Accounting

Accounting for Share Option Plans, Performance Share Plans, and Restricted Share Plans (IFRS 2)

Applicable Standard

  • IFRS 2: Share-Based Payment

TYPES OF SHARE-BASED PAYMENT TRANSACTIONS

Basic Principle

  • Need to recognise the FV of the goods or services received by the company from the employees that are getting the share-based payment).
  • If the goods or services cannot be measured reliably (which is most of the time duh!), the amount recognised is the FV of the equity instruments granted at Grant Date.
  • If the goods or services received do not qualify for recognition as assets (i.e. cannot be capitalised), then the amount is recognised as expenses [so it can either be debit assets, or debit expenses].

Three types of share-based payment

  1. Equity settled: Settled in entity’s shares or share options.
  2. Cash settled: Settled in cash based on entity’s share price (e.g. share appreciation rights)
  3. Settled either by equity or cash: Choice by either the entity or the awardee.

Equity Settled Transactions

Initial Recognition

  • Initial recognition is only for instruments that have vested, those with a vesting period will not be recognised at the Grant Date itself but will be recognised progressively (see Subsequent Recognition for more details).
  • Market-based conditions are factored into the FV of the instruments at Grant Date, while non-market-based conditions are factored into the expected number of instruments that will vest.
  • Accounting entries for issuance of shares
    • Dr Purchases (for payment to suppliers) or Dr Wages (to employees)
    • Cr Share Capital
    • Cr Share Premium
  • Accounting entries for stock options
    • Dr Employment Cost Expense (Income Statement)
    • Cr Share-based payment reserve (Balance Sheet under Equity)

Subsequent Recognition

  • Measurement
    • At each reporting date before the vesting date, estimate the expected number of instruments that will vest. At the vesting date, the number of instruments is the actual number of instruments that vested.
    • Cumulative Cost = Expected number of instruments that will vest * FV of each instrument measured at grant date * (Reporting Date – Grant Date) / (Vesting Date – Grant Date)
      • Expected # of instruments that will vest is affected by # of employees remaining, and performance achieved for non-market conditions
      • FV of each instrument used is measured at grant date, and is not remeasured
      • FV of instrument at grant date can be affected by performance conditions that affect terms of the option (e.g. exercise price changes based on performance), so may need to calculate different FVs as we don’t know which would be used later
      • Vesting date
        • Estimated based on the most likely outcome of performance conditions.
        • For performance condition that is non-market, vesting date estimate needs to be updated to reflect latest estimate.
        • For performance condition that is market
          • If the vesting period is longer than previously estimated, the expense is recognised over the original expected vesting period
          • If the vesting period is shorter than previously estimated, the expense is recognised over the shorter vesting period.
    • Calculate what the cumulative cost should be based on the latest expectations of (i) the # of instruments that will vest, and (ii) the vesting date, then the expense for the period is whatever is required to get to the new estimated cumulative cost.
  • Accounting entries
    • Dr Employment Cost Expense (Income Statement)
    • Cr Share-based payment reserve (Balance Sheet)
    • Amount for both entries is (Cumulative cost at end of current reporting year – Cumulative cost at end of previous reporting year).
  • On early settlement of an award without replacement, a company should charge the balance that would have been charged over the remaining period, i.e. the charges are accelerated.

Cash Settled Transactions

Initial Recognition

  • Liability recognised in Balance Sheet, measured at FV.

Subsequent Recognition

  • Liability remeasured each year at FV until settlement, change in liability is expensed to P&L.
  • If there is a vesting period, the treatment is the same as per equity settled transactions (albeit the value is still recorded as a liability, and not as a reserve account under equity), the only difference is that the FV of the instrument used is the updated FV as of each reporting date.

Transactions Settled either by Equity or Cash

  • If the choice of settlement method lies with the employee, account for it as a Compound Financial instrument.
  • If the choice of settlement method lies with the company, if the company tends to settle in cash, then treated as a cash settled transaction, else treated as an equity settled transaction.

KEY TERMS

Types of Conditions

  • Vesting Conditions
    • Service conditions
      • Requires the completion of a specified period of service during which services are provided to the company.
      • E.g. need to remain in service for 2 years
      • Incorporated via (i) updating the # of instruments expected to vest, and (ii) pro-rating the expected total expense over the vesting period.
    • Performance conditions
      • Requires (a) completion of a specified period of service; and (b) achievement of performance target(s) while rendering the required service in (a)
      • Market conditions
        • Relating to price or value.
        • E.g. stock price of the entity needs to increase by 25%
        • Incorporated via the fair value of each instrument at grant date
      • Non-market conditions
        • Relating to operations or activities.
        • E.g. EBITDA needs to grow by 25%, achieve IPO
        • Incorporated via (i) updating the # of instruments expected to vest, and (ii) pro-rating the expected total expense over the vesting period, the length of which might change if the length of the vesting period also depends on achievement of the non-market condition.
  • Non-Vesting Conditions
    • A non-vesting condition is a condition that does not require a period of service to be completed before the employee is entitled to the share-based payment.
    • E.g. non-compete condition, target based on a commodity index, employee required to contribute to an account to save up for the exercise, etc.
    • Incorporated via the fair value of each instrument at grant date

Grant Date

  • Grant date is the date when both parties
    • Have a shared understanding of the terms and conditions of the arrangement; and
    • Agree to a share-based payment arrangement, where ‘agree’ means that there must be both an offer and acceptance of that offer.
  • Corollaries
    • If agreement is subject to an approval (e.g. by shareholders), grant date is when that approval is obtained.
    • If some terms are not yet agreed, grant date is when all terms are agreed.

VALUATION

Key Inputs to Option Pricing Models

  • Expected term
    • Takes into account early exercise
    • Analyze historical exercise behavior for similar group of recipients and option terms.
    • For plain vanilla share options, companies without sufficient historical data to make reasonable estimates typically apply SAB Topic 14’s Simplified Method
      • Expected term = (time to vest + time to maturity) / 2
      • For multiple vesting tranches, average across the expected terms of each tranche to get a single expected term
      • This cannot be applied if a performance condition is improbable of being achieved because then it is not clear what the vesting time is.
  • Expected volatility
    • Annualised standard deviation of the continuously compounded rates of return on the share over the most recent period that is generally commensurate with the expected term of the option.
    • For newly listed entities, use historical volatility for the longest period for which trading activity is available. Also consider historical volatility of similar entities following a comparable period in their lives.
    • For unlisted entities, use historical/implied volatility of similar listed entities or historical volatility of basis of valuation (e.g. NAV)
  • Expected dividends
    • If employees are entitled to dividends on the underlying shares between grant date and exercise date, expected dividends should be zero (if dividends is non-zero then you are penalising the employee for not receiving the dividends).
    • If employees are not entitled to dividends, expected dividends should be included. For share grants, the value should be reduced by the present value of the expected dividends during the vesting period.
  • Risk-free rate
    • Yield on zero-coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term.

Taking Dilution into Account

When Markets Are Efficient

  • When markets are efficient, as soon as the issuance is announced, the stock price will adjust to reflect potential dilution from all outstanding warrants and stock options, hence dilution does not need to be taken into account in the warrant valuation.
  • For initial stock price in valuation, just use the stock price after announcement.

Incorporating Dilution When There is No Efficient Market

  • Given
    • W = warrant fair value
    • N = original number of outstanding shares
    • M = number of outstanding European options
  •  Conditions
    • That there is only one warrant issue
    • (Value of warrants + common equity) is assumed to be lognormal
  • Value of warrant W= N / (N+M) * Value of regular call option, where
    • If a company issues warrants at fair value, the total equity value increases by M * W, initial equity value per share S is replaced by [S + (M/N) * W]
    • If a company issues warrants for free, the total equity value remains the same but the common equity value would drop by the value of the warrants issued, so original S remains unchanged.
    • Volatility is the volatility of total equity (i.e. common shares + warrants)

Relationship Between Equity Volatility and Common Stock Volatility

  • Given
    • E = value of total equity
    • S = value of common stock
    • Delta of common stock = 1 – delta of warrant
    • Delta of warrant = M / (N+M) * N(d1)
    • N(d1) = Delta for call option on total equity with total equity volatility
  • Volatility of common stock = Delta of common stock * (E/S) * Volatility of total equity
  • Warrants have higher volatility than common stock.

OTHERS

Deferred Tax Implications

  • Some jurisdictions gives a tax allowance for share-based transactions. A Deferred Tax Asset is recognised only if there are sufficient future taxable profits available.
    • Value of the deferred tax asset = Total intrinsic value of all options (i.e. market price – exercise price) * Tax rate * (Reporting Date – Grant Date) / (Vesting Date – Grant Date)
    • See note on IAS 12 for more details.

Situations involving Parent and Subsidiary

  • If a Parent grants rights (to the Parent) to the employees of its Subsidiary, the Parent has the obligation to provide the equity instruments. The Sub will account for it as an equity settled transaction, with the increase in Equity recognised as a contribution from the Parent.
  • If a Sub grants rights (to the Parent) to the Sub’s employees, the Sub has the obligation to provide the equity instruments. The Sub will account for it as a cash settled transaction.
  • Guidance for other situations is provided in IFRIC 11.

-END-

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