It is often the case that employees of a subsidiary will receive part of their remuneration in the form of shares in the parent, or less commonly in shares of some other group entity. In such circumstances, IFRS 2 requires the entity that has received the benefit of the services to recognise an expense. This is so even if the equity instruments issued are those of another group entity.

The scope of the Standard includes an entity that:

• receives goods or services when another entity in the same group (or a shareholder of any group entity) has the obligation to settle the share-based payment transaction; or
• has an obligation to settle a share-based payment transaction when another entity in the same group receives the goods or services;

unless the transaction is clearly for a purpose other than payment for goods or services supplied to the entity receiving them.

Share-based payment transactions include transactions settled in an entity’s own shares, as well as transactions settled in equity instruments of the entity’s parent or any other entity in the same group. If a subsidiary’s employees are awarded options over shares of the parent, the subsidiary will recognise an expense for the employee services received.

Group share-based payment arrangements: parent entity grants share awards to subsidiaries’ employees

A parent grants its shares directly to the employees of subsidiaries A and B. The awards will vest immediately, and the parent will issue new shares directly to the employees. The parent will not charge subsidiaries A and B for the transaction.

In the consolidated financial statements, the transaction is treated as an equity-settled share-based payment; this is because the group has received services in consideration for the group’s equity instruments. An expense is recognised in the group income statement for the grant date fair value of the share-based payment over the vesting period (immediately in this example); and a credit is recognised in equity.

In the subsidiaries’ accounts, the award is treated as an equity-settled sharebased payment; this is because the subsidiaries do not have an obligation to settle the award. An expense for the grant date fair value of the award is recognised over the vesting period; and a credit is recognised in equity. The credit to equity is treated as a capital contribution, because the parent is compensating the subsidiaries’ employees with no recharge to the subsidiaries. In this example, the shares vest immediately; so, an expense is recognised in the subsidiaries’ income statement in full (based on the grant date fair value), and there is a credit to equity.

In the separate financial statements, the parent entity records a debit, recognising an increase in the investment in the subsidiaries, and a credit to equity; this is because the employees are not providing services to the parent.

Group share-based payment arrangements: subsidiary grants rights over parent’s equity instruments

Instead of granting rights over its own equity instruments, subsidiary A grants rights over the parent’s shares to its own employees. The shares vest over two years. When the shares vest, subsidiary A purchases shares from the market and passes them to its employees.

Subsidiary A only makes these purchases when it settles the award with its employees. In the consolidated financial statements of the group, the transaction is treated as an equity-settled share-based payment; this is because the group has received services in consideration for the group’s equity instruments.

An expense is recognised in the income statement for the grant date fair value of the share-based payment over the vesting period; and a credit is recognised in equity. The purchase of shares from the market would be treated as a treasury transaction.

Subsidiary A has the obligation to settle the award (albeit in the parent’s shares); so IFRS 2 requires the award to be treated in subsidiary A’s financial statements as a cash-settled share-based payment, because parent company shares would be an asset (and not equity) in A’s financial statements. An expense is recognised in the income statement over the vesting period; and a liability is recorded as the other side of the entry.

This liability is re-measured at each reporting date until settlement (in accordance with the accounting for cash-settled awards). The above transaction has no impact on the parent’s financial statements; this is because the parent is not a party to the transaction. An arrangement that is similar in substance but results in equity-settled accounting by the subsidiary, is where the parent awards its own shares to the subsidiary’s employees and makes a cash recharge to the subsidiary for the shares that the parent acquires in the market.

Group share-based payment arrangements: parent grants cash-settled awards to subsidiary’s employees

A parent grants share appreciation rights to subsidiary A’s employees. At the end of two years, the parent will pay cash to the employees equivalent to the difference between the share price on vesting and the share price at grant date.

No intra-group recharge is to be made. In the consolidated financial statements, the transaction is treated as a cashsettled share-based payment; this is because the group has received services in consideration for cash payments based on the price of the group’s equity instruments. An expense is recognised in the group income statement for the fair value of the share-based payment over the vesting period; and a liability is recorded as the other side of the entry. This liability is re-measured at each reporting date until settlement.

In subsidiary A’s financial statements, IFRS 2 requires the award to be treated as equity-settled, because the subsidiary does not have an obligation to settle the award. An expense is recognised in the subsidiary’s income statement over the vesting period; and a credit is recognised in equity. The credit to equity is treated as a capital contribution from the parent; this is because the parent is compensating the subsidiary’s employees at no expense to the subsidiary.

The employees are not providing services to the parent; so there is no sharebased payment remuneration expense recorded in the parent’s separate financial statements. Instead, the share-based payment transaction results in a debit to ‘investment in subsidiary’; and a corresponding liability is recorded at fair value at each reporting date.

Measurement would vary between the two sets of accounts. Where an employee receives shares in an unlisted entity, it is important to understand how the employee will realise the value in that award. A parent entity will often agree to exchange a vested equity award for cash or for its own shares (for example, where the parent is listed); this provides an employee with an exit mechanism where there is no market for a subsidiary’s shares.

By doing so, the parent also ensures that its holding in the subsidiary will not be diluted when the shares vest. If the employees have an option to convert their award in the subsidiary into the shares of a listed parent, the award would still be equity-settled on a consolidated basis; but the accounting in the individual entities will depend on which entity has the obligation to provide parent shares to the employees.

Group share-based payment arrangements: options over subsidiary’s shares that are convertible into parent’s shares

A group has a fast-growing subsidiary; it intends to incentivise the subsidiary’s employees by granting them options over shares in the subsidiary.

The options will be granted by the parent. The grant date fair value of the options is C1. The parent is listed.

To provide the employees with an ‘exit mechanism’, the parent will convert all of the vested subsidiary shares into the parent’s shares, with the same fair value, when the employee resigns. For the purposes of the consolidated financial statements, this is an equity-settled share-based payment arrangement granted to the subsidiary’s employees.

The consolidated grant date fair value of C1 would be recorded as an expense in the group income statement over the vesting period. In the subsidiary’s separate financial statements, this would also be an equity-settled share-based payment; this is because the subsidiary has no obligation to settle the award.

In the parent’s separate financial statements, a debit (recognising an increase in its investment in the subsidiary) and a corresponding credit to equity are recognised. These accounting entries are recognised over the award’s vesting period.

Where the entity does not provide an exit mechanism for employees, the majority shareholder or other shareholders might offer to buy the departing employees’ interests. In these circumstances, an entity would still apply the principles of group arrangements to determine the accounting in the entity’s accounts.

Group share-based payment arrangements: shareholders provide an exit mechanism

An unlisted entity grants restricted shares to key management that will vest at the end of three years. The entity is not planning an exit event; so the terms of the award allow for key management to sell their shares (to other shareholders or to an approved third party) for fair value after the three-year vesting period. There are also leaver provisions (even after vesting) which require employees to sell their shares when they leave the entity. But the entity does not have an obligation to purchase the shares; this is because the remaining shareholders are obliged to buy out their fellow shareholders.

The employees will ultimately receive cash; they cannot leave the entity with shares, and so they do not have unconditional rights to the equity instruments. From their perspective, this is a group cash-settled arrangement. But it is the shareholders who have the obligation to settle the cash-settled share-based payment arrangement. The entity should account for the arrangement as equity-settled in its financial statements, because the entity does not have an obligation to settle this arrangement. For equity-settled arrangements, IFRS 2 requires an entity to measure the services received and the corresponding increase in equity (debit expense, credit equity) at the grant date fair value. The fair value will be measured at the grant date and recognised over the vesting period (that is, three years).

Another situation that might occur in group share-based payment arrangements is where shares in the parent entity are issued in a currency other than the subsidiary’s functional currency considers the interaction between foreign exchange and share-based payment accounting.

Group share-based payment arrangements: share awards granted in a different functional currency

Employees of a subsidiary are granted rights to shares in the parent for services provided to the subsidiary. The award is treated as equity-settled by the subsidiary; this is because the parent granted the award, and the subsidiary has no obligation to settle the award. The shares in the parent are traded and reported in US dollars (that is, the presentation and functional currency is US dollars).

The subsidiary’s currency (both presentation and functional) is pounds sterling.

The parent informs the subsidiary of the grant date fair value of the award (in US dollars) for each new participant in the plan. Each year, the subsidiary supplies leaver statistics; and the parent informs the subsidiary of the charge to be reflected in the subsidiary’s income statement (again, in US dollars). For share-based payment accounting, the fair value is fixed at the grant date for equity-settled awards (deemed to be the best estimate of the services provided, where the entity and employee have a shared understanding) and spread over the vesting period, to reflect services provided by the employee.

The grant date fair value is measured in US dollars for recognition in the consolidated group’s and parent entity’s financial statements. The grant date fair value for recognition in the subsidiary entity’s financial statements is calculated by translating the US dollar grant date fair value to pounds sterling, using the spot rate at the grant date.

The amount initially translated at the grant date would be the amount used in local currency accounts over the vesting period. This is in accordance with the IFRS 2 requirements for each reporting entity. It is important to note that, on consolidation, the expense recognised by the subsidiary is replaced with an expense based on the consolidated group’s and parent entity’s grant date fair value, rather than it being re-translated.

Employees move between group entities

IFRS 2 states that, where an employee transfers employment from one subsidiary to another during the vesting period (for example, a service period), each subsidiary should measure the services received from the employee by reference to the grant date fair value of the equity instrument; and it should not re-measure at the date of transfer. If the employee fails to meet a non-market vesting condition (for example, a service condition) after transferring between group entities, each subsidiary should adjust the amount previously recognised in respect of the services received from the employee.

Intermediate holding entities

Where a parent grants a share-based payment to a group entity (and there are intermediate subsidiaries within the group between the parent and the entity in which the goods and services are received), should the intermediate subsidiaries account for the share-based payment? IFRS 2 is silent in this respect. We believe that it would be acceptable to account for the transaction only in the parent and in the subsidiary which receives the goods and services.

Example – Implications for intermediate holding entities

Parent entity (P) owns 100% of an intermediate holding entity (H1). Entity H1 in turn owns 100% of another intermediate holding entity (H2); and entity H2 owns 100% of trading subsidiary entity (S).

Entity P grants equity-settled options over its shares to employees of entity S; and it has the obligation to settle those options. The grant date fair value of the award (which has a two-year vesting period) is C200,000. Should each intermediate holding entity apply IFRS 2, or can entity P recognise an investment in its indirectly held subsidiary (that is, entity S)?

The transaction is between entity P and the employees of entity S. In our view, it is acceptable for entity P to recognise an investment in entity S. There will be no impact on the separate financial statements of entities H1 and H2. This is acceptable, on the basis that an indirectly held subsidiary and its ultimate parent can transact directly without involving intermediate entities. The double entry in entity P’s separate financial statements at the end of each year would be to recognise a capital contribution to entity S as follows:

Funding arrangements between parent and its subsidiary

Where a parent grants rights over its equity instruments to the employees of its subsidiary (accounted for as an equity-settled share-based payment), the debit is recognised in the subsidiary’s income statement; and a credit to equity (as a capital contribution) is recognised over the vesting period of the share-based payment arrangement.

IFRS 2 does not address the accounting within the parent entity for the capital contribution. The IFRIC exposure draft (IFRIC draft interpretation D17), issued prior to the release of IFRIC 11, indicated that the parent entity would debit its investment in the subsidiary; and it would credit equity for the equity instruments granted (that is, if the parent entity was satisfying the obligation). But the final interpretation of IFRIC 11 (which has been incorporated into IFRS 2) did not address this issue, because the IFRS IC “did not wish to widen the scope of the Interpretation to an issue that relates to the accounting for intra-group payment arrangements generally”.

We believe that it was this wider issue (rather than a flaw in the thinking) that resulted in the deletion of the proposed guidance in the draft interpretation. The only alternatives to the parent debiting its investment in the subsidiary would seem to be recognising nothing, which would not comply with IFRS 2, or recognising an expense, which would result in a ‘double debit’ for the transaction, because both parent and subsidiary would recognise an expense. There is no indication in IFRS 2 that the accounting treatment set out in the draft interpretation would be inappropriate; and so we believe that it should continue to be applied

A parent entity might make a recharge to the subsidiary in respect of share options granted to the subsidiary’s employees. IFRS 2 does not address how to account for such intra-group payment arrangements for share-based payment transactions. But the example in the draft interpretation did consider the issue. It concluded that an inter-company charge payable by a subsidiary entity should be debited against the capital contribution in the individual or separate financial statements of the subsidiary and the parent.

We believe that this is particularly appropriate where there is a clear link between the recharge and the share-based payment (for example, where the recharge is based on the intrinsic value when an option is exercised or the market value of the shares when they vest). Consistent with the principle of shareholder distributions, if the amount of the inter-company charge exceeds the capital contribution, the excess should be treated as a distribution from the subsidiary to its parent. We consider this to be an appropriate treatment for such a recharge.

The return of the capital contribution and any excess distribution payment are separate transactions from the credit to equity that arises from the equitysettled share-based payment. So the gross amounts should be separately disclosed.

It is important for management to be able to justify a clear link between the recharge and the share-based payment in order to apply the principle of shareholder distributions (as described in above). If there is no clear link between the recharge and the share-based payment, we believe that the payment between the subsidiary and its parent should be treated in a manner consistent with management recharges.

This would result in an expense being recognised in the income statement for the amount recharged. Note that this would result in a ‘double debit’ to the income statement, because the subsidiary would have already recorded the services received under IFRS 2.

Where there is a clear link between the recharge and the share-based payment, the full amount of the recharge would be recorded within equity. It would not be acceptable for the subsidiary to split the recharge into two components, as follows:

• one equal to the share-based payment expense (which is treated as a return of a capital contribution and recorded in equity); and
• the excess of the recharge over the amount above as an additional recharge expense in the income statement

This would create the same result as if the subsidiary had applied cash-settled accounting. IFRS 2 is clear that this type of arrangement should be treated as an equity-settled award.

Even if there is a clear link between the recharge and the share-based payment, some entities might wish to show the recharge debit entry within the income statement rather than equity; we believe that this approach would also be acceptable, provided that it is applied consistently. This approach will lead to a ‘double debit’ in the income statement, because the IFRS 2 charge should also be recognised.

Transactions with owners in their capacity as owners

The requirements of IFRS 2 should not be applied to transactions with parties (e.g. employees) in their capacity as holders of equity instruments of the entity (referred to as ‘owners’ in IAS 1). For example, a rights issue may be offered to all holders of a particular class of equity (e.g. a right to acquire additional shares at a price that is less than the fair value of those instruments).

If an employee is offered the chance to participate purely because he/she is a holder of that class of equity, IFRS 2 is not applied. The requirements of IFRS 2 are only relevant for transactions in which goods or services are acquired.

Timing of the recharge

Where a subsidiary is recharged by its parent for a share-based payment, the question arises as to when (if at all) a liability should be recorded for the amount that is expected to be recharged in the future (for example, when the award vests or the employees exercise their options). There are two acceptable approaches to accounting for the recharge. One approach is that, where the arrangement can be linked to the IFRS 2 charge, recharges should not be accrued (but should be recognised when paid), for the following reasons: Financial instruments, contracts and obligations under share-based payment transactions are outside the scope of IAS 32 and IFRS 9, except for contracts that can be net settled and in relation to the disclosure of treasury shares.

Our view is that these scope exclusions should be read broadly, and that recharges clearly related to a share-based payment can be considered to be outside the scope of IAS 32 and IFRS 9. There is no scope exclusion for share-based payment arrangements under IAS 37; but such recharge payments would not generally meet the IAS 37 recognition criteria to be recorded as liabilities until paid, because: The subsidiary does not have a present obligation as a result of a past event.

For there to be a clear link between a share-based payment and a recharge, the recharge will generally be linked to employees exercising their options.

Options cannot be exercised until they have vested; and employees are likely to exercise their options once they are in the money. So, there is unlikely to be a present obligation on the entity until all vesting conditions have been satisfied and it is probable that employees will exercise their options (for example, where the options are in the money). This is further supported by the fact that distributions (such as dividends) are only provided for when an entity has a present obligation; and an analogy could be drawn between such recharges and distributions to shareholders (as discussed above).

The distribution is conditional on an uncertain future event (such as employees providing services or choosing to exercise their options) that is not wholly within the control of the entity; so there is no present obligation. It is not probable that an outflow of economic resources will be required.

We consider that the time when it becomes probable that there will be an outflow of economic resources would only be reliably known when the options are close to being exercised. In most cases, we believe that a subsidiary would account for a recharge when the payment is made to the parent.

The recharge would be disclosed as a contingent liability during the time when the recharge payment is not recognised as a liability. It might be appropriate to recognise a liability for a recharge before the payment is made (for example, once an award has vested and the options to be exercised are deeply in the money). But there is diversity in practice in this area, because the IFRS accounting framework contains no specific guidance on recharge arrangements.

Under the alternative approach, the subsidiary would recognise the recharge over the vesting period, on the basis that the recharge payment arises from the sharebased payment arrangement in which employees are providing services. This approach might also be acceptable in practice. Where there is no link between the share-based payment and the future payment by the subsidiary (that is, the ‘double debit’ treatment), it is necessary to consider whether the entity has a present obligation that is, in substance, similar to a management recharge.

Timing of the recharge: recharge on vesting of share award

The recharge is clearly linked to the share-based payment (that is, the market price of the shares at the date of vesting). From the subsidiary’s perspective, this is an equity-settled share-based payment transaction.

The requirement for the subsidiary to make a cash payment to the parent does not make this a cash-settled share-based payment transaction; this is because the subsidiary’s obligation is to its parent, but the providers of the goods or services (that is, the employees) receive the equity instruments.

So the subsidiary will recognise an expense and an increase in equity.) Although a recharge (such as in this example) might be made for a number of reasons, it is often made to enable the parent to acquire shares in the market so as to satisfy the award. In substance, the payment by the subsidiary to the parent would be recorded directly in equity for a payment of up to the share-based payment expense recognised.

Any payment in excess of the amount of capital contribution initially recognised should be treated as a distribution from the subsidiary to its parent. Our view is that the subsidiary should not make a provision for the recharge during the vesting period; this is because it does not have a present obligation and it is not probable that there will be an outflow of economic resources until the awards vest. But the subsidiary will disclose a contingent liability.

There are alternative views whereby the provision could be accrued over the vesting period. It would also be acceptable for the subsidiary to recognise the debit entry for the recharge in the income statement, rather than in equity, as long as this approach is applied consistently. But this debit would be in addition to the debit for the IFRS 2 charge, so there would be two charges to the income statement.

As regards the parent’s separate financial statements, the credit entry would be split between investment in a subsidiary and other income. Some entities might wish to take the full credit entry as other income, rather than reducing the parent’s investment in the subsidiary; and we believe that this approach would also be acceptable, provided that this policy is applied consistently. Where a credit is taken to other income, the parent entity should ensure that it has considered whether its investment in the subsidiary is impaired. In some jurisdictions, the impact of accounting for group share-based payment transactions could impact the ability of an entity to pay dividends. In that case, legal advice should be sought.

Timing of the recharge: settlement in parent’s shares with an advance recharge

Employees of a subsidiary are granted options to acquire 100 shares in the parent entity at a fixed price of C10 per share in exchange for services. The grant date is 1 January 20X6; at that date, the fair value of the total award is C100. The award is subject to a two-year vesting period and performance conditions. The options will vest if the total shareholder return exceeds 5% per year during 20X6 and 20X7. The parent entity agrees to issue new shares to entitled employees when the options are exercised.

At the grant date, the subsidiary pays to the parent an option premium, in exchange for the parent agreeing to satisfy the obligation to employees. The amount paid to the parent is the fair value of the options granted to employees, as determined on 1 January 20X6 (that is, C100). The ‘investment in subsidiary’ in the parent entity balance sheet is in excess of C100. The subsidiary should treat the transaction as an equity-settled share-based payment; this is because it does not have an obligation to settle the award. The subsidiary should record the following:

The payment by the subsidiary is, in substance, an advance payment on the capital contribution that the parent intends to make in the future. The subsidiary can make the payment to its parent in advance or at a later date (such as when employees exercise their awards); the classification of the payment in the subsidiary or the parent accounts will not be affected. If the upfront recharge exceeds the carrying value of the ‘investment in subsidiary’ in the parent’s accounts, the excess should be recognised in the income statement.

A subsidiary might wish to show the debit side of the cash payment as an additional expense (for example, for tax purposes); again, this leads to a double debit. Similarly, a parent might wish to show the cash payment as income.

We believe that these approaches would also be acceptable, provided that they are applied consistently. Where there is no clear link between the share-based payment and the recharge from the parent, we believe that it would be most appropriate to record a second debit through the income statement of the subsidiary; and a credit should be recorded in the income statement of the parent.

Employee share trusts

Share plan trusts are often created by a sponsoring entity for employees. They are designed to facilitate employee shareholding and are often used as a vehicle for distributing shares to employees under remuneration plans.

Entities generally use one of two methods to fund share-based payment arrangements: new issue of shares; or purchase of own shares on the market.

Employee share trusts are usually designed to enable employees to buy shares in their employing entity. An employee share trust typically comprises a trust set up by the sponsoring entity to acquire shares in that entity for the benefit of its employees; and the employees generally acquire the shares at a later stage through share option plans, profit-sharing arrangements or other share incentive plans.

The commercial reasons for establishing an employee share trust include the following:

• It allows a share plan to be extended to new participants without diluting existing shareholders’ interests; this is because it can operate by acquiring and distributing shares that are already in issue, instead of requiring new shares to be issued.
• It can provide a private entity with a market in its shares in order to operate an employee share plan; it achieves this by buying shares from departing employees and other shareholders, warehousing them and distributing them to new and continuing employees.
• It can facilitate employee participation in connection with a management buyout, privatisation or listing of a private entity.
• In cash flow terms, an entity can hedge its obligations in respect of options issued under share option plans; it does so by avoiding exposure to increases in the market value of shares between the grant date and the exercise date of the options.
• In some jurisdictions, using a trust might create a tax benefit for the entity or for employees.

The shares are held in a discretionary employee benefit trust set up by the sponsoring entity for the benefit of its employees. For tax purposes, the trust might be resident in a different jurisdiction; and a subsidiary of the entity will often act as a corporate trustee. The trust buys shares with funds provided (by way of cash or loans) from the entity or with a loan from a third party (which will be guaranteed by the entity).

The shares held by the trust are typically distributed to employees through an employee share plan. The trust’s beneficiaries usually only include the entity’s or group’s employees or former employees and specified close relations.

The legislation in some jurisdictions states that entities are not permitted to hold their own shares. So, many entities set up special purpose share plan trusts to hold the entity’s shares on behalf of the plan participants.

The detailed structures of individual employee share trusts are many and varied; but the main features are often as follows:

The trust provides a warehouse for the sponsoring entity’s shares (for example, by acquiring and holding shares that are to be sold or transferred to employees in the future). The trust will normally buy the shares with funds provided by the sponsoring entity (by way of cash contributions or loans) and/or a third-party bank loan. Loans from the entity are usually interest-free. Where the trust borrows from a third party, the sponsoring entity will often guarantee the loan (that is, it will be responsible for any shortfall if the trust’s assets are insufficient to meet its debt repayment obligations).

The entity will generally make regular contributions to the trust, to enable the trust to meet its interest payments (that is, to make good the shortfall between the trust’s dividend income and the interest payable). As part of this arrangement, the trustees sometimes waive their right to dividends on the shares held by the trust. Shares held by the trust are distributed to employees through an employee share plan.

There are many different arrangements including: the purchase of shares by employees when exercising their share options under an executive share option plan; the purchase of shares by the trustees of plans approved by taxation authorities for allocation to employees under the plan’s rules; and the transfer of shares to employees under an incentive plan. An entity could use a share nominee entity instead of an employee share trust.

A share nominee entity is used by reporting entities to hold shares and other securities on the entity’s behalf to satisfy their obligation for employee share awards.

Accounting for employee share trusts

IFRS 2 does not deal with the accounting for an entity’s shares held by an employee share trust. Nor does it deal with funding arrangements between group entities relating to share-based payments. IFRS 10 provides a definition of ‘control’.

When applying the control principles under IFRS 10, a sponsoring entity has control over an employee share trust if the following criteria are satisfied:

• the sponsoring entity has power over the relevant activities of the employee share trust;
• the sponsoring entity has exposure, or rights, to variable returns from its involvement with the employee share trust; and
• the sponsoring entity has the ability to use its power over the employee share trust to affect the amount of the sponsoring entity’s returns.

An employee share trust is not controlled by means of equity instruments; so, control should be analysed on the basis of the relationship that exists between the employee share trust and other entities involved. IFRS 10 requires that the purpose and design of the employee share trust should be used to determine whether an entity has sufficient rights to give it power over the employee share trust and to affect its exposure to returns.

When assessing the relationship and contractual arrangements, the sponsoring entity should consider whether it is exposed to the downside risks and upside potential arising from the employee share trust. This analysis will also help to determine whether the sponsoring entity has power over the relevant activities of the employee share trust, which are defined as “ the activities of the investee that significantly affect the investee’s returns”.

The following examples might indicate that the sponsoring entity controls the employee share trust (based on its involvement and interest): The employee share trust’s relevant activities (such as acquiring and holding shares under award schemes during the vesting period, and issuing the shares to employees on vesting) are conducted on behalf of the entity and for the benefit of the entity’s employees. For example, an employee share trust is typically used to facilitate the remuneration of the entity’s employees through a share incentive plan. The entity makes decisions as to how the employee share trust is designed and operates at inception.

The employee share trust’s trustees are employees of the entity or another entity within the group. This indicates that the sponsoring entity can direct the employee share trust’s activities through key management. The employee share trust’s trustees should act in compliance with the trust deed at all times; but most trusts are set up to serve an entity’s purpose and to minimise the risk of conflict between the entity and the employee share trust.

The employee share trust depends on the entity to fund its operations or provide guarantees on behalf of the trust. The employee share trust often does not have any assets (other than the shares held under award schemes) to fund employee benefits or support repayment of loans provided by the entity. The financing decisions (and the way in which funds are used) are controlled by the sponsoring entity.

The employee share trust is primarily set up to buy the shares in the entity or another group entity and to hold the shares during the vesting period, to hedge the entity’s cost of providing employee benefits. This mitigates the entity’s exposure to changes in the share price during that period. If an employee leaves the group during the vesting period, the entity can re-allocate their shares to other employees at no additional cost to the entity. This means that the benefits of the shares are not available to other share option holders unless the entity grants new awards. Also, the entity can pass increased benefits to its employees without using its other resources.

All three criteria in IFRS 10 listed above should be satisfied for control to be established. Management should assess the specific circumstances of each arrangement against IFRS 10’s criteria. An employee share trust that is controlled by its sponsoring entity should be consolidated into the financial statements with the sponsoring entity.

In the consolidated financial statements that include the trust, the shares are treated as treasury shares (that is, as a deduction from equity). If the trust prepares separate financial statements, the shares are accounted for as financial assets under IAS 32 and IFRS 9. See chapter 42 para 6.

Example

Entity C decides to set up a trust in connection with its employee share option plan. The trust enters into the share-based payment arrangement on behalf of entity C with its employees.

On the grant date, entity C loans C5,000 to the trust, so that it can buy the same number of shares from the market that have been offered to employees under the plan. The trust has no other assets; and the trust deed states that the trust exists solely to provide remuneration incentives to entity C’s employees. Entity C demonstrates power, because it was involved in the creation and design of the employee share trust at inception.

The trust deed states that the relevant activities are to remunerate entity C’s employees; so the employee share trust was specifically set up to conduct activities for entity C. Also, entity C provides funding to the employee share trust and guarantees its obligations. This indicates that entity C has power over the employee share trust; and it uses its power by making financial decisions and determining how funds are used.

The employee share trust has been set up to buy and hold shares on behalf of entity C; so, entity C manages the exposure to changes in its share price. As a result, entity C uses its power over the employee share trust to affect its returns by limiting its exposure to variability. If it did not use the employee share trust, entity C would have exposure to variability in its share price and in the cash flows to settle the award. Given that all three criteria of control are satisfied, entity C should consolidate the employee share trust.

Separate financial statements of the sponsor

There is no guidance in IFRS 2 on the accounting for an entity’s interest in a trust in its separate financial statements. In our view, the appropriate accounting depends on whether:

• The entity has a beneficial interest in the trust’s residual assets. If so, the entity would recognise an investment in the trust.
• The employees own the beneficial interest in the residual assets. If they do (and there is no formal loan agreement), the entity would record a debit in equity.
• A formal loan arrangement exists between the entity and the trust. The funding could be treated as a loan to the trust. Entities should be aware that this loan could become impaired.

If the transfer of cash to the trust is treated as a ‘loan and receivable’ asset under IAS 39, an impairment charge could often be required; this is because the asset is not recoverable. The entity expects that employees will ultimately receive the shares; at that time, the trust would no longer have any assets to justify the receivable in the sponsoring entity’s accounts; and the asset would be impaired. If the transfer of cash to the trust is treated as a capital contribution, any ‘investment in trust’ balance generated would also be subject to impairment review.

An impairment could result in a ‘double debit’; this is because the entity recognises both the share-based payment charge and an impairment charge. Where the sponsor retains the majority of the risks and rewards relating to the funding arrangement, it is our view that the trust has, in substance, acted as an agent for the sponsor. We believe that it would be acceptable for the sponsor to account for the issue of shares to the trust as the issue of treasury shares; this would eliminate the problem of the ‘double debit’..

Factors that might indicate that the trust has acted merely as an agent – and so the sponsor retains the risks relating to the funding – include:

• the entity bears the ultimate risk of a fall in the price of the shares held by the trust;
• the trust has no other unencumbered assets on which the entity could claim if the shares are issued to employees; and
• the entity has guaranteed any portion of a third-party loan that the trust has obtained.

Separate financial statements of the sponsor: employee trust with loan funding

Entity A decides to set up a trust in connection with its employee share option plan. The trust enters into the share-based payment arrangement on behalf of entity A with its employees. On the date when the terms of the plan are finalised, entity A loans C2,000 to the trust, so that it can buy from entity A the number of shares offered to employees under the plan. The trust has no other assets; and the trust deed states that the trust exists solely to provide remuneration incentives to entity A’s employees.

It would be acceptable for entity A to account for the loan provided as the issue of treasury shares. The trust is clearly acting as an agent for entity A. Entity A retains the risks relating to the loan. Entity A would record the following entry on the date when the loan was provided:

Disclosure

• Extensive disclosure is required under three broad headings: The nature and extent of share-based payment arrangements that existed during the period.
• How the fair value of the goods or services received (or the fair value of the equity instruments granted) during the period was determined.
• The effect of expenses arising from share-based payment.

Nature and extent of share-based payments

IFRS 2 lists minimum disclosures to enable users to understand the nature and extent of share-based payment arrangements. The list includes a description of each share-based payment arrangement, a reconciliation of the movement in the number of share options, the weighted average share price at the date of exercise, and information on the options outstanding at the period end.

Additional information should be provided if the required information is insufficient to enable users of the financial statements to understand the entity’s share-based payment arrangements.

Determination of fair values

Information that enables users to understand how the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined should be disclosed. The level of disclosure will vary, depending on whether the fair value of the goods or services was determined directly or indirectly.

There is a rebuttable presumption that the fair value of goods or services will be measured directly for transactions with parties other than employees. If the presumption is rebutted, the entity should disclose that fact; and it should explain why the presumption has been rebutted.

If the fair value of goods or services has been measured directly, the entity should disclose how this fair value was determined. For example, the fair value might have been determined by reference to a published list of prices or scale rates.

If the fair value of goods or services has been measured indirectly (by reference to the fair value of the equity instruments granted as consideration), the entity should disclose information on how the fair value was measured and information on share-based payment awards that were modified during the period.

Impact on profit or loss

IFRS 2 lists minimum disclosures to enable users to understand the impact of share-based payment arrangements on the profit or loss. The list includes information on the equity-settled expense and the total expense for the period, the carrying amount of any liabilities, and the total intrinsic value of any cash-settled share-based payment transactions.

Measuring the fair value of equity instruments

The fair value of the equity instruments granted should be measured at the relevant measurement date.

Fair value should be based on market prices (if available), taking into account any terms and conditions associated with the grant of the equity instruments.

Fair value should take into account the fact that employees have been granted an award of shares but are not entitled to receive dividends during the vesting period. Similarly, restrictions on transfer after the vesting date should be taken into account, but only to the extent that the post-vesting restrictions affect the price that a knowledgeable, willing market participant would pay for that share. If the shares are actively traded in a deep and liquid market, post-vesting transfer restrictions could have little (if any) effect on the price.

Valuation techniques

Some shares and most share options are not traded on an active market, and alternative valuation techniques are required. The objective is to estimate what the price of those equity instruments would have been at the relevant measurement date in an arm’s length transaction between knowledgeable, willing parties. It might be possible to estimate a market price based on prices of traded shares or options with similar terms and conditions, but this is unlikely in the case of executive options with specific performance criteria. It is more likely that an alternative valuation technique will need to be applied.

Many pricing models are available. IFRS 2 does not specify which should be used, but it does describe the factors that should be taken into account when estimating fair value. It also requires the model used to be consistent with generally accepted valuation methodologies for pricing financial instruments.

All option pricing models take into account (as a minimum) the following factors:

• Exercise price of the option.
• Current price of the underlying share.
• Life of the option.
• Expected volatility of the share price.
• Dividends expected on the underlying shares.
• Risk-free interest rate over the life of the option

The first two items determine the ‘intrinsic value’ of the option, and the remaining four are relevant to its ‘time value’. The time value of an option reflects the holder’s right to participate in future gains, if any. The valuation does not attempt to predict what the future gain will be; it only predicts the amount that a buyer would pay at the valuation date to obtain the right to participate in any future gains. Option pricing models estimate the value of the share option at the measurement date; they do not estimate the value of the underlying share at some future date.

Inputs to an option pricing model: Life of the option

The following factors should be taken into account when estimating the expected life of an option:

• The length of vesting period; this is because the share option typically cannot be exercised until the end of the vesting period. The effect on valuation of expected early exercise is determined on the assumption that the options will vest.
• The average length of time for which similar options in the past have remained outstanding. The price of the underlying shares.
• Experience might indicate that employees tend to exercise options when the share price reaches a specified level above the exercise price.
• The employee’s level within the organisation. For example, experience might indicate that higher-level employees tend to exercise options later than lower-level employees.
• Expected volatility of the underlying shares. Employees might tend to exercise options on highly volatile shares earlier than on shares with low volatility.

When estimating the expected life of share options granted to a group of employees, the entity could base that estimate on an appropriately weighted average expected life for the entire employee group; or it could base it on appropriately weighted average lives for subgroups of employees. This second approach is based on more detailed data about employees’ exercise behaviour.

The distinction is likely to be important. Option value is not a linear function of option term – value increases at a decreasing rate as the term lengthens. A two-year option is worth more than a one-year option, but it is not worth twice as much. Estimating an option value on the basis of a single weighted average life, including widely differing individual lives, would overstate the total fair value of the share options granted.

If the options granted are separated into several groups, and each group has a relatively narrow range of lives included in its weighted average life, that overstatement is reduced.

Expected volatility

Expected volatility is a measure of the amount by which the price of the underlying share is expected to fluctuate during the option’s life. The measure of volatility used in option pricing models is the annualised standard deviation of the continuously compounded rates of return on the share. Volatility is typically expressed in annualised terms, regardless of the time period used in the calculation (for example, daily, weekly or monthly price observations).

The following factors should be taken into account when estimating expected volatility:

• The implied volatility from traded share options on the entity’s shares or other traded instruments that include option features (such as convertible debt).
• The historical volatility of the share price over the most recent period that generally matches the expected term of the option.
• The length of time that an entity’s shares have been publicly traded. Unlisted and recently listed entities are considered further below.
• The tendency of volatility to revert to its long-term average (and other factors indicating that historical volatility might be an unreliable indicator of expected future volatility). For example, if an entity’s share price was extraordinarily volatile for a short period (because of a failed takeover bid or a major restructuring), that period could be disregarded in computing historical average annual volatility.
• Appropriate and regular intervals for price observations. The price observations should be consistent from period to period. For example, an entity could use the closing price for each week or the highest price for each week; but it should not use the closing price for some weeks and the highest price for other weeks.

An unlisted entity will not have historical data on which it can base an estimate of expected future volatility. The following alternative methods could be used:

• If the entity regularly issues options or shares to employees (or other parties), it might have set up an internal market for its shares. The volatility of those share prices could be considered.
• The historical or implied volatility of similar listed entities (for which share price or option price information is available) could be used. This would be appropriate if the entity has also based the value of its shares on the share prices of similar listed entities.
• The entity might not have based its estimate of the value of its shares on the share prices of similar listed entities, but instead used another valuation methodology. It could estimate the expected volatility according to that valuation methodology. For example, the entity might value its shares on an earnings basis; so it could consider the expected volatility of those earnings.

A newly listed entity might not have enough information about historical volatility to estimate expected future volatility. It should compute historical volatility for the longest period for which trading activity is available.

It could also consider the historical volatility of similar entities during a comparable period in their lives. For example, an entity that has been listed for only one year (and grants options with an average expected life of five years) might consider the pattern and level of historical volatility of entities in the same industry for the first six years in which the shares of those entities were publicly traded.

Expected dividend

The question of whether expected dividends should be taken into account when measuring an option’s fair value depends on whether the counterparty is entitled to dividends on the underlying shares.

Employees might be granted options, but they are not entitled to dividends on the underlying shares between grant date and exercise date; in that case, they will have effectively ‘lost’ those dividends. The grant date valuation of the options should take into account expected dividends, and the fair value of the options will be reduced.

The fair value estimate of grants of shares should be reduced by the present value of dividends expected to be paid (and so ‘lost’ by the employees) during the vesting period. Conversely, no adjustment is required for expected dividends if the counterparty is entitled to receive dividends during or at the end of the vesting period. The relatively greater value from receiving dividends during the vesting period is included in the award’s grant date fair value.

An alternative method of accounting for dividends during the vesting period is to consider the grant in two parts; the employee will receive cash for the dividends over the vesting period, and an equity instrument if the award vests.

The entity would first calculate the value of the cash component (that is, dividends expected to be paid over the vesting period), and the remainder would be the equity component. The equity component could be valued by estimating the value of the shares excluding the expected dividends to be paid. Once the award has been allocated between the cash and equity components, the entity should account separately for each element of the grant.

Option pricing models generally call for expected dividend yield; but they can be modified to use an expected dividend amount. If the latter is used, the historical pattern of dividend increases should be taken into account. For example, if an entity’s policy has generally been to increase dividends by around 3% per year, its estimated option value should not assume a fixed dividend amount throughout the option’s life.

Expected dividends should generally be based on publicly available information. An entity that does not pay dividends, and has no plans to do so, should assume an expected dividend yield of zero. But an emerging entity, with no history of paying dividends, might expect to begin paying dividends in the near future. Such an entity could use an average of its past dividend yield (zero) and the dividend yield of a comparable peer group.

Valuation techniques

Option pricing models assume that it is possible to hedge an option exactly by buying (and continually adjusting) a portfolio of the shares over which the option has been granted. Setting up and adjusting the ‘hedge portfolio’ has a cost. In theory, this hedging cost will be the same, whatever happens to the share price. Given that the option can be hedged precisely at a fixed cost, it follows that this cost will be the market value of the option.

In practice, real markets do not always follow the idealised behaviour of financial models; and there are limits on how often a portfolio can be rebalanced. But investment banks do, as a matter of fact, hedge option contracts using dynamically traded hedge portfolios. These portfolios are constructed in line with the theoretical models; and, despite their imperfections, these models have proven robust in practice.

A change in the expected volatility of the share price will generally have the greatest impact of the input assumptions on the option’s fair value; an increase in volatility increases the fair value. A change to the option’s exercise price or its life has the next greatest impact on the option’s fair value; an increase in the option’s exercise price decreases its fair value, and an increase in the option’s expected life increases its fair value. This will be the case, whichever option pricing model is used.

Market conditions are taken into account when estimating fair value. Arguably, all conditions associated with a grant of equity instruments will influence the fair value of those instruments. The IASB’s exposure draft ED 2 proposed that all conditions (market-related or otherwise) should be taken into account when determining fair value.

But respondents to ED 2 raised concerns about the practicality and subjectivity of including non-market vesting conditions in a valuation. In response, IFRS 2 draws a distinction between market and non-market vesting conditions; and only the former are taken into account when estimating fair value. Broadly speaking, a market condition is one that depends on the share price.

Market conditions include target share prices and requirements to achieve a specified level of total shareholder return (that is, the sum of dividends and increases in share price). There are various means by which they could be taken into account when estimating fair value; and some valuation models are better suited than others to dealing with their effects. This is a complex area and specialist advice should be obtained.

Selection of an option pricing model

As noted above, IFRS 2 does not specify which model should be used to estimate an equity instrument’s fair value. Frequent reference is made to the Black-Scholes-Merton formula (more commonly known as the Black-Scholes formula); but other models might sometimes be more suitable, such as the binomial model or Monte-Carlo simulation.

The Black-Scholes formula

The most widely used model for valuing straightforward options was published by Fischer Black and Myron Scholes in 1973; and it is commonly known as the Black-Scholes formula. This model depends on several assumptions:

• Future returns are independent of past returns and the current share price.
• Volatility and interest rates both remain constant throughout the option’s life. The probability distribution of returns is lognormal.
• No transaction costs.
• The original Black-Scholes formula assumed that no dividends were paid out during the life of the option. The formula can be modified to include the impact of dividends, such that the price of a European call option (that is, an option that can only be exercised at the end of its life, regardless of the country in which it is issued).

Although the Black-Scholes formula is widely used, it has several limitations in the context of employee options.

For example: It does not allow for market conditions or non-vesting conditions or other terms and conditions that are relevant for determining fair value. The option is assumed to be exercised at the end of its life.

Early exercise can only be taken into account by use of an expected life rather than a contractual life. Inputs (such as expected volatility) cannot be varied over the option’s life. But, for many of the simpler employee options, the Black-Scholes formula can give a reasonably reliable estimate of fair value.

The binomial model

The binomial model applies the same principles as decision-tree analysis to option pricing. At each point, the possible outcomes are simplified to prices increasing or decreasing by a specified percentage. On this basis, a ‘tree’ or ‘lattice’ is created. Depending on the relative probabilities of each path, an expected outcome can be estimated.

Example An entity grants options that can be exercised in three years’ time. The exercise price of the options is C5; this equates to the current market price of the entity’s shares.

Management has estimated that there is a probability of p that the market price of the entity’s shares will increase by 10% per year; and that there is a probability of (1 − p) that it will reduce by 10%.

In order to estimate the value of p, management can equate the expected outcome of owning a share to the known outcome of earning a risk-free rate of interest on a cash deposit. If the risk-free rate is assumed to be 6%, the value of a C5 investment after one year will be C5.30. So, as regards the share, the value of p can be calculated from the following: p × 5.50 + (1 − p) × 4.50 = 5.30 Thus, p is 0.8, or 80%. The current share price of C5 is assumed to be the correct fair value (that is, a present value which already takes into account alternative future outcomes).

The deviations from the value of C5.30 (which is expected for t+1 (the next year)) that are deemed possible by management (that is, either C5.50 or C4.50) should be assigned probabilities; these average out at a value of C5.30, according to the above equation. On this basis, the possible outcomes and their relative probabilities (for each of the next three years) can be estimated as shown below

For example, there is a probability of 51.2% (80% × 80% × 80%) that the value of a share will be C6.66 in three years’ time.

An option with an exercise price of C5 will only have value if the market price of the share exceeds C5 at the end of three years. If a share is worth C6.66, the option would be worth C1.66 (as shown by the top path of the tree). This represents the intrinsic value of the option. But, if the share is worth C3.65, an option with an exercise price of C5 will be worthless (as shown by the bottom path of the tree). On this basis, the option’s expected value in three years’ time can be derived.

The model sounds simple; but its application can prove complex. For example, the calculation of the probabilities of particular price movements is highly subjective.

However, the model is widely used, and it can often be a more flexible solution than the Black-Scholes formula. Like the BlackScholes formula, the binomial model suffers from limitations, including: It is difficult, although not impossible, to allow for market conditions or other terms and conditions that are relevant to determining fair value. It is also difficult to allow for turnover or exercise patterns. In most cases, the model assumes that options will be sold rather than exercised – only in a few scenarios is early exercise deemed to occur. In view of these limitations, the use of the binomial model might not be appropriate for employee options where the probability of early exercise is significant.

Monte-Carlo simulation

Monte-Carlo simulation takes the binomial model further; it does so by undertaking several thousand simulations of future outcomes for key assumptions, and calculating the option value under each scenario. In the same way as the binomial model, the expected outcome is discounted to give an option value.

Monte-Carlo models can incorporate even the most complex performance conditions, and turnover and exercise patterns (such as those that are a function of gain or time since the grant date). So, they are generally the most reliable models for valuing employee options. The only drawback is their complexity; but this is rarely a problem with modern computing technology.

Impact on fair value when an input is increased

The following diagram summarises the impact on fair value when an input is increased (and all other inputs are held constant). The more arrows shown, the greater the impact on fair value of changing the input assumptions.

Life of the option

Holders of traded options can generally choose to exercise, keep or sell their options at any time during the option’s contractual life. The sale of options realises both their intrinsic and their time values; so this will usually be a more attractive proposition than exercising. The real choice, therefore, is between keeping and selling (note that, where options are traded in a liquid market, an option pricing model is not required; this is because the traded value of the option in the market is the fair value).

A traded option would typically only be exercised (or lapse) at the end of its contractual term. The vast majority of employee options cannot be traded; so employees only have the choice of keeping or exercising their options. But exercising is the only way in which an employee can realise value. Also, it is common for the contractual life of the option to be cut short if the employee leaves the entity.

This means that most employee share options are exercised much earlier than their contractual term. So, when estimating the fair value of an employee option, it is the option’s expected life rather than its contractual life that is considered.

Other factors that could be considered include the following:

• The general state of the equity market or the economy. Employees might be more inclined to hold on to their options where markets are climbing; or, if markets are performing poorly, they might exercise their options when they see a gain.
• The dividend yield on the underlying share. Where no dividend is paid, the option holder does not lose by not exercising. Where the dividend yield is high, the dividends lost by not exercising could outweigh the risk-free return available on the cash; this could encourage early exercise.
• The tax treatment of the benefits. In some jurisdictions, a tax charge could crystallise on vesting; so, employees might have to exercise their options to meet their tax liability.

The experience of an entity that grants options broadly to all levels of employees might indicate that top-level executives tend to hold their options longer than middle-management employees hold theirs; and that lower-level employees tend to exercise their options earlier than any other group. Also, employees who are encouraged or required to hold a minimum amount of their employer’s equity instruments (including options) might exercise options later than employees not subject to that provision.

In those situations, it will be possible to estimate more accurately the total fair value of the share options granted by separating options according to groups of recipients with relatively homogeneous exercise behaviour.

Standard deviation

Standard deviation is a statistical measure of how tightly data are clustered around a mean – the more tightly clustered the data, the smaller the standard deviation. Standard deviation is measured as the square root of the variance; this, in turn, is measured as the average squared difference between each observation and the mean.

Risk-free interest rate

The risk-free interest rate is typically the yield currently available on zero-coupon government bonds of the jurisdiction in whose currency the exercise price is expressed. The remaining term of the bond should be equal to the expected term of the option that is being valued. If no such bonds exist, or circumstances indicate that the yield on zerocoupon government bonds is not representative of the risk-free rate, it might be necessary to use an appropriate substitute. Equally, an appropriate substitute should be used if market participants would typically determine the risk-free rate by using that substitute.