IFRS 2, Share-based Payment

1. Introduction

Business transactions are most commonly settled by the party receiving goods or services (the ‘receiver’) paying cash to the party that provides those goods or services (the ‘provider’). However in recent years it has become increasingly common to see the receiver compensating the provider in ways that are based on the market value of the receiver’s equity shares. This compensation could take any of the following forms:

• The receiver issuing shares or granting share options to the provider (an equity-settled share-based payment transaction).
• The receiver making a cash payment to the provider based on the market value of the receiver’s equity shares (a cash-settled share-based payment transaction).
• The receiver giving the buyer a choice of whether to receive shares/share options or a cash payment based on the market value of the receiver’s equity shares.

IFRS 2 deals with the financial reporting of all share-based payments with the exception of:

• The issue of shares in a business combination, dealt with under IFRS 3 – Business Combinations.
• Share-based payments that become due on speculative contracts under the provisions of either IAS 32 or IFRS9 (this exception is unlikely to be tested in the DipIFR examination).
• The issue of shares to employees in their capacity as shareholders. For example a rights issue of shares to shareholders who are also employees.

In practice the most common circumstances in which share-based payment methods are used is a part of employee remuneration. We will consider the financial reporting treatment of equity settled share-based payments in this article and other types of share-based payments in Part 2 – Cash settled share-based payments and transactions with a choice of settlement.

2. Reporting equity settled share-based payments – basic principles

2.1 – The fair value principle applied generally
A basic principle of IFRS 2 is that equity-settled share-based payments should be measured at fair value. The measurement rules for the fair value of equity-settled share-based payments are contained in IFRS 2 rather than applying the more general fair value measurement rules set out in IFRS 13 – Fair Value Measurement. For any provider other than employees, the fair value of an equity-settled share-based payment is based on the fair value of the goods or services provided.

EXAMPLE 1
Alpha purchased a machine from a provider. Alpha compensated the provider by issuing 1,000 new equity shares in Alpha to the provider. The normal cash selling price of the machine is $5,000.

In these circumstances Alpha would debit property, plant and equipment and credit equity with $5,000, recognising the share issue at $5 per share. The credit to equity would be split between share capital and other components of equity (share premium) as appropriate.

2.2 – The fair value principle applied to transactions with employees
The most common form of equity-settled share-based payment is as a part of an employee remuneration package, either in the form of a direct issue of shares but more often by the granting of share options which vest at some future date. We will use example 2 to illustrate the principles.

EXAMPLE 2
Beta prepares financial statements to 31 December each year. On 1 January 20X3 Beta granted share options to 50 senior executives. Each executive was granted 1,000 options. The options will vest on 31 December 20X5 provided the executives remain employed by Beta throughout the three-year period from 1 January 20X3 to 31 December 20X5. The options are exercisable (ie the shares can be purchased) at any time from 30 June 20X6 to 31 December 20X7. Under the terms of the agreement the shares can be bought for $1.80 per share.

The implication of the options vesting on 31 December 20X5 is that the holders then have the unconditional right (but no obligation) to exercise them at any time during the exercise period. A key reason for imposing vesting conditions of the type shown in example 2 is to encourage key employees to remain with the relevant entity.

Where equity-settled share-based payments are part of an employee remuneration package then ‘fair value’ should be measured with reference to the equity instruments granted, as it is not possible to reliably arrive at a fair value for the employee services provided. Fair value should be measured at the grant date.

3. Reporting equity settled share-based payments – vesting conditions

3.1 – Non-market conditions
Vesting conditions are often based on ‘performance’. IFRS 2 considers performance conditions in two parts, non-market conditions and market conditions. A non-market performance condition typically requires the employee to perform certain actions before the equity instruments vest. These actions might be to complete a required period of service (such as that shown in example 2) or to achieve a certain target (perhaps a sales target or a profit target).

IFRS 2 requires the reporting of such arrangements to be based on the best estimate of the number of equity instruments that will vest at the end of the vesting period. This estimate needs to be made, and updated, at the end of each reporting period.

EXAMPLE 2 (continued)
Further details of Beta’s share-based payment awards are as follows:

• On 1 January 20X3 the shares have a market value of $2.90 per share. Their nominal value is $1.
• The share options had a fair value of $1.20 per option on 1 January 20X3. On that date Beta estimated that 48 of the 50 executives who were granted options would remain in employment until 31 December 20X5.
• During 20X3 1 executive left. At the end of 20X3 Beta estimated that 2 more executives would leave in 20X4 or 20X5. On 31 December 20X3 the fair value of the share options were $1.30.
• During 20X4 1 further executive left. At the end of 20X4 Beta estimated that 2 more executives would leave in 20X5. On 31 December 20X4 the fair value of the share options were $1.40.
• During 20X5 1 executive left and the options of 47 executives actually vested. On 31 December 20X5 the fair value of the share options were $1.45.

The fair value of the share options should be measured at the grant date ($1.20). Each year end the share-based payment is re-measured based on the latest estimate of options vesting. The transaction will be recognised in the financial statements over the vesting period.

The fair value used in the calculation is the fair value of a share option, and not the fair value (or market value) of a share. You would not be expected to compute the fair value of a share option in a DipIFR examination. However in order to understand the financial reporting of such options it is helpful to appreciate that the fair value of a share option is computed with reference to factors such as:

• The difference between the exercise price of an option ($1.80 in our example) and the market value of a share at the date the option is granted ($2.90 in our example). This is known as the intrinsic value of the option and in our example the intrinsic value on 1 January 20X3 is $1.10 ($2.90 – $1.80). The intrinsic value changes over time as the share price changes.
• The expected future movement in the share price during the vesting period. The fact that the fair value of a share option on 1 January 20X3 is $1.20 (higher than its intrinsic value of $1.10) implies that the share price is expected to rise during the vesting period. 

Using example 2 the following illustrates the calculations required to account for this share-based payment for the years ended 31 December 20X3, 20X4 and 20X5:
 

Note 1: each year end this number is re-measured based on actual leavers to date and estimated future leavers.

Note 2: the transaction is spread over the vesting period (3 years)

Note 3: the cumulative amount of the transaction is calculated, taking into account that at 31 December 20X4 the vesting period is 2/3 completed

Note 4: This is an employment cost so the debit entry will either be taken to the statement of profit or loss or included in the carrying amount of another asset. The credit entry would be to equity. IFRS2 does not state where specifically but either in a separate component of equity (typically a share option reserve) but also the credit could be made directly to retained earnings

Once the options have vested the issue of whether or not the executives decide to exercise them does not affect the accounting entries that have already been made during the vesting period. If the options are exercised then any cash received from the option-holders is debited to cash and credited to equity. IFRS 2 is silent on any further issues regarding the treatment of the cumulative balance in equity.

EXAMPLE 2 continued – exercise of options in the year ended 31 December 20X6:
If 45 executives exercised their 1,000 options, paying $1.80 per option, a total of $81,000, (45 x 1,000 x $1.80) this would be accounted for by Beta as:

Debit: Cash – $81,000

Credit: Share capital ($1) – $45,000

Credit: Other components of equity – £36,000

The cumulative amount in equity of $56,400 (see above) is unaffected by the exercise and this is the case whether or not the executives exercise their options or let them lapse. Best practice would be to transfer it to retained earnings once the options are exercised, if a different component of equity was used during the vesting period.

3.2 – Market conditions
Other types of vesting conditions are referred to as market conditions. A market condition is one which is related in some way to the market price of the entity’s equity shares at any given time. Market conditions are taken into account when actually measuring the fair value of a share option at the grant date. Therefore, over the vesting period, the likely impact of market conditions on the number of options vesting does not need to be considered, since it has been factored into the measurement of the fair value of a share option in the first place.

EXAMPLE 3
Gamma prepares financial statements to 30 June each year. On 1 July 20X4 Gamma granted share options to 10 directors. Each director was granted 15,000 options. The fair value of each share option on 1 July 20X4 was estimated to be $1.20 per share. The options will vest on 30 June 20X6 provided the directors remain employed by Gamma throughout the two-year period from 1 July 20X4 to 30 June 20X6 and provided the share price of Gamma on 30 June 20X6 is at least $2.50. On 1 July 20X4 the shares had a market value of $2.30 per share. On 30 June 20X5 the market value of a Gamma share was $2.40. No directors left employment in the year ended 30 June 20X5 and none are expected to do so in the year ended 30 June 20X6.

This share-based payment arrangement has two performance conditions, one is market-based (share price of $2.50 to be achieved) and one is non market-based (must remain in employment for the two years). The market-based condition is taken into account in measuring the fair value of the share option at the grant date and so the fact that the share price on 30 June 20X5 is $2.40 (below the required price ($2.50) for the options to vest) does not influence the way this transaction is reported. Based on the information in the example the non-market based condition is expected to be satisfied so the transaction will be reported as follows for the year ended 30 June 20X5:

• Total fair value = $180,000 (15,000 X 10 X $1.20).
• Attributable to the year ended 30 June 20X5 = $90,000 ($180,000 X ½).
• The debit entry will be recognised as an employment expense and the credit entry will be to equity.

For the year ended 30 June 20X6, provided all 10 directors remain employed by Gamma, a further $90,000 will be recognised as an employment expense and included in equity. This is irrespective of the actual share price at 30 June 20X6 and therefore irrespective of whether or not the options actually vest. This may seem a little counter-intuitive but it is a consequence of the method of accounting for equity-settled share-based payment transactions with market-based performance conditions attached. 

4. Reporting equity settled share-based payments – other issues that can arise

4.1 – Modifications
We have already stated the equity settled share-based payments are most commonly used as a form of employee remuneration. The principle behind this is that where the ‘payments’ are in the form of the granting of options the option price is set in such a way that the outcome for the employee is likely to be favourable on exercising the option. This will be the case in practice if the option price is below the market value of the share at the date (or dates) the option can be exercised. Therefore the higher the market value of the share the more favourable the option package becomes.

If the market value of the share starts to fall the option package becomes less favourable. In such circumstances the company might decide to ‘re-price’ it, by reducing the exercise price and therefore restoring the attractiveness of the package. In such situations IFRS2 requires that:

i. The recognition of the original package over the vesting period (in the manner in which we have already explained in section 3 of this article) shall continue as before.

ii. The increase in the fair value of the package caused by the re-pricing shall be recognised as an additional cost over the remaining vesting period.

EXAMPLE 4
Delta prepares financial statements to 31 December each year. On 1 January 20X2 Delta granted 500 share options each to 10 senior executives. The options vest on 31 December 20X5 provided the relevant executives remain in employment and provide services to Delta until that date. On 1 January 20X2 Delta estimated that all 10 executives would remain in employment for the four-year period and so be entitled to exercise the options. This estimate was confirmed on 31 December 20X2 and 31 December 20X3. The fair value of the option on 1 January 20X2 was $2.20.

During the early months of 20X3 the share price of Delta fell significantly and on 30 June 20X3 Delta re-priced the option package by reducing the exercise price from $4 per option to $3.40 per option. This caused the fair value of the option at 30 June 20X3 to increase by 60 cents per option.

The year total fair value of the original option package would be estimated at $11,000 (500 X 10 X $2.20). This means that an employment expense of $2,750 ($11,000 X ¼) would be recognised for each of the four years of the vesting period. The credits would be to equity.

In the year ended 31 December 20X3 (when the re-pricing occurs) the fair value of the increase caused by the re-pricing on 30 June 20X3 would be estimated as $3,000 (500 X 10 X $0.60). This would be recognised as an additional cost over the period from 1 July 20X3 to 31 December 20X5 (a period of 30 months – or 2½ years). Therefore the amount of this that would be recognised in the year ended 31 December 20X3 would be $600 ($3,000 X 6/30).

Therefore, for the year ended 31 December 20X3, the total employment expense would be $3,350 ($2,750 + $600):

4.2 – Cancellations
There can be situations where an entity decides to change the strategic approach to the use of share-based methods as a means of employee remuneration and move to more ‘conventional’, methods. In such circumstances an entity may decide to cancel a share-based payment arrangement part-way through the vesting period. It may be the case that in such circumstances the affected employees receive an immediate payment in compensation for the cancelled arrangements. In such situations IFRS2 requires that:

• The cancellation should be treated as an ‘acceleration of vesting’. This means that any unrecognised vesting cost should be recognised immediately.
• Any compensation payment to the affected employees should be deducted from equity (ie effectively set against the credits to equity already made).
• If any compensation payment made exceeds the fair value of the relevant equity instrument at the date of cancellation, then the excess should be treated as an additional employment cost. This specific matter is unlikely to be tested in the DipIFR examination.

EXAMPLE 5
Epsilon prepares financial statements to 30 June each year. On 1 July 20X2 Epsilon granted 200 options each to 50 employees. The options vest on 30 June 20X5 provided the employees remain in employment with Epsilon until that date. The fair value of the option on 1 July 20X2 was $2.50. At 30 June 20X3 it was estimated 48 employees would remain in employment until 30 June 20X5.

On 1 January 20X4 Epsilon cancelled the option package. At that date all 50 employees who were granted the options were still in employment. Epsilon made a compensation payment to the affected employees of $2.70 per option, which was the fair value of the option package on 1 January 20X4.

In the year ended 30 June 20X3 we would debit employment costs and credit equity with $8,000 (48 x 200 x $2.50 X 1/3).

In the year ended 30 June 20X4 the cancellation on 1 January 20X4 accelerates vesting and a further $17,000 (50 x 200 x $2.50 – $8,000) is debited to employment costs and credited to equity. The compensation payment of $27,000 (50 X 200 X $2.70) is debited to equity and credited to cash. The fact that the debit to equity exceeds the $25,000 ($8,000 + $17,000) cumulatively credited to equity is not further adjusted for and is a consequence of IFRS 2.

Written by a member of the DipIFR examining team