Designing share-based payment schemes

Designing share-based payment schemesAccounting and business considerations under IFRS June 2007

RSM International

Contents

About this publication | 1

The RSM IFRS Champions group | 2

Introduction | 3

IFRS 2 at a glance | 4

1. The value of the option does not derive solely from its intrinsic value | 6

2. Key dates and terms of a share-based transaction | 9

3. Equity-settled and cash-settled share-based payments | 13

4. Market and non-market conditions (true-up model) | 17

5. Beware of modifi cations, replacements, settlements and cancellations of granted equity instruments | 21

6. Categories of employees targeted by share-based transaction | 24

7. Equity-settled share-based payments hit the EPS indicator twice | 27

8. The charge to the income statement ultimately affects the fi nancial statements of the entity receiving goods or services | 30

9. Not just a case of remuneration… services and goods may also be relevant | 33

10. Newly listed, listed and unlisted entities… complications in calculating volatility | 36

11. Current, deferred taxation and social contribution implications | 39

12. Share-based payment options are measured by applying pricing models | 42

13. Beware the impact of business acquisitions on share-based payments | 46

14. Is the entire value of the stock option award perceived by the option holders? | 49

Glossary | 52

1 | RSM International

Principal editors

Author: Marco Marcellan RSM International

Panel of reviewers:Chandra Sekaran Albazie & Co, Kuwait (Member of RSM International)Jason Croall RSM Bird Cameron, Australia (Member of RSM International)

This publication provides information with regard to the application of IFRS 2 — Share-based payments. The application of IFRS 2 is the responsibility of the management of the relevant entity and therefore this guide cannot be taken as a defi nitive reference and does not replace the need for professional judgment with regard to relevant standards and other requirements and all of the relevant circumstances relating to the issue under review. Moreover, no reference is made to any real tax and legal framework.

No responsibility for any errors or omissions nor loss occasioned to any person or organisation acting or refraining from acting as a result of this publication can be accepted by the author, the reviewers or RSM International.

Views expressed in this publication are the authors and are not necessarily those of RSM International.

Preparers of IFRS fi nancial statements may wish to seek specifi c advice from the local member fi rm of RSM International.

RSM International

The RSM International logo and name are registered trademarks of RSM International Association.

All rights are reserved. No part of this publication may be reproduced, stored in any system, or transmitted in any form or by any means whether electronic, mechanical, photocopied, recorded or otherwise without the prior permission in writing of RSM International Association.

About this publication


This publication has been prepared by the RSM International central IFRS technical team based in London and has been reviewed by some RSM IFRS Champions from member fi rms of RSM International.

In order to provide technical IFRS excellence to its member fi rms and their clients, RSM International has created a team of fully dedicated IFRS experts from RSM member fi rms from all over the world.

These experts meet regularly to discuss leading-edge developments on IFRS and to share experiences arising from their IFRS work.

RSM International has produced a brochure entitled ‘Your partner in understanding the business implications of IFRS’. This brochure highlights RSM’s global expertise regarding International Financial Reporting Standards as well as the contact details of all the members of the RSM Champions group worldwide.

All IFRS publications can be downloaded from www.rsmi.com. Alternatively, you can contact the RSM Executive Offi ce in London or your local RSM member fi rm.

The RSM IFRS Champions group

Your partner in

understanding the

business implications

of IFRS


After a long debate, an International Financial Reporting Standard relating to share-based payments was issued by the International Accounting Standard Board (IASB) and endorsed by the European Community (EU) at the beginning of 2005.

Before the introduction of IFRS 2, companies reporting under IFRS that were largely using share-based payments took advantage of the fact that it represented a valid tool to reward employees as well as focus them on company targets without affecting income statement performances.

Now, as a result of IFRS 2, costs related to share-based payments have to be charged to the income statement. This represents the real accounting innovation introduced by IFRS 2. Companies using share-based payments that have applied IFRS 2 have seen a signifi cant impact on results and, in certain circumstances, rethought company remuneration strategies based on share-based payments.

Moreover, as it requires the use of complex pricing models, IFRS 2 is far from easy to apply. As a result, it is likely that many companies will need to engage external experts to measure and account for share-based payments under IFRS 2.

Before developing a share-based payment plan, management should be aware of some of its key features. By understanding these features more comprehensively, management will have a better understanding of income statement consequences and signifi cantly reduce the impact of complex, time-consuming and costly accounting requirements.

This guide aims to be a friendly explanation of the key points you need to bear in mind when setting up a share-based payment plan. If you know these “golden rules”, you can make your accounting method less complex, reduce your implementation costs and gain a better idea of how future results will be affected by IFRS 2 accounting rules.

Introduction


Types of share-based payments IFRS 2 categorises share-based payments into three major groups:

Equity-settled — where “the entity receives goods or services in exchange for its shares or share options or other own equity instrument”. [IFRS 2 par. 10]

Cash-settled — where “the entity incurs a liability in exchange for goods or services with a supplier. The amount of the liability is based on the price or value of the entity’s shares or other equity instruments of the entity”. [IFRS 2 par. 30]

Choice of settlement — where “both the entity and the supplier of goods or services has a right to choose the transaction to be settled in cash or with equity instruments of the entity”. [IFRS 2 par. 34]

Scope of IFRS 2IFRS 2 must be applied by all entities reporting under IFRS, either listed or not listed, as of 1 January 2005. Transitional provisions apply for existing IFRS preparers. For fi rst time adopters of IFRS, special transition rules are stated in IFRS 1.

IFRS 2 applies to a wide range of share-based payment transactions. The most common share-based payment transaction relates to employee services. However, IFRS 2 also applies to transactions aimed at the acquisition of goods and services. Goods can include inventories, consumables, tangible / intangible assets and other non-fi nancial assets.

IFRS 2 does not apply to:

Transactions with an employee or other party in his / her capacity as a holder of equity instruments. [IFRS 2 par. 4]

Transactions in which the entity acquires goods as part of the net assets acquired in a business combination to which IFRS 3 applies. However, equity instruments granted to employees of the acquiree in their capacity as employees (e.g. in return for continued service) fall under the scope of IFRS 2. [IFRS 2 par. 5]

Certain contracts within the scope of IAS 32 and IAS 39. [IFRS 2 par. 6]

IFRS 2 at a glance


MeasurementIFRS 2 does not clearly state which pricing model should be used for valuation purposes. It simply points out that any valuation technique adopted by the entity shall be consistent with generally accepted valuation methodologies for pricing fi nancial instruments currently used by willing market participants.

Equity-settledMeasurement is based on the fair value of the instrument granted at grant date. IFRS 2 states that, “The fair value of those equity instruments shall be measured at grant date based on a pricing model.” [IFRS 2 par. 11] “The entity shall 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 entity cannot estimate reliably the fair value of the goods or services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted.” [IFRS 2 par. 10]

Cash-settled The entity shall measure the goods or services acquired and the liability incurred at the fair value of the liability. Until the liability is settled, the entity shall re-measure the fair value of the liability at each reporting date and at the date of settlement, with any changes in fair value recognised in profi t or loss for the period.” [IFRS 2 par. 30]

Initial recognition“The entity shall recognise the goods or services received or acquired in a share-based payment transaction when it obtains the goods or as the services are received.” [IFRS 2 par. 7]

Equity-settledThe expense is recognised to the income statement over the vesting period with a corresponding entry to equity.

Cash-settledThe expense is recognised to the income statement over the vesting period with a corresponding entry to liabilities.

Subsequent re-measurementEquity-settled

Market conditions are included in the grant date pricing model fair value; therefore, such a fair value of the equity instruments is no longer revised after the grant date. [IFRS 2 par. 21]

Non-market conditions are not considered as input data for the grant date fair value measurement based on a pricing model. They are assessed in order to revise the number of instruments expected to vest. (True-up model applied.) [IFRS 2 par. 19]

The changes in fair value are recognised to the income statement with a corresponding entry to equity. [IFRS 2 par. 10]

Cash-settledThe fair value of the instrument granted is re-measured at each reporting date. The changes in fair value are recognised in the income statement and as liabilities in the balance sheet. [IFRS 2 par. 30]

IFRS 2 at a glance


KEY MESSAGE Time value is a component of the total value to be charged to the income statement. High volatility and length to expiration increase the time value and therefore the total charge to the income statement.

1. The value of the option does not derive solely from its intrinsic value

(a) TIME VALUE IS A COMPONENT OF THE FAIR VALUE WHICH CANNOT BE IGNORED

The fair value of an option is made up of two components: intrinsic value and time value. Although the intrinsic value would normally represent the major component, time value can be very signifi cant as well. A failure to consider the time value could result in missing a signifi cant part of the value of the option or even the entire value of the option when they are issued at the money.

(b) TIME VALUE IS CAPTURED ONLY BY APPLYING A PRICING MODEL

The time value can be calculated only by adopting ad hoc pricing models. The complexity of the pricing model varies depending on the share-based payment characteristics. In cases where in-house expertise is not available, it could be necessary to request the advice of an external expert.

(c) BOTH VOLATILITY AND THE TIME TO EXPIRATION AFFECT THE TIME VALUE

The higher the volatility of the underlying instrument and the time to expiration of the option, the higher the time value of the option. A high volatility and a lengthy time to expiration are always advantageous for the option holder.

Section 1



Section 1

Intrinsic value

+

Time value

=

Fair value



Additional guidanceIt can be complex to calculate the value of an option; that’s why the pricing models applied have to take into consideration other factors of the option in addition to the intrinsic value.

Basically, the value of an option can be divided into two major components:

Intrinsic value. This is: “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]

Time value. This is the portion of an option’s premium that exceeds the intrinsic value. The time value of an option refl ects the probability that the option will move in the money. Therefore, the longer the time remaining until expiration of the option, the greater its time value. This is also called extrinsic value.

The concept of time value is fundamental when dealing with any kind of option, and therefore also when managing share options for the purpose of IFRS accounting.

In substance, the time value combines two major value-holder factors:

The remaining time to expiration of the option

The volatility of the shares

The time remaining to expiration directly affects the possibility for an option to be in the money, or to increase its fair value before the exercise date. Hence, the longer the time frame, the higher the possibility for an option to be in the money or to increase its fair value before the exercise date.

The volatility is the standard deviation of the change in value of a fi nancial instrument with a specifi c time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualised terms, and it may either be an absolute number or a fraction of the initial value. The higher the volatility, the greater the fl uctuations of the item concerned.

The intrinsic value is usually quite a straightforward calculation, but the same cannot be said for the time value. To calculate the time value, a pricing model is required whose complexity can be variable and which usually requires a certain degree of expertise to manage properly.

It should be noted that the time value could represent a very important portion of the entire value of the option. It is common for certain share-based payment plans to be granted at fair value. This means that in such circumstances the intrinsic value of the option is nil at the grant date. However, if unexpired, the option is valuable itself and its value is represented entirely by the time value. Therefore, had the time value not been considered, the entire value of the option would be missed.

Section 1


KEY MESSAGEShare-based payment costs must be charged to the income statement over the vesting period. A share-based payment transaction with variable “key dates” is more complex and onerous to manage. The length of the plan can be set up in order to stimulate, for example, the benefi ciary’s desired behaviour.

(a) INCOME STATEMENT IS HIT OVER THE VESTING PERIOD

The costs associated with any share-based payment transactions are always charged to the income statement over the vesting period. Normally the vesting period runs from the grant date to the vesting date. However, this is not a defi nitive rule. If the vest date coincides with the grant date, expenses are charged to the income statement immediately.

(b) VARIABILITY IN SOME OF THE TERMS OF THE STOCK OPTION PLAN, DEPENDING ON MARKET CONDITIONS, COULD RESULT IN THE NEED FOR A MORE COMPLEX MODEL

The share-based payment transaction could be set up so that the grant date, number of awards, vesting date and exercise period etc. are variable and depend on stated market conditions. This arrangement must be incorporated into the pricing model, resulting in a more complex pricing model to manage.

(c) ASSESSING THE PROFIT OR LOSS IMPACT OF A LONGER TIME TO EXPIRATION

As already mentioned, the longer the time to expiration of an option, the higher the total time value to be charged to the income statement. The option life can be extended, expanding the vesting period or the exercise period after the vesting date. As a rule of thumb, by extending the vesting period, the period-to-period charge should dilute. However, the incremental time value deriving from the extension could offset such dilution. On the other hand, extending the exercise period should always result in an increase of the cumulative cost to be charged over the entire vesting period. The actual impact of the option life extension on a period-to-period income statement charge must be assessed on a case-by-case basis.

(d) MANAGING PERSONNEL

Share-based payments are usually part of a larger remuneration package. Their peculiarity resides in the fact that they include service and / or performance conditions to be fulfi lled within a certain period of time. This means that the way performance conditions are linked to key dates represents a powerful tool that can be used to stimulate desired behaviours such as loyalty and motivation.

2. Key dates and terms of a share-based transaction

Section 2



Section 2

Grantdate

Vestingdate

Exercisedate

Vestingperiod

Exerciseperiod

Option life

Exerciseprice



Additional guidanceWhen setting up a share-based payment transaction, one of the fi rst steps is to clearly identify the key dates of the transaction itself. It is also crucial to understand how to set up the key dates in order to have a clear view of how the share-based payment plan will work and how it will affect the company’s performance.

The following are the key dates:

Grant date: “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. At grant date the entity confers on the counterparty the right to cash, other assets, or equity instruments of the entity, provided the specifi ed vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained.” [IFRS 2, Appendix A]

Vesting date: the date at which all the specifi ed vesting conditions of a share-based payment arrangement are to be satisfi ed. In turn, the vesting period is “the period during which all the specifi ed vesting conditions of a share-based payment arrangement are to be satisfi ed”. [IFRS 2, Appendix A]

Exercise date: the date at which the option holder exercises the option and obtains the right granted.

Expiration date: the date after which it is no longer possible to exercise the option.

The fair value of an option is determined at grant date, which in substance represents the date “when the entity and the employee enter into an agreement, whereby the employee is granted rights to the share option, provided that specifi c conditions are met”. [IFRS 2 par. BC 89].

The grant date is crucial. It represents the share-based payments measurement date. Share-based payments are measured at fair value; therefore the grant date is the date when the share-based payments are initially measured. As we will see later on, the grant date fair value approach taken by IASB can have signifi cant consequences, particularly for equity-settled instruments.

The period during which all the specifi ed vesting conditions of a share-based payment arrangement are to be satisfi ed is called the vesting period. Normally the vesting period runs from the grant date to the vesting date. The share-based payment transaction is charged on a straight-line basis to the income statement over the vesting period.

As we have said, the exercise date can be represented by a time frame rather than a single date. This type of time frame is called the ‘exercise period’ and represents the period of time during which the options granted could be exercised. The possibility to exercise the option within a time frame rather than a fi xed date is worth considering for the option holder, especially if it extends the option life and therefore increases the value of the option.

The life of certain common options can be divided into the vesting period and the exercise period. Given the total length of such an option, the split between the vesting period and exercise period is not neutral in the option value and therefore in the resulting income statement charge. Bear in mind that the cost of the share-based transaction is charged to the income statement over the vesting period. Usually, the exercise period extends after the vesting date. In that case, the time–frame after the vesting date is not included when calculating the vesting period.

Section 2



Section 2

The share-based payment transaction can be set up so that certain terms of the share-based transaction — such as the grant date, number of awards, vesting date and exercise period etc. — are variable. Their variability can depend on both market and / or non-market conditions. As discussed later, market conditions have to be considered by the pricing model when measuring the grant date fair value. With regard to non-market conditions, the impact on awards expected to vest has to be reassessed at each reporting date, but is not considered on the grant date fair value pricing model. This means that market conditions affect the pricing model fair value calculation and therefore will result in more complex and expensive pricing models.

Motivating employeesSo far, we have talked about numbers and income statement impacts. However, it is important to remember that one of the major goals when choosing the right length of a share-based payment option should be to achieve desired employee behaviours. For instance, for fast-growing start-up companies, share-based payments could be an attractive way to motivate employees to achieve their targets without directly affecting the company’s cash-fl ows. In today’s highly competitive economic environment, retaining talent is one of the key factors that determines the success of a company. In this respect, share-based-payments with a longer vesting period can help inspire loyalty. On the other hand, a very long vesting period might not be recommended in cases where the company needs short-term results and wishes to leverage the motivational factor.

In summary, share-based payments can be a good way to help motivate personnel to achieve a company’s key strategic goals. Therefore share-based payment schemes must be designed to take the overall strategic corporate picture into consideration.


KEY MESSAGEThe total charge to the income statement for two share-based payment transactions with identical conditions, other than the settlement feature (cash or equity), can result in a signifi cantly different income statement impact on both a period-to-period and/or cumulative basis. In general, equity-settled share-based payments have a more predictable income statement impact over the vesting period.

(a) NO FAIR VALUE REMEASUREMENT AFTER INITIAL RECOGNITION FOR EQUITY-SETTLED SHARE-BASED PAYMENTS

For equity-settled share-based payments, the fair value charge to the income statement for awards that ultimately vest is not reversed, irrespective of whether market conditions are met or not met at the exercise date. This means that, if cash-settled share-based payments are out of the money at the exercise date, the total charge to the income statement will be nil. Conversely, if equity-settled share-based payments are out of the money at the exercise date, there is no reversal of the costs charged to the income statement.

(b) CASH-SETTLED SHARE-BASED PAYMENTS MUST BE REMEASURED AT EACH REPORTING DATE

Cash-settled options represent liabilities under IFRS. Hence, they have to be fair valued at each reporting date. Equity-settled options, being equity instruments, need to be fair valued only at the grant date. No subsequent re-measurement of the fair value is required.

(c) CASH-SETTLED AND EQUITY-SETTLED: IMPACT ON INCOME STATEMENT “VOLATILITY”

Given the re-measurement feature of the fair value of cash-settled share-based payments at each reporting date, cash-settled share-based payments result in a higher income statement volatility compared to equity-settled share-based payments. On the other hand, the period-to-period income statement charge of equity-settled options is fi xed since initial determination or decreases in cases where non-market conditions are not met.

(d) PLANNING THE CHARGE TO THE INCOME STATEMENT

As a consequence of the above point, both annual and cumulative income statement charges relating to equity-settled options are more predictable. Conversely, both annual and cumulative charges to the income statement of cash-settled share-based payments are less predictable. They are recalculated at each reporting date.

(e) THE KEY DIFFERENTIATING FEATURE IS THE CASH DISBURSEMENT

Another key element of differentiation between equity-settled and cash-settled share-based payments is that only cash-settled share-based payments involve a cash disbursement (as long as they are exercised and in the money at exercise date). On the other hand, equity-settled share-based payments do not involve a direct cash disbursement. However, when equity–settled share-based payments are exercised, issued shares are paid at a strike price lower than their market value and therefore the cash-in is lower than it should be.

3. Equity-settled and cash-settled share-based payments

Section 3



Section 3Equity-settled

Cash-settled

Choice of cash or equity settlement



Additional guidanceTo classify a share-based payment as equity-settled or cash-settled is not a mere academic distinction. In general, the classifi cation depends on the way the option is settled and this aspect has a signifi cant consequence on how the income statement is charged and the share-based payment is measured.

The following are the defi nitions stated by IFRS 2:

An equity-settled share-based payment transaction is “a share-based payment transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options”. [IFRS 2 par. 10]

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 the entity’s shares or other equity instruments of the entity”. [IFRS 2 par. 30]

The major difference between the two types of settlement, from both an accounting and measurement perspective, is that a cash-settled option meets the defi nitions of a liability according to the IFRS Framework, whilst an equity-settled option always represents an equity instrument. However, “if the requirements of IAS 32 were applied to equity-settled share-based payment transactions, in some situations an obligation to issue equity instruments would be classifi ed as a liability. In such cases, fi nal measurement of the transaction would be at a measurement date later than grant date”. [IFRS 2 par. BC 108] To overcome such inconsistency, “the Board concluded that the requirements in IAS 32, whereby some obligations to issue equity instruments are classifi ed as liabilities, should not be applied in the IFRS on share-based payment. The Board recognises that this creates a difference between IFRS 2 and IAS 32.” [IFRS 2 par. BC 109]

Cash-settled options, representing liabilities, have to be fair valued at each reporting date and the adjustments are recorded to the income statement; conversely, equity-settled options do not need to be re-measured after the grant date.

Common examples of cash-settled options are the share appreciation rights (SARs). In fact, in SARs, the value of the underlying share represents in substance solely a parameter for reference when calculating the fair value of the option. At exercise date, no shares will be issued or delivered to the option holder.

On the other hand, as far as equity-settled share-based payments are concerned, the IASB has adopted the grant date measurement method. At grant date the entity and the employee agree to exchange a service for an amount of money (remuneration). The fair value of the equity instruments granted is used as a surrogate measure of the fair value of the services agreed at that point in time. Once such an agreement is reached, subsequent changes in the fair value of the equity instrument after grant date are irrelevant. In fact, because of the nature of the equity-settled share-based payment, the uncertainty incorporated into it is already factored into its fair value at grant date.

The fair value of an equity-settled option will be charged to the income statement over the vesting period on a straight-line basis, independently of the actual fair value at the exercise date. If the expense is revised as a result of a change in the estimate driven by non-market conditions, the cumulative charge to the income statement will take place as follows:

Equity-settled: number of awards that eventually vested (only non-market condition considered) multiplied by the original grant date fair value

Cash-settled: number of awards that eventually vested multiplied by the exercise date fair value

Most importantly, this means that equity-settled options result in a charge to the income statement, even though the options are not exercised because they are out of the money. However, for equity-settled share-based payments, once the fair value has been fi xed at grant date, it will no longer be revised.

Section 3



Background: Why is the cost of equity-settled share-based payments not reversed if at the exercise date the options are at or out of the money?In paragraph 11, IFRS 2 states that “the entity shall measure the fair value of the services received by reference to the fair value of the equity instruments granted, because typically it is not possible to estimate reliably the fair value of the services received”.

The fair value calculation has to be performed at grant date, adopting a valuation methodology which should “be consistent with valuation methodologies that market participants would use for pricing similar fi nancial instruments, and should incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price”. [IFRS 2 par. BC 305]

As a consequence, the IASB concluded that the “grant date is the most appropriate measurement date for the purpose of providing a surrogate measure of the fair value of the services received”. [IFRS 2 par. BC 96]

In summary, the fair value resulting from the pricing model at grant date is regarded as the best estimate of the remuneration granted by the entity to the employee in exchange for the services expected to be received. Once such remuneration has been agreed, there are no reasons to question this. In fact, the service to be provided by the employee will not fl uctuate according to the subsequent change in fair value of the option granted.

Such an approach is consistent with the general purpose of IFRS 2. In fact, as we already mentioned, this standard utilises the fair value of the option granted as a surrogate in order to estimate the remuneration provided by the employee. Hence “the valuation does not attempt to estimate the future gain, only the amount that the other party would pay to obtain the right to participate in any future gains. Therefore, even if the share option expires worthless or the employee makes a large gain on exercise, this does not mean that the grant date estimate of the fair value of that option was unreliable or wrong”. [IFRS 2 par. BC 295]

As a consequence of the above, the cash or equity feature has an impact on the income statement ultimate charge as well as on the forecast vs actual manageability. As an example, let’s assume that the only difference between two identical share-based payment transactions is the settlement feature (options issued at the money at grant date and identical vesting conditions except for cash-settled versus equity-settled). This would be the impact on the income statement:

If at the exercise date the intrinsic value of the option is higher than the grant date fair value, the cash-settled share-based payment will result in a cumulative charge to the income statement higher than an equity-settled share-based payment.

If at the exercise date the intrinsic value of the option is lower than the grant date fair value, the cash-settled share-based payment will result in no charge to the income statement. The option expires worthless. On the other hand, equity-settled options will result in a charge to income statement based on the grant date fair value even if the options expire worthless.

Finally, in certain circumstances it might not be straightforward to classify a share-based payment as cash-settled or equity-settled. For instance, in cases where benefi ciaries are granted the possibility to return the options to the issuer, this feature could trigger a cash-settled classifi cation. In fact, the whole package might meet the defi nition of a liability and therefore be accounted for accordingly. Each case has to be assessed separately, taking into consideration all the option’s features and circumstances.

Section 3


KEY MESSAGE Unusual or complex market conditions could reduce the fair value of the stock options and, in turn, the total cost charged to income statement, but could result in the need for more complex and costly pricing models.

(a) MARKET CONDITIONS DIRECTLY AFFECT THE PRICING MODEL APPLICATION

Market conditions have to be taken into account when applying the pricing model. If market conditions are sophisticated, the pricing model has to conform accordingly. Normally this results in a more complex and costly model being implemented.

On the other hand, non-market conditions do not have to be included in the pricing model; they have to be considered at grant date and then at each reporting date in order to estimate the impact on vesting conditions for both equity-settled and cash-settled share-based payments.

4. Market and non-market conditions (true-up model)

Section 4


Section 4


Vesting conditions

Service conditionsvs

Performance conditions

Market conditions

Non-market conditions



Additional guidanceUsually, once a share-based payment transaction is set up, payments are subject to the achievement of certain vesting conditions. Such conditions can affect aspects such as the timing and amount of payments or any other characteristic of the rights granted.

Vesting conditionsIFRS 2 classifi es vesting conditions into two categories: “Vesting conditions include service conditions, which require the other party to complete a specifi ed period of service, and performance conditions, which require specifi ed performance targets to be met (such as a specifi ed increase in the entity’s profi t over a specifi ed period of time).” [IFRS 2, Appendix A]

Performance conditionsIn turn, performance conditions fall into two different classes: market conditions and non-market conditions.

Market conditions: “a condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price of the entity’s equity instruments, such as attaining a specifi ed share price or a specifi ed amount of intrinsic value of a share option, or achieving a specifi ed target that is based on the market price of the entity’s equity instruments relative to an index of market prices of equity instruments of other entities.” [IFRS 2, Appendix A]

Non-market conditions: non-market conditions are all those remaining conditions which do not fall into the above category.

Examples of non-market conditions:

The employee has to work for the entity for a certain period before being entitled to exercise the stock options.

The entity has to reach a certain level of sales, operating profi t, EBTDA, etc.

The management has to open a certain number of new stores, branches, subsidiaries etc. by a certain date.

Examples of market conditions:

The value of a listed share has to reach a certain level.

The value of a listed share has to reach a certain value compared to stock index or other industry-specifi c stock indexes.

The TSR (Total Shareholder Return) reaches a certain level.

Section 4


Section 4


Calculating fair value at grant dateThe major difference between market and non-market conditions is how they affect the calculation of fair value at grant date:

Market conditions have to be taken into account in determining the fair value based on a pricing model of the share-based payments at grant date.

Non-market conditions are not taken into account in determining the fair value based on a pricing model of the share-based payments at grant date. That is, they represent a parameter not included in the pricing model, but are considered in determining the fair value anyway.

Basically, the fair value of the share-based payment is a function of two elements: the fair value of the pricing model combined with the estimated impact of non-market conditions.

The characteristic of a performance condition that has to be included or not in a pricing model gives rise to the following consequences, depending on the type of share-based payment plan:

Equity-settled: market conditions are no longer considered for subsequent measurement of the fair value based on a pricing model. However, non-market conditions are revised from the beginning to estimate awards that will eventually vest.

Cash-settled: the revision of both market and non-market conditions is undertaken at each reporting date in order to update the fair value of the instrument granted.

The table below illustrates how market and non-market conditions affect cash-settled and equity-settled share-based payments.

Determination of the grant datefair value based on a pricing model

Determination ofvesting conditions

Vesting conditions

Equity or cash-settled At grant date

Subsequent measurement dates At grant date

Subsequent measurement dates

Market conditions

Equity-settled Considered in the pricing model

No longer revised

Already incorporated in the fair value calculation at grant date

No longer revised

Cash-settled Considered in the pricing model

Revised Already considered in the fair value calculation at grant date

Revised

Non market conditions

Equity-settled Not considered Not considered Considered Revised

Cash-settled Not considered Not considered Considered Revised

In conclusion, when setting up a share-based payment transaction, it is crucial to distinguish between market and non-market conditions as well as to understand their impact on the pricing model to be applied. This directly affects how the income statement will be charged.


KEY MESSAGE As already discussed, for equity instruments the IASB has taken a grant date fair value approach. This means that modifi cations, replacements, settlements and cancellations of granted equity instruments cannot in any way reduce the original grant date fair value that has to be charged to the income statement.

(a) SUBSEQUENT MODIFICATIONS CANNOT REDUCE THE ORIGINAL INCOME STATEMENT CHARGE

In cases where equity instruments are subsequently modifi ed in a way that the fair value of the original equity instrument at the modifi cation date is higher than the fair value of the modifi ed equity instrument at the same date, as a minimum the fair value of the original equity instrument has to be recognised. Put another way, only benefi cial modifi cations have to be recognised. Non-benefi cial modifi cations are ignored.

(b) CANCELLATIONS ARE CONSIDERED VESTING ACCELERATING EVENTS

The cancellation of an equity-settled share-based payment is treated similarly to a modifi cation arrangement, as discussed in the previous paragraph. In substance, the entity has to recognise immediately the amount that would otherwise have been recognised for services received over the remainder of the vesting period.

5. Beware of modifi cations, replacements, settlements and cancellations of granted equity instruments

Section 5



Section 5

Modifi cations

Impacton income statement

Settlements

Cancellations

Replacements


Additional guidanceAn entity might decide to modify the terms and conditions on which the equity instruments were granted. For instance, the entity can: reduce the exercise price of options granted to employees (i.e. reprice the options), which increases the fair value of those options; or extend the option life, which also increases the fair value of those options.

In such cases IFRS 2 requires the entity to recognise:

1) As a minimum, the cost relating to the grant date fair value of the originally granted equity instruments. The true-up model applies in cases where those equity instruments do not vest because of failure to satisfy non-market vesting conditions that were specifi ed in the original arrangement.

2) The increase in the total fair value of the share-based payment arrangement resulting from the effects of modifi cations. In other words, benefi cial modifi cations have to be recognised over the remaining vesting period of newly granted equity instruments.

Basically, IFRS 2 retains a grant date fair value approach for granted equity instruments. An entity cannot avoid recognising remuneration expenses based on the grant date fair value. Once share options are granted, their grant date fair value cannot be cancelled or reduced by modifying the original terms of the arrangement.

The grant date fair value approach is reaffi rmed when dealing with the cancellation or settlement of granted equity instruments. The cancellation or settlement event is considered as an acceleration of vesting. As a result, the cost not yet accounted for has to be recognised immediately.

It should be noted that if cancelled equity instruments are replaced by new granted equity instruments, the entity must account for the granting of replacement equity instruments in the same way as a modifi cation of the original grant of equity instruments. In other words, replacements are accounted for in the same way as the modifi cations previously discussed.


Section 5


KEY MESSAGE Share-based payment plans that embrace different employee categories are more complex to manage and the total income statement charge is affected by employees’ expected behaviour .

(a) THE OPTION LIFE IS AFFECTED BY THE OPTION HOLDER BEHAVIOUR

Employee behaviour can have an impact on the expected option life, especially when the exercise period is particularly long. When larger, less homogeneous groups of people are targeted by a share-based payment plan, the entity will have to consider more complex factors to determine the option life to be included in the pricing model. In addition, as already mentioned, option life directly affects the cost of the option.

Additional guidance

6. Categories of employees targeted by share-based transactions

Section 6


Section 6


Executives

Behaviourconsiderations

Staff

Managers

External providersof services/goods

Age

Seniority



A share-based payment plan can be designed just for an entity’s executives, managers and professional staff, for a combination of those categories of employees, or for all these categories of employees. It can target employees of the parent company or employees of subsidiaries, and subsidiaries can be located in more than one country. Moreover, the share-based payment plan can also be granted to external consultants or external suppliers of services / goods.

Different groups of people with homogeneous characteristics have different behavioural models. Belonging to one or other behavioural group can have a relevant impact on the expected exercise date of the option, particularly when the exercise period is especially long. IFRS 2 requires the entity to take into consideration different expected behaviours of the option holders in case they impact on the expected exercise date of the options. In particular, it is important to estimate and judge a range of reasonable expectations regarding the exercise behaviours, ranking them according to the probability that they will occur. [IFRS 2, Appendix B 12]

In order to carry out the above “judgmental” categorisation exercise, the entity should consider all available information as well as past experience, if any.

Section 6


KEY MESSAGE Because of share issuance, equity-settled share-based payments reduce EPS more than cash-settled share-based payments.

(a) EQUITY-SETTLED SHARE-BASED PAYMENTS HIT THE EPS TWICE

Equity-settled share-based payments hit the EPS indicator twice. Firstly as a result of the increase in the number of shares included in the EPS calculation, and secondly because resources received for those options are consumed. On the other hand, cash-settled share-based payments hit the EPS indicator only once, as no shares are to be issued at exercise date.

7. Equity-settled share-based payments hit the EPS indicator twice

Section 7


Section 7


EPS

Equity-settled

EPSCash-settled


Additional guidanceThere are two EPS indicators under IAS 33: basic EPS and diluted EPS.

When entities enter into a commitment to issue shares in the future, this results in a modifi cation of the basic EPS indicator once shares are issued. Earnings will have to be divided by a greater number of shares and therefore the basic EPS indicator will decrease. This is the case for equity-settled share-based payments. In fact, once equity-settled share-based payments are granted, they incorporate potential shares whose conversion is subject to some vesting conditions. Therefore, as a general rule, equity-settled share-based payments have a dilutive effect. More precisely, they have a double dilutive effect .

In fact, as clarifi ed by IFRS 2, “the dual effect on EPS simply refl ects the two economic events that have occurred: the entity has issued shares or share options, thereby increasing the number of shares included in the EPS calculation — although, in the case of options, only to the extent that the options are regarded as dilutive — and it has also consumed the resources it received for those options, thereby decreasing earnings.” [IFRS 2, BC 56]

On the other hand, cash-settled share-based payments ultimately do not result in the issuance of additional shares. As a consequence they do not have a dual dilutive effect. The dilutive effect is limited to the decrease of earnings resulting from the charge to the income statement of the cost of the cash-settled share-based payments.

To sum up, we can say that equity-settled share-based payment transactions hit the EPS indicator twice whilst cash-settled share-based payment transactions hit the EPS indicator only once.

Example — EPS calculation Entity A has 10,000 total outstanding shares. The profi t for the year is £5,000 and is suitable for EPS calculation. Entity A has granted its executives a share-based payment plan which has had a cumulative fair value charge amounting to £2,000 and involves the issuance of £1,000 ordinary shares.

The EPS calculation is the following: (5,000-2,000) / (11,000) = 0.27.

If the same remuneration amount of £2,000 is paid with a cash-settled share-based payment or any other method not involving the issuance of shares, the EPS would result as follows:

(5,000-2,000) / 10,000 = 0.30.

As shown, the EPS relating to the equity-settled share-based plan results in an EPS indicator of 0.30 compared to 0.27.


Section 7


KEY MESSAGE The costs relating to share-based payments always hit the income statement of the entity receiving goods/services. It does not matter if the share issuer or cash debtor is the shareholder or another group entity, even one outside the IFRS reporting group.

(a) THE COST IS ACCOUNTED FOR BY THE ENTITY RECEIVING THE GOODS / SERVICES

The expense relating to the share-based payment transactions has to be ultimately recognised in the income statement of the company receiving the goods / services. This means that, for example, the issuance of shares from an ultimate parent entity which is not included in the consolidation area does not result in avoiding accounting for IFRS 2 on a consolidation basis, if goods or services are received by an entity included in the consolidation area.

8. The charge to the income statement ultimately affects the fi nancial statements of the entity receiving goods or services

Section 8


Section 8


Parent entity

SubsidiaryB

Consoldation level

Company’s level

Intragroupshare-based

payment schemes

SubsidiaryA

SubsidiaryC



Additional guidanceIt can be the case that shares are not issued by the company receiving goods and services. This is a very common practice within groups. In fact, normally share-based payment transactions make reference to the shares of the shareholder or the group’s parent for employees of all the group entities.

Furthermore, shares could be issued by the holding company of the IFRS group, which could even prepare its fi nancial statements under a different accounting framework.

In any case, whichever is the issuing company of the group, the expense has to be recognised in the income statement of the company receiving the goods or services.

For instance, if the IFRS reporting entity receives goods or services that are to be paid with shares of another entity which is not controlled by the IFRS reporting parent entity, but is under the control of the same holding company, the cost has to be charged to the entity reporting under IFRS anyway.

In this case, the holding company in substance has made a capital contribution to the parent company, which has to be accounted for accordingly in its fi nancial statements.

The key point is that the expense relating to the share-based payment transaction has to be charged to the income statement of the entity receiving the goods or services, irrespective of who is the share-issuing or cash-paying company.

ExampleThe Alpha group is listed on the Stock Exchange and is required by local regulators to prepare consolidated fi nancial statements according to IFRS. The parent company of the Alpha group is 100% held by a holding company which is not listed and does not prepare IFRS fi nancial statements. The employees of Alpha group (both employees of the parent company and overseas subsidiaries) are entitled to stock options which, if vesting conditions are met, grant the possibility of receiving shares in the holding company.

The Alpha group has to account for the stock options in its consolidated fi nancial statements. In fact, the employees have rendered work services to Alpha group and therefore Alpha group is required to account for the expense relating to the service received.

In addition, the expense should be accounted for at each subsidiary level, taking into account current and deferred tax consequences based on local tax legislations.

Section 8


KEY MESSAGE If the fair value of the services or goods contributed is not reliably determinable, the cost of the transaction and therefore the charge to the income statement must be measured at the fair value of the awards granted.

(a) SHARE-BASED PAYMENTS DO NOT RELATE SOLELY TO EMPLOYEE SERVICES

IFRS 2 also applies to share-based payments related to services provided by external providers, the exchange for inventories, consumables, property plant and equipment, intangible assets and other non-fi nancial assets.

(b) FAIR VALUE CALCULATION IN CASE GOODS ARE EXCHANGED

In the case of share-based payments involving goods or services, there shall be a rebuttable presumption that the fair value can be estimated reliably. If this cannot happen, then the entity should make reference to the fair value of the instrument granted.

9. Not just a case of remuneration… services and goods may also be relevant

Section 9


Section 9


“Share-based payments do not just involve employee remuneration. The purchase of external services or goods can also fall within the scope of IFRS 2.”

Third partyservices

Means ofpayment for

Goods

Employee’sservices

Assets



Additional guidanceIn a share-based payment transaction, shares are regarded as a means of payment for goods and services. This means IFRS 2 is not only applied to share-based payments involving employee services. IFRS 2 also applies to share-based payment transactions in which the entity receives “inventories, consumables, property plant and equipment, intangible assets and other non-fi nancial assets”. [IFRS 2 par 5]

However, as mentioned in the introduction, IFRS 2 does not apply in the following circumstances where goods are purchased:

“transaction with an employee (or other party) in his / her capacity as a holder of equity instruments” [IFRS 2 par. 4]

“transaction in which the entity acquires goods as part of the net assets acquired in a business combination to which IFRS 3 Business Combination applies” [IFRS 2 par. 5]

transaction entered into for the purpose of speculating on the price of commodities but not acquiring them. [IFRS 2 par. 6]

IFRS 2 states that, regarding transactions with parties other than employees, there is a rebuttable presumption that the fair value of goods or services received by the entity can be reliably estimated. However, in cases where this is not possible, the fair value of the goods or services received is measured indirectly by estimating the grant date fair value of equity instruments granted. As a result, using the fair value of granted instruments should represent a valuable indicator in “directly” assessing the fair value of services or goods in cases where there is a signifi cant range of discretion. Alternatively, it could represent the “last resort” to estimate “indirectly” such fair value.

Moreover, there could be certain transactions in which the entity cannot identify specifi cally some or all of the goods or services received. In this situation the rebuttable presumption that the fair value of the goods or services received can be estimated reliably does not apply. However, this situation does not exempt the entity from applying IFRS 2. Therefore the entity should instead measure the goods or services received by reference to the fair value of the equity instruments granted. [IFRIC Interpretation 8 — Scope of IFRS 2]

The message seems to be quite clear. If options are granted, they must be fair valued, either directly via the fair value of goods / services received or indirectly via the fair value of granted options. Section 9


KEY MESSAGE Even though volatility is not readily available in respect of stock option schemes for non-listed or newly listed entities, as a rule of thumb, these should be evaluated when adopting a pricing model. This could result in more complex and onerous administrative burdens when setting up the pricing model for non-listed or newly listed entities.

(a) PRICING MODEL FOR UNLISTED AND NEWLY LISTED COMPANIES

In virtually all cases it should be possible to apply a pricing model for these companies, despite the lack of a readily available volatility and share price. This involves further analysis, research and valuation to obtain the necessary information in order to apply the pricing model.

(b) INTRINSIC VALUE

It should almost always be possible to avoid the use of the intrinsic method. It should be noted that, if used, the intrinsic method involves a true-up model for both cash-settled and equity-settled share-based payments. As a result, if the intrinsic value method is used, there is no difference between equity-settled and cash-settled share-based payments.

10. Newly listed, listed and unlisted entities… complications in calculating volatility

Section 10



Section 10

Use intrinsic value only in rare cases where the fair value of the equity

instruments cannot be estimated reliably

Unlisted andnewly listed

entities

Measurementat fair value Measurement

at intrinsic value

Listedentities


Additional guidanceAll the option pricing models require as input data the entity’s share price and the expected volatility. Obviously, for unlisted companies such data is not obtainable from published share quotations.

The same issue concerns newly listed companies. In fact, such companies normally do not have suffi cient historical data to calculate the expected volatility. In addition, the historical data should cover a length at least equal to the duration of the expected option life. This means that if the entity has granted an option with an expected life of fi ve years, the entity should extrapolate the expected volatility from a share quotation time frame of fi ve years.

In spite of the issues abovementioned, IFRS 2 tends to require entities, both listed and unlisted, to estimate the expected volatility in order to calculate the fair value of the options when adopting a pricing model.

Normally, unlisted or newly listed entities should refer to the implied volatility of listed entities that have similar characteristics and are in the same industry sector.

When it is not possible to determine the expected volatility and “the entity has not based its estimate of the value of its shares on the share prices of similar listed entities, and has instead used another valuation methodology to value its shares, the entity could derive an estimate of expected volatility consistent with that valuation methodology”. [IFRS 2 par. BC 30 and BC 139]


In the very few cases where the above approach would not be possible, the last resort would be the valuation at intrinsic value. However, as previously explained, the intrinsic value does not represent the fair value of an option due to the lack of the time value.

In this respect, the view of the Board is clear: “these approaches for estimating the expected volatility of an unlisted entity’s shares are somewhat subjective. However, the Board thought it likely that, in practice, the application of these approaches would result in under-estimates of expected volatility, rather than over-estimates, because entities were likely to exercise caution in making such estimates, to ensure that the resulting option values are not overstated. Therefore, estimating expected volatility is likely to produce a more reliable measure of the fair value of share options granted by unlisted entities than an alternative valuation method, such as the minimum value method.” [IFRS 2 par. BC 140]

In conclusion, the key message of IFRS 2 is that: “in virtually all cases, the estimated fair value of employee share options at grant date can be measured with suffi cient reliability for the purposes of recognising employee share-based payment transactions in the fi nancial statements. The Board therefore concluded that, in general, the IFRS on share-based payment should require a fair value measurement method to be applied to all types of share-based payment transactions, including all types of employee share-based payment. Hence, the Board concluded that the IFRS should not allow a choice between a fair value measurement method and an intrinsic value measurement method, and should not permit a choice between recognition and disclosure of expenses arising from employee share-based payment transactions.” [IFRS 2 par. BC 310]

Section 10


KEY MESSAGE Current and deferred taxation must be evaluated based on the tax regime of the entity receiving services/goods. Also, inter-company recharges must be assessed based on the tax rules of the companies involved.

(a) SHARED-BASED PAYMENTS REQUIRE TAX PLANNING ACTIVITIES

IFRS 2 requires careful tax assessments, especially for share-based payment plans embracing group entities located in different countries. In addition, particular attention has to be paid to inter-company recharge agreements.

(b) DEFERRED TAXATION

Where the expense is deductible for local tax purposes, deferred tax can be recognised if timing differences exist. It should be noted that, for equity-settled transactions, the tax benefi t charged to the income statement cannot exceed the tax benefi t associated to the expense recorded in the fi nancial statement. Any excess is recorded directly to equity.

11. Current, deferred taxation and social contribution implications

Section 11



Section 11

Current taxationDeferred taxation

Tax jurisdiction


Additional guidanceTax and contribution implications depend on the regulations of the country where the share-based payments expenses are charged. Therefore, if the expense is deductible, the amount deductible, the calculation methodology and the timing of deduction etc. should be assessed at country level when planning the share-based payment transaction. In addition, for parent entities granting share-based payment transactions to employees of group entities, there should be consideration as to whether such costs are ultimately re-charged to each group entity via inter-company agreements or not.

Where the expense is deductible and the amount booked in the fi nancial statements equals the tax base and the only difference resides in the timing of recognition, this represents a temporary difference according to IAS 12. As a result, “under that Standard, a deferred tax asset is recognised for all deductible temporary differences to the extent that it is probable that taxable profi t will be available against which the deductible temporary difference can be used (IAS 12, paragraph 24).” [IFRS 2 par. BC 313]

However, although the expense is deductible, a problem arises when the tax deduction differs from the amount of the expenses recognised in the fi nancial statement, because a different measurement basis is applied. In this respect, the IASB concluded that “the measurement of the deferred tax asset should be based on an estimate of the future tax deduction. If changes in the share price affect that future tax deduction, the estimate of the expected future tax deduction should be based on the current share price”. [IFRS 2 par. BC 324]

This means that the future tax deduction has to be based on the available information at each reporting date e.g. the current share price.

As mentioned before, the fi nal tax base could be higher or lower than the fi nal charge to the fi nancial statements because of the different measurement basis applied. IFRS 2 sets out the following recognition rules.

Equity-settled transactions:

“If the tax deduction is less or equal to the cumulative expense, the associated tax benefi ts received should be recognised as tax income and included in profi t or loss for the period.” [IFRS 2 – BC 326 a];

“If the tax deduction received exceeds the cumulative expense, the associated tax benefi ts received should be recognised directly in equity.” [IFRS 2 par. BC 326 b].

Cash-settled transactions:

All tax benefi ts should be recognised to profi t and loss.


Section 11


KEY MESSAGE In-house or outsourced specialists could be necessary to manage pricing models. Both the complexity of pricing models and the related administrative burden depend on how the issues highlighted in the preceding sections have been managed in designing the share-based payment plan.

(a) PRICING MODELS

A share-based payment transaction can be designed to combine a considerable number of characteristics. The table below shows the key points of the most common features and describes their impact on the fair value as well as the complexity of the pricing model to be adopted.

FeaturesIncrease the complexity of pricing model? Increase the fair value?

Variable exercise price YES Depends on circumstances

Variable number of equity awards YES Depends on circumstances

Variable vesting periods subject to conditions other than the share price

YES Depends on circumstances

Multiple market conditions YES NO

Long exercise period YES YES

America-Bermudan options YES YES

Reload features YES YES

Transferability YES YES

Expected dividends YES NO

Multiple behavioural consideration YES Depends on circumstances

12. Share-based payment options are measured by applying pricing models

Section 12



Section 12

Black & Scholes model

Binomialmodel

Montecarlosimulation

Pricingmodels


Additional guidanceIFRS 2 par. 17 states that: “the valuation technique shall be consistent with generally accepted valuation methodologies for pricing fi nancial instruments, and shall incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price.”

IFRS 2 clearly indicates that the fair value of a share-based payment transaction must be fair valued according to a generally accepted pricing model, and provides some guidance on the pricing models most readily accepted by the fi nancial community.

However, it does not indicate that one model must be used in all cases.

Each share-based payment transaction must be assessed and a proper valuation model chosen and applied. As a result, the choice of the right pricing model to apply is crucial in order to obtain a reasonable fair value determination of the option.

Understanding pricing models involves special mathematical and statistical skills, knowledge and experience. Moreover, it must not be forgotten that the choice of the valuation method has to be consistent with the current valuation methods commonly used by market participants. Therefore awareness of valuation methods currently used by the marketplace is required.

On this basis, if such expertise is not available internally, it is likely that a fi nancial statement preparer will need to consult external experts in order to manage the issue.

For the purpose of valuing an option, there are a number of pricing model options. Possibly the most famous is the Black and Scholes Pricing Model, introduced in 1973 by Fischer Black and Myron Scholes. However, since that time other specialists have revised the model, notably Robert Merton and Jonathan Ingerson. Therefore, it should be noted that the Black and Scholes Pricing Method is available in different forms, each with specifi c characteristics.

Another common option pricing model is the Binomial Model. This method is based on the construction of a binomial tree which represents a diagram of different possible paths that the underlying share price might follow over the life of the option. At each step of the diagram, the share price has a certain probability to move up or down. The diagram involves a range of steps where there is a binomial stock price movement. Thus, the model results in a lattice.

The model incorporates an exercise factor, rather than an anticipated exercise date as required under the Black Scholes model, which determines the conditions under which employees are expected to exercise their options. It is defi ned as a multiple of the exercise price (e.g. 2.3 would mean that on average employees tend to exercise their options when the stock price reaches 2.3 times the exercise price). This is in fact more reliable than trying to guess the average time to exercise. For example, trying to estimate an average time after which employees exercise is likely to be inaccurate. The reason is that during periods when the market is high, employees are more likely to exercise early, as opposed to times when the market is low. Using an exercise multiple based on a robust theory of stock price behaviour / distribution overcomes these problems.


Section 12



In general, whichever pricing model is chosen, as a minimum, the following factors should be taken into consideration:

the exercise price of the option

the life of the option

the current price of the underlying shares

the expected volatility of the share price

the dividends expected on the shares (if appropriate)

the risk-free interest rate for the life of the option

However, these are not the only factors to consider. The pricing model should also be tailored in order to consider market conditions characterising the option, the expected behaviour of option holders, exercise restrictions in specifi ed periods, non-transferable features that could trigger early exercise, etc.

In conclusion, the brief and non-exhaustive considerations mentioned here aim to highlight the complexity surrounding the determination of the fair value of share-based payments. Preparers should be aware that option pricing models are likely to require the use of experts to be managed properly and that, as a general rule, their complexity and cost of implementation result from the complexity of the share-based payment itself. In other words, the pricing model complexity and burden can be minimised provided experts in pricing models are involved in the design of the share-based payments from the beginning.

Section 12


KEY MESSAGE Business combination could have a signifi cant impact on the fair value measurement of existing share-based payments and could necessitate their reorganisation. All this could bring unexpected impacts on the Purchase Price Allocation process and the post-combination income statement results.

(a) IMPACT ON THE SHARE-BASED PAYMENT FAIR VALUE

Share-based payments measurement is linked to the value of the underlying shares. The value of shares of an entity could change signifi cantly as a result of a business combination. As a consequence, a business combination could have an impact on the fair value of the granted instruments. Each case must be assessed separately.

(b) IMPACTS OF THE SHARE-BASED PAYMENT REORGANISATION

Business combinations could impact on the reorganisation of the existing acquirer’s and acquiree’s share-based payment schemes. As a result, replacement awards or modifi cation of the existing schemes could result in unexpected impacts on the Purchase Price Allocation process and the post-combination income statement results.

13. Beware the impact of business acquisitions on share-based payments

Section 13


Section 13


PurchasePrice Allocation

IFRS 3Renegotiations

Businesscombinations

Impacton incomestatement

Cancellations


Additional guidanceIFRS 3 and IFRS 2 have little guidance on how to treat share-based payments of entities involved in a business combination.

In this respect, ED IFRS 3 Phase II issued on October 2005 has detailed guidance on how to account for “replacement awards” in a business acquisition. Generally speaking, the impact on Purchase Price Allocation and the post-combination income statements depends on the characteristics of the acquirer’s and acquiree’s share-based payment schemes. However, each case must be analysed and treated separately.

It may be necessary to consider the following issues when dealing with share-based payments within a business acquisition:

Does the value of the new post-combination entity’s shares impact on the fair value of the existing share-based payments and therefore the post-combination income statement?

Does the acquisition date trigger the fair value remeasurement of the share-based payment transaction, especially in the case of replacement?

Do cash-settled share-based payments, equity-settled share-based payments or share-based payment transactions with cash alternatives have a different impact on the Purchase Price Allocation process and the post-combination income statement?

What will happen if the acquirer exchanges its share-based payments for awards held by employees of the acquiree which have different terms and fair value?

What portion of the share-based payments is attributable to the Purchase Price Allocation process and what portion has to be charged to the post-combination income statement?

Each case has to be approached separately. It is important to have a clear understanding of possible post-combination income statement impacts to avoid nasty surprises.


Section 13


KEY MESSAGE There could be a gap in terms of perception between the cost charged to the income statement and the value perceived by the option holder. An effective communication strategy could help the option holders to fully perceive the stock option value and therefore to reduce the perception gap.

(a) EMPLOYEE PERCEPTION OF THE FAIR VALUE

The value of an employee stock option plan charged to the income statement could result from complex formulas, which attempt to capture all measurable variables. However, this value might not be completely understood by employees, or perceived differently. This means that the employee might not recognise as “remuneration” a portion of the cost which nevertheless has hit the income statement.

14. Is the entire value of the stock option award perceived by the option holders?

Section 14


Section 14


Value charged to income statement

vs

Benefi ciaries’ perceived value

vs

Actual value


Additional guidanceThe purpose of IFRS 2 is to measure the fair value of goods or services received. As far as labour services are concerned, the fair value of exchanged shares or share options represents employee remuneration. However, the peculiarity of this remuneration is that it is not directly and easily measurable. In fact, it incorporates both market and individual expectations that have to be taken into account in assessing its fair value.

In addition, such expectations vary according to how the terms of the share-based payments were set up. We could say that each term of a share-based payment has its individual “fair value”. However, the fair value can only be estimated for the entire share-based payment rather than for each of its individual components.

In other words, the pricing model tries to capture as many of these expectations as possible and convert them into “time value” — a fi gure that ultimately represents remuneration.

The question is whether share option holders perceive the value associated to each term of the share option plan resulting from the application of the pricing model and charged to the income statement.

For instance, the holder could perceive the intrinsic value but not the value associated with an exercise period of fi ve years instead of two years. This would result in remuneration charged to the income statement but not perceived by the employee. In other words, we might say that the employee has been over paid but he / she does not realise it.


Section 14


Cash-settled share-based payment transactionA 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 the entity’s shares or other equity instruments of the entity.

Employees and others providing similar services Individuals who render personal services to the entity and either (a) the individuals are regarded as employees for legal or tax purposes, (b) the individuals work for the entity under its direction in the same way as individuals who are regarded as employees for legal or tax purposes, or (c) the services rendered are similar to those rendered by employees. For example, the term encompasses all management personnel, ie those persons having authority and responsibility for planning, directing and controlling the activities of the entity, including non-executive directors.

Equity instrumentA contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Equity instrument grantedThe right (conditional or unconditional) to an equity instrument of the entity conferred by the entity on another party, under a share-based payment arrangement.

Equity-settled share-based payment transactionA share-based payment transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options).

Glossary (source: IFRS 2, Appendix A, Defi ned terms)

Fair valueThe 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.

Grant dateThe 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. At grant date the entity confers on the counterparty the right to cash, other assets, or equity instruments of the entity, provided the specifi ed vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained.

Intrinsic valueThe 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. For example, a share option with an exercise price of CU15,† on a share with a fair value of CU20, has an intrinsic value of CU5.

Market conditionA condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price of the entity’s equity instruments, such as attaining a specifi ed share price or a specifi ed amount of intrinsic value of a share option, or achieving a specifi ed target that is based on the market price of the entity’s equity instruments relative to an index of market prices of equity instruments of other entities.


Measurement dateThe date at which the fair value of the equity instruments granted is measured for the purposes of this IFRS. For transactions with employees and others providing similar services, the measurement date is grant date. For transactions with parties other than employees (and those providing similar services), the measurement date is the date the entity obtains the goods or the counterparty renders service.

Reload featureA feature that provides for an automatic grant of additional share options whenever the option holder exercises previously granted options using the entity’s shares, rather than cash, to satisfy the exercise price.

Reload optionA new share option granted when a share is used to satisfy the exercise price of a previous share option.

Share-based payment arrangementAn agreement between the entity and another party (including an employee) to enter into a share-based payment transaction, which thereby entitles the other party to receive cash or other assets of the entity for amounts that are based on the price of the entity’s shares or other equity instruments of the entity, or to receive equity instruments of the entity, provided the specifi ed vesting conditions, if any, are met.

Share-based payment transactionA transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options), or acquires goods or services for amounts that are based on the price of the entity’s shares or other equity instruments of the entity.

Share optionA contract that gives the holder the right, but not the obligation, to subscribe to the entity’s shares at a fi xed or determinable price for a specifi ed period of time.

VestTo become an entitlement. Under a share-based payment arrangement, a counterparty’s right to receive cash, other assets, or equity instruments of the entity vests upon satisfaction of any specifi ed vesting conditions.

Vesting conditionsThe conditions that must be satisfi ed for the counterparty to become entitled to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. Vesting conditions include service conditions, which require the other party to complete a specifi ed period of service, and performance conditions, which require specifi ed performance targets to be met (such as a specifi ed increase in the entity’s profi t over a specifi ed period of time).

Vesting periodThe period during which all the specifi ed vesting conditions of a share-based payment arrangement are to be satisfi ed.

Glossary (source: IFRS 2, Appendix A, Defi ned terms)

RSM International

Executive Offi ce, 2nd Floor, 11 Old Jewry, London EC2R 8DU, UKT: +44 (0)20 7601 1080 F: +44 (0)20 7601 1090 E: [email protected]

RSM International is an affi liation of independent accounting and consulting fi rms. RSM International and its member fi rms are separate and independent legal entities. RSM International does not practise public accounting or consulting in its own name.

www.rsmi.com © RSM International Association, 2007

RSM International is a global organisation of independent professional service fi rms, united by a common desire to provide the highest quality of services to our clients. We exist to make a positive difference to their futures. Our high standards, common work ethic and clear focus make us valuable partners for our varied client base worldwide.

Our visionTo be the provider of choice to internationally active growing organisations who are looking for accounting, tax, consulting and specialist advisory services that will create lasting success and help them reach their goals.

Our purposeThe RSM difference lies in the close and enduring relationships we forge with our clients and between our member fi rms, and is grounded on the quality and commitment of our people. RSM member fi rms share a common belief that it is through constantly striving for excellence and by working closely together that lasting success is generated.

Documents

Designing share-based payment schemes