Section 26 Share Based Payment Presented by Robert Kirk

Note Worthy Similar to full IFRS and FRS 20 Relates to consideration for goods and services Does not relate to shares issued for cash or for acquisition of subsidiaries, associates or JVs.

A Share Based Payment is a transaction in which an Entity: Issues a fixed number of equity instruments (shares or options) in return for goods or services received (Equity settled) or Incurs a liability for an amount that is based on the entity’s share price for goods or services received from a supplier (Cash settled)

Option for Equity or Cash Settlement Share based Payments Equity Settled Direct Method Cash Settled Indirect Method Option for Equity or Cash Settlement

Value Goods/Services (direct method) Equity Settled Value Goods/Services (direct method) Attribute the value of the Goods/Services to the Equity issued If cannot value Services, value the Equity Attribute the Value of the Equity to the Services received . The value of the Goods & services / Equity is fixed at the original price.

Equity Settled Default Attribute the Fair Value of the Goods and services to the Equity. If not possible to value Goods & Services Value the Share or Share Option (Equity) at fair value, & attribute this value to the Goods & services No further changes to Equity or Goods/services Fair Value of the Share/option stays at the original fair value at the date of the initial agreement.

Example – Equity settled Company purchases Building (Fair Value of $5ml) and issues 5 million shares (Fair Value $1.10 per share) as the consideration. Equity Settled Value the Goods & services first @ $5ml Attribute same value to Equity. $5ml

Equity Settled – cannot value services Company awards bonus to CEO for 2009 performance. Bonus 200,000 shares at Market value of $5 / share. Equity settled – default is to value the services. Not Possible, so value the Equity @ Fair Value. & attribute this value to the services. Equity Issued $1ml Employee Costs $1ml

Fair Value of Shares - Hierarchy If an observable market price is available for the equity instruments granted, use that price, If an observable price is not available, measure the fair value of the equity instruments granted using entity specific observable market data such as; A recent transaction in the entity’s shares A recent independent fair valuation of the entity or its principal assets. If an observable market price is not available, and obtaining a reliable measurement of Fair Value under (b) is impractical, indirectly measure the fair value of the shares using a Valuation method that uses market data to the greatest extent practicable

Value the Liability (indirect method) Cash Settled Value the Liability (indirect method) Value the Goods/Services at the same value This Liability will change as the Share Price changes. The adjustment is w/off to the Income statement

Cash Settled – Valuing the Liability Attribute the Fair Value of the Liability at the date the Obligation arises to the Goods & Services. Liability is equal to: Agreed number of shares x Share Price at the date obligation arises. Subsequent changes Changes to the Liability that arise because of the change in Share Price are recognized in the Income Statement. The Goods & expenses remain at the original price.

Cash Settled Share-based payment Company purchases Building and agrees to pay for it in 1 years time, at the cash equivalent of 1million shares at that date. Fair Value of Building $5.00 ml Fair Value of shares $5.20 ml Fair Value of shares increases to $5.5 in yr 1 Accounting Treatment Value the Liability & give same value to asset Liability 5.20 PPE 5.20 m Year 1, liability increases to 5.5 & P&L expense 0.30m (PPE remains the same)

When to recognise the transaction? An asset or expense to be recognised when the goods services are received. (Not when the shares are vested or liability paid.) Recognition of the expense may be immediate or Spread over the vesting period. (Depending on when services are deemed to be received)  

The Nature of Share Options In an Employee Share Option Scheme, in Return for services rendered or to be rendered, an Employee is given the right to subscribe for new shares in the company at a future date, at a favourable price, that is usually fixed when the share options are awarded.  

Definitions An Option A right without an Obligation Grant Date Date the Share Options are awarded Vesting Period Period between Grant date to Vesting Date

Definitions Vesting Date When conditions are met, the entitlement to new shares becomes Unconditional   Vesting Conditions There are often some conditions attached to the right of the employee to exercise the options & acquire the new shares.

Two Types of Vesting Conditions Performance Conditions Employees must stay in the employment for a number of years. Employee must met performance targets   Market Conditions Usually relates to Equity price performance

Valuing Employee Services Share Options granted to Employees are “Equity settled” transactions. Accordingly, the default method of valuing the transaction is to attribute the Value of the Services to the Share Options. In this case, it is not possible to reliably value the Services, so that the “Indirect method” is used, where the Fair Value of the Share Options are used

Valuing Employee Services The Share Options are valued at the Grant Date (remain fixed for the transaction). The total cost of the Services is the ultimate number of share options that vest at the end of the vesting period.

Expense in Income Statement The Total Cost is allocated to the Income Statement equally over the vesting period based on the best estimate of options expected to vest. Each year, there will be a correction for the over/under estimate of the preceding year automatically built into the current year’s cost.

Grant Value – Performance Conditions The Value of the option at the grant date should not take into account the possibility of employees meeting the Performance Conditions. This will be taken into account at the end of each year when the “Number of employees expected to satisfy Performance Conditions” is estimated

Example A Company Share Option Scheme 1,000 share options granted to each of its 200 employees. Each grant is conditional on the employees working at least three years. The Value of the option at the Grant Date is Euro 12 per option.

Question cont’d Employees to meet Performance Conditions  At end of year 1, company expects 75% of employees to stay 3 years At end of year 2, the company revises this to 85% At end of year 3, 162 employees met the condition Required Calculate Expense & Equity Reserve for Years 1,2, & 3

Solution –Year 1 Year 1 no of options 1000 grant value x $12 Employees granted options x 200 % expected to meet condition x 75% Total Expected cost $ 1,800,000 Allocate 1/3 at year 1 $1,800,000/ 3 Expense in P&L = 600,000, Equity Reserve = 600,000

Solution – Year 2 Year 2 no of options 1000 grant value x $12 Employees granted options x 200 % expected to meet condition x 85% Total expected cost $ 2,040,000 Allocate 2/3 at year 2 $ 1,360,000 Expense in P&L = 760,000 (1,360,000 – 600,000) Equity Reserve = 1,360,000

Solution – year 3 Year 3 no of options 1000 grant value x $12 Employees granted options x 200 % expected to meet condition x 81% (162) Final cost $ 1,944,000 Allocate 3/3 at year 3 $ 1,944,000 Expense in P&L = 584,000 (1,944,000 -1,360,000 ) Equity Reserve = 1,944,000

Failure to satisfy Market Conditions Market Conditions relate to the performance of the Share Price. The shares do not vest because the Share Price does not reach the specified figure. The Grant Value at the outset must reflect the probability of the market conditions being met

Failure to satisfy Vesting Market Conditions   The likelihood of or the actual failure to meet Market Conditions subsequently does not effect the cost of the service or expense recognised in the Accounts. The possibility of this happening is already reflected in the Share Option price at the Grant date.

Market Conditions If it seems unlikely over the vesting period that the target will not be met, it does not effect the expense & equity increase recognised in the accounts   The only matter that effects the expense in the accounts is the number of options that will vest based on Service and Performance Conditions

Market Conditions -example CEO is granted 100,000 share options, If he remains in the company for 3 years. If the Share Price exceeds the current price by 50%. The Grant Value is determined to be $10 per option taking into account the probability of achieving the target Share Price, but not taking the performance condition into account.

Market Conditions -example The Share price dives because of poor results and at year 1& 2, it does not appear likely that the Options will vest. At the end of year 3, the Share price has not recovered. The CEO is still employed by the Company. Required; Show the expense in the Income Statement and the Equity Reserve in the SOFP at end of year 1,2,3

Market Conditions -Solution Year 1, 1,000,000 /3 x1= $ 333,333 Year 2, 1,000,000 /3 x2 =$ 666,667 Year 3, 1,000,000 /3 x3 =$1,000,000 The expense is still recognized regardless that the Options will not vest due to Market Condition.

Amendments to Options   An entity may modify the terms and conditions on which the Equity Instruments are granted. For example, It may reduce the exercise price of the options (price employee has to pay for the shares) which increases the fair-value of the share options

Accounting consequences? The cost of the original scheme will not change, as a result of the modification. The only reason for changing that cost will be the number of shares that vest based on performance conditions.

Cost of Modification No cost, if the Fair Value of the option decreases as a result of the modification. However, the entity shall recognise the effects of modifications that increase the total fair value of the share option. Calculate an additional cost based on the increase of the value of the options. (value after the modification – value immediately before the modification)

Practical Example A Company grants 1,000 share options to each of its 200 employees. Each grant is conditional on the employees working at least three years. The Value of the option at the Grant Date is Euro 12 per option  At end of year 1, company expects 75% of employees to stay 3 years At end of year 2, the company revises this to 85% At end of year 3, 162 employees met the condition

Modification Details The modification takes place at the start of Year 2 The Fair Value of the option has dropped to 2 euro immediately before the modification. (This happens because the Share Price has reduced significantly). The modifications result in the Fair Value of the option immediately increasing to 5 euro.

Extra cost of modification Year 2 1000*3*200 Employees* 85% * 1/2 = 255,000 Expense in P&L = 255,000 Equity Reserve = 255,000 Year 3 1000*3*162 Employees *2/2 = 486,000 P&L = 486,000 – 255,000 = 231,000 Equity at end of year 3 = 486,000 Increase in Value from revision

Termination or early settlement of Share Option Scheme If the company terminates or settles the scheme early, the Cost should be recognized immediately based on the compliance with the performance conditions at the date of termination or settlement. If the company has to pay cash to settle the Scheme, the cash is set off against the Equity reserve and if the Reserve is not sufficient, the surplus is written off to the Income Statement.

Share Appreciation Rights Employees become entitled to a future cash payment based on the increase in the entity’s share price from a specified level over a specified period of time. This is a “Cash settled” Share Based Payment. Therefore, it must be valued at the Fair Value of the liability at the end of each period.

Annual cost of Share Appreciation Rights The entity shall recognise the services received, and a liability to pay for those services, as the employees render those services. Same method of allocation of the cost to the Income statement (as for Share Options) except that the SARs value change annually. (The Share Option Grant price does not change)

Example of SARs A Company grants 1,000 SARS to each of its 200 employees. Each grant is conditional on the Employees working at least three years. The Value of the SAR; Year 1= 5, Year 2 = 6, Year 3 = 7   At end of year 1, company expects 75% of employees to stay 3 years At end of year 2, the company revises this to 85% At end of year 3, 162 employees met the condition

Solution to SARs Year 1 1000*5*200 Employees* 75% * 1/3 = 250,000 SAR price changes annually Year 1 1000*5*200 Employees* 75% * 1/3 = 250,000 Expense in P&L = 250,000, Liability = 250,000 Year 2 1000*6*200 Employees* 85% * 2/3 = 680,000 Expense in P&L = 680,000 – 250,000 = 430,000 Liability= 680,000

Solution to SARs Year 3 1000*7*162 Employees * 3/3 = 1,134,000 SARS price changes annually Year 3 1000*7*162 Employees * 3/3 = 1,134,000 Expense in P&L = 1,134,000 – year 2 cuml 680,000 = 454,000 Liability at end of year 3 = 1,134,000

Differences between SARs & Share Options Share Option is priced at the Grant Price at the outset & never changes. SARS change based on Share Price movement annually. In times when Share Prices are increasing, the SARs will reflect a higher cost in the P&L

Entity has the choice of Settlement? Equity Settled or Cash Settled Cash Settled; The entity shall determine if it has a present obligation to settle in cash and account for the Share based payment transaction accordingly. Get Fair Value of the liability and measure transaction this way.

Obligation to settle in cash The entity has an obligation to settle in cash if The choice of settling in shares has no commercial substance or The entity has a past practice or a stated policy of settling in cash or Generally settles in cash when a Third Party asks for cash

Equity Settled If no such obligation exists, the entity shall account for the transaction as an Equity settled share based payment transaction. Get Fair Value of the goods or services & measure the transaction accordingly. (If fair value can be ascertained)

3rd Party has choice of settlement If the entity has granted the 3rd party the right to choose whether a Share Based Payment is settled in cash or by issuing equity instruments, the entity has granted a “compound financial instrument “ which includes a Debt Component (right to demand payment in cash) & Equity Component (right to demand settlement in Equity Instruments)

Valuation of Debt & Equity Components For transactions with parties other than employees, in which the Fair Value of the goods & services received is measured directly, the Entity shall measure Equity component of the Compound Financial Instrument as the difference between The Fair Value of the Goods/Services received & The Fair Value of the Debt at the date the goods/services are received.  

Valuation of Debt & Equity Components Value Goods/Services Value Debt Balance is the value of the Equity Instrument  

Disclosures A description of each type of Share Based payment arrangement that existed at any time during the period, etc. The number and weighted average exercise price of share options for each of the following groups of options Outstanding at the beginning of the period Granted during the period. Forfeited during the period. Exercised during the period. Outstanding at the end of the period. Exercisable at the end of the period.

Disclosures For Equity settled share based payments, information about how it measured the fair value of goods and services received or the value of the equity instruments granted. For cash settled shared based payment arrangements, information about how it measured fair value. Total expense in the Income Statement. The total carrying amount at the end of the period for liabilities arising from Share Based Payments.