefore, as noted by IFRS 2, the effective time value granted by the entity to the option holder is less than that indicated by the contractual life of the option.

IFRS 2 requires the effect of early exercise as a result of non-transferability and other factors to be reflected either by modelling early exercise in a binomial or similar model or by using expected life rather than contractual life as an input into the option-pricing model. This is discussed further at 8.5.1 below.

Reducing the time to expiry effectively reduces the value of the option. This is a simplified way of reducing the value of the employee stock option to reflect the fact that employees are unable to sell their vested options, rather than applying an arbitrary discount to take account of non-transferability.

8.4.2 Treatment of vesting and non-vesting conditions

Many share-based payment awards to employees have vesting and non-vesting conditions attached to them which must be satisfied before the award can be exercised. It must be remembered that a non-market vesting condition, while reducing the ‘true’ fair value of an award, does not directly affect its valuation for the purposes of IFRS 2 (see 6.2 above). However, non-market vesting conditions may indirectly affect the value. For example, when an award vests on satisfaction of a particular target rather than at a specified time, its value may vary depending on the assessment of when that target will be met, since that may influence the expected life of the award, which is relevant to its fair value under IFRS 2 (see 6.2.3 and 8.2.2 above and 8.5 below).

8.5.1 Expected term of the option

IFRS 2 allows the estimation of the fair value of an employee share award to be based on its expected life, rather than its maximum term, as this is a reasonable means of reducing the value of the award to reflect its non-transferability.

Option value is not a linear function of option term. Rather, value increases at a decreasing rate as the term lengthens. For example, a two year option is worth less than twice as much as a one year option, if all other assumptions are equal. This means that to calculate a value for an award of options with widely different individual lives based on a single weighted average life is likely to overstate the value of the entire award. Accordingly, assumptions need to be made as to what exercise or termination behaviour an option holder will exhibit. Considerations include:

• vesting period – the expected term of the option must be at least as long as its vesting period. The length of time employees hold options after they vest may vary inversely with the length of the vesting period;
• past history of employee exercise and termination patterns for similar grants (adjusted for current expectations) – see 8.5.2 below;
• expected volatility of the underlying share – on average, employees tend to exercise options on shares with higher volatility earlier;
• periods during which exercise may be precluded and related arrangements (e.g. agreements that allow for exercise to occur automatically during such periods if certain conditions are satisfied);
• employee demographics (age, tenure, sex, position etc.); and
• time from vesting date – the likelihood of exercise typically increases as time passes.

As discussed at 8.4 above, IFRS 2 notes that the effect of early exercise can be reflected:

• by treating the expected, rather than the contractual, life of the option as an input to a pricing model, such as the Black-Scholes-Merton formula (see 8.5.1.A below); or
• by using contractual life as an input to a binomial or similar model. [IFRS 2.B16‑17].

8.5.1.A Expected term under the Black-Scholes-Merton formula

An estimate of expected term based on the types of inputs described above can be used in the Black-Scholes-Merton formula as well as a lattice model. However, the formula requires only a single expected term to be used. This is one of the reasons why the Black-Scholes-Merton formula may provide a higher valuation for the same options than a lattice model.

The difference in value that arises from using only a single expected term results, in part, from the convex shape of a typical option valuation curve, as illustrated below.

It is assumed, for the purposes of this illustration, that an at-the-money option on a €10 share with a 10-year contractual term is equally likely to be exercised at the end of each year beginning with year two. An average expected term of six years [(2+3+4+…10)/9] would be used in a Black-Scholes-Merton calculation giving a fair value of €3.10 for the option. If, instead, nine separate valuations were performed, each with a different expected term corresponding to each of the possible terms (from two to ten years), the average of those valuations (also calculated using the Black-Scholes-Merton formula) would be €2.9854. The latter amount is lower than €3.10 because of the convex shape of the valuation curve, reflecting the fact that the value increases at a decreasing rate as the term lengthens. Therefore, the value of the share option with an average expected term of six years will exceed the value derived from averaging the separate valuations for each potential term.

In a lattice model, exercise can occur at any time based on the rules specified in the model regarding exercise behaviour. The lattice model can therefore be thought of as analogous to the calculation in the above example in which the fair value was calculated as the average of the valuations from periods two to ten. In contrast, the Black-Scholes-Merton valuation allows only a single expected term to be specified. Therefore, it is analogous to the valuation described in the above example based on a single average expected term of six years.

Therefore, even if the expected term derived from a lattice model were used as an input in the Black-Scholes-Merton formula (and all other inputs were identical), the two models would give different values.

To mitigate the impact of the convex shape of the valuation curve, an entity with a broad-based share option plan might consider stratifying annual awards into different employee groups for the purposes of estimating the expected option lives (see 8.5.2 below).

Determining a single expected term can be quite challenging, particularly for an entity seeking to base its estimate on the periods for which previously granted options were outstanding, which would have been highly dependent on the circumstances during those periods. For example, if the entity's share price had increased significantly during the option period (as would be the case for share options granted by certain entities at the beginning of a bull market), it is likely that employees would have exercised options very soon after vesting. Alternatively, if options were granted at the end of a bull market and the share price declined significantly after the grant date, it is likely that the options would be exercised much later (if at all). These relationships would exist because, as discussed previously, the extent to which an option is in-the-money has a significant impact on exercise behaviour. Accordingly, deriving a single expected term in these situations involves considerable judgement.

8.5.2 Exercise and termination behaviour

IFRS 2 notes that employees often exercise options early for a number of reasons, most typically:

• restrictions on transferability mean that this is the only way of realising the value of the option in cash;
• aversion to the risk of not exercising ‘in the money’ options in the hope that they increase in value; or
• in the case of leavers, a requirement to exercise, or forfeit, all vested options on or shortly after leaving (see 8.5.2.B below).

Factors to consider in estimating early exercise include:

1. the length of the vesting period, because the share option cannot be exercised until the end of the vesting period. Hence, determining the valuation implications of expected early exercise is based on the assumption that the options will vest;
2. the average length of time similar options have remained outstanding in the past;
3. the price of the underlying shares. Experience may indicate that employees tend to exercise options when the share price reaches a specified level above the exercise price;
4. the employee's level within the organisation. For example, experience might indicate that higher-level employees tend to exercise options later than lower-level employees (see also 8.5.2.A below); and
5. the expected volatility of the underlying shares. On average, employees might tend to exercise options on highly volatile shares earlier than on shares with low volatility. [IFRS 2.B18].

In addition, the pattern of terminations of employment after vesting may be relevant (see 8.5.2.B below).

In our view, past exercise behaviour should generally serve as the starting point for determining expected exercise behaviour. That behaviour should be analysed, correlated to the factors above, and extrapolated into the future. However, significant changes in the underlying share price or in other salient characteristics of the entity, changes in option plans, tax laws, share price volatility and termination patterns may indicate that past exercise behaviour is not indicative of expected exercise behaviour. The expected life may also be estimated indirectly, by using a modified option pricing model to compute an option value, an input to which is an assumption that the options will be expected to be exercised when a particular share price is reached.

Some entities, including recently listed entities, or entities for which all outstanding grants have been out-of-the-money for a long period, may simply not be able to observe any exercise behaviour or may not possess enough history to perform a reasonable analysis of past exercise behaviour. In these cases, in our view, entities may have to look to the exercise history of employees of similar entities to develop expectations of employee exercise behaviour. At present there is only limited publicly-available information about employee exercise patterns, but valuation professionals and human resource consultants may have access to relevant data, based on which they may have articulated specific exercise patterns. In such circumstances, considerable judgement is required in assessing the comparability and appropriateness of the historic data used (including whether the data is current).

In the absence of extensive information regarding exercise behaviour, another solution could be to use a midpoint assumption – i.e. selecting as the expected date of exercise the midpoint between the first available exercise date (the end of the vesting period) and the last available exercise date (the contracted expiry date). However, this should be undertaken only when the entity is satisfied that this does not lead to a material misstatement. It is also plausible to assume exercise at the earliest possible time or to undertake a reasonable analysis of past behaviour and set up the amount of intrinsic value which, when exceeded, will trigger exercise of the option.

8.5.3 Expected volatility of share price

Expected volatility is a measure of the amount by which a price is expected to fluctuate during a period. Share price volatility has a powerful influence on the estimation of the fair value of an option, much of the value of which is derived from its potential for appreciation. The more volatile the share price, the more valuable the option. It is therefore essential that the choice of volatility assumption can be properly supported.

IFRS 2 notes that the measure of volatility used in option pricing models is the annualised standard deviation of the continuously compounded rates of return on the share over a period of time. Volatility is typically expressed in annualised terms that are comparable regardless of the time period used in the calculation (for example, daily, weekly or monthly price observations).

The expected annualised volatility of a share is the range within which the continuously compounded annual rate of return is expected to fall approximately two-thirds of the time. For example, to say that a share with an expected continuously compounded rate of return of 12% has a volatility of 30% means that the probability that the rate of return on the share for one year will be between minus 18% (12% – 30%) and 42% (12% + 30%) is approximately two-thirds. If the share price is €100 at the beginning of the year, and no dividends are paid, the year-end share price would be expected to be between €83.53 (€100 × e^–0.18) and €152.20 (€100 × e^0.42) approximately two-thirds of the time.

The rate of return (which may be positive or negative) on a share for a period measures how much a shareholder has benefited from dividends and appreciation (or depreciation) of the share price. [IFRS 2.B22‑24].

IFRS 2 gives examples of factors to consider in estimating expected volatility including the following: [IFRS 2.B25]

• Implied volatility from traded share options

  Implied volatility is the volatility derived by using an option pricing model with the traded option price (if available) as an input and solving for the volatility as the unknown on the entity's shares. It may also be derived from other traded instruments of the entity that include option features (such as convertible debt).

  Implied volatilities are often calculated by analysts and reflect market expectations for future volatility as well as imperfections in the assumptions in the valuation model. For this reason, the implied volatility of a share may be a better measure of prospective volatility than historical volatility (see below). However, traded options are usually short-term, ranging in general from one month to two years. If the expected lives are much longer than this, both the implied and historical volatilities will need to be considered.

• Historical volatility

  It may be relevant to consider the historical volatility of the share price over the most recent period that is generally commensurate with the expected term of the option (taking into account the remaining contractual life of the option and the effects of expected early exercise). However, this assumes that past share price behaviour is likely to be representative of future share price behaviour. Upon any restructuring of an entity, the question of whether or not past volatility will be likely to predict future volatility would need to be reassessed.

  The historical volatilities of similar entities may be relevant for newly listed entities, unlisted entities or entities that have undergone substantial restructuring (see 8.5.3.A to 8.5.3.C below).

• The length of time the entity's shares have been publicly traded

  A newly listed entity might have a high historical volatility, compared with similar entities that have been listed longer. Further guidance for newly listed entities is given in 8.5.3.A below.

• ‘Mean-reverting tendency’

  This refers to the tendency of volatility to revert to its long-term average level, and other factors indicating that expected future volatility might differ from past volatility. For example, if an entity's share price was extraordinarily volatile for some identifiable period of time because of a failed takeover bid or a major restructuring, that period could be disregarded in computing historical average annual volatility. However, an entity should not exclude general economic factors such as the effect of an economic downturn on share price volatility.

• Appropriate and regular intervals for price observations

  The price observations should be consistent from period to period. For example, an entity might use the closing price for each week or the opening price for the week, but it should not use the closing price for some weeks and the opening price for other weeks. Also, the price observations should be expressed in the same currency as the exercise price. In our view, at least thirty observations are generally required to calculate a statistically valid standard deviation. Our experience has been that, in general, it is more appropriate to make such observations daily or weekly rather than monthly.

8.5.4 Expected dividends

The valuation of an award of options depends on whether or not the holder is entitled to dividends or dividend equivalents (whether in the form of cash payments or reductions in the exercise price) before the award is ultimately exercised. [IFRS 2.B31‑32, B34]. The accounting treatment of awards that entitle the holder to dividends before exercise is discussed further at 15.3 below.

Dividends paid on the underlying share will impact the share option value – the higher the expected dividend yield (i.e. dividend per share ÷ share price), the lower the option value. Option holders generally do not have dividend rights until they actually exercise the options and become shareholders. All other things being equal, a share option for a share yielding a high dividend is less valuable than one for a share yielding a low dividend.

Where employees are entitled to dividends or dividend equivalents, the options granted should be valued as if no dividends will be paid on the underlying shares, so that the input for expected dividends (which would otherwise reduce the valuation of an option) is zero. Conversely, where employees are not entitled to dividends or dividend equivalents, the expected dividends should be included in the application of the pricing model. [IFRS 2.B31‑32, B34].

While option pricing models generally call for an expected dividend yield, they may be modified to use an expected dividend amount rather than a yield. Where an entity uses expected payments rather than expected yields, it should consider its historical pattern of increases in dividends. For example, if an entity's policy has generally been to increase dividends, its estimated option value should not assume a fixed dividend amount throughout the life of the option unless there is evidence to support that assumption. [IFRS 2.B35].

Determination of the expected dividends over the expected term of the option requires judgement. Generally, the expected dividend assumption should be based on current expectations about an entity's anticipated dividend policy. For example, an entity that has demonstrated a stable dividend yield in past years, and has indicated no foreseeable plans to change its dividend policy, may simply use its historical dividend yield to estimate the fair value of its options. If an entity has never paid a dividend, but has publicly announced that it will begin paying a dividend yielding 2% of the current share price, it is likely that an expected dividend yield of 2% would be assumed in estimating the fair value of its options.

Generally, assumptions about expected dividends should be based on publicly available information. Thus, an entity that does not pay dividends and has no plans to do so should assume an expected dividend yield of zero. However, an emerging entity with no history of paying dividends might expect to begin paying dividends during the expected lives of its employee share options. Such entities could use an average of their past dividend yield (zero) and the mean dividend yield of a comparable peer group of entities. [IFRS 2.B36].

8.5.5 Risk-free interest rate

Typically, the risk-free interest rate is the implied yield currently available on zero-coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term of the option being valued (based on the remaining contractual life of the option and taking into account the effects of expected early exercise). It may be necessary to use an appropriate substitute, if no such government issues exist, or where the implied yield on zero-coupon government issues may not be representative of the risk-free interest rate (for example, in high inflation economies). An appropriate substitute should also be used if market participants would typically determine the risk-free interest rate by using that substitute. [IFRS 2.B37].

The risk-free interest rate will not have an impact on most free share grants unless the counterparty is not entitled to dividends during the vesting period and the fair value of the grant has been reduced by the present value of the dividends. Otherwise, grants of free shares have an exercise price of zero and therefore involve no cash outflow for the holder.

8.7.1 Shares

IFRS 2 requires shares granted to employees to be valued at their market price (where one exists) or an estimated market value (where the shares are not publicly traded), in either case adjusted to take account of the terms and conditions on which the shares were granted, other than those vesting conditions that IFRS 2 requires to be excluded in determining the grant date fair value (see 6.2 above). [IFRS 2.B2].

For example, the valuation should take account of restrictions on the employee's right:

• to receive dividends in the vesting period (see below); or
• to transfer shares after vesting, but only to the extent that such restrictions would affect the price that a knowledgeable and willing market participant would pay for the shares. Where the shares are traded in a deep and liquid market, the effect may be negligible.

The valuation should not, however, take account of restrictions on transfer or other restrictions that exist during the vesting period and which stem from the existence of vesting conditions. [IFRS 2.B3].

Whether dividends should be taken into account in measuring the fair value of shares depends on whether the counterparty is entitled to dividends or dividend equivalents (which might be paid in cash) during the vesting period. When the grant date fair value of shares granted to employees is estimated, no adjustment is required if the employees are entitled to receive dividends during the vesting period (as they are in no different a position in this respect than if they already held shares). However, where employees are not entitled to receive dividends during the vesting period, the valuation should be reduced by the present value of dividends expected to be paid during the vesting period. [IFRS 2.B31, B33‑34]. The basis on which expected dividends during the vesting period might be determined is discussed in the context of the impact of expected dividends on the fair value of share options at 8.5.4 above.

The accounting treatment of awards which give the right to receive dividends or dividend equivalents during the vesting period is discussed further at 15.3 below.

8.7.2 Non-recourse loans

Non-recourse loans are loans granted by an entity to the employee to allow the employee to buy shares, and are discussed in more detail at 15.2 below. Generally, however, the loan is interest-free, with the dividends received on the purchased shares being used to repay the loan. The loan acts like an option, in that, at the point in time when the holder decides to sell the shares to repay the loan, if the shares are worth less than the loan, the remaining part of the loan is forgiven, with the effect that, just as in the case of an option, the holder bears no risk of ownership.

8.7.3 Share appreciation rights (SARs)

A share appreciation right (SAR) is a grant whereby the employee will become entitled either to shares or, more commonly, to a future cash payment based on the increase in the entity's share price from a specified level over a period of time (see further discussion at 9 below on cash-settled awards). This essentially has the same payoff as a call option, except the award is generally cash- rather than equity-settled.

8.7.4 Performance rights

A performance right is the right to acquire further shares after vesting, upon certain criteria being met. These criteria may include certain performance conditions which can usually be modelled with either a Black-Scholes-Merton formula or a binomial lattice model or a Monte Carlo Simulation depending on the nature of the conditions attached to the rights. Such awards may be structured as matching share awards, as discussed in more detail at 15.1 below.

8.8.1 Intrinsic value method – the basic accounting treatment

Under the intrinsic value method:

1. the entity measures the intrinsic value of the award at each reporting date between grant date and settlement (whether through exercise, forfeiture or lapse);
2. at each reporting date during the vesting period the cumulative expense should be determined as the intrinsic value of the award at that date multiplied by the expired portion of the vesting period, with all changes in the cumulative expense recognised in profit or loss; and
3. once options have vested, all changes in their intrinsic value until settlement should be recognised in profit or loss. [IFRS 2.24(a)].

The cumulative expense during the vesting period, like that for awards measured at fair value, should always be based on the best estimate of the number of awards that will actually vest (see 6 above). However, the distinction between market vesting conditions, non-market vesting conditions and non-vesting conditions that would apply to equity-settled awards measured at fair value (see 6.1 to 6.4 above) does not apply in the case of awards measured at intrinsic value. [IFRS 2.24(b)]. In other words, where an award measured at intrinsic value is subject to a market condition or non-vesting condition that is not met, there is ultimately no accounting expense for that award. This is consistent with a model requiring constant remeasurement.

The cost of awards measured at intrinsic value is ultimately revised to reflect the number of awards that are actually exercised. However, during the vesting period the cost should be based on the number of awards estimated to vest and thereafter on the number of awards that have vested. In other words, any post-vesting forfeiture or lapse should not be anticipated, but should be accounted for as it occurs. [IFRS 2.24(b)].

Example 34.34 is based on IG Example 10 in the implementation guidance to IFRS 2 and illustrates the intrinsic value method. [IFRS 2 IG Example 10].

If, more realistically, the options had been exercisable, and were exercised, at other dates, it would have been necessary to record as an expense for those options the movement in intrinsic value from the start of the year until exercise date. For example, if the 6,000 options in year 4 had been exercised during the year when the intrinsic value was €20, the expense for that period would have been €511,000 comprising €481,000 change in value for the options outstanding at the end of year [37,000 options × €(28 – 15)] and €30,000 change in value of options exercised during the period [6,000 options × €(20 – 15)].

Since the intrinsic value method will initially be applied at the date at which the entity obtains the goods or the counterparty renders service and continues to be applied at the end of each reporting period until the date of final settlement, in our view the entity should continue to apply this method of measurement throughout the life of such an award even if it becomes possible to measure the fair value of the award at some stage prior to its settlement.

8.8.2 Modification, cancellation and settlement

The methodology of the intrinsic value method has the effect that modification or cancellation is dealt with automatically, and the rules for modification and cancellation of awards measured at fair value (see 7 above) therefore do not apply. [IFRS 2.25].

Where an award accounted for at intrinsic value is settled in cash, the following provisions apply, which are broadly similar to the rules for settlement of awards accounted for at fair value.

If settlement occurs before vesting, the entity must treat this as an acceleration of vesting and ‘recognise immediately the amount that would otherwise have been recognised for services received over the remainder of the vesting period’. [IFRS 2.25(a)]. The wording here is the same as that applicable to settlement of awards accounted for at fair value, which we discuss in more detail at 7.4.3 above.

Any payment made on settlement must be deducted from equity, except to the extent that it is greater than the intrinsic value of the award at settlement date. Any such excess is accounted for as an expense. [IFRS 2.25(b)].

9.2.1 Formal and informal arrangements for the entity to purchase illiquid shares or otherwise settle in cash (awards to be treated as cash-settled, including unlisted company schemes)

Some share-based payment awards, particularly when made by unlisted entities, might appear to be equity-settled in form but, in our view, will need to be accounted for as cash-settled awards under IFRS 2. This reflects either specific arrangements put in place by the entity (or a shareholder) for the employees to sell their shares or, more generally, the illiquid market in the shares which, in the absence of compelling evidence to the contrary, is likely to result in a cash payment by the entity to the counterparty at some stage.

This is similar to the assessment for awards where the agreement states that entities have a choice of settlement in equity or cash (see 10.2.1.A below).

9.2.2 Market purchases of own equity used to satisfy awards

It is common for an entity to choose to settle equity-settled transactions using shares previously purchased in the market rather than by issuing new shares. This does not mean that the transaction is cash-settled, since there is no obligation to deliver cash to the counterparty. [IFRS 2.B48‑49].

The purchase of own shares is accounted for in accordance with the provisions of IAS 32 relating to treasury shares and other transactions over own equity (see Chapter 47 at 9).

A question sometimes asked is whether the entity should recognise some form of liability to repurchase its own equity in situations where the entity has a stated policy of settling equity-settled transactions using previously purchased treasury shares. In our view, the normal provisions of IAS 32 apply. For example, a public commitment to settle equity-settled transactions by purchasing treasury shares is no different in substance to a commitment to a share buyback programme. There would be no question under IAS 32 of recognising a liability to repurchase own equity on the basis merely of a declared intention. It is only when the entity enters into a forward contract or a call option with a third party that some accounting recognition of a future share purchase may be required.

9.2.3 Market purchases of own equity following equity-settlement of award

An entity might sometimes make a market purchase of its own shares shortly after issuing a similar number of shares in settlement of an equity-settled transaction. This raises the question of whether such a scheme would be considered as in substance cash-settled.

In our view, further enquiry into the detailed circumstances of the market purchase is required in order to determine the appropriate analysis under IFRS 2.

Broadly speaking, so long as there is no obligation (explicit or implicit) for the entity to settle in cash with the counterparty, such market purchase arrangements will not require a scheme to be treated as cash-settled under IFRS 2. This will be the case even where the entity, as a means of managing the dilutive impact on earnings per share of equity-settlement, routinely buys back shares broadly equivalent to the number issued in settlement.

However, in our view, there might be situations in which post-settlement market share purchases are indicative of an obligation to the counterparty, such that treatment as a cash-settled scheme would be appropriate.

For example, the shares might be quoted in a market which is not very deep, or in which the entity itself is a major participant. If the entity were to create an expectation by employees that any shares awarded can always be liquidated immediately, because the entity will ensure that there is sufficient depth in the market to do so, it could well be appropriate to account for such a scheme as cash‑settled. The treatment of schemes in which the entity has a choice of settlement, but has created an expectation of cash-settlement, provides a relevant analogy (see 10.2.1 below).

A more extreme example of such a situation would be where the entity has arranged for the shares delivered to the counterparty to be sold on the counterparty's behalf by a broker (see 9.2.4 below), but has at the same time entered into a contract to purchase those shares from the broker. In that situation, in our view, the substance is that:

• the entity has created an expectation by the counterparty of a right to receive cash; and
• the broker is no more than an agent paying that cash to the counterparty on behalf of the entity.

Accordingly, it would be appropriate to account for such an arrangement as a cash-settled award.

In a situation where the entity had pre-arranged to purchase some, but not all, the shares from the broker, in our view it would generally be appropriate to treat the award as cash-settled only to the extent of the shares subject to the purchase agreement.

9.2.4 Arrangements to sell employees’ shares including ‘broker settlement’

Many recipients of share awards, particularly employees in lower and middle ranking positions within an entity, do not wish to become long-term investors in the entity and prefer instead to realise any equity-settled awards in cash soon after receipt. In order to facilitate this, the entity may either sell the shares in the market on the employees’ behalf or, more likely, arrange for a third party broker to do so.

Such an arrangement (sometimes referred to as ‘broker settlement’) does not of itself create a cash-settled award, provided that the entity has not created any obligation to provide cash 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, that may well mean that analysis as a cash-settled scheme is more appropriate (see also 9.2.3 above).

Broker settlement arrangements may raise a general concern that an entity may be masking what are really issues of shares to raise cash to pay its employees as sales of shares on behalf of employees. If an entity were simply to issue shares (or reissue treasury shares) for cash, and then use that cash to pay an employee's salary, the normal accounting treatment for such a transaction would be to credit equity with the proceeds of issue or reissue of shares, and to charge the payment to the employee to profit or loss.

By contrast, 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 an expense will be recognised for the award of shares under IFRS 2. However, 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 therefore for the entity to be able to demonstrate the true economic nature of the transaction.

For this reason, some take the view that a sale of shares can be regarded as part of a broker settlement arrangement only if the shares are first legally registered in the name of the employee. Whilst we understand the concerns that lie behind this view, we nevertheless question whether legal registration is necessary to demonstrate the substance of a broker settlement arrangement. For example, suppose that 100 shares vest in each of 10 employees who all express a wish that the entity sell the shares on their behalf, and the entity then sells 1,000 treasury shares on behalf of the employees, but without first re-registering title to the shares to the employees. We do not believe that the entity should automatically be precluded from regarding this as a broker settlement arrangement, particularly where the treasury shares are held not by the entity directly but through an employee benefit trust or similar vehicle (see 12.3 below) that is permitted to hold or sell shares only for the benefit of employees.

By contrast, the entity might regularly purchase and sell treasury shares, but identify some of the sales as being undertaken on behalf of employees only after they have occurred. Such an arrangement, in our view, is more difficult to construe as a true broker-settlement arrangement.

Where shares are sold on behalf of an employee, they will typically attract transaction costs, such as brokerage fees or taxes. If such costs are borne by the entity, they should, in our view, be included within profit or loss as an additional component of employment costs, rather than deducted from equity as a cost of a transaction in own shares.

This highlights a commercial disadvantage of broker settlement arrangements. The entity may have to:

• purchase shares in the market (incurring transaction costs) on behalf of an employee who does not want them and then sell them back into the market on the employee's behalf (incurring more transaction costs); or
• sell shares in the market (incurring transaction costs) on behalf of an employee who does not want them and then buy them back in the market on behalf of another employee who does want them (incurring more transaction costs).

In order to avoid this, entities may try to structure arrangements with their brokers involving back-to-back sale and purchase contracts, under which shares are never physically delivered, but the entity makes a cash payment to the broker in purported settlement of the purchase by the broker of shares on behalf of the entity and the broker passes it on to the employee in purported settlement of the sale of the shares by the broker on behalf of the employee.

In our view, such arrangements cannot be seen as equity-settled transactions with broker settlement, but must be regarded as cash-settled share-based payment transactions, using the broker as paying agent.

Related issues are raised by the ‘drag along’ and ‘tag along’ rights that are often a feature of awards designed to reward employees for a successful flotation or other exit event (see 15.4.6 below).

9.3.1 Basic accounting treatment

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. Moreover, the cumulative cost recognised until settlement is clearly a liability, not a component of equity.

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 specific requirements of IFRS 2;
• during the vesting period, the liability recognised at each reporting date is the IFRS 2 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.

All changes in the liability are recognised in profit or loss for the period. [IFRS 2.30‑33D, IG Example 12, IG Example 12A]. 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 is not adjusted for changes in the fair value of the liability. [IFRS 2.IG19].

The fair value of the liability should be determined, initially and at each reporting date until it is settled, 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. [IFRS 2.33]. Determination of fair value is subject to the requirements of paragraphs 33A to 33D of IFRS 2, these paragraphs clarify the treatment of vesting and non-vesting conditions and are discussed further at 9.3.2 below. [IFRS 2.33].

This has the effect that, although the liability will ultimately be settled at its then intrinsic value, its measurement at reporting dates before settlement is based on its fair value. Before the initial publication of IFRS 2, a number of respondents to the IASB's earlier exposure draft suggested that, for reasons of consistency and simplicity of calculation, cash-settled transactions should be measured at intrinsic value throughout their entire life. The IASB, while accepting these merits of the intrinsic value approach, rejected it on the basis that, since it does not include a time value, it is not an adequate measure of either the liability or the cost of services consumed. [IFRS 2.BC246‑251].

As noted at 5.5 above, the approach to determining the fair value of share-based payments continues to be that specified in IFRS 2 as share-based payments fall outside the scope of IFRS 13 which applies more generally to the measurement of fair value under IFRSs (see Chapter 14). [IFRS 2.6A].

IFRS 2 uses the term ‘share appreciation rights’ when referring to measurement of the liability but makes clear that this should be read as including any cash-settled share-based payment transaction. [IFRS 2.31].

9.3.2 Application of the accounting treatment

The treatment required by IFRS 2 for cash-settled transactions is illustrated by Example 34.37 below and by Example 34.38 at 9.3.2.C below. These examples are based, respectively, on IG Examples 12 and 12A in the implementation guidance accompanying IFRS 2. [IFRS 2 IG Example 12, IG Example 12A].

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 and not merely at grant date (and at the date of any subsequent modification or settlement) as would be the case for equity-settled transactions.

As Example 34.37 shows, it is not generally necessary, although arguably required by IFRS 2, to determine the fair value of a cash-settled transaction at grant date, at least to determine the expense under IFRS 2. However, for entities subject to IAS 33 – Earnings per Share – the grant date fair value may be required in order to make the disclosures required by that standard – see Chapter 37 at 6.4.2.

We discuss in more detail at 9.3.2.A to 9.3.2.E below the following aspects of the accounting treatment of cash-settled transactions:

• determining the vesting period (see 9.3.2.A below);
• periodic allocation of cost (see 9.3.2.B below);
• treatment of non-market vesting conditions (see 9.3.2.C below);
• treatment of market conditions and non-vesting conditions (see 9.3.2.D below); and
• treatment of modification, cancellation and settlement (see 9.3.2.E below).

9.4.1 Equity-settled award modified to cash-settled award

This section focuses on accounting for a change of settlement method rather than on the accounting treatment of other modifications to an equity-settled award that might be made at the same time as the change of settlement method (see 7.3 above).

Drawing on the principles within the guidance referred to at 9.4 above, we suggest that entities generally select one of the two approaches discussed below to account for the modification of an award from equity-settled to cash-settled during the vesting period. The first approach is based more closely on the IFRS 2 treatment for the modification of an equity-settled award (see 7.3 above) and the second on that for the repurchase or settlement in cash of an equity instrument (see 7.4 above).

Both approaches take into account IG Example 9 in the implementation guidance to IFRS 2 (see 10.1.4 below) which shows the recognition of an expense when the cash-settlement alternative is remeasured in the period following modification, in addition to an expense for the full grant date fair value of the equity-settled arrangement. Although this Example reflects a choice of settlement by the counterparty, rather than the elimination of a method of settlement (as is the case in a modification from equity-settlement to cash-settlement), we believe that an analogy may be drawn between the two situations because the addition of a cash alternative for the counterparty effectively results in the award being treated as cash-settled from the date of modification.

The two approaches are discussed in more detail below and illustrated in Example 34.39. In our view, either approach is acceptable in the absence of clear guidance in IFRS 2 but the choice of approach should be applied consistently to all such modifications.

Both approaches require the recognition, as a minimum, of an IFRS 2 expense which comprises the following elements:

• the grant date fair value of the original equity-settled award (see 7.3 above); plus
• any incremental fair value arising from the modification of that award (see 7.1 above); plus
• any remeasurement of the liability between its fair value at the modification date and the amount finally settled (see 10.1.4 below).

Over the vesting period as a whole, both approaches result in the same total IFRS 2 expense and the same liability/cash settlement amount. Under both approaches, the net overall difference between the expense and the cash settlement amount is an adjustment to equity. However, the timing of recognition of any incremental fair value arising on modification will differ under the two approaches, as explained below.

Approach 1

• At the date of modification a liability is recognised based on the fair value of the cash-settled award as at that date and the extent to which the vesting period has expired.
• The entire corresponding debit is taken to equity. Any incremental fair value of the cash-settled award over that of the equity-settled award as at the modification date will be expensed over the period from the date of modification to the date of settlement of the cash-settled award (i.e. no expense is recognised at the date of modification).
• The total fair value of the cash-settled award is remeasured through profit or loss on an ongoing basis between the date of modification and the date of settlement.

As Approach 1 is based on the accounting treatment for a modification of an equity-settled award, no incremental fair value is recognised as an expense at the modification date. This means that, in cases where the fair value of the modified award is higher at the date of modification than that of the original award, the reduction in equity at the date of modification will be higher than the proportionate fair value at that date of the original equity-settled award. This situation reverses over the remainder of the vesting period when an expense (and corresponding credit to equity) will be recognised for the incremental fair value of the modified award.

Approach 2

• As for Approach 1, at the date of modification a liability is recognised based on the fair value of the cash-settled award as at that date and the extent to which the vesting period has expired.
• Unlike Approach 1, the corresponding debit is taken to equity only to the extent of the fair value of the original equity-settled award as at the date of modification. Any incremental fair value of the cash-settled award over the equity-settled award as at the modification date is expensed immediately on modification to the extent that the vesting period has expired. The remainder of any incremental value is expensed over the period from the date of modification to the date of settlement.
• As for Approach 1, the total fair value of the cash-settled award is remeasured through profit or loss on an ongoing basis between the date of modification and the date of settlement.

Approach 2 is based on the accounting treatment for the repurchase of an equity instrument where a reduction in equity up to the fair value of the equity instrument is recognised as at the date of repurchase with any incremental fair value of the repurchase arrangement being treated as an expense. Whilst Approach 2 avoids the potential problem of an immediate reduction in equity in excess of the fair value of the equity-settled award, its settlement approach could be seen as diverging from the basic IFRS 2 treatment for the modification of an equity-settled award where none of the incremental fair value arising on a modification is expensed at the date of modification.

As noted at the start of this section, the two approaches outlined above are based on the specific principles referred to at 9.4 above. In the absence of clear guidance in the standard, other interpretations of the appropriate expense and equity adjustment are also possible, although these will sometimes result in a higher expense through profit or loss than the two approaches above. For example, in relation to the cash-settled award, the approaches outlined above expense only the difference between the final settlement amount and the full fair value of the liability at the modification date, with the remainder adjusted through equity. An alternative view follows the accounting treatment for cash-settled awards which would lead to the recognition of an expense for the entire remeasurement of the liability from the amount recognised for a part-vested award at modification date to the amount finally settled.

As noted at 9.4 above, the IASB decided that existing implementation guidance in IFRS 2 could be applied by analogy to other types of modification. As an example of this, it states that IG Example 9 illustrates a grant of shares to which a cash settlement alternative is subsequently added. [IFRS 2.BC237K]. The approach in IG Example 9 has been considered within our two suggested accounting approaches and is also discussed further in the context of Example 34.39 below.

9.4.2 Cash-settled award modified to equity-settled award

IFRS 2 provides guidance in situations where the terms and conditions of a cash-settled award are modified so that it becomes equity-settled. Appendix B to IFRS 2 states that if a cash-settled transaction is modified so that it becomes equity-settled, the transaction will be accounted for as such from the date of the modification and specifically:

• the equity-settled share-based payment transaction is measured by reference to the modification date fair value of the equity instruments granted at that date;
• the equity-settled share-based payment transaction is recognised in equity on the modification date to the extent to which goods or services have been received;
• the liability for the cash-settled share-based payment transaction as at the modification date is derecognised on that date; and
• any difference between the carrying amount of the liability derecognised and the amount recognised in equity on the modification date is recognised immediately in profit or loss. [IFRS 2.B44A].

If the vesting period is extended or shortened as a result of the modification, the modified vesting period is reflected in applying the requirements above. The standard also clarifies that these requirements apply even if the modification takes place after the vesting period. [IFRS 2.B44B].

The standard further clarifies that the above requirements apply if a cash-settled share-based payment is cancelled or settled (other than by forfeiture when vesting conditions are not satisfied) and equity instruments are designated as a replacement for the cancelled or settled share-based payment. In order to qualify as a replacement, the equity instruments must be designated as such on the grant date. [IFRS 2.B44C].

The IASB notes in the Basis for Conclusions that the immediate recognition in profit or loss of any difference between the derecognised liability and the amount recognised in equity is consistent with how cash-settled share-based payments are measured in accordance with paragraph 30 of IFRS 2. It also observes that the approach is consistent with the requirements for the extinguishment of a financial liability (fully or partially by the issue of equity instruments) in IFRS 9 and in IFRIC 19 – Extinguishing Financial Liabilities with Equity Instruments. [IFRS 2.BC237H].

IG Example 12C in the implementation guidance of IFRS 2 illustrates the above guidance and forms the basis of Example 34.40 below. [IFRS 2 IG Example 12C].

10.1.1 Transactions in which the fair value is measured directly

Transactions with non-employees are normally measured by reference to the fair value of goods and services supplied at service date (i.e. the date at which the goods or services are supplied) – see 4 and 5 above.

Accordingly where an entity enters into such a transaction where the counterparty has choice of settlement, it determines the fair value of the liability component at service date. The equity component is the difference between the fair value (at service date) of the goods or services received and the fair value of the liability component. [IFRS 2.35].

10.1.2 Transactions in which the fair value is measured indirectly – including transactions with employees

All other transactions, including those with employees, are measured by reference to the fair value of the instruments issued at ‘measurement date’, being grant date in the case of transactions with employees and service date in the case of transactions with non-employees [IFRS 2 Appendix A] – see 4.1 and 5.1 above.

The fair value should take into account the terms and conditions on which the rights to cash or equity instruments were issued. [IFRS 2.36]. IFRS 2 does not elaborate further on this, but we assume that the IASB intends a reporting entity to apply:

• as regards the equity component of the transaction, the provisions of IFRS 2 relating to the impact of terms and conditions on the valuation of equity-settled transactions (see 4 to 6 above); and
• as regards the liability component of the transaction, the provisions of IFRS 2 relating to the impact of terms and conditions on the valuation of cash-settled transactions (see 9.3 above).

The entity should first measure the fair value of the liability component and then that of the equity component. The fair value of the equity component must be reduced to take into account the fact that the counterparty must forfeit the right to receive cash in order to receive shares. The sum of the two components is the fair value of the whole compound instrument. [IFRS 2.37]. IG Example 13 in IFRS 2 (the substance of which is reproduced as Example 34.41 below) suggests that this may be done by establishing the fair value of the equity alternative and subtracting from it the fair value of the liability component. This approach may be appropriate in a straightforward situation involving ordinary shares and cash, as illustrated in the Example in the implementation guidance, but will not necessarily be appropriate in more complex situations that include, for example, the likelihood of options being exercised.

In many share-based payment transactions with a choice of settlement, the value to the counterparty 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. This will mean that the fair value of the liability component is equal to that of the transaction as a whole, so that the fair value of the equity component is zero. In other words, the transaction is accounted for as if it were a cash-settled transaction.

However, in some jurisdictions it is not uncommon, particularly in transactions with employees, for the equity-settlement alternative to have more value (as in Example 34.41 below). 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 cases the equity component will have an independent value. [IFRS 2.37]. Such schemes are discussed in more detail in Examples 34.63 and 34.64 at 15.1 below.

10.1.3 Accounting treatment

10.1.4 Transactions with cash-settlement alternative for employee introduced after grant date

Such transactions are not specifically addressed in the main body of IFRS 2. However, IG Example 9 in the implementation guidance does address this issue, in the context of the rules for the modification of awards (discussed at 7.3 and 9.4 above). The substance of this example is reproduced as Example 34.42 below. [IFRS 2 IG Example 9].

IG Example 9 only illustrates a situation where the grant date fair value of the equity-settled award exceeds the modification date fair value of both the equity and cash alternatives and the settlement date value of the cash alternative. In Example 34.39 at 9.4.1 above we consider alternative scenarios, including one where the modification date fair value exceeds the grant date fair value.

10.1.5 ‘Backstop’ cash settlement rights

Some schemes may provide cash settlement rights to the holder so as to cover more or less remote contingencies. For example, an employee whose nationality and/or country of permanent residence is different from the jurisdiction of the reporting entity may be offered the option of cash settlement in case unforeseen future events make the transfer of equity from the entity's jurisdiction, or the holding or trading of it in the employee's country, inconvenient or impossible.

If the terms of the award provide the employee with a general right of cash-settlement, IFRS 2 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 10.3 below).

10.1.6 Convertible bonds issued to acquire goods or services

In some jurisdictions entities issue convertible bonds to employees or other counterparties in exchange for goods or services. When this occurs, the bond will generally be accounted for under IFRS 2 rather than IAS 32 since it falls within the scope of IFRS 2 as a transaction ‘in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments’ (see 2.2.1 and 2.2.2 above). [IFRS 2.2(c)].

As noted at 10.1 above, the methodology for splitting such an instrument into its liability and equity components under IFRS 2 differs from that under IAS 32. Moreover, under IAS 32 a convertible instrument is (broadly) recognised at fair value on the date of issue, whereas under IFRS 2 the fair value is accrued over time if the arrangement includes the rendering of services after the date of grant.

It is therefore possible that, if an entity has issued to employees convertible bonds that have also been issued in the market, the accounting treatment of the bonds issued to employees will differ significantly from that of the bonds issued in the market.

Where a convertible instrument is issued to an employee, the IFRS 2 expense will be based on the fair value of the instrument. However, if an entity issues a convertible instrument to a non-employee in return for an asset, for example a property, the entity will initially recognise a liability component at fair value and an equity component based on the difference between the fair value of the property and the fair value of the liability component. [IFRS 2.35]. If the fair value of the property were lower than the fair value of the instrument as a whole then, in our view, the entity should also recognise the shortfall in accordance with the requirements of IFRS 2 for unidentified goods or services. [IFRS 2.13A]. In the case of the acquisition of an asset, it is possible that this additional debit could be capitalised as part of the cost of the asset under IAS 16 – Property, Plant and Equipment – but in other cases it would be expensed.

After the initial IFRS 2 accounting outlined above, the question arises as to whether the subsequent accounting for the convertible instrument should be in accordance with IFRS 2 or IFRS 9. In our view, the instrument should generally continue to be accounted for under IFRS 2 until shares or cash are delivered to the counterparty. However, if the vested instrument were freely transferable or tradeable prior to conversion or settlement then a switch to IFRS 9 might be appropriate following transfer to a different counterparty (if considered practical to apply) – see also the discussion at 2.2.2.E above.

10.2.1 Transactions treated as cash-settled

IFRS 2 requires a transaction to be treated as a liability (and accounted for using the rules for cash-settled transactions discussed in 9 above) if:

1. the choice of settlement has no commercial substance (for example, because the entity is legally prohibited from issuing shares);
2. the entity has a past practice or stated policy of settling in cash; or
3. the entity generally settles in cash whenever the counterparty asks for cash settlement. [IFRS 2.41‑42].

These criteria are fundamentally different from those in IAS 32 for derivatives over own shares (which is what cash-settled share-based payment transactions are) not within the scope of IFRS 2. IAS 32 rejects an approach based on past practice or intention and broadly requires all derivatives over own equity that could result in an exchange by the reporting entity of anything other than a fixed number of shares for a fixed amount of cash to be treated as giving rise to a financial instrument (see Chapter 47 at 4).

An important practical effect of the IFRS 2 criteria is that some schemes that may appear at first sight to be equity-settled may in fact have to be treated as cash-settled. For example, if an entity has consistently adopted a policy of granting ex gratia cash compensation to all those deemed to be ‘good’ leavers (or all ‘good’ leavers of certain seniority) in respect of partially vested share options, such a scheme may well be treated as cash-settled for the purposes of IFRS 2 to the extent to which there are expected to be such ‘good’ leavers during the vesting period. ‘Good leaver’ arrangements are also discussed at 5.3.9 above.

Another common example is that an entity may have a global share scheme with an entity option for cash settlement which it always exercises in respect of awards to employees in jurisdictions where it is difficult or illegal to hold shares in the parent. Such a scheme should be treated as a cash-settled scheme in respect of those jurisdictions. However, in our view, it would be appropriate to account for the scheme in other jurisdictions as equity-settled (provided of course that none of the criteria in (a) to (c) above applied in those jurisdictions).

Where an entity has accounted for a transaction as cash-settled, IFRS 2 gives no specific guidance as to the accounting treatment on settlement, but it is clear from other provisions of IFRS 2 that the liability should be remeasured to fair value at settlement date and:

• if cash-settlement occurs, the cash paid is applied to reduce the liability; and
• if equity-settlement occurs, the liability is transferred into equity (see 10.1.3.B above).

10.2.2 Transactions treated as equity-settled

A transaction not meeting the criteria in 10.2.1 above to be treated as cash-settled should be accounted for as an equity-settled transaction using the rules for such transactions discussed in 4 to 8 above. [IFRS 2.43].

However, when the transaction is settled the following approach is adopted:

1. if the entity chooses to settle in cash, the cash payment is accounted for as the repurchase of an equity interest, i.e. as a deduction from equity, except as noted in (c) below;
2. if the entity chooses to settle by issuing equity instruments, no further accounting is required (other than a transfer from one component of equity to another, if necessary), except as noted in (c) below;
3. if the entity chooses the settlement alternative with the higher fair value, as at the date of settlement, the entity recognises an additional expense for the excess value given, i.e. the difference between the cash paid and the fair value of the equity instruments that would otherwise have been issued, or the difference between the fair value of the equity instruments issued and the amount of cash that would otherwise have been paid, whichever is applicable. [IFRS 2.43].

This is illustrated in Examples 34.43 and 34.44 below.

It can be seen in this case that, if the transaction is settled in equity, an additional expense is recognised. If, however, the transaction had simply been an equity-settled transaction (i.e. with no cash alternative), there would have been no additional expense on settlement and the cumulative expense would have been only £1,000 based on the fair value at grant date.

10.2.3 Change in entity's settlement policy or intention leading to change in classification of award after grant date

IFRS 2 does not specify 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 also at each reporting date until it is settled.

However, in describing the accounting treatment IFRS 2 states several times that the accounting depends on whether the entity ‘has a present obligation to settle in cash’ (our emphasis added). In our view, this suggests that IFRS 2 intends the position to be reviewed at each reporting date and not just considered at the inception of the transaction.

IFRS 2 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 9.4 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 10.3 below).

10.3.1 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 under IFRS 2 appears to be whether the reporting entity can unilaterally avoid cash-settlement (see 10.1 and 10.2 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, since there is nothing that the entity could do to prevent cash-settlement. 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 10.1 and 10.2 above.

Whilst, in our view, this is an acceptable accounting approach, it does not seem entirely satisfactory. For example, in a number of jurisdictions, 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 analysis 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 under IAS 19. IAS 19 would generally require the entity to recognise a liability for such a benefit based on an actuarial estimate (see Chapter 35 at 3.6), rather than on a presumption that the entire workforce will die in service.

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

It was presumably considerations such as those above that led the FASB staff to provide an interpretation²⁶ of the equivalent provisions of ASC 718 regarding awards that are cash-settled in certain circumstances. This interpretation states that a cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee's control does not give rise to a liability until it becomes probable that that event will occur.²⁷

In our view, an approach based on the probability of a contingent event that is outside the control of both the counterparty and the entity is also acceptable under IFRS and is frequently applied in practice. The implied rationale (by reference to IFRS literature) is that:

• IFRS 2 clearly notes a number of inconsistencies between IFRS 2 and IAS 32 (see 1.4.1 above) and so there is no requirement to follow IAS 32 in respect of contingent cash settlement arrangements; and
• it is therefore appropriate to have regard to the principles of IAS 37 in determining whether an uncertain future event gives rise to a liability. IAS 37 requires a liability to be recognised only when it is probable (i.e. more likely than not) to occur (see Chapter 26).

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 10.3.3 below).

10.3.3 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 interests arising in the acquired entity when equity-settled awards are settled after the change of control.

The question of whether or not a change of control is within the control of the entity is a matter that has been the subject of much discussion in the context of determining the classification of certain financial instruments by their issuer, and is considered more fully in Chapter 47 at 4.3.

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 in 10.2.1 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 10.1.5 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. Thus, under this approach, the entity could find itself in the situation where it treats:

• as a liability: an award with an 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.

In selecting an accounting policy, an entity should however be aware of the IASB's discussions on whether an approach based on the ‘probable’ outcome should be applied or whether an approach based on the accounting treatment for a compound instrument should be used (see 10.3.5 below).

There is further discussion at 15.4 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 15.4.6 below).

10.3.4 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 (see 10.3.4.A below for discussion of awards that have also been modified). 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 6.3.6 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 9.4 and 10.2.3 above).

As noted at 10.3.5 below, discussions by the Interpretations Committee indicated a preference for treating an award as equity-settled or cash-settled in its entirety, based on the probable outcome, rather than as a compound instrument, but subsequent discussions by the IASB were divided.

10.3.5 Manner of settlement contingent on future events: discussions by the IASB and the Interpretations Committee

Following an earlier request to the Interpretations Committee for clarification on how share-based payment transactions should be classified and measured if the manner of settlement is contingent on either:

• a future event that is outside the control of both the entity and the counterparty; or
• a future event that is within the control of the counterparty,

the IASB agreed that transactions in which the manner of settlement is contingent on future events should be considered together with other issues relating to IFRS 2 (see 3.4 above).²⁸

Prior to discussion by the IASB, the Interpretations Committee discussed the matter again in May 2013, noting that paragraph 34 of IFRS 2 requires an entity to account on a cash-settled basis if, and to the extent that, the entity has incurred a liability to settle in cash or other assets. However, it was further noted that IFRS 2 only provides guidance where the entity or the counterparty has a choice of settlement and not where the manner of settlement is contingent on a future event that is outside the control of both parties. The Interpretations Committee also observed that it was unclear which other guidance within IFRS and the Conceptual Framework would provide the best analogy to this situation. It was concluded that there was significant diversity in practice.²⁹

In September 2013, the Interpretations Committee noted that the results of additional outreach indicated that shared-based payment transactions in which the manner of settlement is contingent on a future event within the control of the counterparty (but not the entity) are not significantly widespread and so the Committee decided not to add this element of the original submission to its agenda.³⁰

The Interpretations Committee also returned to the question of accounting when the manner of settlement is contingent on a future event that is outside the control of both the entity and the counterparty. It was noted that such arrangements are settled either in cash or in equity instruments in their entirety and that neither party to the arrangement has control over the manner of settlement. Accordingly, the Committee observed that the share-based payment should be classified as either equity-settled or cash-settled in its entirety depending on which outcome is probable.

The Interpretations Committee also discussed the accounting for a change in classification of the transaction arising from a change in the more likely settlement method. A majority of the Committee thought that there should be a cumulative adjustment recorded at the time of the change of classification, in such a way that the cumulative cost would be the same as if the change of classification had occurred at the inception of the arrangement (see 10.3.4 above). The Committee decided to recommend that the IASB make a narrow-scope amendment to IFRS 2 based on the approach above.³¹

The IASB discussed these recommendations in February 2014. Some IASB members expressed concern over use of a ‘probable’ approach for deciding the classification of a share-based payment. They took the view that such share-based payment transactions were similar to those in which the counterparty has a choice of settlement method because the entity does not have the unconditional right to avoid delivering cash or other assets. Therefore they considered that such arrangements should be accounted for, by analogy, in accordance with the compound instrument approach set out in paragraphs 35 to 40 of IFRS 2, noting that this would also be consistent with the requirements for contingent settlement provisions in IAS 32.³²

The topic was discussed again by the IASB in April 2014 when, notwithstanding the diversity in practice, the Board decided not to propose an amendment to IFRS 2 for this issue. Some IASB members were concerned that the suggested amendment would introduce a principle for distinguishing between a liability and equity in IFRS 2 that would be inconsistent with the requirements of IAS 32 and also noted that the definition of a liability was being discussed as part of the Conceptual Framework project (see Chapter 2).³³

The IASB revised the Conceptual Framework in 2018 without addressing this specific issue; the boundary between liabilities and equity will be further explored by the IASB in its research project on Financial Instruments with Characteristics of Equity (see 1.4.1 above). Until such time as any revised guidance is issued, we expect Approach 1 or Approach 2, outlined at 10.3.1 and 10.3.2 above, to continue to be applied.

11.2.1 Awards that the acquirer is ‘obliged’ to replace

Where the acquirer is ‘obliged’ to replace the acquiree awards (see below), either all or a portion of the fair value of the acquirer's replacement awards forms part of the consideration transferred in the business combination. [IFRS 3.B56].

IFRS 3 regards the acquirer as ‘obliged’ to replace the acquiree awards if the acquiree or its employees have the ability to enforce replacement, for example if replacement is required by:

• the terms of the acquisition agreement;
• the terms of the acquiree's awards; or
• applicable laws or regulations. [IFRS 3.B56].

The required treatment of replacement awards may be summarised as follows:

1. at the date of acquisition, the fair values of the replacement award and the original award are determined in accordance with IFRS 2;
2. the amount of the replacement award attributable to pre-combination service (and therefore included as part of the consideration transferred for the business) is determined by multiplying the fair value of the original award by the ratio of the vesting period completed, as at the date of the business combination, to the greater of:
   • the total vesting period, as determined at the date of the business combination (being the period required to satisfy all vesting conditions, including conditions added to, or removed from, the original award by the replacement award); and
   • the original vesting period; and
3. any excess of the fair value of the replacement award over the amount determined in (b) above is recognised as a post-combination remuneration expense, in accordance with the normal principles of IFRS 2 (see 3 to 7 above). [IFRS 3.B57‑59].

The requirements summarised in (a) to (c) above have the effect that any excess of the fair value of the replacement award over the original award is recognised as a post-combination remuneration expense. The requirement in (b) above has the effect that, if the replacement award requires service in the period after the business combination, an IFRS 2 cost is recognised in the post-combination period, even if the acquiree award being replaced had fully vested at the date of acquisition. It also has the effect that if a replacement award requires no service in the post-combination period, but the acquiree award being replaced would have done so, a cost must be recognised in the post-combination period. [IFRS 3.B59].

There is no specific guidance in IFRS 3 on how and when to recognise the post-combination remuneration expense in the consolidated financial statements of the acquirer. In our view, the expense should be recognised over the post-combination vesting period of the replacement award in accordance with the general principles of IFRS 2 (see 6.2 to 6.4 above).

The portions of the replacement award attributable to pre- and post-combination service calculated in (b) and (c) above are calculated, under the normal principles of IFRS 2, based on the best estimate of the number of awards expected to vest (or to be treated as vesting by IFRS 2). Rather than being treated as adjustments to the consideration for the business combination, any changes in estimates or forfeitures occurring after the acquisition date are reflected in remuneration cost for the period in which the changes occur in accordance with the normal principles of IFRS 2. Similarly, the effects of other post-acquisition events, such as modifications or the outcome of performance conditions, are accounted for in accordance with IFRS 2 as part of the determination of the remuneration expense for the period in which such events occur. [IFRS 3.B60]. The application of these requirements is discussed in more detail at 11.2.3 below.

The requirements above to split an award into pre-combination and post-combination portions apply equally to equity-settled and cash-settled replacement awards. All changes after the acquisition date in the fair value of cash-settled replacements awards and their tax effects (recognised in accordance with IAS 12 – Income Taxes) are recognised in the post-combination financial statements when the changes occur. [IFRS 3.B61‑62]. IFRS 3 does not specify where in the income statement any changes in the pre-combination element of a cash-settled award should be reflected and, in the absence of clear guidance, an entity will need to consider whether this is remuneration expense or whether it is closer to a change in a liability for contingent consideration.

The treatment of the income tax effects of replacement share-based payment transactions in a business combination is discussed further in Chapter 33 at 10.8.5.

11.2.2 Acquiree awards that the acquirer is not ‘obliged’ to replace

IFRS 3 notes that, in some situations, acquiree awards may expire as a consequence of a business combination. In such a situation, the acquirer might decide to replace those awards even though it is not obliged to do so. It might also be the case that the acquirer decides voluntarily to replace awards that would not expire and which it is not otherwise obliged to replace.

Under IFRS 3 there is no difference in the basic approach to accounting for a replacement award that the acquirer is obliged to make and one that it makes on a voluntary basis (i.e. the approach is as set out at 11.2.1 above). In other words, the accounting is based on the fair value of the replacement award at the date of acquisition, with an apportionment of that amount between the cost of acquisition and post-acquisition employment expense.

However, in situations where the acquiree awards would expire as a consequence of the business combination if they were not voluntarily replaced by the acquirer, none of the fair value of the replacement awards is treated as part of the consideration transferred for the business (and therefore included in the computation of goodwill), but the full amount is instead recognised as a remuneration cost in the post-combination financial statements. The IASB explains that this is because the new award by the acquirer can only be for future services to be provided by the employee as the acquirer has no obligation to the employee in respect of past services. [IFRS 3.B56, BC311B].

11.2.3 Accounting for changes in vesting assumptions after the acquisition date

Whilst the requirements outlined at 11.2.1 above to reflect changes in assumptions relating to the post-acquisition portion of an award through post-combination remuneration appear consistent with the general principles of IFRS 2 and IFRS 3, the application of the requirements to the pre-combination portion is less straightforward.

Paragraph B60 of IFRS 3 appears to require all changes to both the pre- and post-combination portions of the award to be reflected in post-combination remuneration expense. [IFRS 3.B60]. This could lead to significant volatility in post-combination profit or loss as a consequence of forfeitures, or other changes in estimates, relating to awards accounted for as part of the consideration for the business combination.

A second approach relies on a combination of paragraphs B60 and B63(d). Whilst paragraph B60 is clear that no adjustment can be made to the purchase consideration, paragraph B63(d) refers to IFRS 2 providing ‘guidance on subsequent measurement and accounting for the portion of replacement share-based payment awards … that is attributable to employees’ future services’ (emphasis added). [IFRS 3.B60, B63(d)]. Supporters of this view therefore argue that the remeasurement requirements of paragraph B60 apply only to the portion of the replacement award that is attributed to future service and that the award should be split into two parts:

• a pre-combination element that is treated as if it were vested at the acquisition date and then accounted for in the same way as other contingent consideration settled in equity; and
• a post-combination portion that is treated as a new award and reflects only the employees’ post-combination service.

A third approach is based on the guidance in paragraph B59 of IFRS 3 which states that ‘the acquirer attributes any excess of the market-based measure of the replacement award over the market-based measure of the acquiree award to post-combination service and recognises that excess as remuneration cost in the post-combination financial statements’. [IFRS 3.B59]. As for the second approach above, the pre-combination element is considered to be fixed and cannot be reversed. However, any subsequent changes in assumptions that give rise to an incremental expense over the amount recognised as pre-combination service should be recognised as part of the post-combination remuneration expense.

Whilst the second and third approaches above are more consistent with the general requirement under IFRS 2 that vested awards should not be adjusted, the first approach, based on paragraph B60, is arguably the most obvious reading of IFRS 3. In the absence of clear guidance in the standard, we believe that an entity may make an accounting policy choice between the three approaches but, once chosen, the policy should be applied consistently.

The three approaches are illustrated in Example 34.49 below.

12.2.1 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 section 12 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 IFRS 2, we believe that there is no requirement for the intermediate company to account for the award in its separate or individual financial statements (although it might choose to recognise an increase in its investment in the subsidiary and a corresponding capital contribution from the ultimate parent in order for the transaction to be reflected throughout the chain of companies).

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

• whether the award is satisfied using shares purchased in the market 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 employee benefit trust (EBT) is involved. The accounting treatment of transactions undertaken with and by EBTs is discussed in more detail at 12.3 below; and
• the tax consequences of the award. However, for the purposes of the discussion and illustrative examples below, tax effects are ignored, since these will vary significantly by jurisdiction. A more general discussion of the tax effects of share-based payment transactions may be found at 14 below and in Chapter 33 at 10.8.

12.2.2 Scope of IFRS 2 for group share schemes

By virtue of the definition of ‘share-based payment transaction’ (see 2.2.1 and 2.2.2.A above), a group share-based payment transaction is in the scope of IFRS 2 for:

• the consolidated financial statements of the group (the accounting for which follows the general principles set out in 3 to 10 above);
• the separate or individual financial statements of the entity in the group that receives goods or services (see 12.2.3 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 12.2.4 below).

IFRS 2 provides further guidance on the application of its general principles to:

• transactions settled in the equity of the entity, or in the equity of its parent (see 12.2.5 below); and
• cash-settled transactions settled by a group entity other than the entity receiving the goods or services (see 12.2.6 below).

At 2.2.2.A above we consider seven scenarios commonly found in practice and outline the approach required by IFRS 2 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.

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.

IFRS 2 does not directly address the accounting treatment of such intragroup management charges and other recharge arrangements, which is discussed further at 12.2.7 below. [IFRS 2.B45‑46].

Worked examples illustrating how these various principles translate into accounting entries are given at 12.4 to 12.6 below.

12.2.3 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, in its separate or individual financial statements, as equity-settled or cash-settled. It does this by assessing the nature of the awards granted and its own rights and obligations. [IFRS 2.43A].

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 IFRS 2 for equity-settled transactions generally, as discussed at 3 to 6 above. [IFRS 2.43B].

IFRS 2 notes that 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. [IFRS 2.43A]. This is discussed further at 12.6 below.

The cost recognised by the entity receiving goods or services is always calculated according to the principles set out above, regardless of any intragroup recharging arrangement. [IFRS 2.43D, B45]. The accounting for such arrangements is discussed at 12.2.7 below.

12.2.4 Entity settling the transaction

A group entity which settles a share-based payment transaction in which another group entity receives goods or services accounts for the transaction as an equity-settled share-based payment transaction only if it is settled in the settling entity's own equity instruments. Otherwise, the transaction is accounted for as cash-settled. [IFRS 2.43C].

IFRS 2 specifies only the credit entry – the classification of the transaction as equity- or cash-settled, and its measurement. IFRS 2 does not specify the debit entry, which is therefore subject to the general requirement of IFRS 2 that a share-based payment transaction should normally be treated as an expense, unless there is the basis for another treatment under other IFRS (see 3 above).

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

• 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 under IAS 27 – Separate Financial Statements – 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). [IFRS 2.B45]. 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 in the jurisdiction concerned.

We adopt the approach of full capitalisation by the parent entity in the worked examples set out in 12.4 to 12.6 below.

12.2.5 Transactions settled in equity of the entity or its parent

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

IFRS 2 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 and therefore accounts for the transaction as equity-settled, recognising a corresponding credit in equity as a contribution from its parent.

The subsidiary then 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 IFRS 2 discussed at 3 to 6 above. IFRS 2 points out that this will differ from the measurement of the transaction as cash-settled in the consolidated financial statements of the group. [IFRS 2.B56‑57].

In both cases, the parent has an obligation to settle the transaction in cash. Accordingly, the parent accounts for the transaction as cash-settled in both its consolidated and separate financial statements. [IFRS 2.B58].

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.

The IASB specifically considered whether it would be more appropriate to measure that contribution by reference to the cash actually paid by the parent, but concluded that the approach adopted in IFRS 2 better reflects the perspective of the subsidiary as a separate reporting entity. An accounting treatment based on the cash paid by the parent would, in the IASB's view, reflect the perspective of the parent rather than that of the subsidiary. [IFRS 2.BC268H‑268K].

12.2.7 Intragroup recharges and management charges

As noted at 12.2.2 above, IFRS 2 does not deal specifically with the accounting treatment of intragroup recharges and management charges that may be levied within the group on the subsidiary that receives goods or services, the consideration for which is equity instruments or cash provided by another group entity.

The timing of the recognition of intercompany recharges was considered by the Interpretations Committee in 2013 (see 12.2.7.A below).

The accounting requirements of IFRS 2 for group share schemes derive from IFRIC 11 (now incorporated within IFRS 2 – see 1.2 above), which was based on an exposure draft (D17) published in 2005.

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 12.2.3 and 12.2.6 above) up to the amount of that contribution, and a distribution thereafter.³⁴

In our view, whilst IFRS 2 as currently drafted does 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 IFRS 2 charge, and again for the management charge or recharge) which we consider not only less desirable for most entities, but also less appropriate in cases where the amounts are directly related. Accordingly, in the examples at 12.4 to 12.6 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 (once for the IFRS 2 charge, and again for the management charge) rather than debiting the management charge to equity as would be the case for a direct recharge.

IFRS 2 also does 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 12.4 to 12.6 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.

The treatment of a distribution from a subsidiary in the separate financial statements of a parent is more generally discussed in Chapter 8 at 2.4.

A further issue that arises in practice is the timing of recognition of the recharge by the parties to the arrangement. The treatment adopted might depend to some extent 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 respects to the accounting treatment of a provision or financial liability but, unlike the requirements of IAS 37 or IFRS 9, reflects changes in the recognised amount through equity rather than profit or loss and builds up the recharge liability over the life of the award rather than recognising the liability 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 IFRS 2 expense or other changes, should be recognised in the current period and previous periods should not be restated.

Where applicable, the examples at 12.4 to 12.6 below illustrate the first of the two treatments outlined above and recognise the recharge only when it becomes payable at the date of exercise.

12.3.1 Background

For some time entities have established trusts and similar arrangements for the benefit of employees. These are known by various names in different jurisdictions, 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, and from jurisdiction to jurisdiction, 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 some jurisdictions, the direct holding of shares in an entity by the entity itself is unlawful.
• 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, and from jurisdiction to jurisdiction, 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.

12.3.2 Accounting for EBTs

Historically, transactions involving EBTs were accounted for according to their legal form. In other words, any cash gifted or lent to the EBT was simply treated as, respectively, an expense or a loan in the financial statements of the employing entity.

However, this treatment gradually came to be challenged, not least by some tax authorities who began to question whether it was appropriate to allow a corporate tax deduction for the ‘expense’ of putting money into an EBT which in some cases might remain in the EBT for some considerable time (or even be lent back to the entity) before being actually passed on to employees. Thus, the issue came onto the agenda of the national standard setters.

The accounting solution proposed by some national standard setters, such as those in the United States and the United Kingdom, was to require a reporting entity to account for an EBT as an extension of the entity. The basis for this treatment was essentially that, as noted at 12.3.1 above, EBTs are specifically designed 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, suggesting that they are under the de facto control of the entity.

Unlike the approach required by some national standard setters, IFRS does not mandate the treatment of an EBT as an extension of the sponsoring entity in that entity's separate financial statements and the accounting treatment in the separate entity is therefore less clear under IFRS (see 12.3.4 below). If an entity does not treat the EBT as an extension of itself in its own financial statements it will need to assess for its consolidated IFRS financial statements whether the EBT should be consolidated as a separate vehicle. This assessment will be based on the control criteria set out in IFRS 10, as discussed in more detail in Chapter 6. However, in summary, the entity will need to decide whether:

• it has power over the EBT;
• it has exposure, or rights, to variable returns from its involvement with the EBT; and
• it has the ability to use its power over the EBT to affect the amount of the sponsoring entity's returns.

Paragraphs BC70 to BC74 of the Basis for Conclusions to IFRS 2 are clearly written on the assumption that the trust referred to in paragraph BC70 is being included in the financial statements of the reporting entity. This suggests that the IASB regards the consolidation of such vehicles as normal practice. [IFRS 2.BC70‑74].

In addition to a decision as to whether it is appropriate to consolidate an EBT, reporting entities also need to make an assessment as to the level within a group at which the EBT should be consolidated i.e. whether the EBT is controlled by a sponsoring entity at a sub-group level or whether just by the ultimate parent entity. In many cases, an EBT holding shares in the ultimate parent entity will be considered to be under the control of that entity but there will be exceptions in some group scenarios. The discussion below generally assumes that the reporting entity is the sponsoring entity of the EBT and consolidates an EBT holding the reporting entity's own shares.

Consolidation of an EBT will have the following broad consequences for the consolidated financial statements of the reporting entity:

• Until such time as the entity's own shares held by the EBT vest unconditionally in employees (e.g. as the result of the vesting of an award of ordinary shares, or the exercise of a vested option over ordinary shares):
  • any consideration paid for the shares should be deducted in arriving at shareholders’ equity in accordance with IAS 32 (see Chapter 47 at 9); and
  • the shares should be treated as if they were treasury shares when calculating earnings per share under IAS 33 (see Chapter 37 at 3.2).
• Other assets and liabilities (including borrowings) of the EBT should be recognised as assets and liabilities in the consolidated financial statements of the sponsoring entity.
• No gain or loss should be recognised in profit or loss on the purchase, sale, issue or cancellation of the entity's own shares, as required by IAS 32. Although not explicitly required by IFRS, we suggest that entities show consideration paid or received for the purchase or sale of the entity's own shares in an EBT separately from other purchases and sales of the entity's own shares in the reconciliation of movements in shareholders’ equity. This may be particularly relevant for entities in jurisdictions that distinguish between ‘true’ treasury shares (i.e. those legally held by the issuing entity) and those accounted for as such under IFRS (such as those held by an EBT).
• Any dividend income arising on own shares should be excluded in arriving at profit before tax and deducted from the aggregate of dividends paid and proposed. 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 Section 12, 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 unconditionally. 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 be consolidated.

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

The following Examples assume that the EBT is consolidated in accordance with IFRS 10 and show the interaction of the requirements of IFRS 10 with those of IFRS 2. Example 34.50 illustrates the treatment where an award is satisfied using shares previously purchased in the market. Example 34.51 illustrates the treatment where freshly issued shares are used.

Example 34.50 illustrates the importance of keeping the accounting treatment required by IAS 32 for the cost of the shares completely separate from that for the cost of the award required by IFRS 2. 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 IFRS 2 cost of £52,500 is recognised in profit or loss.

12.3.4 Separate financial statements of sponsoring entity

As noted at 12.3.2 above, in contrast to some national GAAPs, where an EBT is treated as a direct extension of the parent or other sponsoring entity, such that the assets and liabilities of the EBT are included in both the separate financial statements of the sponsoring entity and the group consolidated financial statements, under IFRS the accounting model is prima facie to treat the EBT as a separate group entity.

This means that the separate financial statements of the sponsoring entity must show transactions and balances with the EBT rather than the transactions, assets and liabilities of the EBT. This raises some accounting problems, for some of which IFRS currently provides no real solution, as illustrated by Example 34.52 below. This has led the Interpretations Committee and others to discuss whether the ‘separate entity’ approach to accounting for EBTs is appropriate (see further discussion below).

At its meetings in May and July 2006, the Interpretations Committee discussed whether the EBT should be treated as an extension of the sponsoring entity, such as a branch, or as a separate entity. The Interpretations Committee decided to explore how specific transactions between the sponsor and the EBT should be treated in the sponsor's separate or individual financial statements and whether transactions between the EBT and the sponsor's employees should be attributed to the sponsor.

Interestingly, the Interpretations Committee fell short of dismissing the ‘extension of the parent company’ approach and has not since revisited this topic other than to re-confirm in March 2011 that it had not become aware of additional concerns or of diversity in practice and hence it did not think it necessary for this to be considered for the IASB's agenda. In our view, whilst any requirement to consolidate EBTs under IFRS 10 could be argued to give a clear steer towards treating the EBT as a separate entity, until there is any final clarification of this issue, it appears acceptable to treat an EBT as an extension of the sponsoring entity in that entity's separate financial statements. This treatment would result in outcomes essentially the same as those in Examples 34.50 and 34.51 above, while avoiding the problems highlighted in Example 34.52 above.

12.3.5 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 chapter.

12.4.1 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, in this Example, the EBT is consolidated (see 12.3 above). The accounting entries required are set out below. As in other examples in this chapter, where an entry is shown as being made to equity the precise allocation to a particular component of equity will be a matter for local legislation and, possibly, local accounting ‘tradition’, to the extent that this is not incompatible with IFRS.

* 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 6.1 to 6.4 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 IFRS 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 34.50 at 12.3.3 above. In such a case there would be a corresponding adjustment to the debit to equity marked with ‡ above.

12.4.2 Parent

The accounting by the parent will depend on how the EBT is treated (i.e. whether it is accounted for as a separate entity or as an extension of the parent – see 12.3 above for guidance). The parent should apply the accounting set out in the appropriate section below:

• EBT treated as separate entity (see 12.4.2.A below); and
• EBT treated as extension of parent (see 12.4.2.B below).

We also discuss, at 12.4.2.C below, the accounting implications if the parent, rather than – as in Example 34.53 – a subsidiary, is the employing entity.

12.4.3 Employing subsidiary

The employing subsidiary is required to account for the IFRS 2 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 IFRS 2 expense are required by IFRS 2 (see 12.2.3 above). The contribution to the EBT is treated as a distribution (see 12.2.7 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 6.1 to 6.4 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.

12.5.1 Consolidated financial statements

The consolidated financial statements need to deal with:

• the charge required by IFRS 2 in respect of the award; and
• the issue of shares.

Transactions between H plc or S Limited and the EBT are ignored since, in this Example, the EBT is consolidated (see 12.3 above). The accounting entries required are set out below. As in other examples in this chapter, where an entry is shown as being made to equity, the precise allocation to a particular component of equity will be a matter for local legislation and, possibly, local accounting ‘tradition’, to the extent that this is not incompatible with IFRS.

^*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 6.1 to 6.4 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, it may be that, in certain jurisdictions, the entity is required to increase its share capital and share premium (additional paid in capital) accounts by the £10,500 legal consideration for the issue of shares. In that case, this entry would be expanded as below, which effectively treats the £6,000 consideration provided from within the group as a bonus issue.

12.5.2 Parent

The accounting by the parent will depend on how the EBT is treated (i.e. whether it is accounted for as a separate entity or as an extension of the parent – see 12.3 above for guidance). The parent should apply the accounting set out in the appropriate section below:

• EBT treated as separate entity (see 12.5.2.A below); and
• EBT treated as extension of parent (see 12.5.2.B below).

We also discuss, at 12.5.2.C below, the accounting implications if the parent, rather than – as in Example 34.54 – a subsidiary, is the employing entity.

12.5.3 Employing subsidiary

The employing subsidiary is required to account for the IFRS 2 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 IFRS 2 expense are required by IFRS 2 (see 12.2.3 above). The contribution to the EBT is treated as a distribution (see 12.2.7 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 6.1 to 6.4 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 charged to any appropriate component of equity.

12.6.1 Consolidated financial statements

The group has entered into a cash-settled transaction which is accounted for using the methodology discussed at 9.3 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 34.37 at 9.3.2 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 9 above).

12.6.2 Parent

The parent accounts for the share-based payment transaction under IFRS 2 as a cash-settled transaction, since the parent settles the award by delivering cash to the employees of the subsidiary (see 12.2.4 above). However, as discussed at 12.2.4 above, instead of recording a cost, as in its consolidated financial statements, the parent treats the debit entry (including, as a matter of accounting policy choice, any remeasurement of the liability) as 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 34.37 at 9.3.2 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 9 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 12.6.1 above).

12.6.3 Employing subsidiary

The employing subsidiary accounts for the transaction as equity-settled, since it receives services, but incurs no obligation to its employees (see 12.2.3 and 12.2.6 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 6.1 to 6.4 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 IFRS 2 as vesting in the subsidiary's financial statements, because it is accounted for as equity-settled (see 6.3 and 6.4 above).

12.9.1 Financial statements of the associate or joint venture

For the financial statements of the associate, the transaction does not strictly fall within the scope of IFRS 2. In order for a transaction to be in the scope of IFRS 2 for a reporting entity, it must be settled in the equity of the entity itself, or that of another member of the same group. A group comprises a parent and its subsidiaries (see Chapter 6 at 2.2), and does not include associates.

Nevertheless, we believe that it would be appropriate for the associate to account for the transaction as if it did fall within the scope of IFRS 2 by applying the ‘GAAP hierarchy’ in IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors (see Chapter 3 at 4.3). The investor has effectively made a capital contribution to the associate (in the form of the investor's own equity), no less than if it made a capital contribution in cash which was then used to pay employees of the associate.

If the investor in the associate had instead granted an award settled in the equity of the associate, the transaction would have been in the scope of IFRS 2 for the associate, as being the grant of an award over the equity of the reporting entity by a shareholder of that entity (see 2.2.2.A above).

If the award is, or is treated as being, within the scope of IFRS 2 for the associate, the following entries are recorded:

^†Grant date fair value of award €600,000 × 1/3. The credit to equity represents a capital contribution from the investor.

12.9.2 Consolidated financial statements of the investor

The investor has entered into a share-based payment transaction since it has granted an award over its equity to third parties (the employees of the associates) in exchange for their services to a significant investee entity. However, employees of an associate are not employees of a group entity and are therefore not employees of the investor's group.

The issue for IFRS 2 purposes is, therefore, whether the award should be regarded as being made to persons providing similar services to employees (and therefore measured at grant date) or to persons other than employees or those providing similar services to employees (and therefore measured at service date) – see 5.2 to 5.4 above.

In our view, it is more appropriate to regard such awards as made to persons providing similar services to employees and therefore measured at grant date.

There are then, we believe, two possible approaches to the accounting. In our view, in the absence of clear guidance in the standard, an entity should choose the more appropriate approach based on the specific circumstances.

In any event, the investor's consolidated financial statements must show a credit to equity of €200,000 a year over the vesting period. The accounting issue is the analysis of the corresponding debit.

It seems clear that the investor must as a minimum recognise an annual cost of €80,000 (40% of €200,000), as part of its ‘one-line’ share of the result of the associate. The issue then is whether it should account for the remaining €120,000 as a further cost or as an increase in the cost of its investment in its associate.

The argument for treating the €120,000 as an expense is that the associate will either have recorded nothing or, as set out in 12.9.1 above, an entry that results in no net increase in the equity of the associate. Therefore there has been no increase in the investor's share of the net assets of the associate, and there is no basis for the investor to record an increase in its investment. This is broadly the approach required under US GAAP (although US GAAP requires the associate itself to recognise the expense and a corresponding capital contribution applying the grant date measurement model of ASC 718).

It may be possible to conclude in some situations that the €120,000 is an increase in the cost of the investment in associate. IAS 28 – Investments in Associates and Joint Ventures – defines the equity method of accounting as (emphasis added):

• ‘a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor's share of the investee's net assets’. [IAS 28.3].

For example, there may be cases where another shareholder has made, or undertaken to make, contributions to the associate that are not reflected in its recognised net assets (such as an undertaking to provide knowhow or undertake mineral exploration).

Where an entity takes the view that the €120,000 is an increase in the cost of its investment, it is essential to ensure that the resulting carrying value of the investment is sustainable. This may be the case if, for example:

• the fair value of the investment in the associate exceeds its carrying amount; or
• the investor has agreed to enter into the transaction while another major shareholder has agreed to bear equivalent costs.

In other circumstances, the carrying amount of the investment may not be sustainable, and the investor may need to recognise an impairment of its investment in accordance with IAS 36 (see Chapter 20).

12.9.3 Separate financial statements of the investor

The discussion below assumes that the investor accounts for its investment in the associate at cost in its separate financial statements (see Chapter 8).

The issues here are much the same as in 12.9.2 above. The investor has clearly entered into a share-based payment transaction since it has granted an award over its equity to third parties (the employees of the associates) in exchange for their services to a significant investee entity. As in 12.9.2 above, we believe that this is most appropriately characterised as a transaction with persons providing similar services to employees and therefore measured at its grant date fair value.

In any event, the investor's separate financial statements must show a credit to equity of €200,000 a year over the vesting period but, as in 12.9.2 above, the analysis of the debit entry is more complex.