Accounting for Share-Based Payments under IFRS

by Shn 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 companys 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 companys 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.

2.
3.

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.
Determine the grant-date fair value of the award, modified if necessary to reflect any market or
nonvesting conditions identified.
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
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expected. Accountants PricewaterhouseCoopers are quoted as saying in respect of FTSE 350 companies:
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

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PricewaterhouseCoopers are further quoted as saying, FTSE 250 technology companiesincurred

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 companys 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 companys
TSR over the vesting period and that of a group of, say, 11 peer group entities. If the companys 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 companys 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 employeefor 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 Kingdomthe save as you earn (SAYE) schemeunder 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.

Determination of the Grant-Date Fair Value of the Award

For awards of shares rather than share options, determination of grant-date fair value is easiest when the
shares are listed and actively traded, and there are no market or nonvesting conditions. In such cases, the
grant-date fair value is simply the quoted price of the equity, adjusted if appropriate for dividends that may be
foregone during the vesting period.
Determination of grant-date fair value is complicated if there are market conditions. In such cases, the value
of the shares awarded will be higher if the award vests than if the award does not vest, and this must be
factored into determination of the fair value of the award at grant date. The method used most often in such
cases to arrive at a value is Monte Carlo simulation, although its application requires a good understanding
of statistical distributions.

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If the award comprises unlisted shares, a valuation technique will need to be applied to value the unlisted
shares at the grant dateagain an adjustment will be required in respect of any anticipated dividends during
the vesting period.
If share options rather than shares are the subject of the award, an option pricing model will be required
to determine their fair value at grant date. IFRS 2 refers to the Black and Scholes model and the binomial
model. Although these models are both based on the same underlying share price theory, the Black and
Scholes model is formulaic, whereas the binomial model assumes that share prices follow a series of small
steps. In practice, the Black and Scholes model tends to be easier to apply but is less flexible than the
binomial model.
The inputs to each model are the same and comprise the following:

share price on the grant date;

exercise price of the option;
life of the option;
risk-free interest rate over the life of the option;
dividends expected over the life of the option;
expected volatility of the underlying share price over the life of the option.

The most difficult of these inputs to estimate is the expected volatility, which is a measure of the extent to
which the companys share price is expected to go up or down in successive periods.
When the IASB first made clear that option pricing would be necessary in financial statements, there was
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considerable comment that this could cause difficulties. The Financial Times noted in an article in 2005:
The details of IFRS require companies to use complex mathematical models to calculate the fair value of
options.

Truing Up the Profit and Loss Charge in Respect of Expected Achievement of

Nonmarket Conditions
As noted earlier, the grant-date fair value is charged to the profit and loss account only to the extent that
vesting conditions that are not market conditions are achieved over the vesting period. Thus, at the end of
each reporting period after the grant date, an estimate is required of the extent to which any such conditions
will be satisfied.

Case Study
Example of Service Period Conditions and Truing-Up of Profit and Loss Account Charges
Suppose that an entity with a December 31 year-end granted one share option to each of 150 staff on
January 1, 2006, that the options had a grant-date fair value of $3, and that there was a three-year service
period condition with no other vesting or nonvesting conditions.
At December 31, 2006, company management expected that two-thirds of the staff would still be employed
by them on the vesting date of December 31, 2008, and, hence, that the award would vest for 100 of their
staff. Thus, the expected cumulative charge in the profit and loss account over the three-year period would
be 100 $3 = $300.
This $300 would be spread over the three years and, hence, a charge of $100 would be made in the profit
and loss account for the year to December 31, 2006.
At the following year-end, December 31, 2007, company management expected that 80% of the original
150 staff would still be employed on December 31, 2008, and hence that the award would vest for 120 staff.
Thus, the expected cumulative charge over the three-year period would be trued up to 120 $3 = $360.
This expected cumulative charge of $360 would be spread over the three years and, hence, the cumulative
charge after two years would be $240. As $100 was charged to the profit and loss account in the year to

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December 2006, the balance of $140 would need to be charged to the profit and loss account in the year to
December 2007.
Finally, at December 31, 2008, management found that exactly 100 of the original 150 staff were still
employed. Hence, the award would have vested for 100 staff. Thus, the required cumulative charge for three
years would have finally trued up to $300. However, $240 had been charged cumulatively in 2006 and 2007
and, hence, the remaining balance of $60 would have to be charged to the profit and loss account in 2008.

Making It Happen
There are really two stages to reporting under IFRS 2.
1.
2.

The modified grant-date fair value of the award has to be determined.

This fair value has to be charged to the profit and loss account over the vesting period of the award
according to the extent that nonmarket conditions are expected to be achieved.

The first step is the more complex and may require use of an option pricing model for share options or a
valuation technique for unlisted shares. The second step is less complex but may require some clear thinking
and a carefully constructed Excel spreadsheet, especially if there are significant numbers of staff involved or
the actual and expected achievement of nonmarket vesting conditions to reflect.

Conclusion
Although initially many preparers of accounts were concerned about the implications of the introduction of
IFRS 2, most companies have now adjusted to the standard. Some companies have in-house staff able to
perform the complex option pricing calculations, while others use external valuation consultants.

More Info
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

Notes
1 Company profits hit by IFRS 2 rules. Financial Times (September 18, 2006).
2 Ibid.
3 IT companies fear effect of IFRS stock option rules. Financial Times (August 11, 2005).

See Also
Best Practice

Accounting and EconomicsCritical Perspectives

Accounting for Business Combinations in Accordance with International Financial Reporting Standards
(IFRS) Requirements

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Effective Financial Reporting and Auditing: Importance and Limitations

The Rationale of International Financial Reporting Standards and Their Acceptance by Major Countries

Understanding the Requirements for Preparing IFRS Financial Statements

Checklists

Calculating Total Shareholder Return

International Financial Reporting Standards (IFRS): The Basics

Key Accounting Standards and Organizations

The Ten Accounting Principles

Finance Library

Financial Accounting and Reporting

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