Most share-based payment transactions undertaken by entities are awards of shares and options as remuneration to employees, in particular senior management and directors. In a number of countries, shares and options now comprise the greatest element of the total remuneration package of senior personnel, a trend encouraged by the consensus that it is a matter of good corporate governance to promote significant long-term shareholdings by senior management, so as to align their economic interests with those of shareholders.
One advantage of shares and options as remuneration is that they need not entail any cash cost to the entity. If an executive is entitled under a bonus scheme to a free share, the entity can satisfy this award simply by printing another share certificate, which the executive can sell, so that the cash cost of the award is effectively borne by shareholders rather than by the entity itself. However, this very advantage was the source of the controversy surrounding share-based remuneration.
Investors became increasingly concerned that share-based remuneration was resulting in a significant cost to them, through dilution of their existing shareholdings. As a result, there emerged an increasing consensus among investors that awards of shares and share options should be recognised as a cost in the financial statements.
The opposing view, held by most entities, was that the financial statements were simply reflecting the economic reality that such awards are ultimately a cost to other shareholders and not to the entity. Another powerful argument for those opposed to expensing options was to point out that some clearly successful companies, particularly in the new technology sector, would never have shown a profit if they had been required to book an accounting expense for options.
In November 2002, the IASB issued an exposure draft ED 2 – Share-based Payment – proposing that share-based payments for goods and services should be expensed. The exposure draft proved highly controversial. Those who supported it in principle nevertheless had concerns on nearly every detail of the accounting treatment proposed, in particular the fact that it did not permit any ‘truing up’, i.e. reversing any expense previously charged for an award that never actually crystallises. More fundamentally, many questioned whether there yet existed a methodology sufficiently robust for valuing shares and share options subject to the restrictions and performance conditions typically associated with employee share awards. There also remained a significant minority who still questioned the whole principle of expensing options and other share awards.
Despite these comments, the IASB finalised its proposals with the publication of IFRS 2 – Share-based Payment – on 19 February 2004, although some significant changes had been necessary to the prohibition on ‘truing up’ in the ED. In particular, IFRS 2 requires an expense to be recognised only for awards that vest (or are considered by IFRS 2 to vest), but (in the case of awards settled in shares) based on their fair value at the date of grant. Nevertheless, IFRS 2 remains contentious: for example, there is still only limited provision for ‘truing up’, with the result that significant costs can potentially be recognised for awards that ultimately have no value to their recipients, and give rise to no dilution of the interests of other shareholders. Some commentators continue to question whether existing option valuation models can produce a reliable valuation of employee share awards.
The IASB has issued the following amendments to the original version of IFRS 2:
There have also been two interpretations of IFRS 2 by the IFRS Interpretations Committee, IFRIC 8 – Scope of IFRS 2 – and IFRIC 11 – IFRS 2 – Group and Treasury Share Transactions, but these were incorporated into IFRS 2 as part of the June 2009 amendment and the separate interpretations withdrawn. [IFRS 2.64].
Revision of, and amendments to, IFRS 3 – Business Combinations – in 2008 and 2010 respectively, led to consequential amendments to IFRS 2. The revised and amended IFRS 3 provides guidance on the replacement of share-based payment awards in a business combination (see 11 below).
The revision of the Conceptual Framework in 2018 led to a minor consequential amendment to IFRS 2 as part of the Amendments to References to the Conceptual Framework in IFRS Standards.4 The revision amended the footnote to the definition of an equity instrument in Appendix A (see 1.4.1 below). Entities are required to apply the amendment on a retrospective basis for accounting periods beginning on or after 1 January 2020, although earlier application is permitted if all other amendments made by the revised Conceptual Framework are applied (see 16.2 below for more detail on the transitional provisions).
IFRS 2 is supplemented by implementation guidance.
In May 2015, the IASB announced a research project into certain aspects of IFRS 2.5
The objectives of the project were:
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:
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:
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.
This chapter generally discusses the requirements of IFRS 2 for accounting periods beginning on or after 1 January 2020 and reflects those amendments to the original version of IFRS 2, referred to at 1.2 above, that are effective (without early adoption) as at that date. This amended version of IFRS 2 is referred to as ‘IFRS 2’ throughout the chapter. A detailed discussion of the application of earlier versions of the standard can be found in International GAAP 2019 and earlier editions.
IFRS 2 is a complex standard, in part because its overall accounting approach is something of a hybrid. Essentially the total cost (i.e. measurement) of an award is calculated by determining whether the award is a liability or an equity instrument, using criteria somewhat different from those in IAS 32 – Financial Instruments: Presentation (see 1.4.1 below), but then applying the measurement principles generally applicable to liabilities or equity instruments under IAS 32 and IFRS 9 – Financial Instruments. However, the periodic allocation (i.e. recognition) of the cost is determined using something closer to a straight-line accrual methodology, which would not generally be used for financial instruments. For convenience, throughout this chapter we refer to the recognition of a cost for share-based payments. In some cases, however, a share-based payment transaction may initially give rise to an asset (e.g. where employee costs are capitalised as part of the cost of PP&E or inventories).
This inevitably has the result that, depending on its legal form, a transaction of equal value to the recipient can result in several different potential charges in profit or loss for the entity, causing some to call into question the comparability of the information provided. Moreover, IFRS 2 is in many respects a rules-based ‘anti-avoidance’ standard, which often requires an expense to be recorded for transactions that either have no ultimate value to the counterparty or to which, in some cases, the counterparty actually has no entitlement at all.
IFRS 2 has an unusually long Basis for Conclusions – longer in fact than the standard and implementation guidance combined, highlighting some of the controversy in the development of the standard.
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.
This section sets out the objective of IFRS 2 (see 2.1 below) and then considers the scope of the standard in the following sub-sections:
Further details of the transactions and arrangements discussed are given at the start of each sub-section.
The objective of IFRS 2 is ‘to specify the financial reporting by an entity when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees’. [IFRS 2.1].
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
provided the specified vesting conditions, if any, are met.’
A share-based payment transaction is ‘a transaction in which the entity
An equity-settled share-based payment transaction is ‘a share-based payment transaction in which the entity
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:
In such cases, the employees may instead be offered cash equivalent to the value of the shares that they would otherwise have obtained.
Subject to the exceptions noted at 2.2.3 below, IFRS 2 must be applied to all share-based payment transactions, including:
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:
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:
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:
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:
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].
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 …’.
Separate financial statements of Parent
Subsidiary
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)].
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].
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].
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 …’.
Separate financial statements of Parent
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].
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].
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).
In some jurisdictions, it is common for an entity to establish a trust to hold shares in the entity for the purpose of satisfying, or ‘hedging’ the cost of, share-based awards to employees. In such cases, it is often the trust, rather than any entity within the legal group, that actually makes share-based awards to employees.
A sponsoring employer (or its wider group) will need to assess whether it controls the trust in accordance with the requirements of IFRS 10 and therefore whether the trust should be consolidated (see 12.3 below and Chapter 6).
Awards by employee benefit trusts and similar vehicles are within the scope of IFRS 2, irrespective of whether or not the trust is consolidated, since:
A share-based payment transaction as defined (see 2.2.1 above) involves the receipt of goods or services by the reporting entity or by another group entity. Nevertheless, IFRS 2 also applies to share-based payment transactions where no specifically identifiable goods or services have been (or will be) received. [IFRS 2.2].
IFRS 2 asserts that, if the identifiable consideration received (if any) appears to be less than the fair value of consideration given, the implication is that, in addition to the identifiable goods and services acquired, the entity must also have received some unidentifiable consideration equal to the difference between the fair value of the share-based payment and the fair value of any identifiable consideration received. Accordingly, the cost of the unidentified consideration must be accounted for in accordance with IFRS 2. [IFRS 2.13A].
For example, if an entity agrees to pay a supplier of services with a clearly identifiable market value of £1,000 by issuing shares with a value of £1,500, IFRS 2 requires the entity to recognise an expense of £1,500. This is notwithstanding the normal requirement of IFRS 2 that an equity-settled share-based payment transaction with a non-employee be recognised at the fair value of the goods or services received (see 5.1 and 5.4 below).
This requirement was introduced by IFRIC 8 (since incorporated into IFRS 2). The reason for the change is alluded to in an illustrative example. [IFRS 2.IG5D, IG Example 1]. As part of general economic reforms in South Africa, under arrangements generally referred to as black economic empowerment or ‘BEE’ (discussed further at 15.5 below), various entities issued or transferred significant numbers of shares to bodies representing historically disadvantaged communities. Some took the view that these transactions did not fall within the scope of IFRS 2 as originally drafted because the entities concerned were not purchasing goods or services. Rather, BEE arrangements were simply meant to replicate a transfer of shares from one group of shareholders to another. Accordingly, it was argued, such transactions did not fall within the scope of IFRS 2, since it is intrinsic to the definition of a ‘share-based payment transaction’ (see 2.2.1 above) that goods or services are received.
IFRS 2 rejects this argument. It effectively takes the view that, since the directors of an entity would not issue valuable consideration for nothing, something must have been received. [IFRS 2.BC18C]. IFRS 2 suggests that a transfer of equity under BEE and similar schemes is made ‘as a means of enhancing [the entity's] image as a good corporate citizen’. [IFRS 2 IG Example 1].
There seems little doubt that this aspect of IFRS 2 is in part an ‘anti-avoidance’ measure. As discussed in 4 to 8 below, the general measurement rule in IFRS 2 is that share-based payment transactions with employees are measured by reference to the fair value of the consideration given and those with non-employees by reference to the fair value of the consideration received. We argue at 5.2.2 below that the requirement to measure transactions with employees by reference to the consideration given is essentially an anti-avoidance provision. It prevents entities from recognising a low cost for employee share options on the grounds that little incremental service is provided for them beyond that already provided for cash-based remuneration. The changes introduced by IFRIC 8 removed the potential for a similar abuse in accounting for transactions with non-employees.
Nevertheless, the IASB acknowledges that there may be rare circumstances in which a transaction may occur in which no goods or services are received by the entity. For example, a principal shareholder of an entity, for reasons of estate planning, may transfer shares to a relative. In the absence of indications that the relative has provided, or is expected to provide, goods or services to the entity in exchange for the shares, such a transfer would be outside the scope of IFRS 2. [IFRS 2.BC18D].
See also the discussions at 2.2.3.A below relating to transactions with shareholders in their capacity as such and at 2.2.4.K below relating to dual pricing on a share issue.
Many countries encourage wider share-ownership by allowing companies to award a limited number of free or discounted shares to employees without either the employee or the employer incurring tax liabilities which would apply if other benefits in kind to an equivalent value were given to employees.
Some national accounting standards exempt some such plans from their scope, to some extent as the result of local political pressures. Prior to issuing IFRS 2, the IASB received some strong representations that IFRS should give a similar exemption, on the grounds that not to do so would discourage companies from continuing with such schemes.
The IASB concluded that such an exemption would be wrong in principle and difficult to draft in practice. By way of concession, the Basis for Conclusions hints that if the IFRS 2 charge for such schemes is (as asserted by some of the proponents of an exemption) de minimis, then there would be no charge under IFRS 2 anyway, since, like all IFRSs, it applies only to material items. [IFRS 2.BC8‑17]. However, our experience is that, in many cases, the charge is material.
Once a transaction accounted for under IFRS 2 has vested in the counterparty (see 3 below), it does not necessarily cease to be in the scope of IFRS 2 just because the entity has received the goods or services required for the award to vest. This is made clear by the numerous provisions of IFRS 2 referring to the accounting treatment of vested awards.
Once equity shares have been unconditionally delivered or beneficially transferred to the counterparty (e.g. as the result of the vesting of an award of ordinary shares, or the exercise of a vested option over ordinary shares), the holder of those shares will often be in exactly the same position as any other holder of ordinary shares and the shares will generally be accounted for under IAS 32 and IFRS 9 rather than IFRS 2.
If, however, the holder of a share or vested option enjoys rights not applicable to all holders of that class of share, such as a right to put the share or the option to the entity for cash, or holds a special class of share with rights that do not apply to other classes of equity, the share or option might still remain in the scope of IFRS 2 as long as any such rights continue to apply. The same is true of modifications made after vesting which add such rights to a vested share or option or otherwise alter the life of the share-based payment transaction. The special terms or rights will often be linked to the holder's employment with the entity but could also apply to an arrangement with a non-employee.
The significance of this is that issued equity instruments and financial liabilities not within the scope of IFRS 2 would typically fall within the scope of IAS 32 and IFRS 9, which might require a significantly different accounting treatment from that required by IFRS 2. See, for example:
The following transactions are outside the scope of IFRS 2:
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’.
IFRS 2 does not apply to transactions with employees (and others) purely in their capacity as shareholders. For example, an employee may already hold shares in the entity as a result of previous share-based payment transactions. If the entity then raises funds through a rights issue, for example, whereby all shareholders (including the employee) can acquire additional shares for less than the current fair value of the shares, such a transaction is not a share-based payment transaction for the purposes of IFRS 2. [IFRS 2.4].
In some group restructuring arrangements, one entity will transfer a group of net assets, which does not meet the definition of a business, to another entity in return for shares. Careful consideration of the precise facts and circumstances is needed in order to determine whether, for the separate or individual financial statements of any entity affected by the transfer, such a transfer falls within the scope of IFRS 2. If the transfer is considered primarily to be a transfer of goods by their owner in return for payment in shares then, in our view, this should be accounted for under IFRS 2. However, if the transaction is for another purpose and is driven by the group shareholder in its capacity as such, the transaction may be outside the scope of IFRS 2 (see 2.2.3.A above). Accounting for intra-group asset transfers in return for shares is considered further in Chapter 8 at 4.4.1.
IFRS 2 does not apply to share-based payments to acquire goods (such as inventories or property, plant and equipment) as part of a business combination to which IFRS 3 applies.
However, the Interpretations Committee has clarified that in a reverse acquisition involving an entity that does not constitute a business (i.e. an asset acquisition or the provision of a service), IFRS 2 rather than IFRS 3 is likely to apply (see Chapter 9 at 14.8).11
Transactions in which equity instruments are issued to acquire goods as part of the net assets in a business combination are outside the scope of IFRS 2 but equity instruments granted to the employees of the acquiree in their capacity as employees (e.g. in return for continued service following the business combination) are within its scope, as are the cancellation, replacement or modification of a share-based payment transaction as a result of the business combination or other equity restructuring (see 11 and 12.8 below). [IFRS 2.5].
Thus, if a vendor of an acquired business remains as an employee of that business following the business combination and receives a share-based payment for transferring control of the entity and for remaining in continuing employment, it is necessary to determine how much of the share-based payment relates to the acquisition of control (which forms part of the cost of the combination, accounted for under IFRS 3) and how much relates to the provision of future services (which is a post-combination operating expense accounted for under IFRS 2). Guidance on this issue is given in IFRS 3 – see Chapter 9 at 11.2 – and there is discussion of related issues at 2.2.4.B below.
IFRS 2 also does not apply to a combination of entities or businesses under common control (see Chapter 10), or the contribution of a business on the formation of a joint venture as defined by IFRS 11 – Joint Arrangements (see Chapter 12). [IFRS 2.5].
It should be noted that the contribution of non-financial assets (which do not constitute a business) to a joint venture in return for shares is within the scope of IFRS 2 and the assets should be accounted for at fair value in accordance with IFRS 2 (see 2.2.2 above).
IFRS 2 does not directly address other types of transactions involving joint ventures or transactions involving associates, particularly arrangements relating to the employees of associates or joint ventures. These are discussed further at 12.9 below.
IFRS 2 does not apply to transactions within the scope of IAS 32 and IFRS 9 (see Chapter 45). For example, if an entity enters into a share-based payment transaction to purchase a commodity surplus to its production requirements or with a view to short-term profit taking, the contract is treated as a financial instrument under IAS 32 and IFRS 9 rather than a share-based payment transaction under IFRS 2. [IFRS 2.6].
Some practical examples of scope issues involving IFRS 2 and IAS 32/IFRS 9 are discussed at 2.2.4 below.
As noted at 2.2.2 above, IFRS 2 applies to share-based payment transactions involving goods or services, with ‘goods’ defined so as to exclude financial assets, presumably on the basis that these fall within IAS 32 and IFRS 9. However, investments in subsidiaries, associates and joint ventures in the separate financial statements of the investing entity are financial assets as defined in IAS 32 (and hence outside the scope of IFRS 2) but are outside the scope of IFRS 9 where the entity chooses to account for them at cost (see Chapter 8 at 2.1 and Chapter 45 at 3.1).
Moreover, IFRS has no general requirements for accounting for the issue of equity instruments. Rather, consistent with the position taken by the Conceptual Framework (both the 2010 and 2018 versions) that equity is a residual rather than an item ‘in its own right’, the amount of an equity instrument is normally measured by reference to the item (expense or asset) in consideration for which the equity is issued, as determined in accordance with IFRS applicable to that other item.
This means that, when (as is commonly the case) an entity acquires an investment in a subsidiary, associate or joint venture in return for the issue of equity instruments, there is no explicit guidance in IFRS as to the required accounting in the separate financial statements of the investor, and in particular as to how the ‘cost’ of such an item is to be determined. This is discussed further in Chapter 8 at 2.1.1.A.
This section addresses the application of the scope requirements of IFRS 2 to a number of situations frequently encountered in practice:
The following aspects of the scope requirements are covered elsewhere in this chapter:
A transaction is within the scope of IFRS 2 only where it involves the delivery of an equity instrument, or cash or other assets based on the price or value of an ‘equity instrument’, in return for goods or services (see 2.2.1 above).
In some jurisdictions, there can be fiscal advantages in giving an employee, in lieu of a cash payment, a share that carries a right to a ‘one-off’ dividend, or is mandatorily redeemable, at an amount equivalent to the intended cash payment. Such a share would almost certainly be classified as a liability under IAS 32 (see Chapter 47). Payment in such a share would not fall in the scope of IFRS 2 since the consideration paid by the entity for services received is a financial liability rather than meeting the definition of an equity instrument (see the definitions in 2.2.1 above).
If, however, the amount of remuneration delivered in this way were equivalent to the value of a particular number of equity instruments issued by the entity, then the transaction would be in scope of IFRS 2 as a cash-settled share-based payment transaction, since the entity would have incurred a liability (i.e. by issuing the redeemable shares) for an amount based on the price of its equity instruments.
Similarly, if an entity grants an award of equity instruments to an employee together with a put right whereby the employee can require the entity to purchase those shares for an amount based on their fair value, both elements of that transaction are in the scope of IFRS 2 as a single cash-settled transaction (see 9 below). This is notwithstanding the fact that, under IAS 32, the share and the put right might well be analysed as a single synthetic instrument and classified as a liability with no equity component (see Chapter 47).
Differences in the classification of instruments between IFRS 2 and IAS 32 are discussed further at 1.4.1 above.
Put options over instruments that are only classified as equity in limited circumstances (in accordance with paragraphs 16A to 16B of IAS 32) are discussed at 2.2.4.J below.
It is sometimes the case that a subsidiary entity grants an award over its own equity instruments and, either on the same date or later, the parent entity separately grants the same counterparty a put option to sell the equity instruments of the subsidiary to the parent for a cash amount based on the fair value of the equity instruments. Accounting for such an arrangement in the separate financial statements of the subsidiary and the parent will be determined in accordance with the general principles of IFRS 2 (see 2.2.2.A above). However, IFRS 2 does not explicitly address the accounting treatment of all such arrangements in the parent's consolidated financial statements.
In our view, the analysis differs according to whether the put option is granted during or after the vesting period and whether it relates to ordinary shares or to share options.
If the put option is granted during the vesting period (whether at the same time as the grant of the equity instruments or later), the two transactions should be treated as linked and accounted for in the consolidated financial statements as a single cash-settled transaction from the date the put option is granted. This reflects the fact that this situation is similar in group terms to a modification of an award to add a cash-settlement alternative – see 10.1.4 below.
If the put option is only granted once the equity instruments have vested, the accounting will depend on whether the equity instruments in the original share-based payment transaction are unexercised options or whether they are ordinary shares.
If they are unexercised options, the vested options remain within the scope of IFRS 2 until they are exercised (see 2.2.2.E above) and, in this case, the put option should be treated as a linked transaction. Its effect in group terms is to modify the original award from an equity- to a cash-settled transaction until final settlement date.
However, if the equity instruments are fully vested ordinary shares (whether free shares or shares from the exercise of options), rather than unexercised options, they are generally no longer within the scope of IFRS 2 as they are no different from any other ordinary shares issued by the subsidiary. In such cases, the parent entity will need to evaluate whether or not the grant of the put option, as a separate transaction which modifies the terms of certain of the subsidiary's equity instruments, falls within the scope of IFRS 2. For example, the addition of a condition that relates to one (non-controlling) shareholder of a subsidiary might indicate that it continues to be appropriate to account for the arrangement in accordance with the requirements of IFRS 2. By contrast, a modification to an entire class of ordinary shares would generally not be within the scope of IFRS 2.
A similar analysis is required in a situation where an individual sells a controlling interest in an entity for fair value and put and call options are granted over the individual's remaining non-controlling interest or over shares in the acquirer which have been given to the individual in return for the business acquired. To the extent that the exercise price of the call option depends on the fulfilment of a service condition in the period following the acquisition of the controlling interest, it is likely that the arrangement will fall within the scope of IFRS 2 with any payments contingent on future services recognised as compensation costs.
Put options over non-controlling interests that do not fall within the scope of IFRS 2 are addressed in Chapter 7 at 6.2.
An arrangement typically found in entities with venture capital investors is one where an employee (often part of the key management) subscribes initially for, say, 1% of the entity's equity with the venture capitalist holding the other 99%. The employee's equity interest will subsequently increase by a variable amount depending on the extent to which certain targets are met. This is achieved not by issuing new shares but by cancelling some of the venture capitalist's shares. In our view, such an arrangement falls within the scope of IFRS 2 as the employee is rewarded with an increased equity stake in the entity if certain targets are achieved. The increased equity stake is consistent with the definition in Appendix A of IFRS 2 of an equity instrument as ‘a contract that evidences a residual interest …’ notwithstanding the fact that no additional shares are issued.
In such arrangements, it is often asserted that the employee has subscribed for a share of the equity at fair value. However, the subscription price paid must represent a fair value using an IFRS 2 valuation basis in order for there to be no additional IFRS 2 expense to recognise (see 2.2.4.D below).
In certain situations, such as where a special class of share is issued, the counterparty might be asked to subscribe a certain amount for the share which is agreed as being its ‘fair value’ for taxation or other purposes. This does not mean that such arrangements fall outside the scope of IFRS 2, either for measurement or disclosure purposes, if the arrangement meets the definition of a share-based payment transaction. In many cases, the agreed ‘fair value’ will be lower than a fair value measured in accordance with IFRS 2 because it will reflect the impact of service and non-market performance vesting conditions which are excluded from an IFRS 2 fair value. This is addressed in more detail at 15.4.5 below.
An entity might agree to pay its employees a €100 cash bonus if its share price remains at €10 or more over a given period. Intuitively, this appears to be within the scope of IAS 19 – Employee Benefits – rather than that of IFRS 2 because the employee is not being given cash of equivalent value to a particular number of shares. However, it could be argued that it does fall within the scope of IFRS 2 on the basis that the entity has incurred a liability, and the amount of that liability is ‘based on’ the share price (in accordance with the definition of a cash-settled share-based payment transaction) – it is nil if the share price is below €10 and €100 if the share price is €10 or more. In our view, either interpretation is acceptable.
As noted at 2.2.1 above, IFRS 2 includes within its scope transactions in which the entity acquires goods or services by incurring a liability ‘based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity’. Employees of an unquoted entity may receive a cash award based on the value of the equity of that entity. Such awards are typically, but not exclusively, made by venture capital investors to the management of entities in which they have invested and which they aim to sell in the medium term. Further discussion of the accounting implications of awards made in connection with an exit event may be found at 15.4 below.
More generally, where employees of an unquoted entity receive a cash award based on the value of the equity, there is no quoted share price and an ‘enterprise value’ has therefore to be calculated as a surrogate for it. This begs the question of whether such awards are within the scope of IFRS 2 (because they are based on the value of the entity's equity) or that of IAS 19.
In order for an award to be within the scope of IFRS 2, any calculated ‘enterprise value’ must represent the fair value of the entity's equity. Where the calculation uses techniques recognised by IFRS 2 as yielding a fair value for equity instruments (as discussed at 8 below), we believe that the award should be regarded as within the scope of IFRS 2.
Appendix B of IFRS 2 notes that an unquoted entity may have calculated the value of its equity based on net assets or earnings (see 8.5.3.B below). [IFRS 2.B30]. In our view, this is not intended to imply that it is always appropriate to do so, but simply to note that it may be appropriate in some cases.
Where, for example, the enterprise value is based on a constant formula, such as a fixed multiple of earnings before interest, tax, depreciation and amortisation (‘EBITDA’), in our view it is unlikely that this will represent a good surrogate for the fair value of the equity on an ongoing basis, even if it did so at the inception of the transaction. It is not difficult to imagine scenarios in which the fair value of the equity of an entity could be affected with no significant change in EBITDA, for example as a result of changes in interest rates and effective tax rates, or a significant impairment of assets. Alternatively, there might be a significant shift in the multiple of EBITDA equivalent to fair value, for example if the entity were to create or acquire a significant item of intellectual property.
For an award by an individual entity, there is unlikely to be any significant difference in the cost ultimately recorded under IFRS 2 or IAS 19. However, the disclosure requirements of IFRS 2 are more onerous than those of IAS 19. In a group situation where the parent entity grants the award to the employees of a subsidiary, the two standards could result in different levels of expense in the books of the subsidiary because IAS 19, unlike IFRS 2, does not require the employing subsidiary to recognise an expense for a transaction which it has no direct obligation to settle and for which the parent does not allocate the cost (see Chapter 35 at 2.2.2).
The accounting treatment of awards based on the ‘market price’ of an unquoted subsidiary or business unit – where there is no actual market for the shares – raises similar issues about whether an equity value is being used, as discussed more fully at 6.3.8 below.
Many entities award their employees options with a foreign currency strike price. This will arise most commonly in a multinational group where employees of overseas subsidiaries are granted options on terms that they can pay the option strike price in their local currency. Such awards may also arise where an entity, which has a functional currency different from that of the country in which it operates (e.g. an oil company based in the United Kingdom with a functional currency of United States dollars), grants its UK-based employees options with a strike price in pounds sterling, which is a foreign currency from the perspective of the currency of the financial statements.
Under IAS 32, as currently interpreted, such an award could not be regarded as an equity instrument because the strike price to be tendered is not a fixed amount of the reporting entity's own currency (see Chapter 47 at 5.2.3). However, under IFRS 2, as discussed at 2.2.1 above, equity instruments include options, which are defined as the right to acquire shares for a ‘fixed or determinable price’. Moreover, it is quite clear from the Basis for Conclusions in IFRS 2 that an award which ultimately results in an employee receiving equity is equity-settled under IFRS 2 whatever its status under IAS 32 might be (see 1.4.1 above). Thus, an option over equity with a foreign currency strike price is an equity instrument if accounted for under IFRS 2.
The fair value of such an award should be assessed at grant date and, where the award is treated as equity-settled, should not subsequently be revised for foreign exchange movements (on the basis that the equity instrument is a non-monetary item translated using the exchange rate at the date when the fair value was measured). This applies to the separate financial statements of a parent or subsidiary entity as well as to consolidated financial statements. Where the award is treated as cash-settled, however, the periodic reassessment through profit or loss of the fair value of the award required by IFRS 2 will also need to take into account any exchange difference arising from the requirements of IAS 21 – The Effects of Changes in Foreign Exchange Rates.
Entities often seek to hedge the cost of share-based payment transactions, most commonly by buying their own equity instruments in the market. For example, an entity could grant an employee options over 10,000 shares and buy 10,000 of its own shares into treasury at the date that the award is made. If the award is share-settled, the entity will deliver the shares to the counterparty. If it is cash-settled, it can sell the shares to raise the cash it is required to deliver to the counterparty. In either case, the cash cost of the award is capped at the market price of the shares at the date the award is made, less any amount paid by the employee on exercise. It could of course be argued that such an arrangement is not a true hedge at all. If the share price goes down so that the option is never exercised, the entity is left holding 10,000 of its own shares that cost more than they are now worth.
Whilst these strategies may cap the cash cost of share-based payment transactions that are eventually exercised, they will not have any effect on the charge to profit or loss required by IFRS 2 for such transactions. This is because purchases and sales of own shares are accounted for as movements in equity and are therefore never included in profit or loss (see 4.1 below).
The illustrative examples of group share schemes at 12.4 and 12.5 below show the interaction of the accounting required for a holding of own shares and the requirements of IFRS 2.
As noted at 2.2.3.E above, IFRS 2 does not apply to transactions within the scope of IAS 32 and IFRS 9. However, if shares or warrants are granted by a borrower to a lender as part of a loan or other financing arrangement, the measurement of those shares or warrants might fall within the scope of IFRS 2. The determination of the relevant standard is likely to require significant judgement based on the precise terms of individual transactions. If the shares or warrants are considered to be granted by the borrower in lieu of a cash fee for services provided by the lender then IFRS 2 is likely to be the appropriate standard, but if the shares or warrants are considered instead to be part of the overall return to the lender on the financing arrangement then IAS 32 and IFRS 9 are more likely to apply.
Some entities, such as certain types of trust, issue tradeable puttable instruments that are classified as equity instruments rather than as a financial liability because the entity has no other equity instruments. This classification is based on a specific exception in IAS 32 that makes it clear that such instruments are not equity instruments for the purposes of IFRS 2. [IAS 32.16A‑16B, 96C]. However, should options over such instruments granted to employees – and allowing them to obtain the instruments at a discount to the market price – be treated as cash-settled awards under IFRS 2 or are they outside the scope of IFRS 2 and within that of IAS 19?
The entity has no equity apart from the instruments classified as such under the narrow exception in IAS 32 and, in the absence of equity, the entity cannot logically issue equity instruments in satisfaction of an award to employees nor can it pay cash based on the price or value of its equity instruments. In our view, paragraph 96C of IAS 32 should be interpreted as meaning that, for the purposes of IFRS 2, such awards are not share-based payments and the appropriate standard is IAS 19 rather than IFRS 2.
Those who take the view that such options could be cash-settled share-based payments seem to rely more on the general IAS 32 definition of equity than on the more specific requirements of paragraph 96C of IAS 32 (that ‘these instruments should not be considered as equity instruments under IFRS 2’). We believe that the more specific guidance should take precedence over the general definition.
In the context of a flotation or other equity fundraising, an entity might offer identical shares at different prices to institutional investors and to individual (retail) investors. Should the additional discount given to one class of investor be accounted for under IFRS 2 as representing unidentified goods or services received or receivable?
The Interpretations Committee was asked to clarify the accounting treatment in this area. The request submitted to the Committee referred to the fact that the final retail price could differ from the institutional price because of:
For example, a discount to the institutional investor price might need to be offered to encourage retail investors to buy shares in order to meet the requirements of a particular stock exchange for an entity to have a minimum number of shareholders.
The Interpretations Committee considered whether the discount offered to retail investors in the above example involves the receipt of identifiable or unidentifiable goods or services from the retail shareholder group and, therefore, whether the discount is a share-based payment transaction within the scope of IFRS 2.
IFRS 2 was specifically amended for situations where the identifiable consideration received by the entity appears to be less than the fair value of the equity instruments granted (see 2.2.2.C above). [IFRS 2.2, 13A]. The Interpretations Committee noted that the application of this guidance requires judgement and consideration of the specific facts and circumstances of each transaction.
In the circumstances underlying the submission to the Interpretations Committee, the Committee observed that the entity issues shares at two different prices to two different groups of investors for the purpose of raising funds. Any difference in price between the two groups appears to relate to the existence of different markets – one accessible only to retail investors and the other accessible only to institutional investors – rather than to the receipt of additional goods or services. The only relationships involved are those between the investors and the investee entity and the investors are acting in their capacity as shareholders.
The Interpretations Committee therefore observed that the guidance in IFRS 2 is not applicable because there is no share-based payment transaction.
A distinction was drawn between the example above and a situation considered by the Interpretations Committee in 2013 (accounting for reverse acquisitions that do not constitute a business – see 2.2.3.C above). In the latter situation, a stock exchange listing received by the accounting acquirer was considered to be a service received from the accounting acquiree and to represent the difference between the fair value of the equity instruments issued and the identifiable net assets acquired. Hence an IFRS 2 expense would be required in order to recognise this difference. In the situation relating to retail and institutional investors considered above, however, there is no service element and the difference in prices for the two different types of investor is due solely to an investor-investee relationship rather than to unidentifiable goods or services received from the investors.
At its July 2014 meeting the Interpretations Committee decided not to add this matter to its agenda on the basis that sufficient guidance exists without further interpretation or the need for an amendment to a standard.12
In other situations, an entity might voluntarily offer a discount to one class of investor, e.g. to an institution underwriting the share issue. In our view, this type of discount is likely to require an IFRS 2 expense to be recognised unless there is evidence that separate prices, and therefore different fair values, are required for each category of investor.
However, in some cases – such as the example above where an institution provides underwriting services – it might be possible to conclude that any additional cost under IFRS 2 is actually a cost of issuing the equity instruments and should therefore be debited to equity rather than to profit or loss.
Similar considerations to those discussed in this section apply when, in advance of an IPO, a private company issues convertible instruments at a discount to their fair value in order both to attract key investors and to boost working capital. There is further discussion on convertible instruments at 10.1.6 below.
The recognition rules in IFRS 2 are based on a so-called ‘service date model’. In other words, IFRS 2 requires the goods or services received or acquired in a share-based payment transaction to be recognised when the goods are acquired or the services rendered. [IFRS 2.7]. For awards to employees (or others providing similar services), this contrasts with the measurement rules, which normally require a share-based payment transaction to be measured as at the date on which the transaction was entered into, which may be some time before or after the related services are received – see 4 to 7 below.
Where the goods or services received or acquired in exchange for a share-based payment transaction do not qualify for recognition as assets they should be expensed. [IFRS 2.8]. The standard notes that typically services will not qualify as assets and should therefore be expensed immediately, whereas goods will generally be recognised initially as assets and expensed later as they are consumed. However, some payments for services may be capitalised (e.g. as part of the cost of PP&E, intangible assets or inventories) and some payments for goods may be expensed immediately (e.g. where they are for items included within development costs written off as incurred). [IFRS 2.9].
The corresponding credit entry is, in the case of an equity-settled transaction, an increase in equity and, in the case of a cash-settled transaction, a liability (or decrease in cash or other assets). [IFRS 2.7].
The primary focus of the discussion in the remainder of this chapter is the application of these rules to transactions with employees. The accounting treatment of transactions with non-employees is addressed further at 5.1 and 5.4 below.
Under IFRS 2, the point at which a cost is recognised for goods or services depends on the concept of ‘vesting’. The following definitions in Appendix A to IFRS 2 are relevant.
A share-based payment to a counterparty is said to vest when it becomes an entitlement of the counterparty. Under IFRS 2, a share-based payment arrangement vests when the counterparty's entitlement is no longer conditional on the satisfaction of any vesting conditions. [IFRS 2 Appendix A].
A vesting condition is a condition that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. A vesting condition is either a service condition or a performance condition. [IFRS 2 Appendix A].
A service condition is a vesting condition that requires the counterparty to complete a specified period of service during which services are provided to the entity. If the counterparty, regardless of the reason, ceases to provide service during the vesting period, it has failed to satisfy the condition. A service condition does not require a performance target to be met. [IFRS 2 Appendix A]. For example, if an employee is granted a share option with a service condition of remaining in employment with an entity for three years, the award vests three years after the date of grant if the employee is still employed by the entity at that date.
A performance condition is a vesting condition that requires:
The period of achieving the performance target(s):
A performance target is defined by reference to:
A performance target might relate either to the performance of the entity as a whole or to some part of the entity (or part of the group), such as a division or individual employee. [IFRS 2 Appendix A].
The definition of a market condition is included at 6.3 below.
In order for a condition to be a vesting condition – rather than a ‘non-vesting’ condition (see 3.2 below) – there must be a service requirement and any additional performance target must relate to the entity or to some part of the entity or group. Thus a condition that an award vests if, in three years’ time, earnings per share has increased by 10% and the employee is still in employment, is a performance condition. If, however, the award becomes unconditional in three years’ time if earnings per share has increased by 10%, irrespective of whether the employee is still in employment, that condition is not a performance condition but a non-vesting condition because there is no associated service requirement.
The different types of performance condition and the related accounting requirements are discussed more fully at 6 below. The distinction between vesting and non-vesting conditions is discussed at 3.2 below.
The accounting treatment in a situation where the counterparty fails to meet a service condition – a situation now explicitly covered by the definition of a service condition above – is considered in more detail at 7.4.1.A below.
In addition to the general discussion throughout section 3, specific considerations relating to awards that vest on a flotation or change of control (or similar exit event) are addressed at 15.4 below.
The definitions of ‘vesting condition’, ‘service condition’ and ‘performance condition’ reproduced above reflect the amendments in the IASB's Annual Improvements to IFRSs 2010‑2012 Cycle aimed at clarifying the distinction between different types of condition attached to a share-based payment (see 1.2 above).
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:
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.
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.
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:
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:
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.
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:
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).
The vesting period is the period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied. [IFRS 2 Appendix A]. This is not the same as the exercise period or the life of the option, as illustrated by Example 34.1 below.
It is also important to distinguish between vesting conditions and other restrictions on the exercise of options and/or trading in shares, as illustrated by Example 34.2 below.
The accounting implications of vesting conditions, non-vesting conditions and vesting periods for equity-settled transactions are discussed in 4 to 7 below and for cash-settled transactions in 9 below.
In January 2010 the Interpretations Committee added to its agenda a request for clarification of the following:
The amendments to IFRS 2 published in December 2013 as part of the IASB's Annual Improvements to IFRSs 2010‑2012 Cycle were intended to address the first bullet point together with related application issues that had been raised with the Interpretations Committee (see 3.1 and 3.2 above).
In addition to considering matters subsequently addressed by the IASB in the Annual Improvements, the Interpretations Committee tentatively decided at its meetings in July and September 201015 that a non-compete provision should be presumed to be a ‘contingent feature’ – a term not defined in IFRS 2.16
The Interpretations Committee subsequently concluded that the classification of a non-compete provision and the question of how to account for the interaction of multiple vesting conditions should be referred to the IASB.17 In September 2011 the IASB agreed that these issues should be considered as future agenda items.18
The IASB launched and concluded a research project into IFRS 2 (see 1.2.1 above). The IASB decided in May 2016 not to perform further research and published a summary of the research findings in October 2018 – even though the issues continue to result in some diversity in practice (see also 3.2.3 above and 6.3.6 to 6.3.7 below).19
The detailed provisions of IFRS 2 are complex, but their key points can be summarised as follows.
The requirements summarised in (d) to (g) above can have the effect that IFRS 2 requires a cost to be recorded for an award that ultimately has no value to the counterparty, because the award either does not vest or vests but is not exercised. These rather counter-intuitive requirements of IFRS 2 are in part ‘anti-abuse’ provisions to prevent entities from applying a ‘selective’ grant date model, whereby awards that increase in value after grant date remain measured at grant date while awards that decrease in value are remeasured. This is discussed further in the detailed analysis at 5 to 7 below.
As noted at (c) in the summary in 4.1 above, the basic accounting entry for an equity-settled share-based payment transaction is: debit profit or loss for the period (often classified as employee costs), credit equity (classified as a transaction with owners in their capacity as owners rather than as part of other comprehensive income).
IFRS 2 does not prescribe the component of equity to which the credit should be taken. The IASB presumably adopted this non-prescriptive approach so as to ensure there was no conflict between, on the one hand, the basic requirement of IFRS 2 that there should be a credit in equity and, on the other, the legal requirements of various jurisdictions as to exactly how that credit should be allocated within equity. Depending on the requirements of the particular jurisdiction, it might be appropriate to take the credit to retained earnings or to a separate component of equity or entities may be able to make a policy choice.
Occasionally there will be a credit to profit or loss (see for instance Example 34.11 at 6.2.4 below) and a corresponding reduction in equity.
In some arrangements the share-based payment transaction will be settled in equity instruments of a subsidiary of the reporting entity. This is most commonly the case where the subsidiary is partly-owned with traded shares held by external shareholders. In the consolidated financial statements, the question arises as to whether the credit entry for such transactions should be presented as a non-controlling interest (NCI) or as part of the equity attributable to the shareholders of the parent. This is discussed further in Chapter 7 at 5.6.
The general measurement rule in IFRS 2 is that an entity must measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the fair value of the goods or services received cannot be estimated reliably, the entity must measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. [IFRS 2.10]. ‘Fair value’ is defined as the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction. [IFRS 2 Appendix A]. IFRS 2 has its own specific rules in relation to determining the fair value of share-based payments which differ from the more general fair value measurement requirements in IFRS 13 – Fair Value Measurement (see 5.5 below). [IFRS 2.6A].
On their own, the general measurement principles of IFRS 2 would suggest that the reporting entity must determine in each case whether the fair value of the equity instruments granted or that of the goods or services received is more reliably determinable. However, IFRS 2 goes on to clarify that:
Moreover, transactions with employees are measured at the date of grant (see 5.2 below), whereas those with non-employees are measured at the date when goods or services are received (see 5.4 below).
The overall position can be summarised by the following matrix.
Counterparty | Measurement basis | Measurement date | Recognition date |
Employee | Fair value of equity instruments awarded | Grant date | Service date |
Non-employee | Fair value of goods or services received | Service date | Service date |
The Basis for Conclusions addresses the issue of why the accounting treatment for apparently identical transactions should, in effect, depend on the identity of the counterparty.
The main argument put forward to justify the approach adopted for transactions with employees is essentially that, once an award has been agreed, the value of the services provided pursuant to the transaction does not change significantly with the value of the award. [IFRS 2.BC88‑96]. However, some might question this proposition, on the grounds that employees are more likely to work harder when the value of their options is rising than when it has sunk irretrievably.
As regards transactions with non-employees, the IASB offers two main arguments for the use of measurement at service date.
The first is that, if the counterparty is not firmly committed to delivering the goods or services, the counterparty would consider whether the fair value of the equity instruments at the delivery date is sufficient payment for the goods or services when deciding whether to deliver the goods or services. This suggests that there is a high correlation between the fair value of the equity instruments at the date the goods or services are received and the fair value of those goods or services. [IFRS 2.BC126]. This argument is clearly vulnerable to the challenge that it has no relevance where (as would more likely be the case) the counterparty is firmly committed to delivering the goods or services.
The second is that non-employees generally provide services over a short period commencing some time after grant date, whereas employees generally provide services over an extended period beginning on the grant date. This leads to a concern that transactions with non-employees could be entered into well in advance of the due date for delivery of goods or services. If an entity were able to measure the expense of such a transaction at the grant date fair value, the result, assuming that the entity's share price rises, would be to understate the cost of goods and services delivered. [IFRS 2.BC126‑127].
The true reason for the IASB's approach may have been political as much as theoretical. One effect of a grant date measurement model is that, applied to a grant of share options that is eventually exercised, it ‘freezes’ the accounting cost at the (typically) lower fair value at the date of grant. This excludes from the post-grant financial statements the increased cost and volatility that would be associated with a model that constantly remeasured the award to fair value until exercise date. The IASB might well have perceived it as a marginally easier task to persuade the corporate sector of the merits of a ‘lower cost, zero volatility’ approach as opposed to a ‘fair value at exercise date’ model (such as is used for cash-settled awards – see 9 below).
The price to be paid in accounting terms for the grant date model is that, when an award falls in value after grant date, it continues to be recognised at its higher grant date value. It is therefore quite possible that, during a period of general economic downturn, financial statements will show significant costs for options granted in previous years, but which are currently worthless. This could well lead to (in fact, sometimes groundless) accusations of rewarding management for failure.
These will comprise the great majority of transactions accounted for under IFRS 2, and include all remuneration in the form of shares, share options and any other form of reward settled in equity instruments of the entity or a member of its group.
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:
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.
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.
As noted above, IFRS 2 requires equity-settled transactions with employees to be accounted for at fair value at grant date, defined as ‘the date at which the entity and another party (including an employee) agree to a share-based payment arrangement, being when the entity and the counterparty have a shared understanding of the terms and conditions of the arrangement…’. [IFRS 2 Appendix A].
The determination of grant date is critical to the measurement of equity-settled share-based transactions with employees, since grant date is the date at which such transactions must be measured (see 5.2.2 above).
In practice, it is not always clear when a mutual understanding of the award (and, therefore, grant date) has occurred. Issues of interpretation can arise as to:
As a consequence, the determination of the grant date is often difficult in practice. We discuss the following issues in more detail in the sections below:
The grant date for ‘matching’ awards (i.e. arrangements where an additional award of shares is granted to match an initial cash bonus or award of shares) is discussed at 15.1 below.
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.
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.
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:
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.
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.
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.
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:
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.
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).
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.
Many schemes contain provisions designed to ensure that the value of awards is maintained following a major capital restructuring (such as a share split or share consolidation – see 7.8 below) or a major transaction with shareholders as a whole (such as the insertion of a new holding company over an existing group (see 12.8 below), a major share buyback or the payment of a special dividend). These provisions will either specify the adjustments to be made in a particular situation or, alternatively, may allow the entity to make such discretionary adjustments as it sees fit in order to maintain the value of awards. In some cases the exercise of such discretionary powers may be relatively mechanistic (e.g. the adjustment of the number of shares subject to options following a share split). In other cases, more subjectivity will be involved (e.g. in determining whether a particular dividend is a ‘special’ dividend for the purposes of the scheme).
In our view, where the scheme rules specify the adjustments to be made or where there is a legal requirement to make adjustments in order to remedy any dilution that would otherwise arise, the implementation of such adjustments would not result in the recognition of any incremental IFRS 2 fair value. This assumes that the adjustment would simply operate on an automatic basis to put the holders of awards back to the position that they would have been in had there not been a restructuring and hence there would be no difference in the fair value of the awards before and after the restructuring (or other specified event).
However, where there is no such explicit requirement in the scheme rules or under relevant legislation, we believe that there should be a presumption that the exercise of the entity's discretionary right to modify is a ‘modification’ as defined in IFRS 2. In such a situation, the fair values before and after the modification may differ and any incremental fair value should be expensed over the remaining vesting period (see 7.3 below).
More problematic might be the exercise of any discretion by the entity or its remuneration committee to interpret the more general terms of a scheme in deciding whether performance targets have been met and therefore whether, and to what extent, an award should vest. Suppose, for example, that an entity makes an award to its executives with a market performance condition based on total shareholder return (TSR) with a maximum payout if the entity is in the top quartile of a peer group of 100 entities (i.e. it is ranked between 1 and 25 in the peer group).
It might be that the entity is ranked 26 until shortly before the end of the performance period, at which point the entity ranked 25 suddenly announces that it is in financial difficulties and ceases trading shortly afterwards. This then means that the reporting entity moves up from 26 to 25 in the rankings. However, the entity might take the view that, in the circumstances, it could not be considered as having truly been ranked 25 in the peer group, so that a maximum payout is not justified.
In this case, the entity's intervention might be considered to be a modification. However, as the effect would be to reduce the fair value of the award, it would have no impact on the accounting treatment (see 7.3.2 below).
If such an intervention were not regarded as a modification, then the results might be different depending on the nature of the award. Where an award is subject to a market condition, as here, or to a non-vesting condition, an expense might well have to be recognised in any event, if all the non-market vesting conditions (e.g. service) were satisfied – see 6.3 and 6.4 below.
However, suppose that the award had been based on a non-market performance condition, such as an EPS target, which was met, but only due to a gain of an unusual, non-recurring nature, such as the revaluation of PP&E for tax purposes, giving rise to a deferred tax credit. The remuneration committee concludes that this should be ignored, with the effect that the award does not vest. If this is regarded as the exercise of a pre-existing right to ensure that the award vests only if ‘normal’ EPS reaches a given level, then there has been no modification. On this analysis, the award has not vested, and any expense previously recognised would be reversed. If, however, the committee's intervention is regarded as a modification, it would have no impact on the accounting treatment in this particular case, as the effect would not be beneficial to the employee and so the modification would be ignored under the general requirements of IFRS 2 relating to modifications (see 7.3.2 below).
Some schemes may give the entity the power to increase an award in circumstances where the recipient is considered to have delivered exceptional performance, or some such similar wording. In our view, unless the criteria for judging such exceptional performance are so clear as to be, in effect, performance conditions under IFRS 2, the presumption should be that any award made pursuant to such a clause is granted, and therefore measured, when it is made. We note at 15.1 below that there may be circumstances where an award described as ‘discretionary’ may not truly be so, since the entity has created an expectation amounting to an obligation to make the award. However, we believe that it would be somewhat contradictory to argue that such expectations had been created in the case of an award stated to be for (undefined) exceptional performance only.
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).
In some cases the types of person who are ‘good leavers’ may be explicitly defined in the original terms of the arrangement (common examples being persons who die or reach normal retirement age before the end of the full vesting period, or who work for a business unit that is sold or closed during the vesting period). In other cases, the entity may have the discretion to determine on a case-by-case basis whether a person should be treated as a ‘good leaver’.
In addition, some schemes may specify the entitlement of a ‘good leaver’ on leaving (e.g. that the leaver receive a portion of the award pro rata to the extent that the performance conditions have been met), whereas others leave the determination of the award to the entity at the time that the employee leaves.
Whichever situation applies, any expense relating to an award to a good leaver must be fully recognised by the leaving date because, at that point, the good leaver ceases to provide any services to the entity and any remaining conditions attached to the award will be treated as non-vesting rather than vesting conditions (see 3.2 above).
In our view, an award which vests before the end of the original vesting period due to the operation of a ‘good leaver’ clause is measured at the original grant date only where, under the rules of the scheme as understood by both parties at the original grant date, the award is made:
Where, as outlined above, the rules of the scheme make clear the categories of ‘good leaver’ and their entitlement, the entity should assess at grant date how many good leavers there are likely to be and to what extent the service period for these particular individuals is expected to be shorter than the full vesting period. The grant date fair value of the estimated awards to good leavers should be separately determined, where significant, and the expense relating to good leavers recognised over the expected reduced vesting period between grant date and leaving employment. In this situation the entity would re-estimate the number of good leavers and adjust the cumulative expense at each reporting date. This would be a change of estimate rather than a modification of the award as it would all be in accordance with the original terms and would require no discretionary decisions on the part of the entity. We would not generally expect an entity to have significant numbers of good leavers under such an arrangement.
It is important to draw a clear distinction between the IFRS 2 accounting on a straight-line basis over a reduced vesting period in the above case and that on a graded vesting basis in a situation of broader entitlement as outlined at 5.3.9.C below.
At 5.3.9.A above we discuss awards where the arrangements for leavers are clear as at the original grant date of the award. However, where – as is more usually the case – the entity determines only at the time that the employee leaves either that the employee is a ‘good leaver’ or the amount of the award, grant date or modification date (see further below) should be taken as the later of the date on which such determination is made or the date on which the award is notified to the employee. This is because the employee had no clear understanding at the original grant date of an automatic entitlement to equity instruments other than through full vesting of the award at the end of the full service period.
In our view, an entity should assess the appropriate accounting treatment based on the particular facts and circumstances and the extent to which the discretionary award is linked to the original award. The discretionary award at the time of leaving is considered to be either a modification of an original award in the employee's favour (for example, where vesting conditions are waived to allow an individual to keep an award) or the forfeiture of the original award and the granting of a completely new award on a discretionary basis (see 7.3 and 7.5 below).
In some cases, a good leaver will be allowed, on a discretionary basis, to keep existing awards that remain subject to performance conditions established at the original grant date. In this situation, any conditions that were previously treated as vesting conditions will become non-vesting conditions following the removal of the service requirement (see 3.1 and 3.2 above). This will be the case whether the discretionary arrangement is accounted for as the forfeiture of the old award plus a new grant or as a modification of the original award.
The non-vesting conditions will need to be reflected in the measurement of the fair value of the award as at the date of modification or new grant (although the non-vesting conditions alone will not result in any incremental fair value). Any fair value that is unrecognised as at the date of the good leaver ceasing employment will need to be expensed immediately as there is no further service period over which to recognise the expense.
There is further discussion of modifications at 7.3 below and of replacement and ex gratia awards granted on termination of employment at 7.5 below.
In some jurisdictions entities establish schemes where a significant number of the participants will potentially leave employment before the end of the full vesting period and will be allowed to keep a pro rata share of the award. This gives rise to a much broader category of employee than the small number of good leavers that one would generally expect under a scheme where ‘good leaver’ refers only to employees who die, retire or work for a business unit that is sold or closed (see 5.3.9.A above).
The substance of an arrangement where significant numbers of employees are expected to leave with a pro rata entitlement is that the entire award to all participants vests on a graded basis over the vesting period as a whole. So, for example, an arrangement that gives employees 360 shares at the end of three years but, whether under the rules of the scheme or by precedent, allows the majority of leavers to take a pro rata share – based on the number of months that have elapsed – at their date of departure, should be treated as vesting at the rate of 10 shares per month for all employees. Such an arrangement should be accounted for using the graded vesting approach illustrated at 6.2.2 below.
Some take the view that the situation outlined in the previous paragraph does not require graded vesting and that a straight-line approach may be taken because the award only vests pro rata if an employee leaves employment. Supporters of this view argue that the requirement to leave employment in order to receive the award before the end of the full vesting period is itself a substantive condition over and above the requirement to provide ongoing service. If an employee remains in employment the award only vests on completion of three years’ service and there is no earlier entitlement on a pro rata basis. Although this treatment has some appeal, in our view it is difficult to reconcile to the standard and is not therefore an appropriate alternative accounting treatment to the graded approach outlined above.
In other cases, rather than just a pro rata apportionment, any good leaver will be allowed to keep the entire award regardless of when they leave employment. If this is the case, and in substance there is no required minimum service period attached to the award, then the award should be treated as immediately vested in all employees and fully expensed at the grant date.
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 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.
In accounting for equity-settled transactions with non-employees, the entity must adopt a rebuttable presumption that the value of the goods or services received provides the more reliable indication of the fair value of the transaction. The fair value to be used is that at the date on which the goods are obtained or the services rendered. [IFRS 2.13]. This implies that, where the goods or services are received on a number of dates over a period, the fair value at each date should be used, although in the case of a relatively short period there may be no great fluctuation in fair value.
If ‘in rare cases’ the presumption is rebutted, the entity may use as a surrogate measure the fair value of the equity instruments granted, but as at the date when the goods or services are received, not the original grant date. However, where the goods or services are received over a relatively short period where the share price does not change significantly, an average share price can be used in calculating the fair value of equity instruments granted. [IFRS 2.13, IG5, IG6‑7].
This contrasts with US GAAP20 which requires the fair value of goods or services received from non-employees to be measured at grant date of the equity-instruments to be received, rather than based on the fair value at the date the goods are obtained or services are rendered.
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:
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).
As discussed in 5.2 and 5.4 above, IFRS 2 requires the following equity-settled transactions to be measured by reference to the fair value of the equity instruments issued rather than that of the goods or services received:
There will also be situations where the identifiable consideration received (if any) from non-employees appears to be less than the fair value of consideration given. In such cases, the cost of the unidentifiable goods or services received, if any, must be accounted for in accordance with IFRS 2 by determining the fair value of the equity instruments. This requirement is discussed at 2.2.2.C above.
For all transactions measured by reference to the fair value of the equity instruments granted, IFRS 2 requires fair value to be measured at the ‘measurement date’ – i.e. grant date in the case of transactions with employees and service date in the case of transactions with non-employees. [IFRS 2 Appendix A]. Fair value should be based on market prices if available. [IFRS 2.16]. In the absence of market prices, a valuation technique should be used to estimate what the market price would have been on the measurement date in an arm's length transaction between informed and willing parties. The technique used should be a recognised technique and incorporate all factors that would be taken into account by knowledgeable and willing market participants. [IFRS 2.17].
Appendix B to IFRS 2 contains more detailed guidance on valuation, which is discussed at 8 below. [IFRS 2.18]. IFRS 2 also deals with those ‘rare’ cases where it is not possible to value equity instruments reliably, where an intrinsic value approach may be used. This is more likely to apply to awards of options than to awards of shares and is discussed further at 8.8 below.
IFRS 2 rather confusingly states that the fair value of equity instruments granted must take into account the terms and conditions on which they were granted, but this requirement is said to be ‘subject to the requirements of paragraphs 19‑22’. [IFRS 2.16]. When those paragraphs are consulted, a somewhat different picture emerges, since they draw a distinction between:
These are discussed in more detail at 6.2 to 6.4 and at 8 below, but the essential difference is that, while non-vesting conditions and market conditions must be taken into account in any valuation, other vesting conditions must be ignored. [IFRS 2.19‑21A]. As we explain in the more detailed discussion later, these essentially arbitrary distinctions originated in part as anti-avoidance measures.
The ‘fair value’ of equity instruments under IFRS 2 therefore takes account of some, but not all, conditions attached to an award rather than being a ‘true’ fair value.
The approach to determining the fair value of share-based payments continues to be that specified in IFRS 2 and 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].
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.
Equity-settled transactions, particularly those with employees, raise particular accounting problems since they are often subject to vesting conditions (see 3.1 above) that can be satisfied only over an extended vesting period. This raises the issue of whether a share-based payment transaction should be recognised:
An award of equity instruments that vests immediately is presumed, in the absence of evidence to the contrary, to relate to services that have already been rendered, and is therefore expensed in full at grant date. [IFRS 2.14]. This may lead to the immediate recognition of an expense for an award to which the employee may not be legally entitled for some time, as illustrated in Example 34.5.
Where equity instruments are granted subject to vesting conditions (as in many cases they will be, particularly where payments to employees are concerned), IFRS 2 creates a presumption that they are a payment for services to be received in the future, during the ‘vesting period’, with the transaction being recognised during that period, as illustrated in Example 34.6. [IFRS 2.15].
In practice, the calculations required by IFRS 2 are unlikely to be as simple as that in Example 34.6. In particular:
In order to deal with such issues, IFRS 2 requires a continuous re-estimation process as summarised in 6.1.1 below.
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:
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:
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].
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:
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 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.
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].
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.
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.
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.
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.
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.
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:
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.
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:
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:
Matrix 1 | |||
Service condition met? | TSR target (market condition) met? | IFRS 2 expense? | |
1 | Yes | Yes | Yes |
2 | Yes | No | Yes |
3 | No | Yes | No |
4 | No | No | No |
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’).
Matrix 2 | ||||
Service condition met? | TSR target (market condition) met? | EPS target (non-market condition) met? | IFRS 2 expense? | |
1 | Yes | Yes | Yes | Yes |
2 | Yes | No | Yes | Yes |
3 | Yes | Yes | No | No |
4 | Yes | No | No | No |
5 | No | Yes | Yes | No |
6 | No | No | Yes | No |
7 | No | Yes | No | No |
8 | No | No | No | No |
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.
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].
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:
Year | Calculation of cumulative expense | Cumulative expense (£) | Expense for period (£) |
1 | 8 employees × 10,000 options × £25 × 1/5 | 400,000 | 400,000 |
2 | 8 employees × 10,000 options × £25 × 2/5 | 800,000 | 400,000 |
3 | 8 employees × 10,000 options × £25 × 3/5 | 1,200,000 | 400,000 |
4 | 8 employees × 10,000 options × £25 × 4/4 | 2,000,000 | 800,000 |
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.
The discussion at 6.3.2 above addressed the accounting treatment of awards with multiple conditions that must all be satisfied, i.e. a market condition and a non-market vesting condition. However, entities might also make awards with multiple conditions, only one of which need be satisfied, i.e. the awards vest on satisfaction of either a market condition or a non-market vesting condition. IFRS 2 provides no explicit guidance on the treatment of such awards, which is far from clear, as illustrated by Example 34.17 below.
Ultimately, this is an issue which only the IASB can solve, since it arises from the inconsistent treatment by IFRS 2 of awards with market conditions and those with non-market conditions. As noted at 3.4 above, the IASB has concluded not to perform further research into IFRS 2.22 Therefore we continue to believe that ongoing reassessment during the vesting period is most consistent with the general approach of IFRS 2 for awards with multiple possible outcomes.
Arrangements are also seen where a share-based payment transaction vests on the satisfaction of either a market condition or a non-vesting condition.
In our view, an entity granting an award on the basis of a service condition (and any other non-market vesting conditions) plus either a market condition or a non-vesting condition should measure the fair value of the award at grant date taking into account the probability that either the market condition or the non-vesting condition will be met. The fact that there are two alternative conditions on which the award might vest means that, unless the two conditions are perfectly correlated, the grant date fair value of such an award will be higher than that of an award where there is only one possible basis on which the award might vest. Irrespective of whether the market condition and/or the non-vesting conditions are met, the entity will recognise the grant date fair value provided all other service and non-market vesting conditions are met (i.e. the expense recognition is consistent with that of any award with market and/or non-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:
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).
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:
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:
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.
The situations discussed above and at 2.2.4.F above relate to ongoing conditions linked to the calculated value of an unlisted entity's equity instruments and therefore differ from those where the condition is linked to the market price at which a previously unlisted entity floats. On flotation there is clearly a market and a market price for the entity's equity instruments and the achievement of a specific price on flotation would, in our view, be a market condition when accompanied by a corresponding service requirement (see 15.4 below).
The accounting treatment for awards with non-vesting conditions has some similarities to that for awards with market conditions in that:
However, in some situations the accounting for non-vesting conditions differs from that for market conditions as regards the timing of the recognition of expense if the non-vesting condition is not satisfied (see 6.4.3 below).
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.
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).
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 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).
It is quite common for equity instruments to be modified or cancelled before or after vesting. Typically this is done where the conditions for an award have become so onerous as to be virtually unachievable, or (in the case of an option) where the share price has fallen so far below the exercise price of an option that it is unlikely that the option will ever be ‘in the money’ to the holder during its life. In such cases, an entity may take the view that the equity awards are so unattainable as to have little or no motivational effect, and accordingly replace them with less onerous alternatives. Conversely, and more rarely, an entity may make the terms of a share award more onerous (possibly because of shareholder concern that targets are insufficiently demanding). In addition an entity may ‘settle’ an award, i.e. cancel it in return for cash or other consideration.
A target entity might modify existing share-based payment arrangements in the period leading up to a business combination. In this situation, it needs to be determined whether the guidance in IFRS 2 is applicable or whether the modification is being made for the benefit of the acquirer or the combined entity, in which case the guidance in IFRS 3 is likely to apply (see 11.2 below).
IFRS 2 contains detailed provisions for modification, cancellation and settlement. Whilst these provisions (like the summary of them below) are framed in terms of share-based payment transactions with employees, they apply to transactions with parties other than employees that are measured by reference to the fair value of the equity instruments granted (see 5.4 above). In that case, however, all references to ‘grant date’ should be taken as references to the date on which the third party supplied goods or rendered service. [IFRS 2.26].
In the discussion below, any reference to a ‘cancellation’ is to any cancellation, whether instigated by the entity or the counterparty. As well as more obvious situations where an award is cancelled by either the entity or the counterparty, cancellations include:
The discussion below is not relevant to cancellations and modifications of those equity-settled transactions that are (exceptionally) accounted for at intrinsic value (see 8.8 below).
The basic principles of the rules for modification, cancellation and settlement, which are discussed in more detail at 7.3 and 7.4 below, can be summarised as follows.
It might be thought that, when an award has been modified, and certainly when it has been cancelled altogether, it no longer exists, and that it is therefore not appropriate to recognise any cost for it. However, such a view would be consistent with a vesting date measurement model rather than with the grant/service date measurement model of IFRS 2. Under the IFRS 2 model, the value of an award at grant date or service date cannot be changed by subsequent events.
Another reason given for the approach in IFRS 2 is that if entities were able not to recognise the cost of modified or cancelled options they would in effect be able to apply a selective form of ‘truing up’, whereby options that increased in value after grant would remain ‘frozen’ at their grant date valuation under the general principles of IFRS 2, whilst options that decreased in value could be modified or cancelled after grant date and credit taken for the fall in value. [IFRS 2.BC222‑237].
These provisions have the important practical consequence that, when an award is modified, cancelled or settled, the entity must obtain a fair value not only for the modified award, but also for the original award, updated to the date of modification. If the award had not been modified, there would have been no need to obtain a valuation for the original award after the date of grant.
Any modification of a performance condition clearly has an impact on the ‘real’ value of an award but it may have no direct effect on the value of the award for the purposes of IFRS 2. As discussed at 6.2 to 6.4 above, this is because market vesting conditions and non-vesting conditions are taken into account in valuing an award whereas non-market vesting conditions are not. Accordingly, by implication, a change to a non-market performance condition will not necessarily affect the expense recognised for the award under IFRS 2.
For example, if an award is contingent upon sales of a given number of units and the number of units required to be sold is decreased, the ‘real’ value of the award is clearly increased. However, as the performance condition is a non-market condition, and therefore not relevant to the original determination of the value of the award, there is no incremental fair value required to be accounted for by IFRS 2. If the change in the condition results in an increase in the estimated number of awards expected to vest, the change of estimate will however give rise to an accounting charge (see 6.1 to 6.4 above).
If an award is modified by changing the service period, the situation is more complex. A service condition does not of itself change the fair value of the award for the purposes of IFRS 2, but a change in service period may indirectly change the life of the award, which is relevant to its value (see 8 below). Similar considerations apply where performance conditions are modified in such a way as to alter the anticipated vesting date.
The valuation requirements relating to cancelled and settled awards are considered further at 7.4 below.
When an award is modified, the entity must as a minimum recognise the cost of the original award as if it had not been modified (i.e. at the original grant date fair value, spread over the original vesting period, and subject to the original vesting conditions). This applies unless the award does not vest because of failure to satisfy a vesting condition (other than a market condition) that was specified at grant date. [IFRS 2.27, B42].
In addition, a further cost must be recognised for any modifications that increase the fair value of the award. This additional cost is spread over the period from the date of modification until the vesting date of the modified award, which might not be the same as that of the original award. Where a modification is made after the original vesting period has expired, and is subject to no further vesting conditions, any incremental fair value should be recognised immediately. [IFRS 2.27, B42‑43].
Whether a modification increases or decreases the fair value of an award is determined as at the date of modification, as illustrated by Example 34.18. [IFRS 2.27, B42‑44].
IFRS 2 provides further detailed guidance on this requirement as discussed below.
If the modification increases the fair value of the equity instruments granted, (e.g. by reducing the exercise price or changing the exercise period), the incremental fair value, measured at the date of modification, must be recognised over the period from the date of modification to the date of vesting for the modified instruments, as illustrated in Example 34.19 below. [IFRS 2.B43(a), IG15, IG Example 7].
In effect, IFRS 2 treats the original award and the incremental value of the modified award as if they were two separate awards.
A similar treatment to that in Example 34.19 above is adopted where the fair value of an award subject to a market condition has its value increased by the removal or mitigation of the market condition. [IFRS 2.B43(a), B43(c)]. Where a vesting condition other than a market condition is changed, the treatment set out in 7.3.1.C below is adopted. IFRS 2 does not specifically address the situation where the fair value of an award is increased by the removal or mitigation of a non-vesting condition. It seems appropriate, however, to account for this increase in the same way as for a modification caused by the removal or mitigation of a market condition – i.e. as in Example 34.19 above.
If the modification increases the number of equity instruments granted, the fair value of the additional instruments, measured at the date of modification, must be recognised over the period from the date of modification to the date of vesting for the modified instruments. If there is no further vesting period for the modified instruments, the incremental cost should be recognised immediately. [IFRS 2.B43(b)].
Where a vesting condition, other than a market condition, is modified in a manner that is beneficial to the employee, the modified vesting condition should be taken into account when applying the general requirements of IFRS 2 as discussed in 6.1 to 6.4 above – in other words, the entity would continuously estimate the number of awards likely to vest and/or the vesting period. [IFRS 2.B43(c)]. This is consistent with the general principle of IFRS 2 that vesting conditions, other than market conditions, are not taken into account in the valuation of awards, but are reflected by recognising a cost for those instruments that ultimately vest on achievement of those conditions. See also the discussion at 7.2 above.
IFRS 2 does not provide an example that addresses this point specifically, but we assume that the intended approach is as in Example 34.20 below. In this Example, the entity modifies an award in a way that is beneficial to the employee even though the modification does not result in any incremental fair value. The effect of the modification is therefore recognised by basing the expense on the original grant date fair value of the awards and an assessment of the extent to which the modified vesting conditions will be met.
The difference between the accounting consequences for different methods of enhancing an award could cause confusion in some cases. For example, it may sometimes not be clear whether an award has been modified by increasing the number of equity instruments or by lowering the performance targets, as illustrated in Example 34.21.
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.
If the modification decreases the fair value of the equity instruments granted (e.g. by increasing the exercise price or reducing the exercise period), the decrease in value is effectively ignored and the entity continues to recognise a cost for services as if the awards had not been modified. [IFRS 2.B44(a)]. This approach also applies to reductions in the fair value of an award by the addition of a market condition or by making an existing market condition more onerous. [IFRS 2.B44(a), B44(c)]. Although IFRS 2 has no specific guidance on the point, we assume that reductions in the fair value resulting from the addition or amendment of a non-vesting condition are similarly ignored.
It can be seen that the only expense reversal relates to those employees who have forfeited their options by failing to fulfil the employment condition. There is no reversal of expense for those employees who met the service condition but whose options did not vest (in real terms) because the market condition was not met. In IFRS 2 terms the options of those eight employees vested because all non-market conditions were met and so the entity has to recognise the grant date fair value for those awards. This is the case even though the original grant date fair value did not take account of the effect of the market condition (unlike an award with a market condition specified from grant date). This outcome is the result of the different treatment of market and non-market conditions under IFRS 2 and the requirement to recognise an expense for an award with a market condition provided all other conditions have been met (see further discussion at 6.3.2 above).
If the modification reduces the number of equity instruments granted, IFRS 2 requires the reduction to be treated as a cancellation of that portion of the award (see 7.4 below). [IFRS 2.B44(b)]. Essentially this has the effect that any previously unrecognised cost of the cancelled instruments is immediately recognised in full, whereas the cost of an award whose value is reduced by other means continues to be spread in full over the remaining vesting period.
In situations where a decrease in the number of equity instruments is combined with other modifications so that the total fair value of the award remains the same or increases, it is unclear whether IFRS 2 requires an approach based on the value of the award as a whole or, as in the previous paragraph, one based on each equity instrument as the unit of account. This is considered further at 7.3.4 below.
Where a non-market vesting condition is modified in a manner that is not beneficial to the employee, again it is ignored and a cost recognised as if the original award had not been modified, as shown by Example 34.23 (which is based on IG Example 8 in the implementation guidance to IFRS 2). [IFRS 2.B44(c), IG15, IG Example 8].
It is noted in IG Example 8 that the same accounting result would have occurred if the entity had increased the service requirement rather than modifying the performance target. Because such a modification would make it less likely that the options would vest, which would not be beneficial to the employees, the entity would take no account of the modified service condition when recognising the services received. Instead, it would recognise the services received from the twelve employees who remained in service for the original three year vesting period. Other modifications to vesting periods are discussed below.
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:
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.
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).
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.
Where an award is cancelled or settled (i.e. cancelled with some form of compensation), other than by forfeiture for failure to satisfy the vesting conditions:
The treatment of the cancelled or settled award in (a) above is similar, in its effect on profit or loss, to the result that would have occurred if:
It should be noted that the calculation of any additional expense in (b) above depends on the fair value of the award at the date of cancellation or settlement, not on the cumulative expense already charged. This has the important practical consequence that, when an entity pays compensation on cancellation or settlement of an award, it must obtain a fair value for the original award, updated to the date of cancellation or settlement. If the award had not been cancelled or settled, there would have been no need to obtain a valuation for the original award after the date of grant.
These requirements raise some further detailed issues of interpretation on a number of areas, as follows:
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.
Based on the guidance in paragraph 28 of IFRS 2 referred to at 7.4.1 above, it might not always be immediately clear whether cancellation or forfeiture has occurred, particularly where options lapse as the result of a termination of employment by the entity. For example, an entity might grant options to an employee at the beginning of year 1 on condition of his remaining in employment until at least the end of year 3. During year 2, however, economic conditions require the entity to make a number of its personnel, including that employee, redundant, as a result of which his options lapse. Is this lapse a forfeiture or a cancellation for the purposes of IFRS 2?
The uncertainty arises because it could be argued either that the employee will be unable to deliver the services required in order for the options to vest (suggesting a forfeiture) or that the options lapse as a direct result of the employer's actions (suggesting a cancellation).
The IASB addressed this question by amending the definition of ‘service condition’ in IFRS 2 (see 3.1 above). The definition includes the following guidance:
‘… If the counterparty, regardless of the reason, ceases to provide service during the vesting period, it has failed to satisfy the condition. …’ [IFRS 2 Appendix A].
Therefore, IFRS 2 requires the failure to satisfy a service condition as the result of any termination of employment to be accounted for as a forfeiture rather than as a cancellation.
It is sometimes the case that an employee, often a member of senior management, will decide – or be encouraged by the entity – to surrender awards during the vesting period. The question arises as to whether this should be treated as a cancellation or forfeiture for accounting purposes. IFRS 2 allows forfeiture accounting, and the consequent reversal of any cumulative expense, only in situations where vesting conditions are not satisfied. A situation where the counterparty voluntarily surrenders an award, and therefore the opportunity to meet the vesting conditions, is a decision within the control of the counterparty rather than a failure to satisfy a vesting condition and should be accounted for as a cancellation rather than as a forfeiture.
In its amendment of IFRS 2 (as discussed at 7.4.1.A above), we do not believe that the IASB's intention was to allow an employee to ‘fail’ to meet a service condition by voluntarily surrendering an award. Such an action should therefore continue to be treated as a cancellation rather than as a forfeiture.
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.
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:
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.
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.
Whether or not an award is a ‘replacement’ award (and therefore recognised at only its incremental, rather than its full, fair value) is determined by whether or not the entity designates it as such on the date that it is granted. In other words, the accounting treatment effectively hinges on declared management intent, notwithstanding the IASB's systematic exclusion of management intent from many other areas of financial reporting. The Basis for Conclusions does not really explain the reason for this approach, which is also hard to reconcile with the fact that the value of an award is unaffected by whether, or when, the entity declares it to be a ‘replacement’ award for the purposes of IFRS 2. Presumably, the underlying reason is to prevent a retrospective, and possibly opportunistic, assertion that an award that has been in issue for some time is a replacement for an earlier award.
Entities need to ensure that designation occurs on grant date as defined by IFRS 2 (see 5.3 above). For example, if an entity cancels an award on 15 March and notifies an employee in writing on the same day of its intention to ask the remuneration committee to grant replacement options at its meeting two months later, on 15 May, such notification (although formal and in writing) may not strictly meet IFRS 2's requirement for designation on grant date (i.e. 15 May). However, in our view, what is important is that the entity establishes a clear link between the cancellation of the old award and the granting of a replacement award even if there is later formal approval of the replacement award following the communication of its terms to the counterparty at the same time as the cancellation of the old award.
As drafted, IFRS 2 gives entities an apparently free choice to designate any newly granted awards as replacement awards. In our view, however, such designation cannot credibly be made unless there is evidence of some connection between the cancelled and replacement awards. This might be that the cancelled and replacement awards involve the same counterparties, or that the cancellation and replacement are part of the same arrangement.
Where an award is designated as a replacement award, any incremental fair value must be recognised over the vesting period of the replacement award. The incremental fair value is the difference between the fair value of the replacement award and the ‘net fair value’ of the cancelled or settled award, both measured at the date on which the replacement award is granted. The net fair value of the cancelled or settled award is the fair value of the award, immediately before cancellation, less any compensation payment that is accounted for as a deduction from equity. [IFRS 2.28(c)]. Thus the ‘net fair value’ of the original award can never be less than zero (since any compensation payment in excess of the fair value of the cancelled award would be accounted for in profit or loss, not in equity – see Example 34.27 at 7.4.3 above).
There is some confusion within IFRS 2 as to whether a different accounting treatment is intended to result from, on the one hand, modifying an award and, on the other hand, cancelling it and replacing it with a new award on the same terms as the modified award. This is explored in the discussion of Example 34.29 below, which is based on the same fact pattern as Example 34.19 at 7.3.1.A above.
It will be seen that both the periodic allocation of expense and the total expense differ under each interpretation. This is because, under the first interpretation, the cost of the original award is accelerated at the end of year 1 for all 390 employees expected at that date to be in employment at the end of the vesting period, whereas under the second interpretation a cost is recognised for the 397 employees whose awards finally vest. The difference between the two total charges of €7,000 (€714,600 – €707,600) represents 397 – 390 = 7 employees @ €1,000 [100 options × €10[€15 + €3 – €8]] each = €7,000.
We believe that either interpretation is valid, and an entity should adopt one or other consistently as a matter of accounting policy.
In Example 34.29 above, we base the cancellation calculations on 390 employees (the number expected to be employed at the end of the vesting period as estimated at the cancellation date) rather than on 460 employees (the number in employment at the cancellation date). As discussed in Example 34.28 at 7.4.3 above, either approach may be adopted but the selected approach should be applied consistently.
The illustrative examples above involve a relatively straightforward fact pattern where, as at the date of cancellation and replacement, there was an amount to accelerate in respect of the cancelled awards and an incremental fair value associated with the replacement awards. In other scenarios, the two accounting outcomes might result in greater divergence. For example, if the cancelled awards were expected never to vest, because performance conditions had become unachievable and this had been the conclusion for some time (see 7.4.3 above), the cancelled awards might have a value of zero on a cancellation basis and the full value of the replacement awards would be recognised. If modification accounting were applied, however, the entity would have to recognise the grant date fair value of the cancelled awards plus any incremental value of the replacement awards over the fair value of the cancelled awards as at cancellation date. The latter approach might result in a significantly higher cost.
The discussion above relates to situations in which awards are cancelled and replaced for reasons other than expected, or actual, failure by the counterparty to meet a service condition. Changes to awards in contemplation, or as a consequence, of cessation of employment are considered at 5.3.9.B above and at 7.5 and 7.6 below.
The rules for replacement awards summarised in paragraph (c) at 7.4 above apply ‘if a grant of equity instruments is cancelled or settled during the vesting period …’. [IFRS 2.28]. However, if the original award has already vested when a replacement award is granted, there is no question of accelerating the cost of the cancelled award, as it has already been recognised in full during the vesting period. The issue is rather the treatment of the new award itself. IFRS 2 does not explicitly address this point but it appears that such a replacement award should be treated in the same way as a completely new award. In other words, its full fair value should be recognised immediately or, if there are any vesting conditions for the replacement award, over its vesting period.
By contrast, the rules for modification of awards discussed in 7.3 above apply whether the award has vested or not. Paragraphs 26 and 27 of IFRS 2 (modifications) are not restricted to events ‘during the vesting period’ in contrast to paragraph 28 (cancellation and settlement, including replacement awards), which is restricted to events ‘during the vesting period’. [IFRS 2.26‑28].
This has the effect that the accounting cost of modifying an already vested award (i.e. the incremental fair value of the modified award) may, at first sight, appear to be lower than the cost of cancelling and replacing it, which requires the full fair value of the new award to be expensed. However, the full fair value of the new replacement award will be reduced by the fair value of the cancelled award that the employee has surrendered as part of the consideration for the new award. This analysis will, in many cases, produce an accounting outcome similar to that of the modification of an unvested award.
When an employee's employment is terminated during the vesting period of an award of shares or options, the award will typically lapse in consequence. It is common in such situations, particularly where the employee was part of the senior management, for the entity to make an alternative award, or to allow the employee to retain existing awards, as part of the package of benefits agreed with the employee on termination of employment.
Generally, such an award is an ex gratia award – in other words, it is a discretionary award to which the outgoing employee had no legal entitlement under the terms of the original award. However, a number of plan rules set out, in a ‘good leaver’ clause (see 5.3.9 above), the terms on which any ex gratia award may be made, usually by applying a formula to determine, or limit, how much of the original award can be considered to have vested.
In many cases the award will be made on a fully vested basis, i.e. the employee has full entitlement without further conditions needing to be fulfilled. In other cases, however, an employee will be allowed to retain awards that remain subject to the fulfilment of the original conditions (other than future service). Whichever form the award takes, in IFRS 2 terms it will be treated as vesting at the date of termination of employment because any remaining conditions will be accounted for as non-vesting conditions in the absence of an explicit or implied service condition (see 3.2 above).
As discussed at 7.4.1.A above, IFRS 2 requires an entity to apply forfeiture (rather than cancellation) accounting to awards that lapse if an employee is unable to satisfy a service condition for any reason. In amending the standard to make clear that forfeiture accounting applied to the termination of employment, the IASB did not specifically address the accounting for any replacement or ex gratia awards on termination of employment.
If the original award is accounted for as a forfeiture and any previously recognised cost reversed in anticipation of the employee's expected departure, it perhaps follows that any replacement award will be treated as a completely new award and recognised and measured based on its own grant date. However, the standard is not clear and there might be situations where entities consider it more appropriate to apply modification accounting (recognising the original grant date fair value of the award that would otherwise be forfeited on its original terms (because the service condition would not be met) plus the incremental value of the modified terms). In the absence of clarity in IFRS 2, we believe that judgement will be required based on the specific facts and circumstances and the extent to which the changes to the arrangements are considered to be a waiver of existing conditions in connection with the cessation of employment rather than the introduction of a discretionary replacement arrangement on completely new terms.
Example 34.30 assumes that the entity treats the entire award as the unit of account. An entity that has instead made a policy choice to base its modification accounting on an individual share or option as the unit of account (see further discussion at 7.3.4 above) will have a different accounting outcome.
As discussed at 6.1.1 and 6.1.2 above, IFRS 2 requires an entity to determine a cumulative IFRS 2 charge at each reporting date by reference to the ‘best available estimate’ of the number of awards that will vest (within the special meaning of that term in IFRS 2).
In addition to the normal difficulties inherent in any estimation process, it is not entirely clear which anticipated future events should be taken into account in the IFRS 2 estimation process and which should not, as illustrated by Example 34.31 below.
In our view, there is no basis in IFRS 2 for accounting for an anticipated future change to the terms of an award. The entity must account for those awards in issue at the reporting date, not those that might be in issue in the future. Accordingly we do not consider approach (c) above to be appropriate if any change to the issued awards was simply an intention.
Equally, we struggle to support approach (a) above. IFRS 2 requires the entity to use its ‘best available estimate’ and its best available estimate as at the end of year 1 must be that the unit will be closed, and the employees’ employment terminated, in year 2. This view is supported by the fact that, unlike IAS 36 – Impairment of Assets (see Chapter 20) and IAS 37 (see Chapter 26), IFRS 2 does not explicitly prohibit an entity from taking account of the consequences of reorganisations and similar transactions to which it is not yet committed.
Accordingly, we believe that approach (b) should be followed under IFRS 2.
The entity's best estimate at the end of year 1 must be that none of the awards currently in place will vest (because all the employees will be made redundant and so will not meet the service condition before the end of the vesting period). It therefore applies forfeiture accounting at the end of year 1 and reverses any cost previously recorded for the award.
When the terms of the award are changed at the time of the redundancy in year 2 to allow full vesting, the entity will either recognise the full cost of the new award (as all cost relating to the original award has been reversed) or will treat the revised arrangement as a modification of the original award that is beneficial to the employee. In effect, the modification approach is based on a view that the original award is not now going to lapse because it will be modified before employment ceases and the forfeiture crystallises. In our view, in the absence of clarity in IFRS 2, the entity should assess the more appropriate approach based on the particular facts and circumstances.
Either approach will have what many may see as the less than ideal result that the entity will recognise a credit in profit or loss in year 1 and an expense in year 2, even though there has been no change in management's best estimate of the overall outcome. This follows from the analysis, discussed above, that we do not believe that the entity can account in year 1 for the award on the basis of what its terms may be in year 2.
The best estimate is made as at each reporting date. A change in estimate made in a later period in response to subsequent events affects the accounting expense from that later period only (i.e. there is no restatement of earlier periods presented).
In some jurisdictions, it is not straightforward to cancel or modify an award. This may be because cancellation or modification triggers either a legal requirement for the entity to pay compensation to the holder, or adverse tax consequences for the holder. In such cases, where an award has become unattractive (for example, because it is ‘out-of-the-money’), the entity may issue a second award rather than cancel or modify the original award. The second award cannot be designated as a replacement award, because the original award is still in place. The entity therefore has two awards running ‘in parallel’.
However, a mechanism is then put in place to ensure that the employee can receive only one award. For instance, if the original award were 1,000 options, it might be replaced with a second award of 1,000 options, but on condition that, if options under one award are exercised, the number of options exercisable under the other award is correspondingly reduced, so that no more than 1,000 options can be exercised in total.
The accounting for such arrangements is discussed in Example 34.32 below.
Examples of other types of arrangement with multiple outcomes are illustrated at 6.2.5 above and at 10.3 and 15.4 below.
It is common for an entity to divide its existing equity share capital into a larger number of shares (share splits) or to consolidate its existing share capital into a smaller number of shares (share consolidations). The impact of such splits and consolidations is not specifically addressed in IFRS 2, and a literal application of IFRS 2 could lead to some rather anomalous results.
Suppose that an employee has options over 100 shares in the reporting entity, with an exercise price of £1. The entity undertakes a ‘1 for 2’ share consolidation – i.e. the number of shares in issue is halved such that, all other things being equal, the value of one share in the entity after the consolidation is twice that of one share before the consolidation.
IFRS 2 is required to be applied to modifications to an award arising from equity restructurings. [IFRS 2.BC24]. In many cases, a share scheme will provide for automatic adjustment so that, following the consolidation, the employee holds options over only 50 shares with an exercise price of £2. As discussed at 5.3.8.A above, all things being equal, it would be expected that the modified award would have the same fair value as the original award and so there would be no incremental expense to be accounted for.
However, it may be that the scheme has no such provision for automatic adjustment, such that the employee still holds options over 100 shares. The clear economic effect is that the award has been modified, since its value has been doubled. It could be argued that, on a literal reading of IFRS 2, no modification has occurred, since the employee holds options over 100 shares at the same exercise price before and after the consolidation. The Interpretations Committee discussed this issue at its July and November 2006 meetings but decided not to take it onto its agenda because it ‘was not a normal commercial occurrence and … unlikely to have widespread significance’.23 This decision was re-confirmed by the Interpretations Committee in March 2011.24 In our view, whilst it seems appropriate to have regard to the substance of the transaction, and treat it as giving rise to a modification, it can be argued that IFRS 2 as drafted does not require such a treatment, particularly given the decision of the Interpretations Committee not to discuss the issue further.
Sometimes, the terms of an award give the entity discretion to make modifications at a future date in response to more complex changes to the share structure, such as those arising from bonus issues, share buybacks and rights issues where the effect on existing options may not be so clear-cut. These are discussed further at 5.3.8.A above.
The IASB provides some guidance on valuation in Appendix B to the standard, which we summarise and elaborate upon below. The guidance is framed in terms of awards to employees which are valued at grant date, but many of the general principles are equally applicable to awards to non-employees valued at service date. [IFRS 2.B1].
As discussed in more detail at 4 to 7 above, IFRS 2 requires a ‘modified grant-date’ approach, under which the fair value of an equity award is estimated on the grant date without regard to the possibility that any service conditions or non-market performance vesting conditions will not be met. Although the broad intention of IFRS 2 is to recognise the cost of the goods or services to be received, the IASB believes that, in the case of services from employees, the fair value of the equity instruments awarded is more readily determinable than the fair value of the services received.
As noted at 5.1 above, IFRS 2 defines fair value as ‘the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction’.
IFRS 2 requires fair value to be based on the market price of the equity instruments, where available, or calculated using an option-pricing model. While fair value may be readily determinable for awards of shares, market quotations are not available for long-term, non-transferable share options because these instruments are not generally traded.
As discussed further at 8.2.2 below, the fair value of an option at any point in time is made up of two basic components – intrinsic value and time value. Intrinsic value is the greater of (a) the market value of the underlying share less the exercise price of the option and (b) zero.
Time value reflects the potential of the option for future gain to the holder, given the length of time during which the option will be outstanding, and possible changes in the share price during that period. Because market price information is not normally available for an employee share option, the IASB believes that, in the absence of such information, the fair value of a share option awarded to an employee generally must be estimated using an option-pricing model. [IFRS 2.BC130]. This is discussed further at 8.3 below.
The discussion below aims to provide guidance on the valuation of options and similar awards under IFRS 2; it is not intended to provide detailed instructions for constructing an option pricing model.25
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].
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.
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:
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:
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:
If this variable increases, | the option value … |
Share price | Increases |
Exercise price | Decreases |
Volatility | Increases |
Time to expiry | Usually increases* |
Interest rate | Increases |
Dividend yield/payout | Decreases |
* 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.
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:
Holders of freely-traded share options (i.e. those outside a share-based payment transaction) can choose to ‘sell’ their options (typically by writing a call option on the same terms) rather than exercise them. By contrast, employee share options are generally non-transferable, leading to early (and sub-optimal) exercise of the option. This will lower the value of the options.
Holders of freely-traded share options can maintain their positions until they wish to exercise, regardless of other circumstances. In contrast, employee share options cannot normally be held once employment is terminated. If the options have not vested, they will be lost. If the options have vested, the employee will be forced to exercise the options immediately or within a short timescale, or forfeit them altogether, losing all time value. This will lower the value of the options.
Holders of freely-traded share options have an unconditional right to exercise their options. In contrast, employee share options may have vesting and non-vesting conditions attached to them, which may not be met, reducing their value. This is discussed in more detail in 8.4 below.
Although a non-market vesting condition reduces the ‘true’ fair value of an award, it 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 8.5.1 below).
Holders of freely-traded American or Bermudan share options can exercise at any time during the exercisable window. In contrast, employees may be subject to ‘blackout’ periods in which they cannot exercise their options, for example to prevent insider trading. While this could conceivably make a significant impact if the shares were significantly mis-priced in the market, in an efficient market blackout periods will only marginally decrease the value.
In the case of freely-traded share options, it is reasonable to justify the theoretical valuation on the basis that, for any other value, arbitrage opportunities could arise through hedging. In contrast, employee share options are usually awarded only in relatively small amounts, and the employees are usually subject to restrictions on share trading (especially short selling the shares, as would be required to hedge an option). When considered in combination with the non-transferability of the options (see 8.2.3.A above), this means that exercising the options is the only way to remove exposure to fluctuations in value, which lowers the value of the options.
When third parties write traded share options, the writer delivers shares to the option holder when the options are exercised, so that the exercise of the traded share options has no dilutive effect. By contrast, if an entity writes share options to employees and, when those share options are exercised, issues new shares (or uses shares previously repurchased and held in treasury) to settle the awards, there is a dilutive effect as a result of the equity-settled awards. As the shares will be issued at the exercise price rather than the current market price at the date of exercise, this actual or potential dilution may reduce the share price, so that the option holder does not make as large a gain as would arise on the exercise of similar traded options which do not dilute the share price.
Where, as will almost always be the case, there are no traded options over the entity's equity instruments that mirror the terms of share options granted to employees, IFRS 2 requires the fair value of options granted to be estimated using an option-pricing model. The entity must consider all factors that would be considered by knowledgeable, willing market participants in selecting a model. [IFRS 2.B4‑5].
The IASB decided that it was not necessary or appropriate to prescribe the precise formula or model to be used for option valuation. It notes that there is no particular option pricing model that is regarded as theoretically superior to the others, and there is the risk that any model specified might be superseded by improved methodologies in the future. [IFRS 2.BC131].
The three most common option-pricing methodologies for valuing employee options are:
It is important to understand all the terms and conditions of a share-based payment arrangement, as this will influence the choice of the most appropriate option pricing model.
IFRS 2 names the Black-Scholes-Merton formula and the binomial model as examples of acceptable models to use when estimating fair value, [IFRS 2.BC152], while noting that there are certain circumstances in which the Black-Scholes-Merton formula may not be the most appropriate model (see 8.3.1 below). Moreover, there may be instances where, due to the particular terms and conditions of the share-based payment arrangement, neither of these models is appropriate, and another methodology is more appropriate to achieving the intentions of IFRS 2. A model commonly used for valuing more complex awards is Monte Carlo Simulation (often combined with the Black-Scholes-Merton formula or the binomial model). This can deal with the complexities of a plan such as one with a market condition based on relative total shareholder return (TSR), which 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.
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 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:
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.
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).
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.
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.
Ranking in peer group | Percentage vesting |
Below 50 | 0% |
50 | 50% |
51‑74 | 50% plus an additional 2% for each increase of 1 in the ranking |
75 or higher | 100% |
Figure 34.5 below summarises the Monte Carlo approach.
The valuation could be performed using either:
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.
Since the option-pricing models discussed in 8.3 above were developed to value freely-traded options, a number of adjustments are required in order to account for the restrictions usually attached to share-based payment transactions, particularly those with employees. The restrictions not accounted for in these models include:
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.
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).
As discussed at 6.3 and 6.4 above, IFRS 2 requires market-based vesting conditions and non-vesting conditions to be taken into account in estimating the fair value of the options granted. Moreover, the entity is required to recognise a cost for an award with a market condition or non-vesting condition if all the non-market vesting conditions attaching to the award are satisfied regardless of whether the market condition or non-vesting condition is satisfied. This means that a more sophisticated option pricing model may be required.
As discussed at 6.2 above, IFRS 2 requires non-market vesting conditions to be ignored when estimating the fair value of share-based payment transactions. Instead, such vesting conditions are taken into account by adjusting the number of equity instruments included in the measurement of the transaction (by estimating the extent of forfeiture based on failure to vest) so that, ultimately, the amount recognised is based on the number of equity instruments that eventually vest.
IFRS 2 notes that, as discussed at 8.2.2 above, option pricing models take into account, as a minimum:
Of these inputs, only the exercise price and the current share price are objectively determinable. The others are subjective, and their development will generally require significant analysis. The discussion below addresses the development of assumptions for use both in a Black-Scholes-Merton formula and in a lattice model.
IFRS 2 requires other factors that knowledgeable, willing market participants would consider in setting the price to be taken into account, except for those vesting conditions and reload features that are excluded from the measurement of fair value – see 5 and 6 above and 8.9 below. Such factors include:
However, the entity should not consider factors that are relevant only to an individual employee and not to the market as a whole (such as the effect of an award of options on the personal motivation of an individual). [IFRS 2.B10].
The objective of estimating the expected volatility of, and dividends on, the underlying shares is to approximate the expectations that would be reflected in a current market or negotiated exchange price for the option. Similarly, when estimating the effects of early exercise of employee share options, the objective is to approximate the expectations about employees’ exercise behaviour that would be developed by an outside party with access to detailed information at grant date. Where (as is likely) there is a range of reasonable expectations about future volatility, dividends and exercise behaviour, an expected value should be calculated, by weighting each amount within the range by its associated probability of occurrence. [IFRS 2.B11‑12].
Such expectations are often based on past data. In some cases, however, such historical information may not be relevant (e.g. where the business of the entity has changed significantly) or even available (e.g. where the entity is unlisted or newly listed). An entity should not base estimates of future volatility, dividends or exercise behaviour on historical data without considering the extent to which they are likely to be reasonably predictive of future experience. [IFRS 2.B13‑15].
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:
As discussed at 8.4 above, IFRS 2 notes that the effect of early exercise can be reflected:
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.
IFRS 2 notes that employees often exercise options early for a number of reasons, most typically:
Factors to consider in estimating early exercise include:
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.
IFRS 2 emphasises that the estimated life of an option is critical to its valuation. Therefore, where options are granted to a group of employees, it will generally be necessary to ensure that either:
IFRS 2 suggests that it may become apparent that middle and senior management tend to exercise options later than lower-level employees, either because they choose to do so, or because they are encouraged or compelled to do so as a result of required minimum levels of ownership of equity instruments (including options) among more senior employees. [IFRS 2.B19‑21].
Most employee share options provide that, if employment is terminated, the former employee typically has only a short period (e.g. 90 days from the date of termination of employment) in which to exercise any vested options, the contractual expiry of which would otherwise be some years away. Accordingly, an entity should look at its prior termination patterns, adjust those patterns for future expectations and incorporate those expected terminations into a lattice model as expected early exercises.
Patterns of employee turnover are not necessarily linear and may be a non-linear function of a variety of factors, such as:
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 × e0.42) 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 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.
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).
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.
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.
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.
As noted under ‘Historical volatility’ at 8.5.3 above, an entity should consider the historical volatility of the share price over the most recent period that is generally commensurate with the expected option term. If a newly listed entity does not have sufficient information on historical volatility, it should compute historical volatility for the longest period for which trading activity is available. It should also consider the historical volatility of similar entities. For example, an entity that has been listed for only one year and grants options with an average expected life of five years might consider the historical volatility of entities in the same industry, which are of a similar size and operate similar businesses, for the first six years in which the shares of those entities were publicly traded. [IFRS 2.B26].
An unlisted entity will have neither historical nor current market information to consider when estimating expected volatility. IFRS 2 suggests that, in some cases, an unlisted entity that regularly issues options or shares might have set up an internal market for its shares. The volatility of those share prices could be considered when estimating expected volatility. Alternatively, if the entity has based the value of its shares on the share prices of similar listed entities, the entity could consider the historical or implied volatility of the shares of those similar listed entities. [IFRS 2.B27‑29].
If the entity has not used a valuation methodology based on the share prices of similar listed entities, the entity could derive an estimate of expected volatility consistent with the valuation methodology used. For example, the entity might consider it appropriate to value its shares on a net asset or earnings basis if this approximates to the fair value of the equity instruments, in which case it could consider the expected volatility of those net asset values or earnings. [IFRS 2.B30].
An issue not specifically addressed by IFRS 2 is the approach required in the case of an entity that has been listed for some time but which has recently undergone significant restructuring or refocusing of the business (e.g. as a result of acquisitions, disposals or refinancing). In such cases, it may well be appropriate to adopt the approach advocated for newly listed entities in 8.5.3.A above.
In calculating the fair value of a share option using the Black-Scholes-Merton formula, a single expected volatility assumption must be used. That amount should be based on the volatility expected over the expected term of the option. Frequently, expected volatility is based on observed historical share price volatility during the period of time equal to the expected term of the option and ending on the grant date. Implied volatilities (i.e. volatilities implied by actual option prices on the entity's shares observed in the market) also may be considered in determining the expected volatility assumption (see 8.5.3 above).
When developing an expected volatility assumption, current and historical implied volatilities for publicly traded options and historical realised share volatilities should be considered for shares of the grantor and shares of other entities in the grantor's industry and comparable entities.
The volatility of a market index will not generally provide an appropriate input as the diversified nature of the index tends to produce a lower volatility figure than that applicable to individual shares.
Expected volatility is more accurately taken into account by lattice models than by the Black-Scholes-Merton formula, because lattice models can accommodate dynamic assumptions regarding the term structure and path-dependence of volatility. For example, there is evidence that volatility during the life of an option depends on the term of the option and, in particular, that short-term options often exhibit higher volatility than similar options with longer terms. Additionally, volatility is path-dependent, in that it is often lower (higher) after an increase (decrease) in share price.
An entity that can observe sufficiently extensive trading of options over its shares may decide, when developing a term structure of expected volatility, to place greater weight on current implied volatilities than on historical observed and implied volatilities. It is likely that current implied volatilities are better indicators of the expectations of market participants about future volatility.
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].
Closed-form option-pricing models generally call for a single expected dividend yield as an input. That input should be determined based on the guidance at 8.5.4 above.
Lattice models can be adapted to use an expected dividend amount rather than a dividend yield, and therefore can also take into account the impact of anticipated dividend changes. Such approaches might better reflect expected future dividends, since dividends do not always move in a fixed fashion with changes in the entity's share price. This may be a time- or price-dependent assumption, similar to those described in the discussion of the binomial model at 8.3.2 above. Expected dividend estimates in a lattice model should be determined based on the general guidance above. Additionally, when the present value of dividends becomes significant in relation to the share price, standard lattice models may need to be amended.
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.
The Black-Scholes-Merton formula expressed at 8.3.1 above uses a continuously compounded interest rate, which means that any interest rate calculated or obtained needs to be in this format. The continuously compounded interest rate is given by the formula:
where ln represents a natural logarithm. For example, a 1.50% annual effective rate results in a continuously compounded rate of 1.49%:
At each node in the lattice, the option values in the lattice should be discounted using an appropriate forward rate as determined by a yield curve constructed from the implied yield on zero-coupon government bond issues. In stable economies this will have minimal impact and it is therefore likely that a flat risk-free rate that is consistent with the expected life assumption will be a reasonable estimate for this input.
Typically, traded share options are written by third parties, not the entity issuing the shares that are the subject of the option. When these share options are exercised, the writer delivers to the option holder shares acquired from existing shareholders. Hence the exercise of traded share options has no dilutive effect. By contrast, when equity-settled share options written by the entity are exercised, new shares may be issued (either in form or in substance, if shares previously repurchased and held in treasury are used), giving rise to dilution. This actual or potential dilution may reduce the share price, so that the option holder does not make as large a gain on exercise as would be the case on exercising an otherwise similar traded option that does not dilute the share price. [IFRS 2.B38‑39].
Whether or not this has a significant effect on the value of the share options granted depends on various factors, such as the number of new shares that will be issued on exercise of the options compared with the number of shares already issued. Also, if the market already expects that the option grant will take place, the market may have already factored the potential dilution into the share price at the date of grant. However, the entity should consider whether the possible dilutive effect of the future exercise of the share options granted might have an impact on their estimated fair value at grant date. Option pricing models can be adapted to take into account this potential dilutive effect. [IFRS 2.B40‑41].
In practice, in our view, it is unlikely that a listed entity would be required to make such an adjustment unless it makes a very large, unanticipated grant of share options. Indeed, even in that case, if the potential dilution is material and is not already incorporated into the share price, it would be expected that the announcement of the grant would cause the share price to decline by a material amount. Unlisted entities should consider whether the dilutive impact of a very large option grant is already incorporated into the estimated share price used in their option-pricing model. If that is not the case, some adjustment to the fair value may be appropriate.
As noted at 8.1 above, the discussion in 8.3 to 8.5 above may well be relevant to share-based payments other than options. These include, but are not restricted to:
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:
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.
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.
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.
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.
IFRS 2 acknowledges that there may be rare cases where it is not possible to determine the fair value of equity instruments granted. In such cases, the entity is required to adopt a method of accounting based on the intrinsic value of the award (i.e. the price of the underlying share less the exercise price, if any, for the award). This is slightly puzzling in the sense that, for unlisted entities, a significant obstacle to determining a reliable fair value for equity instruments is the absence of a market share price, which is also a key input in determining intrinsic value. In fact, the intrinsic value model is arguably more onerous than the fair value model since, as discussed further in 8.8.1 and 8.8.2 below, it requires intrinsic value to be determined not just once, but at initial measurement date and each subsequent reporting date until exercise.
Under the intrinsic value method:
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.
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)].
Some share options contain a reload feature (see 5.5.1 above). Reloads commonly provide that, where an exercise price is satisfied in shares of the issuing entity rather than cash, there is a new grant of at-the-money options over as many shares as are equal to the exercise price of the exercised option. For example, if there were 100 options with an exercise price of $10, and the new share price were $15, 67 options (€1,000 ÷ €15) would be re-issued.
Even though the reload feature (i.e. the possibility that additional options would be issued in the future) is a feature of the original option, and can be readily incorporated into the valuation of the original option using a lattice model, the IASB concluded that the fair value of a reload feature should not be incorporated into the estimate of the fair value of the award at grant date. As a result, subsequent grants of reload awards under the reload feature would be accounted for as new awards and measured on their respective grant dates. [IFRS 2.BC188‑192].
On the assumption that the exercise price of an award is at least the share price at grant date, the grant-date fair value of the reload award will generally be greater than the incremental value of the reload feature as at the date the original award was granted. This is because the reload award will only be granted if the original option is in-the-money and is exercised. As a result, the award would have increased in the period between the original grant date and the reload grant date, and the higher share price would be used to value the reload grant. However, from the perspective of the aggregate compensation cost, this result is mitigated by the fact that, as the value of the underlying share increases, fewer shares must be tendered to satisfy the exercise price requirement of the exercised option and, therefore, fewer reload options will be granted (as above when only 67 options are re-issued for the 100 originally issued).
If the reload feature were incorporated into the valuation of the original grant, then not only would a lower price be used, but the valuation would consider the possibility that the original option would never be exercised and, therefore, that the reload options would not be granted. Under the approach in IFRS 2, if the original award expires unexercised, no compensation cost results from the reload feature, so that the compensation cost is lower than would be the case if the value of the reload feature were incorporated into the measurement of the original award. Effectively, the approach in IFRS 2 incorporates subsequent share price changes into the valuation of a reload award.
Entities may make an award of shares to a fixed monetary value (see 5.3.5 above). This is commonly found as part of a matching share award where an employee may be offered the choice of receiving cash or shares of an equivalent value, or a multiple of that value (see 15.1 below).
IFRS 2 does not address directly the valuation of such awards. Intuitively, it might seem obvious that an award which promises (subject to vesting conditions) shares to the value of €10,000 must have a grant date fair value of €10,000, adjusted for the time value of money, together with market conditions and non-vesting conditions. However, matters are not so clear-cut, as Example 34.35 illustrates:
The Basis for Conclusions to IFRS 2 creates some confusion over this point. Paragraphs BC106 to BC118 discuss in general terms why IFRS 2 adopts a definition of equity instrument different from that in IAS 32. Paragraphs BC107 to BC109 particularly note that the IASB did not believe it appropriate that a fixed-cost award and a variable-cost award ultimately delivered in shares should be classified, and measured, (as would be the case under IAS 32) as, respectively, equity and a liability. [IFRS 2.BC106‑118].
Whilst the primary focus of the discussion in the Basis for Conclusions is whether variable equity-settled awards should be liabilities (as they would be under IAS 32) or equity (as they are under IFRS 2), the reference to measurement as well as classification of awards can be read as meaning that the IASB believed that two awards that ultimately deliver 1,000 shares (as in Example 34.35 above) should have the same grant date fair value.
Some argue that an award of shares to a given monetary amount contains a market condition, since the number of shares ultimately delivered (and therefore vesting) depends on the market price of the shares on the date of delivery. This allows the award to be valued at a fixed amount at grant date. We acknowledge that a literal reading of the definition of ‘market condition’ in IFRS 2 supports this view, but question whether this can really have been intended. In our view, the essential feature of a share-based payment transaction subject to a market condition must be that the employee's ultimate entitlement to the award depends on the share price rather than the share price simply being used to determine the number of shares.
In our view, the principal question is whether the measurement under IFRS 2 should be based on the overall award or on each share or share equivalent making up the award. In the absence of clear guidance in IFRS 2 as to the appropriate unit of account, entities may take a number of views on how to value awards of shares to a given value, but should adopt a consistent approach for all such awards (and to other areas of share-based payment accounting where the unit of account issue is significant – see, for example, 5.3.6, 7.3.4 and 7.5 above).
Throughout the discussion in this section, ‘cash’ should be read as including ‘other assets’ in accordance with the definition of a cash-settled share-based payment transaction (see 2.2.1 above).
Cash-settled share-based payment transactions include transactions such as:
However, IFRS 2 looks beyond the simple issue of whether an award entitles an employee to receive instruments that are in form shares or options to the terms of those instruments. For example, an award of shares or options over shares whose terms provide for their redemption either mandatorily according to their terms (e.g. on cessation of employment) or at the employee's option would be treated as a cash-settled, not an equity-settled, award under IFRS 2. [IFRS 2.31]. This is consistent with the fact that IAS 32 would regard a share with these terms as a financial liability rather than an equity instrument of the issuer (see Chapter 47 at 4).
In some cases the boundary between equity-settled and cash-settled schemes may appear somewhat blurred, so that further analysis may be required to determine whether a particular arrangement is equity-settled or cash-settled. Some examples of such arrangements are discussed at 9.2 below.
There are a number of possible circumstances in which, on, or shortly after, settlement of an equity-settled award either:
Such situations raise the question of whether such schemes are in fact truly equity-settled or cash-settled.
Examples of relatively common mechanisms for delivering the cash-equivalent of an equity-settled award to employees are discussed below. It emerges from the analysis below that, in reality, IFRS 2 is driven by questions of form rather than substance. To put it rather crudely, what matters is often not so much whether the entity has made a cash payment for the fair value of the award, but rather the name of the payee.
The significance of this is that the analysis affects the profit or loss charge for the award, as illustrated by Example 34.36 below.
The analyses below all rely on a precise construction of the definition of a cash-settled share-based payment transaction, i.e. one ‘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’ (emphasis added). [IFRS 2 Appendix A]. Thus, if the entity is not actually required – legally or constructively – to pay cash to the counterparty, there is no cash-settled transaction under IFRS 2, even though the arrangement may give rise to an external cash flow and, possibly, a liability under another standard.
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).
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.
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:
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.
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:
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).
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:
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].
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:
The rules for determining vesting periods are the same as those applicable to equity-settled transactions, as discussed in 6.1 to 6.4 above. Where an award vests immediately, IFRS 2 creates a presumption that, in the absence of evidence to the contrary, the award is in respect of services that have already been rendered, and should therefore be expensed in full at grant date. [IFRS 2.32].
Where cash-settled awards are made subject to vesting conditions (as in many cases they will be, particularly where payments to employees are concerned), IFRS 2 creates a presumption that they are a payment for services to be received in the future, during the ‘vesting period’, with the transaction being recognised during that period, as illustrated in Example 34.37 above. [IFRS 2.32].
IFRS 2 states that the required treatment for cash-settled transactions is simply to measure the fair value of the liability at each reporting date, [IFRS 2.30], which might suggest that the full fair value, and not just a time-apportioned part of it, should be recognised at each reporting date – as would be the case for any liability that is a financial instrument and measured at fair value under IFRS 9.
However, the standard goes on to clarify that the liability is to be measured at an amount that reflects ‘the extent to which employees have rendered service to date’, and the cost is to be recognised ‘as the employees render service’. [IFRS 2.32‑33]. This, together with IG Examples 12‑12A in IFRS 2 (the substance of which is reproduced as Examples 34.37 above and 34.38 below), indicates that a spreading approach is to be adopted.
IFRS 2 clarifies how performance vesting conditions and non-vesting conditions should be treated in the measurement of cash-settled share-based payment transactions. In this section we consider non-market performance conditions; market performance conditions and non-vesting conditions are discussed at 9.3.2.D below.
The standard makes clear that:
IG Example 12A of the implementation guidance accompanying IFRS 2 illustrates the accounting treatment of a cash-settled award with a non-market performance condition. [IFRS 2 IG Example 12A]. This example forms the basis of Example 34.38 below and supplements the illustration of a service condition in IG Example 12 (broadly reproduced as Example 34.37 above).
IFRS 2 clarifies that market conditions and non-vesting conditions should be taken into account when estimating the fair value of a cash-settled share-based payment when it is initially measured and at each remeasurement date until settlement. [IFRS 2.33C]. There will be no ultimate cost for a cash-settled award where a market condition or non-vesting condition is not satisfied as any liability would be reversed. The cumulative amount recognised will be equal to the cash paid. [IFRS 2.33D]. This is different from the accounting model for equity-settled transactions with market conditions or non-vesting conditions, which can result in a cost being recognised for awards subject to a market or non-vesting condition that is not satisfied (see 6.3 and 6.4 above).
IFRS 2 includes guidance for modifications that change the classification of a share-based payment transaction from cash-settled to equity-settled (see 9.4 below). Apart from this, IFRS 2 provides no specific guidance on modification, cancellation and settlement of cash-settled awards. However, as cash-settled awards are accounted for using a full fair value model no such guidance is needed. It is clear that:
An entity will sometimes modify the terms of an award in order to change the manner of settlement. In other words, an award that at grant date was equity-settled is modified so as to become cash-settled, or vice versa.
IFRS 2 provides no explicit guidance for modifications that change an award from being equity-settled to being cash-settled. As part of the discussions relating to the June 2016 amended guidance for modifications from cash-settled to equity-settled, the IASB considered, but rejected, suggestions that additional examples be added to the implementation guidance to illustrate other types of modification, including equity-settled to cash-settled (see further discussion at 9.4.1 below).
In order to develop the suggested accounting approaches discussed at 9.4.1 below we have used the provisions of IFRS 2 in respect of:
As noted at 10.2.3 below, the accounting in this section also applies where an entity with a choice of settlement in equity or cash switches between settlement methods.
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:
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
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
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.
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:
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].
It is common for share-based payment transactions (particularly those with employees) to provide either the entity or the counterparty with the choice of settling the transaction either in shares (or other equity instruments) or in cash (or other assets). The general principle of IFRS 2 is that a transaction with a cash alternative, or the components of that transaction, should be accounted for:
More detailed guidance is provided as to how that general principle should be applied to transactions:
Some specific types of arrangement that include cash and equity alternatives, either as a matter of choice or depending on the outcome of certain events are covered elsewhere in this chapter, as outlined below.
A common type of arrangement seen in practice is the ‘matching’ award or deferred bonus arrangement where an employee is offered a share award or a cash alternative to ‘match’ a share award or a cash bonus earned during an initial period. This type of arrangement is addressed at 15.1 below.
Rather than providing either the entity or the counterparty with a choice between settlement in equity or in cash, some transactions offer no choice but instead require an arrangement that will generally be equity-settled to be settled in cash in certain specific and limited circumstances (awards with contingent cash settlement). There will also be situations where there is contingent settlement in equity of an award that is otherwise cash-settled. These types of arrangement are considered in more detail at 10.3 below.
Some awards offer an equity alternative and a cash alternative where the cash alternative is not based on the price or value of the equity instruments. These arrangements are considered at 10.4 below.
Where the counterparty has the right to elect for settlement in either shares or cash, IFRS 2 regards the transaction as a compound transaction to which split accounting must be applied. The general principle is that the transaction must be analysed into a liability component (the counterparty's right to demand settlement in cash) and an equity component (the counterparty's right to demand settlement in shares). [IFRS 2.35]. Once split, the two components are accounted for separately. The methodology of split accounting required by IFRS 2 is somewhat different from that required by IAS 32 for issuers of other compound instruments (see Chapter 47 at 6).
A practical issue is that, where a transaction gives the counterparty a choice of settlement, it will be necessary to establish a fair value for the liability component both at grant date and at each subsequent reporting date until settlement. By contrast, in the case of transactions that can be settled in cash only, a fair value is not generally required at grant date for IFRS 2 accounting purposes, but a fair value is required at each subsequent reporting date until settlement (see 9 above). However, for entities subject to IAS 33, the grant date fair value is required in order to make the disclosures required by that standard – see Chapter 37 at 6.4.2.
We consider in more detail at 10.1.1 to 10.1.3 below the accounting treatment required by IFRS 2 for transactions where the counterparty has a settlement choice. In addition, the following specific situations are discussed:
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].
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:
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.
Having established a fair value for the liability and equity components as set out in 10.1.1 and 10.1.2 above, the entity accounts for the liability component according to the rules for cash-settled transactions (see 9 above) and for the equity component according to the rules for equity-settled transactions (see 4 to 8 above). [IFRS 2.38].
Example 34.41 below illustrates the accounting treatment for a transaction with an employee (as summarised in 10.1.2 above) where the equity component has a fair value independent of the liability component.
The above Example is based on IG Example 13 in IFRS 2, in which the share price at each reporting date is treated as the fair value of the cash alternative. As discussed more fully at 9 above, the fair value of a cash award is not necessarily exactly the same as the share price as it will depend on the terms and conditions of the award (see 9.3.2 above). Accordingly, in adapting IG Example 13 as Example 34.41 above, we have deliberately described the numbers used in respect of the liability component as ‘fair value’ and not as the ‘share price’. [IFRS 2 IG Example 13].
Example 34.41 also ignores the fact that transactions of this type often have different vesting periods for the two settlement alternatives. For instance, the employee might have been offered:
IFRS 2 offers no guidance as to how such transactions are to be accounted for. Presumably, however, the equity component would be recognised over a five year period and the liability component over a three year period. This is considered further in the discussion of ‘matching’ share awards at 15.1 below.
At the date of settlement, the liability component is restated to fair value through profit or loss. If the counterparty elects for settlement in equity, the restated liability is transferred to equity as consideration for the equity instruments issued. If the liability is settled in cash, the cash is obviously applied to reduce the liability. [IFRS 2.39‑40]. In other words, if the transaction in Example 34.41 above had been settled in shares the accounting entry would have been:
€ | € | |
Liability* | 60,000 | |
Equity† | 60,000 |
If the transaction had been settled in cash the entry would simply have been:
€ | € | |
Liability | 60,000 | |
Cash | 60,000 |
If the transaction is settled in cash, any amount taken to equity during the vesting period (€7,600 in Example 34.41 above) is not adjusted. However, the entity may transfer it from one component of equity to another (see 4.2 above). [IFRS 2.40].
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.
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).
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.
The accounting treatment for transactions where the entity has choice of settlement is quite different from transactions where the counterparty has choice of settlement, in that:
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:
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:
Some awards may nominally give the reporting entity the choice of settling in cash or equity, while in practice giving rise to an economic compulsion to settle only in cash. In addition to the examples mentioned at 10.2.1 above, this will often be the case where an entity that is a subsidiary or owned by a small number of individuals, such as members of the same family, grants options to employees. In such cases there will normally be a very strong presumption that the entity will settle in cash in order to avoid diluting the existing owners’ interests. Similarly, where the entity is not listed, there is little real benefit for an employee in receiving a share that cannot be realised except when another shareholder wishes to buy it or there is a change in ownership of the business as a whole.
In our view, such schemes are generally most appropriately accounted for as cash-settled schemes from inception. In any event, once the scheme has been operating for a while, it is likely that there will be a past practice of cash settlement such that the scheme is required to be treated as a liability under the general provisions of IFRS 2 summarised above.
A similar conclusion is often reached even where the terms of the agreement do not appear to offer the entity a choice of settling the award in cash but it has established a constructive obligation or a past practice of so doing (see 9.2.1 above).
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:
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.
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).
This section is written with a focus on awards with contingent cash settlement. However, similar considerations will apply in a situation where it is the settlement in equity that depends on the outcome of circumstances outside the control of the entity or both the entity and the counterparty.
Rather than giving either the entity or the counterparty a general right to choose between equity- or cash-settlement, some awards require cash settlement in certain specific and limited circumstances but otherwise will be equity-settled. These arrangements are referred to by IAS 32 as contingent settlement provisions and are driven by the occurrence or non-occurrence of specific outcomes rather than by choice (see Chapter 47 at 4.3). In the absence of specific guidance in IFRS 2, questions then arise as to whether such an award should be accounted for as equity-settled or cash-settled and whether this should be re-assessed on an ongoing basis during the vesting period. This is a subject that has been considered by both the Interpretations Committee and the IASB and their discussions are considered further at 10.3.5 below.
In the sections below we consider:
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.
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:
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).
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:
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).
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.
Some awards include arrangements for contingent cash-settlement if an event outside the control of the entity and the counterparty, such as some forms of exit, has not happened within a certain timescale. During the initial period of such an arrangement there might be an expectation that the exit (or other event) will take place. In this case, the award would be treated as equity-settled using an approach based on the probability of this outcome, as outlined at 10.3.4 above. However, if it is decided, close to the end of the period during which equity-settlement would apply, to modify the terms of the award so that this period is extended, the entity needs to re-assess the arrangement on both its original and modified terms.
It might therefore be the case that cash-settlement under the original terms of the award becomes the more likely outcome for a short time and that the entity has to switch the award from an equity-settled to a cash-settled basis in line with the guidance at 10.3.4 above. If a modification is then made to extend the period during which the award can be equity-settled and hence the settlement in cash once again becomes less likely, the entity should then switch again to an equity-settled basis of accounting using modification accounting (see 9.4.2 above).
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:
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.
Some awards may provide a cash-settlement alternative that is not based on the share price. For example, an employee might be offered a choice between 500 shares or €1,000,000 on the vesting of an award. Whilst an award of €1,000,000, if considered in isolation, would obviously not be a share-based payment transaction, it nevertheless falls within the scope of IFRS 2, rather than – say – IAS 19, if it is offered as an alternative to a transaction that is within the scope of IFRS 2. The Basis for Conclusions to IFRS 2 states that the cash alternative may be fixed or variable and, if variable, may be determinable in a manner that is related, or unrelated, to the price of the entity's shares. [IFRS 2.BC256].
It is frequently the case that an entity (A) acquires another (B) which, at the time of the business combination, has outstanding employee share options or other share-based awards. If no action were taken by A, employees of B would be entitled, once any vesting conditions had been satisfied, to shares in B. This is not a very satisfactory outcome for either party: A now has non-controlling (minority) shareholders in subsidiary B, which was previously wholly-owned, and the employees of B are the owners of unmarketable shares in an effectively wholly-owned subsidiary.
The obvious solution, adopted in the majority of cases, is for some mechanism to be put in place such that the employees of B end up holding shares in the new parent A. This can be achieved, for example, by:
This raises the question of how such a substitution transaction should be accounted for in the consolidated financial statements of A (the treatment in the single entity financial statements of B is discussed at 11.4 below).
IFRS 3 addresses the accounting treatment required in a business combination where an acquirer:
Section 11 relates only to business combinations. Share-based payment arrangements in the context of group reorganisations are addressed at 12.8 below.
A more comprehensive discussion of the requirements of IFRS 3 may be found in Chapter 9.
IFRS 3 requires an acquirer to measure a liability or an equity instrument related to the replacement of an acquiree's share-based payment awards in accordance with IFRS 2, rather than in accordance with the general principles of IFRS 3. References to the ‘fair value’ of an award in the following discussion therefore mean the fair value determined under IFRS 2, for which IFRS 3 uses the term ‘market-based measure’. The fair value measurement is to be made as at the acquisition date determined in accordance with IFRS 3. [IFRS 3.30].
IFRS 3 notes that a transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than that of the acquiree (or its former owners) before the combination, is likely to be a transaction separate from the business combination itself. This includes a transaction that remunerates employees or former owners of the acquiree for future services. [IFRS 3.52]. Target entities will therefore need to consider carefully whether any modifications to existing share-based payment arrangements in the period leading up to the business combination are straightforward modifications by the target entity for its own benefit or that of its owners at the time (and hence fully within the scope of IFRS 2) or whether the changes need to be assessed under the guidance in IFRS 3 because they are for the benefit of the acquirer or the combined entity. The indicators in paragraph B50 of IFRS 3 should be used to determine when the modification should be measured and recognised. [IFRS 3.B50].
The Application Guidance in Appendix B to IFRS 3 and the illustrative examples accompanying the standard explain how the general principle of paragraph 52 is to be applied to replacement share-based payment transactions. Essentially, however, IFRS 3 appears to view an exchange of share options or other share-based payment awards in conjunction with a business combination as a form of modification (see 7.3 above). [IFRS 3.B56].
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 required treatment of replacement awards may be summarised as follows:
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.
IFRS 3 provides some examples in support of the written guidance summarised above, the substance of which is reproduced as Examples 34.45 to 34.48 below. [IFRS 3.IE61‑71]. These deal with the following scenarios.
Is post-combination service required for the replacement award? | Has the acquiree award being replaced vested before the combination? | Example |
Not required | Vested | 34.45 |
Not required | Not vested | 34.46 |
Required | Vested | 34.47 |
Required | Not vested | 34.48 |
In all the examples, it is assumed that the replacement award is equity-settled.
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].
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 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.
It may occasionally happen that the acquirer does not replace awards of the acquiree at the time of the acquisition. This might be the case where, for example, the acquired subsidiary is only partly-owned and is itself listed.
IFRS 3 distinguishes between vested and unvested share-based payment transactions of the acquiree that are outstanding at the date of the business combination but which the acquirer chooses not to replace.
If vested, the outstanding acquiree share-based payment transactions are treated by the acquirer as part of the non-controlling interest in the acquiree and measured at their IFRS 2 fair value at the date of acquisition.
If unvested, the outstanding share-based payment transactions are fair valued in accordance with IFRS 2 as if the acquisition date were the grant date. The fair value should be allocated to the non-controlling interest in the acquiree on the basis of the ratio of the portion of the vesting period completed to the greater of:
The balance is treated as a post-combination remuneration expense in accordance with the general principles of IFRS 2. [IFRS 3.B62A-B62B]. Forfeitures in the post-combination period will need to be assessed in accordance with the approaches set out at 11.2.3 above.
The replacement of an award based on the acquiree's equity with one based on the acquirer's equity is, from the perspective of the acquired entity, a cancellation and replacement, to be accounted for in accordance with the general principles of IFRS 2 for such transactions (see 7.4 above). However, in addition to considerations about whether this is accounted for as a separate cancellation and new grant or as a modification of the original terms, the acquiree needs to take into account its new status as a subsidiary of the acquirer.
If the acquirer is responsible for settling the award in its own equity with the acquiree's employees, the acquiree will continue to account for the award on an equity-settled basis. If, however, the acquiree is responsible for settling the award with shares of the acquirer, then the acquiree would have to switch from an equity-settled basis of accounting to a cash-settled basis of accounting (see 2.2.2.A and 9.4.1 above). [IFRS 2.43B, B52(b), B55].
Even if the acquiree continues to account for the award on an equity-settled basis, the share-based payment expense recorded in the consolidated financial statements (based on fair value at the date of the business combination) will generally not be the same as that in the financial statements of the acquired entity (based on fair value at the date of original grant plus any incremental value granted at the date of acquisition, if modification accounting is applied). The exact timing of the recognition of the expense in the financial statements of the acquired entity after the date of cancellation and replacement will depend on its interpretation of the requirements of IFRS 2 for the cancellation and replacement of options (see Example 34.29 at 7.4.4.B above).
In this section we consider various aspects of share-based payment arrangements operated within a group and involving several legal entities. The focus of the section is on the accounting by the various parties involved and includes several comprehensive illustrative examples. The main areas covered are as follows:
Whilst associates and joint arrangements accounted for as joint ventures do not meet the definition of group entities, there will sometimes be share-based payment arrangements that involve the investor or venturer and the employees of its associate or joint venture. These arrangements are discussed at 12.9 below.
In this section we use the term ‘share scheme’ to encompass any transaction falling within the scope of IFRS 2, whether accounted for as equity-settled or cash-settled.
It is common practice for a group to operate a single share scheme covering several subsidiaries. Depending on the commercial needs of the entity, the scheme might cover all group entities, all group entities in a particular country or all employees of a particular grade throughout a number of subsidiaries.
The precise terms and structures of group share schemes are so varied that it is rare to find two completely identical arrangements. From an accounting perspective, however, group share schemes can generally be reduced to a basic prototype, as described below, which will serve as the basis of the discussion.
A group scheme typically involves transactions by several legal entities:
In practice, it might not always be a simple assessment to determine which entity is receiving an employee's services and which entity is responsible for settling the award. For example, the scheme may be directed by a group employee services entity or an individual might be a director of the parent as well as providing services to other operating entities within the group.
Where an employee services company is involved it will be necessary to evaluate the precise group arrangements in order to decide whether that entity is, in substance, the employer or whether the entity or entities to which it makes a recharge for an individual's services should be treated as the employer(s). It will also often be the case that the services company is simply administering the arrangements on behalf of the parent entity.
Where an individual provides services to more than one group entity, an assessment will need to be made as to which entity or entities are receiving the individual's services in return for the award. This will depend on the precise facts and circumstances of a particular situation.
A share-based award is often granted to an employee by the parent, or a group employee services entity, which will in turn have an option exercisable against the EBT for the shares that it may be required to deliver to the employee. Less commonly, the trustees of the EBT make awards to the employees and enter into reciprocal arrangements with the parent.
If the parent takes the view that it will satisfy any awards using existing shares it will often seek to fix the cash cost of the award by arranging for the EBT to purchase in the market, on the day that the award is made, sufficient shares to satisfy all or part of the award. This purchase will be funded by external borrowings, a loan from the parent, a contribution from the employing subsidiary, or some combination. The cash received from the employee on exercise of the option can be used by the EBT to repay any borrowings.
If the parent takes the view that it will satisfy the options with a fresh issue of shares, these will be issued to the EBT, either:
As noted in (a) above, the employing subsidiary often makes a non-refundable contribution to the EBT in connection with the scheme, so as to ensure that employing subsidiaries bear an appropriate share of the overall cost of a group-wide share scheme.
From a financial reporting perspective, it is generally necessary to consider the accounting treatment in:
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:
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:
IFRS 2 provides further guidance on the application of its general principles to:
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.
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.
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:
Whichever policy is chosen, it may then be necessary to review the carrying value of the investment to ensure that it is not impaired.
We adopt the approach of full capitalisation by the parent entity in the worked examples set out in 12.4 to 12.6 below.
Where a subsidiary grants an award to its employees and settles it in its own equity, the subsidiary accounts for the award as equity-settled.
The parent accounts for the award as equity-settled in its consolidated financial statements. In its separate financial statements, the parent is not required by IFRS 2 to account for the award. In both cases, the transaction may have implications for other aspects of the financial statements, since its settlement results in the partial disposal of the subsidiary (see Chapter 7).
Where the parent is responsible for settling the award, it accounts for the transaction as equity-settled in its consolidated financial statements. In its separate financial statements, however, it accounts for the award as cash-settled, since it is settled not in its own equity, but in the equity of the subsidiary. From the perspective of the parent's separate financial statements, the equity of a subsidiary is a financial asset. [IFRS 2.B50].
Where the parent grants an award directly to the employees of a subsidiary and settles it in its own equity, the subsidiary accounts for the award as equity-settled, with a corresponding increase in equity as a contribution from the parent. [IFRS 2.B53].
The parent accounts for the award as equity-settled in both its consolidated and separate financial statements. [IFRS 2.B54].
Where a subsidiary grants an award of equity in its parent to its employees and settles the award itself, it accounts for the award as cash-settled, since it is settled not in its own equity, but in the equity of its parent. From the perspective of the subsidiary's separate or individual financial statements, the equity of the parent is a financial asset. [IFRS 2.B55].
This requirement potentially represents something of a compliance burden. For the purposes of the parent's consolidated financial statements the fair value of the award needs to be calculated once, at grant date. For the purposes of the subsidiary's financial statements, however, IFRS 2 requires the award to be accounted for as cash-settled, with the fair value recalculated at each reporting date.
It is, however, important to note that IFRS 2 requires this accounting treatment only for a subsidiary that ‘grants’ such an award. [IFRS 2.B52, headings to B53 & B55]. In some jurisdictions it is normal for grants of share awards to be made by the parent, or an employee service company or EBT, rather than by the subsidiary, although the subsidiary may well make recommendations to the grantor of the award as to which of its employees should benefit.
In those cases, the fact that the subsidiary may communicate the award to the employee does not necessarily mean that the subsidiary itself has granted the award. It may simply be notifying the employee of an award granted by another group entity and which the other group company has the obligation to settle. In that case the subsidiary should apply the normal requirement of IFRS 2 to account for the award as equity-settled.
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:
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].
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:
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:
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.
In January 2013 the Interpretations Committee discussed whether a subsidiary's liability to pay to its parent the settlement value of share-based payments made by the parent to the subsidiary's employees should be recognised by the subsidiary from the grant date of the award or only at the date of settlement of the award.
While outreach conducted by the Interpretations Committee suggested that there is diversity in practice (as indicated at 12.2.7 above), the Interpretations Committee concluded in May 2013 that the topic could not be restricted to recharges relating to share-based payments and therefore decided not to add this issue to its agenda.35
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:
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:
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:
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:
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.
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.
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.
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.
The discussion in 12.4.1 to 12.4.3 below is based on Example 34.53 and addresses the accounting treatment for three distinct aspects of a group share scheme – a share-based payment arrangement involving group entities (see 12.2 above), the use of an EBT (see 12.3 above) and a group recharge arrangement (see 12.2.7 above).
This illustrative example treats the recharge by the parent to the subsidiary as an income statement credit in the individual accounts of the parent and recognises the recharge when it is paid. In some situations, entities might consider it appropriate to apply alternative accounting treatments (see 12.2.7 above).
So far as the consolidated financial statements are concerned, the transactions to be accounted for are:
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.
£ | £ | ||
y/e 31.12.20x1 | Profit or loss (employee costs)* | 500 | |
Equity | 500 | ||
1.1.20x2 | Own shares (equity) | 6,000 | |
Cash | 6,000 | ||
y/e 31.12.20x2 | Profit or loss (employee costs)* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Profit or loss (employee costs)* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Profit or loss (employee costs)* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash (option proceeds)† | 4,500 | |
Equity‡ | 1,500 | ||
Own shares (equity)** | 6,000 |
* 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.
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:
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.
The parent accounts for the share-based payment transaction under IFRS 2 as an equity-settled transaction, since the parent settles the award by delivering its own equity instruments 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 records an increase in the carrying value of its investment in subsidiary. It might then be necessary to consider whether the ever-increasing investment in subsidiary is supportable or is in fact impaired. As this is a matter to be determined in the light of specific facts and circumstances, it is not considered in this example. Any impairment charge would be recorded in profit or loss.
In addition to accounting for the share-based payment transaction, the parent records its transactions with the EBT and the purchase of shares.
This gives rise to the following entries:
£ | £ | ||
y/e 31.12.20x1 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.1.20x2 | Loan to EBT | 6,000 | |
Cash | 6,000 | ||
y/e 31.12.20x2 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash | 6,000 | |
Loan to EBT | 6,000 |
*Total increase in investment £3,000 (3000 shares × £1 fair value of each option) recognised over 36 months. Increase during 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 adjustment would be based on a continually revised cumulative adjustment (see further discussion at 6.1 to 6.4 above).
The parent accounts for the share-based payment transaction under IFRS 2 as an equity-settled transaction, since the parent settles the award by delivering its own equity instruments 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 records an increase in the carrying value of its investment in subsidiary. It might then be necessary to consider whether the ever-increasing investment in subsidiary is supportable or is in fact impaired. As this is a matter to be determined in the light of specific facts and circumstances, it is not considered in this example. Any impairment charge would be recorded in profit or loss.
In addition to accounting for the share-based payment transaction, the parent records the transactions of the EBT and the purchase of shares.
This gives rise to the following entries:
£ | £ | ||
y/e 31.12.20x1 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.1.20x2 | Own shares (equity) | 6,000 | |
Cash | 6,000 | ||
y/e 31.12.20x2 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash† | 6,000 | |
Equity‡ | 1,500 | ||
Profit or loss§ | 1,500 | ||
Own shares** (equity) | 6,000 |
*Total increase in investment £3,000 (3000 shares × £1 fair value of each option) spread over 36 months. Increase during 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 adjustment would be based on a continually revised cumulative adjustment (see further discussion at 6.1 to 6.4 above).
†£4,500 option exercise proceeds from employee plus £1,500 contribution from S Limited.
‡This is essentially a balancing figure representing the fact that the entity is distributing own shares with an original cost of £6,000, but has treated £1,500 of the £6,000 of the cash it has received as income (see § below) rather than as payment for the shares.
§The £1,500 contribution by the subsidiary to the EBT has been treated as a distribution from the subsidiary (see 12.2.7 above) and recorded in profit or loss. It might then be necessary to consider whether, as a result of this payment, the investment in the subsidiary had become impaired (see Chapter 8 at 2.4). 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.
**£6,000 cost of own shares purchased on 1 January 20x2 now transferred to 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.
If, in Example 34.53, the employing entity were the parent rather than the subsidiary, it would record an expense under IFRS 2. It would also normally waive £1,500 of its £6,000 loan to the EBT (i.e. the shortfall between the original loan and the £4,500 option proceeds received from the employee).
If the EBT is treated as an extension of the parent, the accounting entries for the parent would be the same as those for the group, as set out in 12.4.1 above.
If the EBT is treated as a separate entity, the accounting entries might be as follows:
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 500 | |
Equity | 500 | ||
1.1.20x2 | Loan to EBT | 6,000 | |
Cash | 6,000 | ||
y/e 31.12.20x2 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Profit or loss* | 500 | |
Equity | 500 | ||
1.9.20x6 | Own shares (Equity)† | 1,500 | |
Cash | 4,500 | ||
Loan to EBT | 6,000 | ||
Equity | 1,500 | ||
Own shares (Equity) | 1,500 |
*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 takes the approach of treating the parent as having a gross-settled purchased call option over its own equity (see Example 34.52 at 12.3.4 above), under which it can acquire 3,000 own shares from the EBT for the consideration of the waiver of £1,500 of the original £6,000 loan. The £4,500 cash inflow represents the £4,500 option exercise proceeds received by the EBT from the employee, which is then used to pay the balance of the original £6,000 loan.
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).
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 500 | |
Equity | 500 | ||
y/e 31.12.20x2 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Profit or loss* | 500 | |
Equity | 500 | ||
1.9.20x6 | Equity† | 1,500 | |
Cash | 1,500 |
*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.
Such schemes raise slightly different accounting issues. Again, these are most easily illustrated by way of an example. The discussion in 12.5.1 to 12.5.3 below is based on Example 34.54. As with Example 34.53 at 12.4 above, this section addresses the accounting treatment for three distinct aspects of a group share scheme – a share-based payment arrangement involving group entities (see 12.2 above), the use of an EBT (see 12.3 above) and a group recharge arrangement (see 12.2.7 above).
This illustrative example treats the recharge by the parent to the subsidiary as an income statement credit in the individual accounts of the parent and recognises the recharge when it is paid. In some situations, entities might consider it appropriate to apply alternative accounting treatments (see 12.2.7 above).
The consolidated financial statements need to deal with:
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.
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 500 | |
Equity | 500 | ||
y/e 31.12.20x2 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Profit or loss* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash | 4,500 | |
Equity† | 4,500 |
*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.
£ | £ | ||
1.9.20x6 | Cash | 4,500 | |
Other equity | 6,000 | ||
Share capital/premium | 10,500 |
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:
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.
The parent accounts for the share-based payment transaction under IFRS 2 as an equity-settled transaction, since the parent settles the award by delivering its own equity instruments, via its EBT, 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 records an increase in the carrying value of its investment in subsidiary. It might then be necessary to consider whether the ever-increasing investment in subsidiary is supportable or is in fact impaired. As this is a matter to be determined in the light of specific facts and circumstances, it is not considered in this example. Any impairment charge would be recorded in profit or loss.
In addition to accounting for the share-based payment transaction, the parent records its transactions with the EBT and the issue of shares.
£ | £ | ||
y/e 31.12.20x1 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
y/e 31.12.20x2 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash† | 10,500 | |
Share capital/premium | 10,500 |
*Total increase in investment £3,000 (3000 shares × £1 fair value of each option), recognised over 36 months. Increase in 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 adjustment would be based on a continually revised cumulative adjustment (see further discussion at 6.1 to 6.4 above).
†£10,500 from EBT (which has received £4,500 option exercise proceeds from employee plus £6,000 contribution from the subsidiary).
The parent accounts for the share-based payment transaction under IFRS 2 as an equity-settled transaction, since the parent settles the award by delivering its own equity instruments, via its EBT, 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 records an increase in the carrying value of its investment in subsidiary. It might then be necessary to consider whether the ever-increasing investment in subsidiary is supportable or is in fact impaired. As this is a matter to be determined in the light of specific facts and circumstances, it is not considered in this example. Any impairment charge would be recorded in profit or loss.
In addition to accounting for the share-based payment transaction, the parent records the transactions of the EBT and the issue of shares.
£ | £ | ||
y/e 31.12.20x1 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
y/e 31.12.20x2 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Investment in subsidiary* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Investment in subsidiary* | 500 | |
Equity | 500 | ||
1.9.20x6 | Cash† | 10,500 | |
Equity‡ | 6,000 | ||
Profit or loss** | 6,000 | ||
Share capital/premium | 10,500 |
*Total increase in investment £3,000 (3000 shares × £1 fair value of each option) spread over 36 months. Increase during 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 adjustment would be based on a continually revised cumulative adjustment (see further discussion at 6.1 to 6.4 above).
†£4,500 option exercise proceeds from employee plus £6,000 contribution from the subsidiary.
‡This assumes that local law requires the entity to record share capital and share premium (additional paid-in capital) of £10,500, as in 12.5.2.A above. However, IFRS prima facie requires the £6,000 cash received by the EBT from the subsidiary to be treated as income (see ** below) rather than as part of the proceeds of the issue of shares. In order, in effect, to reconcile these conflicting analyses, £6,000 of the £10,500 required by law to be capitalised as share capital and share premium has been treated as an appropriation out of other equity.
**The £6,000 contribution by the subsidiary to the EBT has been treated as a distribution from the subsidiary (see 12.2.7 above) and recorded in profit or loss. It might then be necessary to consider whether, as a result of this payment, the investment in the subsidiary had become impaired (see Chapter 8 at 2.4). 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.
If, in Example 34.54, the employing entity were the parent rather than the subsidiary, it would clearly have to record an expense under IFRS 2. It would also have to fund the £6,000 shortfall between the option exercise proceeds of £4,500 and the £10,500 issue proceeds of the shares.
If the EBT is treated as an extension of the parent, the accounting entries for the parent would be the same as those for the group, as set out in 12.5.1 above.
In our view, the treatment in 12.5.1 above may also be appropriate for this specific transaction, even where the EBT is treated as a separate entity. The issue of shares requires the parent company to fund the EBT with £6,000 which immediately returns it to the parent, along with the £4,500 received from the employee, in exchange for an issue of shares. Whilst this ‘circulation’ of the £6,000 might have some significance for legal purposes it is, economically speaking, a non-transaction that could be ignored for accounting purposes under IFRS. It might, however, be relevant, under local law, to the amount of equity shown as share capital and share premium (additional paid-in capital), in which case the expanded entry in 12.5.1 above would be appropriate.
Where, however, the EBT is treated as a separate entity, and the cash used to subscribe for the shares arises from a prior transaction, such as an earlier loan to the EBT, matters are more complicated. Suppose that, during the life of the award under discussion, the company were to advance £50,000 to the EBT for general funding purposes. At that point it would clearly record the entry:
£ | £ | |
Loan to EBT | 50,000 | |
Cash | 50,000 |
Suppose that, on exercise of the option, the EBT were to use some of that cash to fund the parent's ‘top up’ for the share issue. This effectively impairs the loan by £6,000 and leaves a ‘missing debit’ indicated by ‘?’ in the journal below:
£ | £ | |
Cash | 10,500 | |
? | 6,000 | |
Loan to EBT | 6,000 | |
Share capital/premium | 10,500 |
This looks very much like an impairment loss on the loan required to be reported in profit or loss. On the other hand, it does not resemble a loss in any conventional sense. This suggests that another analysis may be possible.
Example 34.52 at 12.3.4 above addresses the situation where an EBT is pre-funded to enable it to buy the reporting entity's own shares in the market, and those shares are finally delivered to the entity for distribution to employees. Example 34.52 suggests that this could be construed as the execution of a gross-settled purchased call option by the entity.
If that analogy is extended, the present situation could be construed as comprising a back-to-back:
If these two call options are accounted for under IAS 32 (see Chapter 47 at 11.2), the write-off of the loan to the EBT can be effectively charged to equity, as follows:
£ | £ | |
Cash | 10,500 | |
Share capital/premium | 10,500 | |
Exercise by EBT of written call | ||
Own shares (Equity) | 6,000 | |
Loan to EBT | 6,000 | |
Exercise by entity of purchased call | ||
Equity (other) | 6,000 | |
Own shares (Equity) | 6,000 | |
Issue of shares to employee |
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).
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 500 | |
Equity | 500 | ||
y/e 31.12.20x2 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x3 | Profit or loss* | 1,000 | |
Equity | 1,000 | ||
y/e 31.12.20x4 | Profit or loss* | 500 | |
Equity | 500 | ||
1.9.20x6 | Equity† | 6,000 | |
Cash | 6,000 |
*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.
The discussion in 12.6.1 to 12.6.3 below is based on Example 34.55.
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:
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 900 | |
Liability | 900 | ||
y/e 31.12.20x2 | Profit or loss* | 3,150 | |
Liability | 3,150 | ||
y/e 31.12.20x3 | Profit or loss* | 1,950 | |
Liability | 1,950 | ||
y/e 31.12.20x4 | Profit or loss* | 2,700 | |
Liability | 2,700 | ||
y/e 31.12.20x5 | Profit or loss* | 1,200 | |
Liability | 1,200 | ||
y/e 31.12.20x6 | Profit or loss* | 600 | |
Liability | 600 | ||
1.9.20x6 | Liability | 10,500 | |
Cash | 10,500 |
*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).
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.
£ | £ | ||
y/e 31.12.20x1 | Investment in subsidiary* | 900 | |
Liability | 900 | ||
y/e 31.12.20x2 | Investment in subsidiary* | 3,150 | |
Liability | 3,150 | ||
y/e 31.12.20x3 | Investment in subsidiary* | 1,950 | |
Liability | 1,950 | ||
y/e 31.12.20x4 | Investment in subsidiary* | 2,700 | |
Liability | 2,700 | ||
y/e 31.12.20x5 | Investment in subsidiary* | 1,200 | |
Liability | 1,200 | ||
y/e 31.12.20x6 | Investment in subsidiary* | 600 | |
Liability | 600 | ||
1.9.20x6 | Liability | 10,500 | |
Cash | 10,500 |
*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).
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.
£ | £ | ||
y/e 31.12.20x1 | Profit or loss* | 750 | |
Equity | 750 | ||
y/e 31.12.20x2 | Profit or loss* | 1,500 | |
Equity | 1,500 | ||
y/e 31.12.20x3 | Profit or loss* | 1,500 | |
Equity | 1,500 | ||
y/e 31.12.20x4 | Profit or loss* | 750 | |
Equity | 750 |
*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:
It is not uncommon for an employee to be granted an equity-settled share-based payment award while in the employment of one subsidiary in the group, but to transfer to another subsidiary in the group before the award is vested, but with the entitlement to the award being unchanged.
In such cases, each subsidiary measures the services received from the employee by reference to the fair value of the equity instruments at the date those rights to equity instruments were originally granted, and the proportion of the vesting period served by the employee with each subsidiary. [IFRS 2.B59]. In other words, for an award with a three-year vesting period granted to an employee of subsidiary A, who transfers to subsidiary B at the end of year 2, subsidiary A will (cumulatively) record an expense of 2/3, and subsidiary B 1/3, of the fair value at grant date. However, any subsidiary required to account for the transaction as cash-settled in accordance with the general principles discussed at 12.2 above accounts for its portion of the grant date fair value and also for any changes in the fair value of the award during the period of employment with that subsidiary. [IFRS 2.B60].
After transferring between group entities, an employee may fail to satisfy a vesting condition other than a market condition, for example by leaving the employment of the group. In this situation each subsidiary adjusts the amount previously recognised in respect of the services received from the employee in accordance with the general principles of IFRS 2 (see 6.1 to 6.4 above). [IFRS 2.B61]. This imposes upon the original employing entity the rather curious burden of tracking the service record of its former employees, where the accounting impact is expected to be significant.
Following a group reorganisation, such as the insertion of a new parent entity above an existing group, share-based payment arrangements with employees are often amended or replaced so that they relate to the shares of the new parent. Group reorganisations of entities under common control are not within the scope of IFRS 3 and so the requirements set out at 11 above are not directly applicable.
In some cases, the terms and conditions of a share-based payment arrangement will contain provisions relating to restructuring transactions (see 5.3.8.A above) so that the application of any changes is not necessarily considered to be a modification in IFRS 2 terms. Where no such provision is made, the situation is less clear-cut.
In our view, in the consolidated financial statements, such changes to share-based payments would generally be construed as a cancellation and replacement to which modification accounting could be applied (see 7.4.4 above). However, in most cases, the changes made to the share-based payment awards following a group reorganisation are likely to be such that there is no incremental fair value arising from the cancellation and replacement, the intention being simply to replace like with like.
A subsidiary receiving the services of employees but with no obligation to settle the amended award would continue to apply equity-settled accounting in its own financial statements and, as for the consolidated financial statements, would strictly account for the changes as a cancellation and replacement of the original award. The accounting consequences would be more complicated if the subsidiary itself had an obligation to settle the award in the shares of its new parent, when previously it had had to settle in its own shares, as this would mean a change from equity-settled to cash-settled accounting (see 9.4 above). However, we would expect this to be a rare occurrence in practice (see 12.2.5.B above in relation to the grantor of an award in a situation involving parent and subsidiary entities).
The new parent entity becomes a party to the share-based payment arrangements for the first time and, assuming it has no employees of its own but is considered to have granted and to have the obligation to settle the awards, needs to account for the awards to the employees of its subsidiaries (see 12.2.4 and 12.2.5 above). The requirements of IFRS 2 in this situation are unclear and one could argue:
In our view, either approach is acceptable provided it is applied consistently.
The majority of share-based payment transactions with employees involve payments to employees of the reporting entity or of another entity in the same group. Occasionally, however, share-based payments may be made to employees of significant investees of the reporting entity such as joint ventures or associates. For example, if one party to a joint venture is a quoted entity and the other not, it might be commercially appropriate for the quoted venturer to offer payments based on its quoted shares to employees of the joint venture, while the unquoted party contributes to the venture in other ways.
Such arrangements raise some questions of interpretation of IFRS 2, as illustrated by Example 34.56 below. References to an associate in the example and discussions below should be read as also referring to a 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:
€000 | €000 | ||
Year 1 | Employee costs† | 200 | |
Equity | 200 | ||
Year 2 | Employee costs | 200 | |
Equity | 200 | ||
Year 3 | Employee costs | 200 | |
Equity | 200 |
†Grant date fair value of award €600,000 × 1/3. The credit to equity represents a capital contribution from 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):
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:
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).
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.
IFRS 2 requires three main groups of disclosures, explaining:
All of the disclosure requirements of IFRS 2 are subject to the overriding materiality considerations of IAS 1 (see Chapter 3 at 4.1.5). However, depending on the identity of the counterparty and whether, for example, the individual is a member of key management, it will be necessary to assess whether an arrangement is material by nature even if it is immaterial in monetary terms.
IFRS 2 requires an entity to ‘disclose information that enables users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the period’. [IFRS 2.44].
In order to satisfy this general principle, the entity must disclose at least:
The reconciliation in (b) above should, in our view, reflect all changes in the number of equity instruments outstanding. In addition to awards with a grant date during the period, the reconciliation should include subsequent additions to earlier grants e.g. options or shares added to the award in recognition of dividends declared during the period (where this is part of the original terms of the award), and changes to the number of equity instruments as a result of demergers, share splits or consolidations and other similar changes.
The following extract from the financial statements of Dairy Crest Group plc shows additional awards from the reinvestment of dividends within the reconciliation of outstanding awards.
As drafted, the requirements in (b) to (d) above appear to apply only to share options. However, since there is little distinction in IFRS 2 between the treatment of an option with a zero exercise price and the award of a free share, in our view the disclosures should not be restricted to awards of options.
IFRS 2 requires an entity to ‘disclose information that enables users of the financial statements to understand how the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined’. [IFRS 2.46].
As drafted, this requirement, and some of the detailed disclosures below, appears to apply only to equity-settled transactions. However, it would be anomalous if detailed disclosures were required about the valuation of an award to be settled in shares, but not one to be settled in cash. In our view, therefore, the disclosures apply both to equity-settled and to cash-settled transactions.
If the entity has measured the fair value of goods or services received as consideration for equity instruments of the entity indirectly, by reference to the fair value of the equity instruments granted (i.e. transactions with employees and, in exceptional cases only, with non-employees), the entity must disclose at least the following:
These requirements can be seen to some extent as an anti-avoidance measure. It would not be surprising if the IASB had concerns that entities might seek to minimise the impact of IFRS 2 by using unduly pessimistic assumptions that result in a low fair value for share-based payment transactions, and the disclosures above seem designed to deter entities from doing so. However, these disclosures give information about other commercially sensitive matters. For example, (a)(i) above effectively requires disclosure of future dividend policy for a longer period than is generally covered by such forecasts. Entities may need to consider the impact on investors and analysts of dividend yield assumptions disclosed under IFRS 2.
In our view, it is important for entities, in making these disclosures, to ensure that any assumptions disclosed, particularly those relating to future performance, are consistent with those used in other areas of financial reporting that rely on estimates of future events, such as the impairment of property, plant and equipment, intangible assets and goodwill, income taxes (recovery of deferred tax assets out of future profits) and pensions and other post-retirement benefits.
If the entity has measured a share-based payment transaction directly by reference to the fair value of goods or services received during the period, the entity must disclose how that fair value was determined (e.g. whether fair value was measured at a market price for those goods or services). [IFRS 2.48].
As discussed at 5.4 above, IFRS 2 creates a rebuttable presumption that, for an equity-settled transaction with a counterparty other than an employee, the fair value of goods and services received provides the more reliable basis for assessing the fair value of the transaction. Where the entity has rebutted this presumption, and has valued the transaction by reference to the fair value of equity instruments issued, it must disclose this fact, and give an explanation of why the presumption was rebutted. [IFRS 2.49].
IFRS 2 requires an entity to ‘disclose information that enables users of the financial statements to understand the effect of share-based payment transactions on the entity's profit or loss for the period and on its financial position.’ [IFRS 2.50].
In order to do this, it must disclose at least:
The disclosures section of IFRS 2 has a final paragraph requiring an entity to disclose additional information about its share-based payments should the information requirements set out above and at 13.1 and 13.2 above be insufficient to meet the general disclosure principles of the standard. [IFRS 2.52].
As an example of such additional disclosure, IFRS 2 says that if an entity has classified any share-based payment transactions as equity-settled when there is a net settlement feature for withholding tax obligations (see 14.3.1 below), it should disclose the estimated future payment to the tax authority when it is necessary to inform users of the financial statements about the future cash flow effects of a share-based payment arrangement. [IFRS 2.52].
An example of many of the disclosures required by IFRS 2 may be found in the financial statements of Aviva plc for the year ended 31 December 2018.
Depending on the precise regulatory requirements of a particular jurisdiction, it might be possible to meet some of the IFRS 2 disclosure requirements by means of a cross-reference between the financial statements and other parts of an annual report published together with the financial statements, such as a management commentary or statutory remuneration report (as in the case of Aviva plc above). However, even where such an approach is permissible, care needs to be taken to ensure that any such cross-reference is clear and specific and that all of the relevant IFRS 2 requirements have been addressed as these requirements vary depending on when an award was granted. For example, detailed fair value information for an equity-settled award is generally required only in the year of grant (and as comparative information in the following period(s)), whereas the conditions attached to an award are required to be disclosed in every period in which that award is outstanding.
In many jurisdictions entities are entitled to receive income tax deductions for share-based payment transactions. In many, if not most, cases the tax deduction is given for a cost different to that recorded under IFRS 2. For example, some jurisdictions give a tax deduction for the fair or intrinsic value of the award at the date of exercise; others may give a tax deduction for amounts charged to a subsidiary by its parent, or by a trust controlled by the parent, in respect of the cost of group awards to the employees of that subsidiary. In either case, both the amount and timing of the expense for tax purposes will be different from the amount and timing of the expense required by IFRS 2.
The particular issues raised by share-based payment transactions are addressed in IAS 12 and discussed further in Chapter 33 at 10.8.
It is frequently the case that an employing entity is required to pay employment taxes or social security contributions on share options and other share-based payment transactions with employees, just as if the employees had received cash remuneration. This raises the question of how such taxes should be accounted for.
The choice of accounting method does not affect the total expense ultimately recognised (which must always be the tax actually paid), but rather its allocation to different accounting periods. IFRS is unclear as to which standard should be applied in accounting for such employment taxes. Some consider that such taxes are most appropriately accounted for under IAS 37 (see 14.2.1.A below), others favour IFRS 2 (see 14.2.1.B below) or IAS 19 (see 14.2.1.C below). A reporting entity may therefore choose what it considers an appropriate policy for employment taxes in its particular circumstances.
Such taxes do not fall within the scope of IFRS 9 since, like income taxes, they are not contractual liabilities (see Chapter 45 at 2.2.1).
Some consider that, for the reasons set out in 14.2.1.B and 14.2.1.C below, employment taxes of the employer do not fall within the scope of IFRS 2 or of IAS 19. Accordingly, since the amount ultimately payable is uncertain, the most appropriate standard to apply is IAS 37.
Where IAS 37 is applied, the entity will recognise a provision for the employment tax in accordance with IFRIC 21 – Levies – which requires identification of the activity that triggers the payment, as identified by the legislation (see Chapter 26 at 3.1 and 6.8). However, there is some room for discussion as to what constitutes the activity that triggers the payment. Is it:
Entities applying IAS 37 need therefore to consider the appropriate treatment of employment taxes in the light of IFRIC 21.
Some argue that, since the employment taxes are a payment of an amount of cash typically directly linked to the share price, they should be accounted for as a cash-settled share-based payment transaction under IFRS 2. This would require the taxes to be measured at each reporting date at fair value, multiplied by the expired vesting period of the award to which they relate (see 9.3.1 above).
A difficulty with this analysis is that IFRS 2 defines a cash-settled share-based payment transaction as one in which the entity incurs a liability to the ‘supplier of … goods or services’. The liability for such employment taxes is clearly due to the tax authorities, not to the supplier of goods and services (i.e. the employee). Some who support the application of IFRS 2 accept that IFRS 2 is not directly applicable but argue that it is nevertheless the most appropriate standard to apply under the ‘GAAP hierarchy’ in IAS 8 (see Chapter 3 at 4.3). The objective of IFRS 2 (see 2.1 above) states that the standard is intended to apply to ‘expenses associated with transactions in which share options are granted to employees’. [IFRS 2.2]. However, the standard contains no explicit provisions relevant to this objective.
Some argue that such payments are more appropriately accounted for under IAS 19 (see Chapter 35) especially when the taxes are social security contribution, as such contributions benefit the employee indirectly on retirement. Again the difficulty is that IAS 19 defines employee benefits as ‘all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment’ [IAS 19.8] which would appear to rule out payments to the tax authority, but for the fact that IAS 19 refers to social security contributions as a component part of short-term employee benefits. [IAS 19.9(a)]. However, many share-based payment transactions would, if they were within the scope of IAS 19, be classified as long-term benefits. That brings the added complication that IAS 19 would require the employment taxes due on long-term benefits to be accounted for, like the benefits themselves, using the projected unit credit method, which seems an unduly complex approach in the circumstances.
In some situations the entity may require employees to discharge any liability for employment taxes. The accounting issues raised by such arrangements are discussed at 14.2.2 and 14.3 below.
As discussed at 14.2 above, in some jurisdictions employers are required to pay employment taxes on share-based payment transactions. This detracts from one of the key attractions for an employer of a share-based payment transaction, namely that it entails no cash cost. This is particularly the case where the tax payable is based on the fair value of the award at vesting, meaning that the employer's liability is potentially unlimited.
Accordingly, employers liable to such taxes will sometimes make it a condition of receiving a share-based award that the employee bear all or some of the employer's cash cost of any related employment taxes. This may be done in a number of ways, including:
The accounting treatment of arrangements where the recovery of the employer's tax cost from the employee is made through surrendering of a number of shares with an equivalent value is similar to that discussed at 14.3 below for the recovery of the employee's taxes.
Where the scheme requires direct cash reimbursement by employees of the cost of the employer's taxes, different considerations apply, as illustrated by Example 34.57 below.
As noted at 14.2 above, an award of shares or options to an employee may also give rise to an employment tax liability for the employer, often related to the fair value of the award when it vests or, in the case of an option, is exercised. Employers may hold their own shares in order to hedge this liability (in an economic sense, if not under the criteria in IFRS 9 – see 2.2.4.H above), and later sell as many shares as are needed to raise proceeds equal to the tax liability.
These are two separate transactions. The purchase and sale of own shares are treasury share transactions accounted for in accordance with IAS 32 (see Chapter 47 at 9). The accounting treatment of the employment tax liability is discussed at 14.2.1 above.
In some jurisdictions, an award of shares or options to an employee gives rise to a personal tax liability for the employee, often related to the fair value of the award when it vests or, in the case of an option, is exercised. In order to meet this tax liability, employees may wish to sell or surrender as many shares as are needed to raise proceeds equal to the tax liability (sometimes described respectively as ‘sell to cover’ or ‘net settlement’).
This in itself does not, in our view, require the scheme to be considered as cash-settled, any more than if the employee wished to liquidate the shares in order to buy a car or undertake home improvements. However, if the manner in which the cash is passed to, or realised for, the employee gives rise to a legal or constructive obligation for the employer, then the scheme might well be cash-settled (see 9.2.2 to 9.2.4 above), to the extent of any such obligation.
In some jurisdictions where employees must pay income tax on share awards, the tax is initially collected from (and is a legal liability of) the employer, but with eventual recourse by the tax authorities to the employee for tax not collected from the employer. Such tax collection arrangements mean that even an equity-settled award results in a cash cost for the employer for the income tax.
In such a situation, the employer may require the employee, as a condition of taking delivery of any shares earned, to indemnify the entity against the tax liability, for example by:
If the entity requires the employee to surrender the relevant number of shares, in our view it is appropriate to treat the scheme as cash-settled to the extent of the indemnified amount, unless the criteria to account for the arrangement as equity-settled under the limited exception in IFRS 2 are met (see further below). This view relating to the general requirements of IFRS 2 was confirmed by the IASB in its discussions relating to the introduction of the exception into the standard. [IFRS 2.BC255G].
IFRS 2 contains a limited exception to the general requirement to consider whether a net-settled arrangement needs to be split into equity-settled and cash-settled portions. An entity is required to account for net-settled arrangements meeting certain specified criteria as equity-settled in their entirety. However, the exception is narrow in scope and the requirement to assess whether an arrangement has an equity-settled element and a cash-settled element continues to be relevant in many cases. The exception is discussed and illustrated further at 14.3.1 below.
The following example illustrates the application of IFRS 2 to an arrangement where the exception does not apply and so the entity has to separate the transaction into two elements.
IFRS 2 contains an exception for specific types of share-based payment transaction with a net settlement feature.
The exception was introduced as a result of discussions by the Interpretations Committee about the classification of a share-based payment transaction in which an entity withholds a specified portion of shares that would otherwise be issued to the counterparty at the date of exercise or vesting. The shares are withheld in return for the entity settling the counterparty's tax liability relating to the share-based payment. The question asked was whether the portion of the share-based payment that is withheld should be classified as cash-settled or equity-settled in a situation where, in the absence of the net settlement feature, the award would be treated in its entirety as equity-settled?
The exception to the usual requirements of the standard (which are set out at 14.3 above) is narrow in scope and applies only in situations where there is a statutory withholding obligation. The standard explains that ‘tax laws or regulations may oblige an entity to withhold an amount for an employee's tax obligation associated with a share-based payment and transfer that amount, normally in cash, to the tax authority on the employee's behalf. To fulfil this obligation, the terms of the share-based payment arrangement may permit or require the entity to withhold the number of equity instruments equal to the monetary value of the employee's tax obligation from the total number of equity instruments that otherwise would have been issued to the employee upon exercise (or vesting) of the share-based payment (i.e. the share-based payment arrangement has a “net settlement feature”)’. [IFRS 2.33E].
If a transaction meeting the above criteria would have been classified entirely as equity-settled were it not for this net settlement feature, then the exception in IFRS 2 applies and the transaction is accounted for as equity-settled in its entirety (rather than being divided into an equity-settled portion and a cash-settled portion as discussed at 14.3 above). [IFRS 2.33F, BC255G-I].
An entity applying the exception has to account for the withholding of shares to fund the payment to the tax authority as a deduction from equity (in accordance with paragraph 29 of IFRS 2). However, the deduction from equity may only be made up to the fair value at the net settlement date of the shares required to be withheld. [IFRS 2.33G]. If the payment exceeds this fair value, the excess is expensed through profit or loss.
Where the entity withholds any equity instruments in excess of the employee's tax obligation associated with the share-based payment (i.e. the entity withholds an amount of shares that exceeds the monetary value of the employee's tax obligation), then the excess shares should be accounted for as a cash-settled share-based payment when this amount is paid in cash (or other assets) to the employee. [IFRS 2.33H(b)]. In other words, such shares are treated as a separate cash-settled share-based payment and fully recognised as an expense (rather than as a deduction from equity) as at the date of settlement.
To illustrate the application of the exception, the IASB has added an example to the implementation guidance accompanying IFRS 2. [IFRS 2 IG Example 12B]. The substance of this example is reproduced as Example 34.59 below.
An entity applying the exception will also need to consider whether additional disclosures are needed in respect of the future cash payment to the tax authorities (see 13.3 above). [IFRS 2.52].
The IASB notes in the Basis for Conclusions to IFRS 2 that the exception is designed to alleviate the operational difficulties, and any associated undue cost, encountered by entities when they are required, under the requirements of IFRS 2, to divide a share-based payment transaction into an equity-settled element and a cash-settled element (see 14.3 above). [IFRS 2.BC255J].
The IASB made it very clear during its discussions that the exception only addresses the narrow situation where the net settlement arrangement is designed to meet an entity's obligation under tax laws or regulations to withhold a certain amount to meet the counterparty's tax obligation associated with the share-based payment and transfer that amount in cash to the taxation authorities. This point has been incorporated into IFRS 2 as follows:
‘The exception in paragraph 33F does not apply to:
Other types of arrangement that are very frequently seen in practice might appear similar in substance to the legal or regulatory obligation covered by the exception. For example, as discussed and illustrated at 14.3 above, the terms of a share-based payment arrangement between an entity and an employee might require the employee to forfeit sufficient shares to meet the tax liability or the employee might have some choice over whether or not shares are withheld and/or directly sold in order to raise cash to settle the tax liability. However, unless the arrangements for net settlement are put in place to meet the entity's obligation under tax laws or regulations as described above, the exception will not apply. Therefore, careful analysis of such arrangements continues to be necessary to determine whether part of the award should be treated as cash-settled or whether the exception applies and the entire arrangement should therefore be treated as equity-settled.
We discuss below the following aspects of the practical application of IFRS 2:
As noted in the discussion at 10.1.2 above, the rules in IFRS 2 for awards where there is a choice of equity- or cash-settlement do not fully address awards where the equity and cash alternatives may have significantly different fair values and vesting periods. In some jurisdictions, a popular type of scheme giving rise to such issues is a matching share award. This section will generally refer to matching share awards but arrangements to defer bonus payments for later settlement in shares (without a matching element) raise a number of similar issues.
Under a matching share award, the starting point is usually that an employee is awarded a bonus for a one year performance period. At the end of that period, the employee may then be either required or permitted to take all or part of that bonus in shares rather than cash. To the extent that the employee takes shares rather than cash, the employing entity may then be required or permitted to make a ‘matching’ award of an equal number of shares (or a multiple or fraction of that number). The matching award will typically vest over a longer period.
Whilst such schemes can appear superficially similar, the accounting analysis under IFRS 2 may vary significantly, according to whether:
Examples 34.60 to 34.64 below set out an analysis of the five basic variants of such schemes, as summarised in the following matrix.
Employee's taking shares required or discretionary? | Employer's matching required or discretionary? | Example |
Required | Required | 34.60 |
Required | Discretionary | 34.61 |
Discretionary | No provision for matching award | 34.62 |
Discretionary | Required | 34.63 |
Discretionary | Discretionary | 34.64 |
A requirement for the employee to retain a base shareholding for the duration of the matching arrangement is a non-vesting condition and this is considered at the end of this section (following Example 34.64).
If, as is often the case in practice, the employee had to retain his original holding of shares and complete a further period of service in order for the matching award to vest, the requirement to retain the original shares would be treated as a non-vesting condition and taken into account in the grant date fair value of the matching award (see 6.4 above). Failure to meet this non-vesting condition, by disposing of the shares whilst remaining in employment during the matching period, would be treated as a cancellation of the matching award as holding the shares is a condition within the employee's control (see 6.4.3 above).
In some jurisdictions, share awards to employees are made by means of so-called ‘limited recourse loan’ schemes. The detailed terms of such schemes vary, but typical features include the following:
The effect of such an arrangement is equivalent to an option exercisable within five years with an exercise price per share equal to the share price at grant date less total dividends since grant date – a view reinforced by the Interpretations Committee.36 There is no real loan at the initial stage. The entity has no right to receive cash or another financial asset, since the loan can be settled by the employee returning the (fixed) amount of equity ‘purchased’ at grant date.
Indeed, the only true cash flow in the entire transaction is any amount paid at the final stage if the employee chooses to acquire the shares at that point. The fact that the exercise price is a factor of the share price at grant date and dividends paid between grant date and the date of repayment of the ‘loan’ is simply an issue for the valuation of the option.
The arrangement is valued using an option-pricing model and the fair value is based on the employee's implicit right to buy the shares at a future date rather than being the share price at grant date (the face value of the loan).
The loan arrangement might have a defined period during which the employee must remain in service (five years in the example above) and during which there might also be performance conditions to be met. Where this is the case, the IFRS 2 expense will be recognised by the entity over this period. However, where, as is frequently the case, such an award is subject to no future service or performance condition, i.e. the ‘option’ is, in effect, immediately exercisable by the employee should he choose to settle the ‘loan’, IFRS 2 requires the cost to be recognised in full at grant date (see 6.1 above).
There are also some arrangements where the loan to the employee to acquire the shares is a full recourse loan (i.e. it cannot be discharged simply by surrendering the shares and there can be recourse to other assets of the employee). However, the amount repayable on the loan is reduced not only by dividends paid on the shares, but also by the achievement of performance targets, such as the achievement of a given level of earnings.
The appropriate analysis of such awards is more difficult, as they could be viewed in two ways:
The different analyses give rise to potentially significantly different expenses. This will particularly be the case where one of the conditions for mitigation of the amount repayable on the loan is linked to the price of the employer's equity. As this is a market condition, the effect of accounting for the arrangement under IFRS 2 may be that an expense is recognised in circumstances where no expense would be recognised under IAS 19.
Such awards need to be carefully analysed, in the light of their particular facts and circumstances, in order to determine the appropriate treatment. Factors that could suggest that IFRS 2 is the more relevant standard would, in our view, include:
Some awards entitle the holder to receive dividends on unvested shares (or dividend equivalents on options) during the vesting period.
For example, in some jurisdictions, entities make awards of shares that are regarded as fully vested for the purposes of tax legislation (typically because the employee enjoys the full voting and dividend rights of the shares), but not for accounting purposes (typically because the shares are subject to forfeiture if a certain minimum service period is not achieved). In practice, the shares concerned are often held by an EBT until the potential forfeiture period has expired.
Another variant of such an award that is sometimes seen is where an entity grants an employee an option to acquire shares in the entity which can be exercised immediately. However, if the employee exercises the option but leaves within a certain minimum period from the grant date, he is required to sell back the share to the entity (typically either at the original exercise price, or the lower of that price or the market value of the share at the time of the buy-back – see also the discussions at 15.4.5 below).
Such awards do not fully vest for the purposes of IFRS 2 until the potential forfeiture or buy-back period has expired. The cost of such awards should therefore be recognised over this period.
This raises the question of the accounting treatment of any dividends paid to employees during the vesting period, either as a charge to profit or loss as employee costs or a return on an equity instrument. Conceptually, it could be argued that such dividends cannot be dividends for financial reporting purposes since the equity instruments to which they relate are not yet regarded as issued for financial reporting purposes. One consequence of this, is that shares subject to such an award are excluded from the number of ordinary shares outstanding for the purposes of calculating EPS in accordance with IAS 33. These dividend entitlements would, however they are accounted for, constitute a reduction in earnings available to ordinary shareholders when applying IAS 33 (which is discussed in Chapter 37. As it is argued that equity instruments to which the dividends relate are not yet regarded as issued for financial reporting purposes, this would lead to the conclusion that dividends paid in the vesting period should be charged to profit or loss as an employment cost.
However, the charge to be made for the award under IFRS 2 will already take account of the fact that the recipient is entitled to receive dividends during the vesting period. If the recipient is not entitled to receive dividends during the vesting period a discount would be reflected in the fair value of the award; if the recipient is entitled to dividends, no such adjustment is made (see 8.5.4 above). Thus, it could be argued that also to charge profit or loss with the dividends paid is a form of double counting. Moreover, whilst the relevant shares may not have been fully issued for financial reporting purposes, the basic IFRS 2 accounting does build up an amount in equity over the vesting period. It could therefore be argued that – conceptually, if not legally – any dividend paid relates not to an issued share, but rather to the equity instrument represented by the cumulative amount that has been recorded for the award as a credit to equity, and can therefore appropriately be shown as a deduction from equity.
The argument above is valid only to the extent that the credit to equity represents awards that are expected to vest. It cannot apply to dividends paid to employees whose awards are either known not to have vested or treated as expected not to vest when applying IFRS 2 (since there is no credit to equity for these awards). Accordingly, we believe that the most appropriate approach is to analyse the dividends paid so that, by the date of vesting, cumulative dividends paid on awards treated by IFRS 2 as vested are deducted from equity and those paid on awards treated by IFRS 2 as unvested are charged to profit or loss. The allocation for periods prior to vesting should be based on a best estimate of the final outcome, as illustrated by Example 34.65 below.
Entities frequently issue awards connected to a significant event such as a flotation, trade sale or other change of control of the business. It may be that an award that would otherwise be equity-settled automatically becomes cash-settled if such an event crystallises and the entity has no choice as to the method of settlement (as discussed at 10.3 above).
However, it may also be the case that an award vests only on such an event, which raises various issues of interpretation, as discussed below.
The sections below should be read together with the more general discussions elsewhere in this chapter (as referred to in the narrative below) on topics such as grant date, vesting period, vesting and non-vesting conditions and classification as equity-settled or cash-settled. References to flotation should be read as also including other exit events.
Sometimes such awards are structured so that they will vest on flotation or so that they will vest on flotation subject to further approval at that time. For awards in the first category, grant date as defined in IFRS 2 will be the date on which the award is first communicated to employees (subject to the normal requirements of IFRS 2 relating to a shared understanding, offer and acceptance, as discussed at 5.3 above). For awards in the second category, grant date will be at or around the date of flotation, when the required further approval is given.
This means that the IFRS 2 cost of awards subject to final approval at flotation will generally be significantly higher than that of awards that do not require such approval. Moreover, as discussed further at 5.3.2 above, it may well be the case that employees begin rendering service for such awards before grant date (e.g. from the date on which the entity communicates its intention to make the award in principle). In that case, the entity would need to make an initial estimate of the value of the award for the purpose of recognising an expense from the date services have been provided, and continually re-assess that value up until the actual IFRS 2 grant date. As with any award dependent on a non-market vesting condition, an expense would be recognised only to the extent that the award is considered likely to vest. The classification of a requirement to float as a non-market vesting condition is discussed further at 15.4.3 below.
Many awards that vest on flotation have a time limit – in other words, the award lapses if flotation has not occurred on or before a given future date. In principle, as discussed at 6.2.3 above, when an award has a variable vesting period due to a non-market performance condition, the reporting entity should make a best estimate of the likely vesting period at each reporting date and calculate the IFRS 2 charge on the basis of that best estimate.
In practice, the likely timing of a future flotation is notoriously difficult to assess months, let alone years, in advance. In such cases, it would generally be acceptable simply to recognise the cost over the full potential vesting period until there is real clarity that a shorter period may be more appropriate. However, in making the assessment of the likelihood of vesting, it is important to take the company's circumstances into account. The likelihood of an exit event in the short- to medium-term is perhaps greater for a company owned by private equity investors seeking a return on their investment than for a long-established family-owned company considering a flotation.
It is worth noting that once an exit event becomes likely, the IFRS 2 expense will in some cases need to be recognised over a shorter vesting period than was originally envisaged as the probability of the exit event occurring will form the basis at the reporting date of the estimate of the number of awards expected to vest (see also the discussion at 6.2.3 and 7.6 above).
This contrasts with the US GAAP approach where, in practice, an exit event that is a change in control or an initial public offering is only recognised when it occurs. In a situation where a change in control or an initial public offering occurs shortly after the reporting date, it is therefore possible that the expense will need to be recognised in an earlier period under IFRS than under US GAAP.
There was debate in the past about whether a requirement for a flotation or sale to occur in order for an award to vest was a vesting condition or a non-vesting condition. The argument for it being a non-vesting condition was that flotation or sale may occur irrespective of the performance of the entity. The counter-argument was essentially that the price achieved on flotation or sale, which typically affects the ultimate value of the award (see 15.4.4 below), reflects the performance of the entity and is therefore a non-market performance condition (provided there is an associated service condition – see further below).
As part of its wider project on vesting and non-vesting conditions, the Interpretations Committee reached a tentative decision in July 2010 that a condition requiring an initial public offering (IPO) or a change of control should be deemed to be a performance vesting condition rather than a non-vesting condition. This was subsequently reflected in general terms through the IASB's amendments to the definition of a performance condition in the Annual Improvements to IFRSs 2010‑2012 Cycle (see 3.1 and 3.2 above). The amendments were intended, inter alia, to make clear that a requirement for flotation or sale (with an associated service condition) is a performance condition rather than a non-vesting condition on the basis that the flotation or sale condition is by reference to the entity's own operations.
The amendments also made it clear that a performance target period cannot extend beyond the end of the associated service period in order for the definition of a performance vesting condition to be met (see 3.2.2 above). Therefore, the flotation or sale condition will be treated as a non-vesting condition, rather than as a vesting condition, if the service period is not at least as long as the duration of the flotation or sale condition.
It is possible that in a share-based payment transaction a flotation or sale condition can be both a performance vesting condition and a non-vesting condition in an award that vests in instalments, ‘graded vesting’ (see 6.2.2 above). Where the share-based payment transaction vests in instalments and the service period is not at least as long as the duration of the flotation or sale condition, that condition will be treated as a non-vesting condition (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 3.1 above), this is illustrated in Example 34.66 below:
The floatation or sale condition even though is deemed to relate to the entity's own operations and therefore generally classified as a performance condition, it will sometimes be concluded that fulfilment of the condition is outside the control of both the entity and the counterparty. The settlement of an award in equity or cash might depend on the outcome of the condition i.e. there might be either cash- or equity-settlement that is entirely contingent on the exit event. Such contingent arrangements are discussed at 10.3 above.
Some awards with a condition dependent on flotation (or another similar event) vest only if a minimum price per share is achieved. For example, an entity might grant all its employees share options, the vesting of which is conditional upon a flotation or sale of the shares at a price of at least €5 per share within five years, and the employee still being in employment at the time of the flotation or sale.
Taken alone, the requirement for a flotation or sale to occur is a non-market performance condition (see further below and at 15.4.3 above). However, if a minimum market price has to be achieved, the question arises as to whether, in addition to the service requirement, such an award comprises:
The significance of this is the issue discussed at 6.3 above, namely that an expense must always be recognised for all awards with a market condition, if all the non-market vesting conditions are satisfied, even if the market condition is not. In either case, however, there is a market condition which needs to be factored into the valuation of the award.
If the view is that ‘flotation or sale at €5 within five years’ is a single market condition, the entity will recognise an expense for the award for all employees still in service at the end of the five year period, since the sole non-market vesting condition (i.e. service) will have been met. Note that this assumes that the full five-year period is considered the most likely vesting period at grant date (see 6.3.4 and 15.4.2 above).
If, on the other hand, the view is that ‘flotation or sale within five years’ and ‘flotation or sale share price €5’ are two separate conditions, and no flotation or sale occurs, no expense will be recognised since the performance element of the non-market vesting condition (i.e. ‘flotation or sale within five years’) has not been satisfied. However, even on this second analysis, if a sale or flotation is achieved at a price less than €5, an expense must be recognised, even though the award does not truly vest, since the non-market condition (i.e. ‘flotation or sale within five years’ with its associated service requirement) will have been met.
In our view, the appropriate analysis is to regard ‘flotation or sale within five years’ and ‘flotation or sale share price €5’ as two separate conditions.
The example above assumes that there is a service condition equal in duration to the other conditions attached to the award and hence the analysis above only considers vesting conditions. If the fact pattern were such that there was no service condition, or a service condition that was of a shorter duration than the other conditions, then those conditions would need to be treated as non-vesting conditions rather than as performance vesting conditions (see 3.1 and 3.2 above and Example 34.66 above).
As noted at 2.2.4.D above, entities that are contemplating a flotation or trade sale may invite employees to subscribe for shares (often a special class of share) for a relatively nominal amount. In the event of a flotation or trade sale occurring, these shares may be sold or will be redeemable at a substantial premium. It is often argued that the initial subscription price paid represents the fair value of the share at the time, given the inherent high uncertainty as to whether a flotation or trade sale will in fact occur.
The premium paid on the shares in the event of a flotation or trade sale will typically be calculated in part by reference to the price achieved. The question therefore arises as to whether such awards fall within the scope of IFRS 2. It might be argued for example that, as the employee paid full fair value for the award at issue, there has been no share-based payment and, accordingly, the instrument should be accounted for under IAS 32 and IFRS 9.
In our view, in order to determine whether the arrangement falls within the scope of IFRS 2, it is necessary to consider whether the award has features that would not be expected in ‘normal’ equity transactions – in particular, a requirement for the holder of the shares to remain in employment until flotation or sale and/or individual buyback arrangements. If this is the case, regardless of the amount subscribed, the terms suggest that the shares are being awarded in connection with, and in return for, employee services and hence that the award is within the scope of IFRS 2. This may mean that, even if the award has no material fair value once the subscription price has been taken into account (and therefore gives rise to no IFRS 2 expense), it may be necessary to make the disclosures required by IFRS 2.
Moreover, even if the amount paid by the employees can be demonstrated to be fair value for tax or other purposes, that amount would not necessarily constitute fair value under IFRS 2. Specifically, a ‘true’ fair value would take into account non-market vesting conditions (such as a requirement for the employee to remain in employment until flotation or a trade sale occurs). However, a valuation for IFRS 2 purposes would not take such conditions into account (see 5.5 and 6.2.1 above) and would therefore typically be higher than the ‘true’ fair value.
If the arrangement relates to a special class of share rather than ordinary equity shares, the underlying shares might well be classified as a liability rather than as equity under IAS 32. However, if the redemption amount is linked to the flotation price of the ‘real’ equity, the arrangement will be a cash-settled share-based payment transaction under IFRS 2 (see 2.2.4.A above).
It is common in such situations for the cost of satisfying any obligations to the special shareholders to be borne by shareholders rather than by the entity itself. This raises a number of further issues, which are discussed at 2.2.2.A above and at 15.4.6 below.
The approach outlined in this section, i.e. that there will generally be no additional IFRS 2 expense to recognise when the counterparty subscribes for a share at fair value, is the approach most commonly applied in practice by entities accounting under IFRS. In this type of arrangement, the subscription price, or market value if lower, is often refundable to employees who leave employment before the shares vest. In such cases, subscription amounts paid by the counterparty for the shares are generally classified as a liability by the entity until such time as the shares finally vest (at which point the cash paid will be treated as the proceeds of issuing shares).
However, this is not the only approach seen in practice. US GAAP, for example, requires in certain circumstances the recognition of an expense (representing the amount potentially at risk) in cases where an employee subscribes for a share at fair value but risks forfeiting some, or all, of the price paid for that share, together with any subsequent increases in value, should he fail to fulfil the service condition. In determining whether an expense must be recognised for the amount risked by the employee, an entity applying US GAAP must establish that there is a clear business purpose for the employee taking such a risk. In our view, in the absence of specific guidance, the recognition of such an expense is not a requirement based on IFRS 2 as currently drafted.
An award might be structured to allow management of an entity to acquire a special class of equity at fair value (as in 15.4.5 above), but (in contrast to 15.4.5 above) with no redemption right on an exit event. However, rights are given:
Such schemes are particularly found in entities where the ‘normal’ equity is held by a provider of venture capital, which will generally be looking for an exit in the medium term.
It may well be that, under the scheme, the entity itself is required to facilitate the operation of the drag along or tag along rights, which may involve the entity collecting the proceeds from the buyer and passing them on to the holder of the special shares.
This raises the issue of whether such an arrangement is equity-settled or cash-settled. The fact that, in certain circumstances, the entity is required to deliver cash to the holder of a share suggests that the arrangement is an award requiring cash settlement in specific circumstances, the treatment of which is discussed at 10.3 above.
However, if the terms of the award are such that the entity is obliged to pass on cash to the holder of the share only if, and to the extent that, proceeds are received from an external buyer, in our view, the arrangement may be economically no different to the broker settlement arrangements typically entered into by listed entities, as discussed at 9.2.4 above. This could allow the arrangement to be regarded as equity-settled because the entity's only involvement as a principal is in the initial delivery of shares to employees, provided that consideration is given to all the factors (discussed at 9.2.4 above) that could suggest that the scheme is more appropriately regarded as cash-settled.
In making such an assessment, care needs to be taken to ensure that the precise facts of the arrangement are considered. For example, a transaction where the entity has some discretion over the amount of proceeds attributable to each class of shareholder might indicate that it is inappropriate to treat the entity simply as an agent in the cash payment arrangement. It might also be relevant to consider the extent to which, under relevant local law, the proceeds received can be ‘ring fenced’ so as not to be available to settle other liabilities of the entity.
It is also the case that arrangements that result in employees obtaining similar amounts of cash can be interpreted very differently under IFRS 2 depending on how the arrangement is structured and whether, for example:
The appropriate accounting treatment in such cases requires a significant amount of judgement based on the precise facts and circumstances.
As part of general economic reforms in South Africa, arrangements – commonly referred to as black economic empowerment or ‘BEE’ deals – have been put in place to encourage the transfer of equity, or economic interests in equity, to historically disadvantaged individuals. Similar arrangements have also been put in place in other jurisdictions. These arrangements are intended to give disadvantaged individuals, or entities controlled by disadvantaged individuals, a means of meaningful participation in the economy.
An entity can enhance its BEE status in a number of ways (through employment equity, skills development or preferential procurement policies to name but a few). This section focuses on BEE deals involving transfers of equity instruments, or interests in equity instruments, to historically disadvantaged individuals at a discount to fair value.
Such transfers have generally been concluded at a discount to the fair value of the equity instruments concerned, even where the fair value takes into account any restrictions on these equity instruments. As a result of having empowered shareholders, the reporting entity is able to claim its ‘BEE credentials’, thus allowing the reporting entity greater business opportunities in the South African economy. These arrangements raise a number of practical issues of interpretation, and indeed led to the scope of IFRS 2 being extended to include transactions where the consideration received appears less than the consideration given, as discussed further at 2.2.2.C above.
The goods or services received from the disadvantaged people or entities controlled by them in return for the equity instruments may or may not be specifically identifiable. As explained in guidance issued by the South African Institute of Chartered Accountants (SAICA),37 it is therefore the case that IFRS 2 applies to the accounting for BEE transactions where the fair value of cash and other assets received is less than the fair value of equity instruments granted to the BEE partner, i.e. to the BEE equity credentials.
BEE deals are typically complex and their specific structures and terms may vary considerably. However, they do exhibit certain features with some regularity, as discussed below.
Typically BEE arrangements have involved the transfer of equity instruments to:
The arrangements generally lock the parties in for a minimum specified period and if they want to withdraw they are able to sell their interest only to others with qualifying BEE credentials, usually with the lock-in provision also transferred to the buyer.
Generally these individuals have not been able to raise sufficient finance in order to purchase the equity instruments. Accordingly, the reporting entity often facilitates the transaction and assists the BEE party in securing the necessary financing.
A BEE arrangement often involves the creation of a trust or corporate entity, with the BEE party holding beneficial rights in the trust which in turn holds equity instruments of the reporting entity (or a member of its group).
The awards made by the trust may be in the form of:
The accounting issues arising from such schemes include:
The first issue to consider in any accounting analysis is whether any trust to which the equity instruments of the reporting entity have been transferred meets the requirements for consolidation by the reporting entity under IFRS 10 (see Chapter 6). Factors that may indicate that the trust should be consolidated include:
but all the IFRS 10 control criteria will need to be assessed.
The generic form of a BEE arrangement normally requires the reporting entity either to finance the acquisition of the shares by the trust or to provide cross guarantees to the financiers of the trust. Alternative methodologies that have been employed include capital enhancements created in the trust by the sale of equity instruments at a severely discounted amount.
When the reporting entity finances the arrangement, the finance is generally interest-free or at a lower than market interest rate. The debt is serviced with the dividends received and, at the end of the repayment period, any outstanding balance can be treated in various ways; refinanced or waived by the reporting entity, or settled by the return of a number of shares equal to the outstanding value.
In summary, the BEE party generally injects only a notional amount of capital into the trust, which obtains financing to acquire the shares in the reporting entity and uses the dividend cash flows to service the debt it has raised. In such generic schemes, the BEE party faces a typical option return profile: the maximum amount of capital at risk is notional and the potential upside increase in value of the shares of the reporting entity accrues to the BEE party through the party's beneficial rights in the trust.
If the analysis under 15.5.1 above is that the trust should be consolidated, the transfer of equity instruments to that entity is essentially the same as a transfer of own equity to an employee benefit trust, as discussed at 12.3 above. Such a transfer, considered alone, is an intra-entity transaction and therefore does not give rise to a charge under IFRS 2. The equity instruments held by the trust are therefore treated as treasury shares, and no non-controlling interests are recognised.
It is only when the trust itself makes an award to a third party that a charge arises, which will be measured at the time at which the grant to the third party occurs. In a rising stock market this will lead to a higher charge than would have occurred had there been a grant, as defined in IFRS 2, on the date that the equity instruments were originally transferred to the trust. Generally, the value of the award is based on an option pricing model and the BEE party is treated as the holder of an option.
Where the trust is not consolidated, the presumption will be that the transfer of equity instruments to the trust crystallises an IFRS 2 charge at the date of transfer. However, it is important to consider the terms of the transaction in their totality. For example, if the entity has the right to buy back the equity instruments at some future date, the benefit transferred may in fact be an economic interest in the equity instruments for a limited period. This may, depending on the method used to determine the buy-back price, influence the measurement of any IFRS 2 charge (which would normally be based on the presumption that the benefits of a vested share had been passed in perpetuity).
Some have sought to argue that BEE credentials result in the recognition of an intangible asset rather than an expense. In order to be recognised as an asset, an entity must have control over the resource as a result of a past event. Paragraphs 13 and 16 of IAS 38 – Intangible Assets – indicate that control over an intangible asset may be evidenced in two ways:
In BEE transactions, a contract is usually entered into with a BEE partner. The contract between the entity and the BEE partner may include a contractual lock-in period or a clause that only allows the transfer of such equity instruments to another BEE partner, usually with the lock-in provision also transferred to the buyer. However, the contract does not provide the entity with legal rights that give it the power to obtain the future economic benefits arising from the BEE transaction, nor the ability to restrict the access of others to those benefits. Therefore, BEE credentials do not qualify for recognition of intangible assets and the difference between the fair value of the award and the consideration received should be expensed. This is consistent with guidance issued by SAICA.38
An issue to be considered in determining the timing of the IFRS 2 expense is that many BEE transactions require the BEE party to be ‘locked into’ the transaction for a pre-determined period. During this period the BEE party or trust is generally prohibited from selling or transferring the equity instruments. As no specific performance is generally required during this period, it is not considered part of the vesting period (see 3.3 and 6.1 above). Rather, the post-vesting restrictions would be taken into account in calculating the fair value of the equity instruments (see 8.4.1 above). This is illustrated in the following example (based in part on Example 5 in the SAICA guidance).
Certain schemes, particularly where the reporting entity is not listed, give the BEE party the right to put the shares back to the entity (or another group entity) after a certain date. This is often done to create liquidity for the BEE parties, should they decide to exit the scheme. Such a feature would require the scheme to be classified as cash-settled (see 9.1 above).
Similarly, where the BEE transaction is facilitated through a trust, the trust may have granted awards to beneficiaries in the form of units in the trust. The trustees may have the power to reacquire units from beneficiaries in certain circumstances (e.g. where the beneficiaries are employees, when they leave the employment of the entity). Where the trust does not have sufficient cash with which to make such payments, the reporting entity may be obliged, legally or constructively, to fund them.
Such arrangements may – in their totality – create a cash-settled scheme from the perspective of the reporting entity. In analysing a particular scheme, it should be remembered that, under IFRS 2, cash-settled schemes arise not only from legal liabilities, but also from constructive or commercial liabilities (e.g. to prevent a former employee having rights against what is essentially an employee trust) – see 10.2 above.
Finally, a transaction may be structured in such a way that the trust holds equity instruments of the reporting entity for an indefinite period. Dividends received by the trust may be used to fund certain expenses in a particular community in which the reporting entity operates (e.g. tuition fees for children of the reporting entity's employees or the costs of certain community projects). The scheme may even make provision for the shares to be sold after a certain period with the eventual proceeds being distributed amongst members of the community.
In such a case it is necessary to consider the nature of the distribution requirement and whether or not the reporting entity (through the trust) has a legal or constructive obligation under the scheme to make cash payments based on the price or value of the shares held by the trust. Where there is such an obligation, the arrangement would be classified as a cash-settled scheme. If however the trust merely acts as a conduit through which:
the precise terms of the arrangement should be assessed to determine whether or not the arrangement meets the definition of a cash-settled share-based payment (see 15.4.6 above for a discussion of similar considerations in the context of ‘drag along’ and ‘tag along’ rights).
Any dividend payments by the Group for the period that the trust is consolidated should be treated as an equity distribution or as an expense, as appropriate, in accordance with the principles discussed at 15.3 above.
The requirements of IFRS 1 – First-time Adoption of International Financial Reporting Standards – in relation to share-based payment arrangements are discussed in Chapter 5 at 5.3. However, one provision may remain relevant for entities that have already adopted IFRS and would no longer generally be considered ‘first-time adopters’.
IFRS 1 does not require an entity to account for equity-settled transactions:
However, where such an award is modified, cancelled or settled, the rules regarding modification, cancellation and settlement (see 7 above) apply in full unless the modification occurred before the date of transition to IFRS. [IFRS 1.D2]. The intention of this provision is to prevent an entity from avoiding the recognition of a cost for a new award by structuring it as a modification to an earlier award not in the scope of IFRS 2.
There is slight ambiguity on this point in the wording of IFRS 1, paragraph D2 of which refers only to the modification of such awards. However, paragraph D2 also requires an entity to apply ‘paragraphs 26‑29’ of IFRS 2 to ‘modified’ awards. Paragraphs 26‑29 deal not only with modification but also with cancellation and settlement, and indeed paragraphs 28 and 29 are not relevant to modification at all. This makes it clear, in our view, that the IASB intended IFRS 1 to be applied not only to the modification but also to the cancellation and settlement of such awards.
As noted at 1.2 above, the revision of the Conceptual Framework in 2018 led to a minor consequential amendment to IFRS 2. The revision amended the footnote to the definition of an equity instrument in Appendix A to refer to the revised definition of a liability. The definition of an equity instrument remains unchanged. The revision is not expected to have a significant effect on IFRS 2 (see 1.4.1 above).
The amendment applies for annual periods beginning on or after 1 January 2020. Earlier application is permitted if at the same time an entity also applies all other amendments made by Amendments to References to the Conceptual Framework in IFRS Standards. The amendment is to be applied to IFRS 2 retrospectively in accordance with IAS 8, subject to the transitional provisions set out in paragraphs 53 to 59 of IFRS 2. [IFRS 2.63E].
If an entity determines that retrospective application would be impracticable or would involve undue cost or effort, the entity should apply the amendment to IFRS 2 by reference to paragraphs 23 to 28, 50 to 53 and 54F of IAS 8. [IFRS 2.63E].