Modifications

An entity might modify the terms and conditions on which equity instruments were granted. The new or modified instruments are viewed as instruments in their own right under IFRS 2.

Examples of modifications

The principles of IFRS 2 apply to modifications that increase the fair value of equity instruments granted (such as reductions in the exercise price of options); and they also apply to other modifications that are otherwise beneficial to the employees.

Examples include:

• An increase in the number of instruments granted.
• A reduction in the vesting period.
• The modification or elimination of a performance condition.

Accounting treatment of modifications

The period over which the impact of a modification is recognised will depend on when it occurs and any vesting conditions that it imposes. For example, if the modification described (reduction in option exercise price) occurs during the vesting period, the incremental fair value granted is included in the measurement of the amount recognised for services received over the following period: from the modification date until the date when the modified equity instruments vest.

But IFRS 2 does not specify whether (in the case of a modification that reduces the vesting period) the change in vesting period should be accounted for prospectively or retrospectively. We believe that either approach is acceptable; and our reasons are set out.

Entities sometimes ‘rebase’ share-based payment awards by replacing existing tax-inefficient awards with a new award that is more tax efficient. Where the total fair value of an award is the same immediately before and after modification (irrespective of whether the change gives tax benefits to the entity or employee), this is treated as a non-beneficial modification (that is, the entity should continue to account for the original award as if the modification had not occurred). The accounting treatment of modifications to terms and conditions is considered further below.

Accounting treatment of modifications: existing options rolled into new award: reduction in exercise price

An entity has previously operated a share option award with an option exercise price of C15; this is equal to the market price of the shares at the grant date. Management decides to roll the options into a new award.

So, the entity cancels the original option plan and issues share options under the new award. The new options are granted at a lower exercise price of C12; this is because the market price of the shares has fallen to C11 since the grant date of the initial plan; as a result, the exercise price of the new options is now below the exercise price of the original options and, therefore, employees are more likely to exercise their rights.

The terms of the original options are otherwise the same (that is, they have the same exercise date). This would be treated as a modification, rather than as a cancellation and a new award.

This is because the entity has indicated that the new award replaces a cancelled award; and so, it is treated as if the original award had been modified. As a result, the entity should account for the incremental fair value of the new award (compared with the existing award) at the date of modification; and it would spread this amount over the vesting period of the new award. This would be in addition to the entity continuing to charge for the original award over the original vesting period.

Note that replacement awards are sometimes structured with similar terms to those of the original award; and so, it is possible that there would be no incremental fair value. If the entity had not identified the new award as a replacement award at the same date that the new options were granted, the cancellation and new award would be unrelated; in that case, the entity would need to accelerate the vesting of the original award and recognise immediately the amount that would otherwise have been recognised for services received over the remainder of the vesting period.

There would also be a fair value charge for the new award over the new vesting period.

Accounting treatment of modifications: reduction in option exercise price

On 1 January 20X5, entity A grants an award of 1,000 options to each of its 60 employees, on condition that the recipients remain in the entity’s employment for three years. The grant date fair value of each option is C5.

Towards the end of 20X5, entity A’s share price dropped; so, on 1 January 20X6, management chose to reduce the exercise price of the options. At the date of the re-pricing, the fair value of each of the original share options granted was C1; and the fair value of each re-priced option was C3. So, the incremental fair value of each modified option was C2.

At the date of the award, management estimated that 10% of employees would leave the entity before the end of three years (that is, 54 awards would vest). During 20X6, it became apparent that fewer employees than expected were leaving; so, management revised its estimate of the number of leavers to only 5% (that is, 57 awards would vest).

At the end of 20X7, awards to 55 employees actually vested. The amount recognised as an expense in each year is as follows:

Accounting treatment of modifications: increase in the number of options granted

The facts are similar to previous one, except that, instead of reducing the option exercise price on 1 January 20X6, the number of options to which each employee is entitled is increased to 1,500. The fair value of each of these additional options is C1. The amount recognised as an expense in each year is as follows:

Accounting treatment of modifications: reduction in the vesting period: prospective versus retrospective adjustment

On 1 January 20X6, entity B awarded 100 shares (with no entitlement to dividends during the vesting period) to an employee, on condition that the employee remained in service for three years. The fair value of each share at the award date was C6. On 1 December 20X6, entity B decided to reduce the service requirement from three years to two years; so, the vesting period was reduced to two years. It is assumed that the employee remains in service beyond 31 December 20X6. Any change to the vesting period has no impact on the fair value of the unvested shares, because no dividends are expected to be paid during the vesting period. We believe that entity B has a policy choice of retrospective or prospective treatment – in respect of accounting for modifications of equity-settled awards that reduce the vesting period, where the modifications occur part way through a reporting period.

Retrospective treatment

The modification could be accounted for retrospectively, to reflect the best estimate available (as at that date) of awards that are expected to vest. This is supported by paragraph 19 of IFRS 2, which states that “… the amount recognised for goods or services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest”. Where there is a change in estimate of the period over which the awards are expected to vest and that change occurs during the year, the cumulative expense could be ‘trued up’ at the balance sheet date, to reflect the best estimate of awards expected to vest as of that date. So, the expense each year (as a result of the modification) would be as follows:

Prospective treatment

Alternatively, the modification could be accounted for prospectively from the date of modification (that is, 1 December 20X6). Although paragraph 19 of IFRS 2 states that the expense should be recognised based on the best estimate available, it does not specify the point at which changes in those estimates should be accounted for. An analogy can be made with IAS 8, where a change in estimate is accounted for prospectively from the date of change. [IAS 8 para 36]. Accounting prospectively for the change in vesting period would also be consistent with the principle set out in paragraph B43 of IFRS 2 (where other types of modification are accounted for prospectively). In addition, where equity instruments do not vest until the counterparty completes a specified service period, the entity accounts for those services when they are rendered by the counterparty over the specified vesting period. [IFRS 2 para 15]. Before modification, employee services received as consideration were presumed to be received over a three-year period; and the expense would be recognised on this basis. When the vesting period is modified, the presumption changes from three years to two years; so, it would be appropriate to account for the modification prospectively; and the recognition of expense should be amended as follows:

Year Expense for the year Cumulative expense Calculation of cumulative expense C C 31 December 20X6 215 215 Original charge, 11 months to 1 December 20X6: 100 × C6× 1/3 × 11/12 = 183 Modification occurs 1 December 20X6. Expense over remaining 13 months to 31 December 20X7: 600 – 183 = 417 Expense for December 20X6: 417 / 13 = 32 Therefore, total expense for year to 31 December 20X6: 183 + 32 = 215

31 December 20X7 385 600 100 × C6 Whichever approach is followed, the policy should be clearly explained and consistently applied. Where vesting is conditional on an exit event of some kind (such as an IPO), the estimated time until the exit event should be reassessed at each reporting date; and adjustments should be made retrospectively.

Prospective treatment would not be appropriate; this is because any adjustment would be a change in estimate and not a modification.

Accounting treatment of modifications: reduction in the vesting period before resignation

On 1 January 20X5, entity C grants an award of 1,000 options to its finance director. The only condition associated with the award is that the director should remain employed by the entity for four years. The grant date fair value of each option is C40.

The entity expects the director to meet the service condition. On 1 October 20X6, the finance director informed the entity that he wished to take early retirement; and that, after serving his three-month notice period, he would resign from employment. The remuneration committee, in its ultimate discretion, made a decision in November 20X6 (that is, before the director failed to meet the service vesting condition by retiring) that entity C would still provide his award on termination of service. This would be accounted for as a beneficial modification (that is, a reduction in the vesting period) and a change in the number of options expected to vest.

It would not be viewed as a substantive forfeiture of the original award and grant of a new award. The amount recognised as an expense in each year is as follows:

Year Expense for the year Cumulative expense Calculation of cumulative expense C C 31 December 20X5 10,000 10,000 1,000 × 40 × 1/4 31 December 20X6 30,000 40,000 1,000 × 40

Accounting treatment of modifications: modification or cancellation

Due to an unexpected significant decline in entity D’s share price, management reduces the exercise price of an award from C50 to C20. At the same time, the number of options awarded is also reduced from 100 to 17. The 17 remaining options have the same total fair value as the 100 options immediately before the re-pricing.

The accounting for this can be viewed in two different ways. One view is that, for the options that remain, the treatment is the same as for a simple reduction in exercise price, and the other options are cancelled, so the recognition of the grant date fair value is accelerated in accordance with IFRS 2.

The other view, which we believe better reflects the economics of the situation, is that there is no change in the aggregate fair value of the award; so, there is neither an incremental fair value nor a cancellation.

As a result, any element of the grant date fair value of the original award will continue to be charged over the original vesting period. The accounting treatment to be applied to a reduction in the number of awards – and a corresponding (or greater) increase in the fair value of each award – is a judgement that will depend on the specific facts of each case and should be applied consistently.

Accounting treatment of modifications: re-priced options and extension of vesting period

Management grants 1,000 share options to employees in exchange for services. The exercise price is C10 per share. The grant date is 1 January 20X4; and the options are subject to a two-year vesting period. The grant date fair value of the options is C5,000; and all options are expected to vest at the end of the vesting period.

The options were modified on 1 January 20X5, by reducing the exercise price to C5 per share (that is, the current market value) and extending the vesting period by six months to 30 June 20X6. The fair value of the options at 1 January 20X5 was C1,000 before modification and C2,500 after modification. At the modification date, all options were expected to vest.

The original grant date fair value is recognised over the original vesting period. The expense for the year to 31 December 20X4 is C2,500 (C5,000 × 50%). The expense for the year to 31 December 20X5 is C3,500 (C5,000 × 50% plus the recognised incremental fair value of the modification of C1,500 × 66.7%). The incremental fair value is recognised over the vesting period from 1 January 20X5 to 30 June 20X6; 66.7% of this period had elapsed before the balance sheet date.

The incremental fair value is the difference between the fair value of the re-priced options immediately before and after the modification (that is, C2,500 less C1,000). The expense for the six months to 30 June 20X6 is C500 (C1,500 × 33.3%).

If an employee leaves during the six-month period to 30 June 20X6 (and so fails to meet the revised vesting condition), it is only the re-pricing impact that is reversed. The original grant date fair value expense of C5,000 is unaffected; this is because the employee satisfied the two-year service condition for the original award.

Accounting treatment of modifications: impact of rights issue and modification of share schemes

Entity F is planning a rights issue to offer shares at a 30% discount. The entity operates numerous share schemes. The employees in those share schemes will be worse off after the rights issue; this is because the market value of the shares will be reduced.

Entity F plans to modify the share schemes at a later date, to ensure that the awards granted to employees are uplifted to the equivalent value of the original award granted.

Management believes that the rights issue and subsequent share-based payment modification are linked. So, it wants to treat the impact of the rights issue and the modification as a single event. A share-based payment modification occurs when the terms and conditions of the equity instruments change. So, the modification in this case would be later than – and not at the date of – the rights issue.

When a modification occurs, an entity needs to compare the fair value of the new and old awards at the modification date; and it should consider whether there is an uplift in fair value. Any uplift will then be expensed (with the charge for the original awards) over the remaining vesting period. Because this modification is happening at a later date than the rights issue, it is likely that there will be an increase in fair value as a result of changes in volatility, market value and time value of money (since the date of the rights issue).

If entity F had structured the transaction differently (so that the awards were modified at the same time as the rights issue), it is likely that the difference between the new and old awards would be nil; so, there would be no additional charge.

Reclassification from equity-settled to cash-settled

Reclassification of a share-based payment award might occur because: An entity is de-listing. To provide greater liquidity to employees, the entity might change the share-based payment from equity-settled to cash-settled. The entity has changed its settlement practice.

Where an entity modifies a share-based payment award, so that it will be settled in cash instead of shares, the entity measures the liability using the modification date fair value of the equity-settled award based on the elapsed portion of the vesting period. This amount is recognised as a credit to liability and a debit to equity (by analogy with paragraph 29 of IFRS 2, which states that the repurchase of vested equity instruments is accounted for as a deduction from equity).

The entity re-measures the liability at the date of change and at each subsequent reporting date; and it recognises any additional expense from increases in the liability.

Example

Entity N has an equity-settled share-based payment that will vest after employees have provided four years of continuous service. The grant date fair value is C10; and the vesting period is four years. At the end of year 2, a cumulative charge of C5 has been recognised in the income statement; and a corresponding increase has been recognised in equity.

At the end of year 2, entity N decides to change the share-based payment award from equity-settled to cash-settled. The employees will now receive a cash payment based on the fair value of the shares at the end of year 4. An award that is modified to become cash-settled is accounted for as the repurchase of an equity interest (that is, a deduction from equity).

Any excess over the grant date fair value should be treated as a deduction from equity (not as an expense), provided that the deduction is not greater than the fair value of the equity instruments when measured at the modification date.

The accounting is illustrated by the following two scenarios: where, immediately before the change in classification, the fair value of the grant:

(a) has increased: Assume that the fair value immediately before modification is C20. At the start of year 3, a liability of C10 (20/2) is recognised; and there is a corresponding debit to equity of C10. This is because, in substance, the modification represents the repurchase by the entity of its own shares, so no further expense is recognised. The subsequent measurement of the liability would follow the requirements for a cash-settled share-based payment.

(b) has decreased: IFRS 2 requires an entity to recognise a charge in the income statement for services received of at least the grant date fair value, regardless of any modifications to or cancellations of the grant. The only exception to this is where a non-market vesting condition is not satisfied. Assume that the fair value immediately before modification is C5; and there are no further movements in the fair value in years 3 and 4. The accounting would be:

Years 1 and 2: a total expense and increase in equity of C5 is recognised. At the start of year 3: a liability of C2.5 (5 × 2 / 4) is recognised; and there is a corresponding decrease to equity. Years 3 and 4: an expense of C2.5 is recognised each year; and there is a corresponding increase in the liability of C1.25 and equity of C1.25. The C1.25 expense and increase in equity ensure that the income statement expense is at least equal to the grant date fair value.

At the end of the vesting period, the total expense is C10 (of which C5 was a credit to equity and C5 a credit to liability). The total expense is equal to the grant date fair value of C10. If the fair value changed in years 3 and 4, the entity would need to recalculate the expense amounts in these years, as follows: record the expense based on the grant date fair value and allocate this expense between debt and equity (based on the ratio of debt to equity on the modification date); and re-measure the value of the liability based on movements in the share price.

For example, assume that, at the end of year 3, the fair value of the award had decreased to C4. The entity would: record an expense (based on the grant date fair value) of C2.5 and a corresponding increase in the liability and equity of C1.25 (based on the ratio of equity to cash on the date of modification); and re-measure the value of the liability through the income statement from C3.75 to C3 (representing three-quarters of the fair value of the liability of C4, because three years of the four-year vesting period have passed).

Business combinations and formations of joint ventures

Goods acquired in a business combination or on formation of a joint venture generally excluded from the scope of IFRS 2

IFRS 2 applies to share-based payment transactions in which an entity acquires or receives goods or services. Goods include inventories, consumables, property, plant and equipment, intangible assets and other non-financial assets. However, IFRS 2 is not applied to transactions in which an entity acquires goods as part of the net assets acquired in a business combination (as defined by IFRS 3), in a combination of entities or businesses under common control, or the contribution of a business on formation of a joint venture (as defined by IFRS 11).

Modifications and business combinations

IFRS 3 provides detailed guidance on when and how an acquirer should allocate equity instruments between the cost of the business combination and post-combination services for replacement awards granted to the acquiree’s employees. Where an acquiree’s employee awards expire as a consequence of a business combination and the acquirer replaces those awards (even though it is not obliged to do so), IFRS 3 requires the entire grant date fair value of the replacement awards to be recognised as remuneration cost in the post combination financial statements. In all other situations, replacements of share-based payment awards are accounted for as modifications under IFRS 2.

Depending on facts, some or all of the IFRS 2 measure of the replacement awards is allocated to the consideration transferred for the purposes of IFRS 3.

The principle of IFRS 3 is to allocate a portion of a replacement award to the business combination, based on the fair value of acquiree awards and the degree to which the acquiree awards have been earned at the date of acquisition.

Any excess value in the replacement awards is accounted for as post-combination employee services; these will incorporate any new or amended vesting conditions.

The following example illustrates the modification of a share-based payment award occurring at the same time as an acquisition.

Example – Modification as a result of acquisition Entity C grants share options to its employees on 1 May 20X5. The options are exercisable, subject to the completion of three years’ service from that date. On 30 April 20X7, entity D acquires entity C. Entity D is obliged, as part of the sale and purchase agreement, to replace entity C’s share plans. The terms of the share options are modified on acquisition, with the following effect: at the end of the original three-year period, employees will be entitled to shares in entity D rather than shares in entity C. The modified terms make clear that entity D, the acquirer, has granted (and has the obligation for) the replacement award. The terms of the plan are otherwise unchanged. Entity C’s financial statements Entity C originally granted an equity-settled share-based payment award to its employees. As part of the acquisition, the plan’s terms were modified; and the new parent, entity D, had the obligation to settle the award. In accordance with the guidance in IFRS 2 on group settled share-based payments, the award will continue to be treated as equity-settled in entity C’s financial statements.

The remainder of the original IFRS 2 charge (measured on 1 May 20X5) will continue to be spread over the vesting period to 30 April 20X8. Also, if the modification has increased the award’s fair value (measured as the difference between the award’s fair value immediately before and after modification), the incremental fair value will be spread over the remaining period to 30 April 20X8. [IFRS 2 para B43]. Entity D’s separate and consolidated financial statements from 30 April 20X7, entity D, as the acquirer, has granted an equity-settled award in its own shares to the employees of its new subsidiary, entity C.

This will be accounted for as a new award in entity D’s separate and consolidated financial statements. Assume that the award’s fair value is C900, measured at the grant date, 30 April 20X7. The terms of the award require employees to provide three years’ service to entity C – from 1 May 20X5 to 30 April 20X8; so, part of the award’s fair value relates to recombination services; and this amount will be part of entity D’s consideration transferred for the purchase of entity C.

Management will need to follow the IFRS 3 guidance, to determine the allocation between pre- and post-combination services; since two-thirds of the vesting period has passed and there is no incremental fair value or change in the vesting period, it would be appropriate to allocate two-thirds (C600) of the fair value of entity C’s award at the date of acquisition to pre-combination services (so this would be included as part of entity D’s consideration transferred for entity C).

One-third (C300) of the fair value of entity C’s award at the date of acquisition (plus any incremental fair value between entity C’s and entity D’s award at the date of acquisition) would be treated as post-combination services (so this would be recognised as an expense over the period to 30 April 20X8) in the consolidated financial statements. For the year ended 30 April 20X8, the IFRS 2 entries in the consolidated financial statements are as follows:

A modification might increase the number of equity instruments granted. The entity should include the fair value of the additional equity instruments (measured at the date of the modification) in the measurement of the amount recognised for services received.

An entity might modify the vesting conditions associated with an award (for example, by reducing the vesting period or eliminating a performance condition other than a market condition). Vesting condition modifications should be taken into account when considering the estimate of the number of equity instruments expected to vest, but does not impact the measurement of the value of each instrument. A change of a market or non-vesting condition would impact the fair value of each instrument.

Market performance condition not met but remuneration committee agrees to allow award to vest

Employees were awarded share options in entity A, subject to entity A’s share price increasing by 10% between 1 July 20X0 and 30 June 20X3. The 10% target was not achieved. But entity A’s remuneration committee decided, on 30 June 20X3, that all of the share options should vest anyway.

Entity A modified the share option award on 30 June 20X3. There is likely to be a cumulative charge for the original award; this is because the likelihood of meeting the share price target (a market performance condition) would have been factored into the original calculation of the grant date fair value, and this charge is recognised regardless of whether the market performance condition is achieved or not, assuming the recipients provide the required service.

But the fair value of the original share option award at the modification date is nil, because the market performance condition has not been met. So, the modified award has incremental fair value which should be recognised as additional compensation cost. If the vesting condition had been a non-market performance condition (such as achieving a net profit target), there would be no cumulative charge for the original award, because this would have been reversed when it became clear that the net profit target would not be met. But the full grant date fair value of the modified award would be recognised.

In practice, the ability of a remuneration committee to make this kind of ‘modification’ might be set out in the award’s terms and conditions; and this could mean that there is no grant date.

Accounting treatment of modifications: modification that is not beneficial to employees

An entity grants 100 share options to employees at an exercise price of C10 per share. The grant date is 1 January 20X4 and the options are subject to a two-year vesting period. The grant date fair value of each option is C50. The entity modified the options at 31 December 20X4 by extending the vesting period to 30 June 20X6.

At the modification date, management expected that the number of options outstanding at 31 December 20X5 (that is, the original vesting date) would be 90. The actual number of options outstanding at 31 December 20X5 was 85; of these, only 80 vested on 30 June 20X6. The modification did not increase the options’ fair value. In this case the extension of the vesting period should be ignored.

Modification of an equity-settled share-based payment award in a manner that is not beneficial to employees should not be taken into account when determining amounts to be recognised. An extension of the vesting period could be beneficial for example if a vesting condition had not been met on the original vesting date or if an option would expire underwater without the extension. The expense and corresponding increase in equity recognised for 20X4 is C2,250 (C50 × 90 options × 50% of the original two-year vesting period).

The expense for 20X5 is C2,000 (C50 × 85 options × 100% of the original two-year vesting period, less C2,250 expensed in 20X4). No expense is recognised in 20X6; and no adjustment is made to reflect the fact that only 80 awards actually vest, because this occurred after the original vesting date.

An entity might modify the terms and conditions of a grant of equity instruments in a manner that reduces the arrangement’s total fair value or is otherwise not beneficial to the employee.

The accounting treatment of such modifications is consistent with the treatment of beneficial modifications, but it is based on the principle that the incremental fair value is zero and not a negative amount (cannot create income). The entity should continue to account for the original grant as follows:

• If the modification reduces the fair value of the equity instruments granted, this should be ignored. The entity should not recognise reduced expense as a result of the modification. This prevents an entity from modifying an award in order to reduce the overall income statement charge.
• If the modification reduces the number of equity instruments granted, this should be accounted for as a cancellation of that portion of the grant.

If an entity modifies the vesting conditions associated with an award in a non-beneficial way (for example, making it less likely that an award will vest by increasing the vesting period or adding a non-market performance condition), this should not be taken into account when considering the estimate of the number of equity instruments expected to vest.