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Home > Accountancy Best Practice > Accounting for Share-Based Payments under IFRS

Accountancy Best Practice

Accounting for Share-Based Payments under IFRS

by Shân Kennedy

Executive Summary

  • In 2005 the International Accounting Standards Board (IASB) introduced International Financial Reporting Standard, IFRS 2, Share-based Payment, to address the issue of accounting for remuneration paid to employees in the form of equity, derivatives of equity, or cash linked to the price of equity.

  • Most awards are made as shares or share options, and are known as equity-settled share-based payments.

  • Valuation and accounting issues affect how such awards are reflected in a company’s financial statements.

  • A valuation exercise is required in respect of the fair value of the awards at the date they were granted.

  • An accounting exercise is required in respect of the extent to which the grant-date fair value is charged to the company’s profit and loss account.

  • These valuation and accounting exercises take full account of any conditions attaching to the earning of the award by the employee.

Introduction

Share-based payments are often made to employees for the purpose of incentivizing them to remain with a company or to improve their standard of performance and, thus, may be granted subject to certain conditions. IFRS 2, Share-based Payment, analyzes in detail the types of condition that might be applied and how they impact the accounting treatment.

The standard requires that equity-settled share-based payment awards are accounted for using the modified grant-date approach. This requires the measurement of the fair value of the award at the grant date, adjusted to reflect certain types of conditions, known as market conditions and nonvesting conditions. The extent to which this adjusted, i.e. modified, fair value is charged to the profit and loss account is determined according to the extent to which other conditions, known as vesting conditions that are not market conditions, apply and are satisfied. No charge is made on a cumulative basis over the vesting period if such other conditions apply but are not satisfied.

The following steps are involved in application of the modified grant-date approach:

  1. Identify whether there are conditions attaching to the award and determine which of the following three categories they fall into:

    • market (vesting) conditions;

    • nonmarket (vesting) conditions;

    • nonvesting conditions.

  2. Determine the grant-date fair value of the award, modified if necessary to reflect any market or nonvesting conditions identified.

  3. At the end of each reporting period, true up the modified grant-date fair value in respect of the extent to which vesting conditions that are not market conditions, i.e. nonmarket vesting conditions, are expected to be achieved.

When the standard was first introduced, there was concern that it could result in substantial charges to the profit and loss account. Ultimately, however, charges have on average not been as large as originally expected. Accountants PricewaterhouseCoopers are quoted as saying in respect of FTSE 350 companies:1 “At the median the expense charge represents approximately 2 per cent of profit before tax and before IFRS 2 charge.”

The charge varies according to the extent to which entities use share-based payments to incentivize staff, and there is therefore some concentration of charges in particular industries. Accountants PricewaterhouseCoopers are further quoted as saying,2 “FTSE 250 technology companies…incurred average reductions in profits of about 12 per cent to IFRS 2 charges.”

Identification of Conditions Attaching to Awards

Conditions are classified as either vesting or nonvesting. Vesting conditions are defined as those that determine whether the company has received the services that entitle the employee to receive the award, and they can be either service period conditions or performance conditions. The vesting period is the period during which any specified vesting conditions are to be achieved. Service period conditions require the employee to work for the company for a specified period of time, often three years. Performance conditions require the employee to work for the company for a specified period of time and to achieve a specified performance target.

Performance conditions themselves may include what is known as a market condition. This is a condition that relates to the price of the underlying equity. For instance, share price and total stockholder return (TSR) targets are examples of market conditions. However, profit targets, earnings per share targets, sales targets, and service period conditions are not market conditions as they have no connection with the underlying share price. Generally, market conditions are attached only to awards to relatively senior members of staff, who are considered to be in a position to have some impact on a company’s share price.

For instance, a directors’ share plan might be granted to all executive directors that entitles them to the award if the share price increases by 50% over a three-year period. A more complex type of award might be that entitlement varies according to a sliding scale and is based on a comparison between the company’s TSR over the vesting period and that of a group of, say, 11 peer group entities. If the company’s TSR is in the top quartile of that of the peer group, a maximum level of award is made; if the TSR is in the second quartile, a sliding scale of say, 50%, 60%, or 70% of the maximum level of award is made, depending on the precise position within the quartile. If the company’s TSR is in the bottom half for the peer group, no award will vest.

Nonvesting conditions are those that determine whether the employee receives the award but not whether he or she has provided the services that entitle him/her to the award. Thus, such conditions may be outside the control of the employee—for instance, they could take the form of an inflation or interest rate target for a country. Alternatively, they may be within the control of the employee but may not relate to whether the employee has provided the services required to earn the reward. For instance, there is a type of award that is common in the United Kingdom—the save as you earn (SAYE) scheme—under which the employee saves a certain amount from his or her salary each month over the vesting period, and he or she may subsequently use the cumulative amount saved to exercise options at the end of the vesting period. In some cases, employees stop saving during the vesting period and withdraw their cash saved to date, thereby losing their entitlement to exercise options at the end of the vesting period; however, this does not mean that the employee has not provided the required services during the vesting period.

Almost all awards include service period conditions. Some relatively straightforward awards do not include any other type of condition.

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Further reading

Websites:

  • Various option-pricing calculators are available online that use the Black and Scholes or binomial models. Websites that provide these include:
  • BloBek AB: www.blobek.com
  • FinCAD: www.fincad.com
  • Hoadley Trading & Investment Tools: www.hoadley.net/options/options.htm
  • There are many valuation advisers that will run any of these models, including valuation advisers from the Big Four accountants, smaller firms of accountants, and valuation consultants or actuaries.
  • Crystal Ball, add-on to MS Excel for Monte Carlo simulation: www.oracle.com/crystalball

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