1. Prepared by: Sara Alsarghali 1

2. Introduction The use of share-based payments to compensate managers and other employees has increased over time and can be attributable to the attempts to 1) Overcome agency problem by better aligning employees interest with those of shareholders. 2) Attract and retain employees while conserving cash as company will pay lower fixed salaries. 3) Increase reported income. Although options are expense, old accounting treatment allowed non recognition against profit 2

3. Share Options Share option is a call option that allows the holder to purchase a specific number of shares at a specific price at a specific date if the option is vested. Terminology : Grant date: The date at which the employees are granted the option to purchase the shares at a future point in time. Vesting date: the date at which the employee qualify for the option. This date follows the vesting period (the period during which employee satisfies conditions) Exercise date: the date at which the employees can exercise their options. 3

4. Share Options Originally, when share-options were used to compensate managers, there were no reliable way to value the option as the option pricing theory was not yet founded. So, accountant used the intrinsic value method Under intrinsic value method, companies have to compare between the market price of the share at the grant date and the exercise price. If Exercise price < market price. Then the option is said to be (in the money) and the company should charge the difference to income at the grant date. If Exercise price> Market price. The option is said to be (out of the money) and the company will not record any thing. 4

5. Change in Accounting Treatment Increased use of share-based payments, made many question the validity of the accounting treatment of (zero value) assumption The disparity between managers compensation and actual performance especially after the accounting scandals, caused public outrage on those compensation. Therefore, reconsideration of accounting treatment was need. 5

6. Share options accounting treatment under IFRS 2 The IASB issued IFRS 2 share-based payments that covers all share-based payments both cash and equity settled. Under this standard the company must recognize a compensation expense that is charged against income. We will only cover equity-settled share based payment and more specifically share options. 6

7. Share options accounting treatment under IFRS 2 Compensation expense should be allocated through out the service period. The value of the option is its fair value at grant date. ( this can be calculated using an option pricing model such as Black -Schole). Any subsequent changes in market values are not considered. If non-market conditions are not met (such as the length of service or the level of earning per-share),options do not vest and no compensation expense should be recognized. Market conditions are already considered in calculating the fair value of the option at the grant date. The expense is recognized whether market conditions are achieved or not. 7

8. Share options accounting treatment under IFRS 2 (explanation of entries) At Grant date : No Entry At the end of first year of service: Dr. Compensation expense (total fair value of options*(1/service period)) Cr. share premium-share option  Total fair value of options=value of the option at grant date*number of employees* number of options each 8

9. Share options accounting treatment under IFRS 2 At the end of the 2 nd year Dr. Compensation expense (total fair value of option expected to vest* 2/service period)-accumulated compensation expense previously recognized Cr. share premium-share option  All following service periods will have the same entries following the same technique of calculation. 9

10. Share options accounting treatment under IFRS 2 During exercise period: If exercised Dr. Cash ( exercise price* number of shares exercised ) Dr. Share premium-share options ( fair value of options exercised ) Cr. share capital ordinary( par value *number of shares exercised ) Cr. share premium-Ordinary ( balancing figure )  If not exercised Dr. share premium –share option ( fair value of shares expired ) Cr. Share premium- share option expired 10

11. Example 1: Grant where the number of equity instruments expected to vest varies Seers Company grants 100 share options to each of its 50 employees. Each grant is conditional on the employee working for the company for the next 3 years. The fair value of each share option is estimated at $25. On the basis of a weighted average probability, the company estimates that 10% of its employees will leave during the 3-year period and therefore forfeit their rights to the share options. 11

12. Example 1 ( continued) During the year immediately following grant date (year 1) three employees leave, and at the end of year 1 the company revised its estimate of total employee departures over the full 3 year period from 10%(5 employees) to 16% (8 employees). During year 2 a further 2 employees leave, and the company revised its estimate of total employee departures across the 3 year period down to 12% (six employees). During year 3 a further employee leaves 12

13. Example 1 Solution Grant date : No entry Calculation of compensation expense year 1: Expense= number of employees *share option each* % of employees expected to stay with the company * fair value of options at grant date *1/vesting period Expense= 50 * 100* 84% *25*( 1/3)= 35000 Dr. compensation expense 35000 Cr. Share premium –share option 35000 13

14. Example 1 Solution ( continued) Compensation expense Year 2= (50*100*88%*25*(2/3)) - 35000 Compensation expense year 2 =73333- 35000=38333 Dr. Compensation expense 38333 Cr. Share premium share option 38333 14

15. Example 1 Solution ( continued) Expense year 3= (44*100*25) - 73333 Expense year 3= 110000-73333= 36667 Dr. Compensation expense 36667 Cr. Share premium- share option 36667 15

16. Example 2:Grant with a performance condition linked to earnings Example 2: At the beginning of year 1 Benning Ltd. grants 100 share options to its 50 employees conditional on the employee remaining in the company during the 3- year vesting period. The share options have a fair value of $20 each at grant date. Additionally, the vesting conditions allow the options to vest at the end of: * Year 1 if the company's earnings have increased more than 18% * Year 2 if earnings have increased by more than 13% averaged across the 2-year period. * Year 3 if earnings have by more than 10% averaged across the 3-year period 16

17. Example 2 (continued) By the end of year 1, Benning Ltd's earning have increased by only 14% and three employees have left. The company expects that earnings will continue to increase at a similar rate in year 2 and shares will vest at the end of year 2. It also expects that a further 3 employees will leave during year 2. So the expense in year 1 is: Compensation Expense year 1 =(50-6) *100*20 *1/2= 44000 17

18. Example 2 (continued) By the end of year 2 the company's earnings have increased by only 10%, resulting in an average of 12 % and so the shares do not vest. Two employees left during the year. The company expects that another 2 employees will leave during year 3 and its earnings will increase by at least 6% thereby achieving the average of 10% per year. So the expense in year 2 is: Compensation expense=(( 50-7)*100*20*2/3)- 44000=13333 18

19. Example 2 (continued) Another 3 employees leave during year 3 and the company's earnings have increased by 8% resulting in an average increase of 10.67% over the 3-year period. Therefore, the performance condition has been satisfied. So the expense in year 3 is Compensation expense= ((50-8)*100*20)-(44000+13333)=26667 19

20. Example 3:Grant with a market condition At the beginning of year 1 Smallville Ltd grants 5000 share options to a senior executive, conditional on that executive remaining in the company’s employ until the end of year 3. The share options cannot be exercised unless the share price has increased from $10 at the end of year 1 to above $25 at the end of year 3. The share price options can be exercised any time during the next 7 years ( that is by the end of year 10). The company applies an option pricing model that takes into account the possibility that the share price will/will not exceed $25 at the end of year 3 and result in a fair value estimate of $9 per option. The executive completes the 3 year service period with the company. 20

21. Example 3 (continued) Year1 Expense= 5000*9*1/3=15000 Year 2 expense= (5000*9*2/3) -15000=15000 Year 3 expense=(5000*9)-30000=15000  Expense is recognized whether market conditions are met or not. 21