In recent years it has become increasingly common for entities to acquire goods and services from third parties by issuing shares or granting share options rather than making payments in cash. Before an accounting standard was issued on the subject, there was considerable scope for a variety of accounting treatments for such transactions, making comparability between entities extremely difficult. Examples of where varied treatments could occur would include:
It was largely due to these factors that the International Accounting Standards Board (IASB) issued IFRS 2 – Share-based payment – (IFRS 2) in 2009.
IFRS 2 applies to share-based payment arrangements that lead to a share-based payment transaction. Share-based payment arrangements are basically agreements between an entity and a third party (the ‘third party’ in such arrangements is often an employee of the entity) that entitle the third party to receive:
A share-based payment transaction is one in which the entity receives goods or services from a third party in a share-based payment arrangement. Such transactions will be equity settled or cash settled depending upon the type of share-based payment arrangement involved (see above).
Certain transactions that might potentially be considered to be ‘share-based payment transactions’ are specifically excluded from the scope of the standard:
IFRS 2 states that an entity should recognise the goods or services received in a share-based payment transaction when it obtains the goods or receives the services from the relevant third party. Given that the ‘third party’ is often an employee of the entity, the services ‘received’ will be the services of the employee over a specified period. The debit entry to record the transaction will usually be to expenses (employment expenses) but could also be to an asset account if the relevant cost qualified for recognition is an asset (eg inventory).
Where the transaction is an equity-settled share-based payment transaction the corresponding credit is to equity (IFRS 2 doesn’t say where in equity). If the transaction is a cash-settled share-based payment transaction then the corresponding credit is to liabilities.
The basic measurement principle for equity-settled share-based payment transactions is that they should be measured at fair value. The way in which ‘fair value’ is determined is laid out in IFRS 2. The detailed guidance in IFRS 13 – Fair value measurement – (IFRS 13) is not followed when measuring share-based payment transactions (this is a specific scope exemption in IFRS 13).
IFRS 2 states that, unless the third party is an employee of the entity (which is actually usually the case!) then ‘fair value’ should be measured based on the fair value of the goods or services supplied, provided such a measure is readily available. Where such a measure is not readily available, then ‘fair value’ should be based on the fair value of any equity instruments granted. Where (as is usually the case) the third party is an employee, then ‘fair value’ should always be based on the fair value of the equity instruments granted.
The most common form of equity-settled share-based payment transaction is where an entity grants share options to employees. This means that the transaction should be measured using the fair value of the options granted. IFRS 2 states that the fair value of such transactions should be measured at the grant date. Subsequent changes in the fair value of such share options should be ignored by the entity when accounting for equity-settled share-based payment transactions.
Where share options are granted to employees, they cannot usually be unconditionally exercised until a given future date. This date is referred to in IFRS 2 as the vesting date and there are usually conditions that must be satisfied before the options vest. These conditions are called vesting conditions and if they are not satisfied the options will not vest. Sometimes the vesting conditions will be service conditions – meaning that the employee must remain in employment for a specified period for the options to vest. IFRS 2 states that, where the vesting condition is a service condition, the cost should be based on the estimated number of options that will ultimately vest. This estimate should be based on the latest estimated numbers vesting at the date the financial statements are approved.
Entity A prepares financial statements to 31 December each year. On 1 January 2012 A granted 300 options to 400 employees. The options vest on 31 December 2014 provided the relevant employees remain in employment with A throughout the three-year period.
On 1 January 2012 the fair value of each share option was $2.40. The fair value increased to $2.50 by 31 December 2012, to $2.70 on 31 December 2013, and was $2.75 on 31 December 2014.
On 1 January 2012 the directors of entity A estimated that 340 employees would remain in employment throughout the three-year period ending on 31 December 2014. This estimate was re-computed to 350 employees on 31 December 2012 and 360 employees on 31 December 2013. The actual number of employees who remained over the three-year period was 365 employees.
We will show the impact on the financial statements of entity A for each of the three years:
Year ended 31 December 2012
The estimated total cost is 300 (number of options per employee) x 350 (the estimated number of employees in whom the options will vest) x $2.40 (the fair value of each option at the grant date – this estimate is NOT updated) = $252,000. This cost is recognised over the three-year vesting period so the cost to date is $84,000 ($252,000 x 1/3). This amount is debited to employment expenses and credited to equity.
Year ended 31 December 2013
The estimated total cost is 300 x 360 (note this estimate is updated) x $2.40 (note this estimate is NOT updated) = $259,200. This cost is recognised over the three-year vesting period so the cost to date is $172,800 ($259,200 x 2/3). This is the cumulative amount that is included in equity. Therefore the additional employment expense charge for 2013 is $88,800 ($172,800 – $84,000).
Year ended 31 December 2014
The actual total cost is 300 x 365 x $2.40 = $262,800. The vesting period is now complete so this is the total cost recognised. Therefore the additional employment expense charge for 2014 is $90,000 ($262,800 – $172,800).
The effect of the transactions on the three years can be summarised in the following table:
|Charge to |
|Cumulative balance |
Equity settled share-based payment arrangements often contain vesting conditions that relate to performance, rather than merely to service. IFRS 2 differentiates between two types of performance condition: (1) a non-market condition ; and (2) a market condition.
(1) A non-market condition – where the performance target is not directly based on the share price of the entity. Such conditions are taken into account when estimating the number of options that will vest at the end of the vesting period.
Entity B prepares financial statements to 30 November each year. On 1 December 2012 entity B granted share options to a group of 200 employees. The options will vest on 30 November 2015 provided the employees remain in employment over the three-year period ending 30 November 2015. The number of options that will vest for each eligible employee will depend on the cumulative growth in revenue for the three-year period ending 30 November 2015:
The directors of entity B made the following estimates regarding the vesting conditions at relevant dates:
Number of eligible employees
|Cumulative growth in revenue in the three-year period|
|1 December 2012||180||22%|
|30 November 2013||183||24%|
|30 November 2014||185||28%|
The fair value of a share option on 1 December 2012 was $3.60. The impact of the share-based payment arrangement on the financial statements for the years ended 30 November 2013 and 2014 is demonstrated below.
Year ended 30 November 2013
Based on latest estimates 250 options will vest for 183 employees. Since this is the first year of a three-year vesting period the charge to profit or loss and the credit to equity will be $54,900 (250 x 183 x $3.60 x 1/3).
Year ended 30 November 2014
Based on latest estimates 300 options will vest for 185 employees. Since this is the second year of a three-year vesting period the cumulative credit to equity will be $133,200 (300 x 185 x $3.60 x 2/3). The charge to profit or loss for this period will be $78,300 ($133,200 – $54,900).
(2) A market condition – where the performance target is directly based in some way on the share price of the entity at a specified date. In such cases the performance condition is taken into account when estimating the fair value of the option at the grant date rather than considering whether or not the options will vest. This leads to the slightly surprising fact that there can be a charge to profit or loss in this case for options that never vest! In circumstances where the vesting date is dependent on the entity’s share price reaching a specified level then the vesting period should be based upon the assumptions regarding share price behaviour that were used in estimating the fair value of the option at the grant date.
Entity C prepares financial statements to 30 September each year. On 1 October 2011 entity C granted 200 options to 20 senior executives. The options only vest if entity C’s share price reaches $20 on set dates and the relevant executives remain employed by the entity on those dates. The options can vest:
On 1 October 2011 the directors of entity C estimated that the fair value of a share option under this scheme was $18. This estimate was arrived at based upon the assumption that the options would vest on 30 September 2015. In fact the share price reached $20 on 1 June 2014 and remained at or above that level until 30 September 2014. Therefore the options vested on 30 September 2014. The directors consistently estimated that all 20 executives would remain employed by entity C over the relevant vesting period and all executives were in employment when the options vested.
The impact of the share-based payment arrangement on the financial statements for the years ended 30 September 2013 and 2014 is shown below.
Year ended 30 September 2013
The options do not vest in this period so the charge to profit or loss and the credit to equity is based on the assumptions made when estimating the fair value of the options at the grant date – ie a three-year period with a vesting date of 30 September 2015. Therefore the charge to profit or loss and the credit to equity is $24,000 (200 x 20 x $18 x 1/3).
Year ended 30 September 2014
The options actually vest in this period so the total cumulative cost needs to be recognised in equity by that date. The total amount to be recognised is $72,000 (200 x 20 x $18). This means the charge to profit or loss in this accounting period is $48,000 ($72,000 – $24,000).
Assuming, as an alternative, that the share price remained below $20 for the whole of the three-year period ending 30 September 2015 so the options never vested, there would be a charge to profit or loss, and a corresponding credit to equity, of $24,000 for each of the three years ending 30 September 2013, 2014 and 2015. Therefore there would be a charge to profit or loss even though the options never vested. This would never happen for non-market vesting conditions.
It has already been stated that equity settled share-based payment arrangements often form part of the remuneration package of employees. In order to provide a benefit, the terms of the arrangement have to be attractive from the viewpoint of the employee. The extent to which this is true depends largely on the share price at the time the option is able to be exercised. If the entity’s share price falls unexpectedly, then the employees may feel the value of the initial award is compromised. In such circumstances the entity may modify the terms of the arrangement to make it more attractive based on the new circumstances. When this occurs:
Entity D prepares financial statements to 30 June each year. On 1 July 2012 entity D granted 1,000 options to 500 employees. The options vest on 30 June 2016 provided the relevant employees remain in service throughout the four-year period ending on 30 June 2016. Estimates of the number of employees who would remain and become eligible to exercise the options have changed as follows:
Estimated number of eligible employees
1 July 2012
30 June 2013
30 June 2014
30 June 2015
On 1 July 2012 the fair value of a share option was $6. During the year ended 30 June 2014 entity D suffered very difficult trading conditions and the fair value of the option fell to $1.50. Therefore on 1 July 2014 entity D re-priced the options and this caused their fair value to rise to $5.10.
The impact of the share-based payment arrangement on each of the years ended 30 June 2013, 2014 and 2015 is shown below.
Year ended 30 June 2013
Based on latest estimates the cumulative amount taken to equity should be $723,000 (1,000 x 482 x $6 x ¼). This is also the charge to profit or loss since this is the first year of the scheme.
Year ended 30 June 2014
Based on latest estimates the cumulative amount taken to equity should be $1,452,000 (1,000 x 484 x $6 x 2/4). The charge to profit or loss will be $729,000 ($1,452,000 – $723,000).
Year ended 30 June 2015
Once the options have vested the third parties (usually employees) are able to exercise the options if they wish. In reality they probably will exercise their options because, as has already been stated, they are deliberately priced so as to be favourable for the employees. However whether they do or do not exercise the options has no bearing on the accounting entries already made during the vesting period (and covered in the various examples we have already considered earlier in this article).
When the options are exercised, the entity will debit cash and credit equity with the option proceeds. The exact nature of the credit to equity depends on the legal requirements in the relevant jurisdiction. Specifically, if shares in the particular legal jurisdiction have a par (or nominal) value then the par value will be credited to share capital and any excess (or ‘premium’) will be credited to other components of equity. Any separate component of equity that may have been created when crediting equity during the vesting period would normally be transferred to retained earnings when the options are exercised (although this is not a specific requirement of IFRS 2).
In such transactions entities acquire goods or services by incurring a liability to transfer cash to the supplier based on the value of the equity instruments of the entity. A typical example would be where an entity grants share appreciation rights to its employees as part of their remuneration package. In such arrangements employees will become entitled to a future cash payment based on the increase in the entity’s share price over a specified period of time. Such arrangements usually have vesting conditions and the rights do not vest until the conditions have been satisfied.
Much of the accounting for such transactions bears a close similarity to accounting for equity settled transactions. A particular area of similarity is that the expected cost of the transaction is recognised over the vesting period, taking account of the vesting conditions. However there are two important differences:
Entity E prepares financial statements to 30 September each year. On 1 October 2012 entity E granted 240 share appreciation rights (SARs) to 300 employees. The rights can only be exercised if the relevant employees remain in employment throughout the three year period ending on 30 September 2015. The rights can be exercised by eligible employees either on 30 September 2015 or on 30 September 2016. Relevant data is a follows:
Estimated number of eligible employees
Fair value of a SAR
Intrinsic value of a SAR
1 October 2012
30 September 2013
30 September 2014
30 September 2015
150 employees exercised their SARs on 30 September 2015, the remaining 135 will exercise their SARs on 30 September 2016.
NB: The intrinsic value of a SAR is the amount that would be received by an eligible employee who exercised his or her right to redeem the SAR on that particular date. The reason the fair value of a SAR on 30 September 2015 is greater than its intrinsic value on that date is that there is an expectation the share price will rise further in the year to 30 September 2016 which will improve the amount receivable by those employees who choose to wait.
The impact of the share-based payment arrangement on each of the years ended 30 September 2013, 2014 and 2015 is shown below.
Year ended 30 September 2013
Based on the latest fair value estimate, the estimated total liability is $1,488,960 (240 x 282 x $22). Since we are only one year through a three year vesting period the amount recognised is $496,320 ($1,488,960 x 1/3). The employment expense for the year will be $496,320.
Year ended 30 September 2014
Based on the latest fair value estimate the estimated total liability is $1,635,840 (240 x 284 x $24). Since we are two years through a three year vesting period the amount recognised is $1,090,560 ($1,635,840 x 2/3). The employment expense for the year will be $594,240 ($1,090,560 – $496,320).
Year ended 30 September 2015
At the end of this period the vesting period is complete. 150 of the eligible employees will have received a cash payment at the year end (based on the intrinsic value of the SAR) of $900,000 (240 x 150 x $25). There will be a liability to the remaining 135 (285 – 150) employees (based on the fair value of the SAR) of $842,200 (240 x 135 x $26). The employment expense for the year can be arrived at as a balancing figure as shown in the following table:
Liability at 1 October 2014
Employment expense for the period (balancing figure)
Payment made to 150 employees on exercising their SARs
Liability to 135 employees at
Some share-based payment arrangements provide either the entity or the third party with a choice of whether to have the transaction settled by an issue of equity instruments (equity settled) or pay a cash payment (cash settled). The treatment of such transactions depends on who has the choice regarding the method of settlement.
If the third party has the choice then the entity has effectively issued a compound financial instrument with a liability (debt) component (to be accounted for as a cash-settled share-based payment transaction) and an equity component (to be accounted for as an equity-settled share-based payment transaction).
The way this works in practice is that the entity first estimates the fair value of the debt component. The equity component is then measured taking account of the fact that the cash payment would be foregone in these circumstances.
Entity F prepares financial statements to 31 December each year On 1 January 2012 entity F grants an employee the right to a payment equal to the value of 5,000 shares, or the receipt of 6,000 shares. The right can only be exercised, or the shares received, after a three-year vesting period ending on 31 December 2014. If the equity alternative is chosen, the shares cannot be sold for at least four years after the vesting date – ie not before 31 December 2018. On 1 January 2012 the share price of entity F is $60. After taking account of the restriction on selling the fair value of the share alternative on 1 January 2012 is $54.
The fair value of the debt component is initially measured at $300,000 (5,000 x $60). The fair value of the share alternative is $324,000 (6,000 x $54). Therefore the equity component is $24,000 ($324,000 – $300,000).
Assuming the employee remains employed over the three year vesting period the equity element will be measured based on the grant date fair value so $8,000 ($24,000 x 1/3) will be credited to equity and debited as an employment expense each year.
The liability element will be measured based on the latest estimates of the amount payable, spread over the vesting period. Assuming that the share price of entity F changed as follows over the three-year period:
31 December 2012
31 December 2013
31 December 2014
The financial statements would be affected as follows regarding this information:
5,000 x 63 x 1/3
5,000 x 64.5 x 2/3
5,000 x 66
If the employee chooses the cash alternative at 31 December 2014 the liability will be settled in cash. If the employee chooses the share alternative the liability will be transferred to equity as ‘issue proceeds’.
If the choice of settlement is with the entity, rather than the third party, then unless there is an obligation, either legal (because for whatever reason the entity is legally prohibited from issuing shares) or constructive (because the entity has a past practice or stated policy of settling in cash) then the transaction is accounted for as an equity settled share-based payment transaction.
To conclude, share-based payments are a complex topic, however, an in-depth understanding of the material in this article should help you to feel more comfortable when answering exam questions from this syllabus area.