Chapter 4: Impact of vesting and non-vesting conditions

Vesting condition – definition

Appendix A of IFRS 2 defines a vesting condition as “a condition that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. A vesting condition is either a service condition or a performance condition”.

This definition is clear that vesting conditions are restricted to only service conditions and performance conditions. A market condition is a type of performance condition.

A share-based payment vests when the counterparty’s entitlement to it is no longer conditional on future service or performance conditions. Therefore, restrictive conditions such as non-compete provisions and transfer restrictions, which apply after the counterparty has become entitled to the share-based payment, are not vesting conditions.

Service condition – definition

Appendix A of IFRS 2 defines a service condition as “[a] vesting condition that requires the counterparty to complete a specified period of service during which services are provided to the entity. If the counterparty, regardless of the reason, ceases to provide service during the vesting period, it has failed to satisfy the condition. A service condition does not require a performance target to be met”.

The vesting period is “[t]he period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied”.

Performance condition – definition

Appendix A of IFRS 2 defines a performance condition as follows.

A vesting condition that requires:

(a) the counterparty to complete a specified period of service (ie a service condition); the service requirement can be explicit or implicit; and

(b) specified performance target(s) to be met while the counterparty is rendering the service required in (a).

The period of achieving the performance target(s):

(a) shall not extend beyond the end of the service period; and

(b) may start before the service period on the condition that the commencement date of the performance target is not substantially before the commencement of the service period.

A performance target is defined by reference to:

(a) the entity’s own operations (or activities) or the operations or activities of another entity in the same group (i.e., a non-market condition); or

(b)the price (or value) of the entity’s equity instruments or the equity instruments of another entity in the same group (including shares and share options) (i.e., a market condition).

A performance target might relate either to the performance of the entity as a whole or to some part of the entity (or part of the group), such as a division or an individual employee.”

Therefore, a performance condition (which is a vesting condition) must involve both a service condition and a performance target. A performance target with no related service condition is a non-vesting condition. A performance target that extends beyond the service period is also a non-vesting condition.

It should be noted, however, it is not necessary that there be a demonstrable correlation between an employee’s responsibility and a performance target for that target to be a performance condition.

Examples of performance conditions include the vesting of options based upon:

• the total shareholder return (TSR) of the entity, either in absolute terms or relative to a comparator group or index (market-based);
• meeting a specific target share price (market-based); or
• levels of revenues (non-market-based).

A target based on the performance of a share market index (e.g. a stock exchange index required to reach a specified target) is not a performance condition; it is a non-vesting condition. This is the case even if the entity’s shares form part of the share market index. This conclusion is based on the fact that a share market index not only reflects the performance of the entity but also the performance of other entities outside the group.

Market condition – definition

Appendix A of IFRS 2 defines a market condition as “[a] performance condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price (or value) of the entity’s equity instruments (or the equity instruments of another entity in the same group), such as:

(a) attaining a specified share price or a specified amount of intrinsic value of a share option; or

(b) achieving a specified target that is based on the market price (or value) of the entity’s equity instruments (or the equity instruments of another entity in the same group) relative to an index of market prices or equity instruments of other entities.

A market condition requires the counterparty to complete a specified period of service (ie a service condition); the service requirement can be explicit or implicit”.

[Para 19]

In contrast, vesting conditions that are not market conditions are not taken into consideration when determining the grant date fair value of an award. Instead, they are taken into consideration when estimating the number of awards that will vest. So, on a cumulative basis, no amount is recognised for goods or services received where an award does not vest, because a specified non-market vesting condition has not been met.

As a result, the IFRS 2 expense can change during the vesting period, depending on changes in expectations.

[Para 21]

The treatment of vesting conditions (see paras 13.35–13.41 for descriptions of vesting conditions) will vary according to whether they relate to the market price of the entity’s equity instruments. Such conditions (which IFRS 2 calls ‘market conditions’) are taken into account when determining the grant date fair value of the equity instruments granted. They are ignored for the purpose of estimating the number of equity instruments that will vest.

Non-vesting conditions are taken into account when determining the grant date fair value of the equity instruments granted.

What is Reload Feature?

Some share options contain a reload feature. This provides for an automatic grant of additional options (‘reload options’) whenever the option holder exercises previously granted options using the entity’s shares (rather than cash) to satisfy the exercise price.

Like vesting conditions, the existence of a reload feature might influence the value of the option to the holder, but it is not considered when estimating fair value. Instead, a reload option is accounted for as a new option grant when it is granted.

Exception to fair value measurement

It is normally possible to estimate the fair value of equity instruments granted. There might be rare situations in which fair value cannot be reliably estimated. In these circumstances, IFRS 2 requires the following approach:

• The equity instruments granted should be measured at their intrinsic value on the following dates: initially; at each reporting date; and at the date on which the award is finally settled. For a grant of share options, the award is finally settled when the options are exercised or forfeited, or when they lapse. Any change in intrinsic value is recognised in the statement of comprehensive income.
• The amount recognized as an expense should be based on the number of equity instruments that ultimately vest or, in the case of options, are ultimately exercised.

The fair value of cash-settled share-based payment transactions is measured using the same principles as for measuring equity-settled transactions:

• The objective is to measure the goods or services acquired and the liability incurred at fair value (as defined in IFRS 2, not IFRS 13).
• Fair value can be determined using an option pricing model (taking into account the terms and conditions of the award).
• The goods or services are recognised when they are received by the entity.

Measurement of cash-settled share-based payment transactions

On 1 January 20X5, an entity grants 1,000 share appreciation rights (SARs) to each of its 40 management employees. The SARs provide the employees with the right to receive (at the date when the rights are exercised) cash equal to the appreciation in the entity’s share price since the grant date. All of the rights vest on 31 December 20X6; and they can be exercised during 20X7 and 20X8. Management estimates that, at grant date, the fair value of each SAR is C11; and it estimates that 10% of the employees will leave evenly during the two-year period.

The fair values of the SARs at each year-end are shown below:

Year	Fair value at year end
31 December 20X5	12
31 December 20X6	8
31 December 20X7	13
31 December 20X8	12

10% of employees left before the end of 20X6. On 31 December 20X7 (when the intrinsic value of each SAR was C10), six employees exercised their options; and the remaining 30 employees exercised their options at the end of 20X8 (when the intrinsic value of each SAR was equal to the fair value of C12).

The amount recognised as an expense in each year (and as a liability at each year-end) is as follows:

Year	Expense	Liability	Calculation of liability
	C	C
31 December 20X5	216,000	216,000	36 × 1,000 × 12 × ½
31 December 20X6	72,000	288,000	36 × 1,000 × 8
31 December 20X7	162,000	390,000	30 × 1,000 × 13

Expense comprises an increase in the liability of C102,000 and cash paid to those exercising their SARs of C60,000 (6 × 1,000 × 10). 31 December 20X8 (30,000) 0 Liability extinguished.

Previous cost reversed, because cash paid to those exercising their SARs of C360,000 (30 × 1,000 × 12) was less than the opening liability of C390,000. For cash-settled transactions, it can be more difficult to understand the difference between the fair value of a right and its intrinsic value.

In the previous example, the fair value of each right at 31 December 20X7 was C13. But the amount paid to each employee who exercised rights on that day was only C10 (that is, the intrinsic value). The reason for the higher fair value is the same for cash-settled transactions as for equity-settled transactions.

The fair value of each SAR at 31 December 20X7 is made up of its intrinsic value (reflected by the current market price of the entity’s shares) and its time value. The time value reflects the fact that the holders of the SARs have the right to participate in future gains. At 31 December 20X8, all of the outstanding SARs should be exercised; as a result, holders have no right to participate in future gains. So, the fair value (C12) at that date is made up entirely of the intrinsic value.

Before IFRS 2, some territories might have measured the cash-settled share-based payment using the intrinsic value. But IFRS 2 requires measurement at fair value; so, territories changing to IFRS need to re-measure liabilities. Although the IASB considered using intrinsic values to measure cash-settled share-based payment transactions, it concluded that such a method was not consistent with the overall fair value objective of its share-based payment standard.

Note:

• Non-vesting conditions and market conditions are included in the estimate of fair value, and service or non-market vesting conditions are included in the estimate of the number of awards expected to vest.
• The fair value of the liability for cash-settled transactions is re-measured at each reporting date and at the date of settlement. Any changes in fair value are recognised in profit or loss for the period. Equity-settled awards are not re-measured after the grant date.

Expense relating to a cash-settled award

A question could arise as to whether the expense relating to a cash-settled award should be split between the value of the services received (based on the grant date fair value); and the movement as a result of changes in the liability’s fair value.

Our view is that the full movements in the liability are employee-related during the vesting period; so, the full movement should be employee compensation. After vesting, the movements could be taken to finance costs or continue to be shown as employee costs; this is because there is no longer a link to employee service. This policy choice should be applied consistently.