Chapter 5: Employee compensation arrangements

Employee compensation arrangements in a business combination should be analysed, to determine whether all or a portion of the value of the arrangement relates to compensation for post-combination services that should be accounted for separately from the business combination.

Assessment of employee compensation arrangements

Employee compensation arrangements in a business combination are assessed to determine whether they represent: compensation for pre-combination services (that is, the amount that relates to employees in the capacity of shareholders), which should be accounted for as part of the consideration transferred for the acquiree; compensation for post-combination services, which should be accounted for separately from the business combination; or a combination of pre- and post-combination services, with a portion accounted for as part of the consideration transferred for the acquiree and a portion accounted for as compensation cost in the post-combination financial statements, respectively. This assessment will not always be straightforward and might require significant judgement.

Deferred consideration

Part of the consideration for a business combination might be unconditional, becoming payable at a date after the business combination has been completed. Such deferred consideration could take the form of cash, shares or other consideration where the amounts are known with certainty.

Where the deferred consideration is conditional, this is ‘contingent consideration’.

Share-based payment awards

An acquirer might exchange its share-based payment awards (replacement awards) for awards held by employees of the acquiree. Either all or a portion of the value of the share-based payment awards could be included in the measurement of consideration transferred.

Replacements of share-based payment awards are accounted for as modifications of the acquiree’s existing share-based payment awards, in accordance with IFRS 2. The acquirer should assess terms and provisions of replacement awards, to identify amounts that might be included into consideration.

This assessment of terms and provisions of replacement awards applies to share-based payment transactions that are classified as liabilities, as well as to those classified as equity-settled transactions in accordance with IFRS 2.

The value of the replaced acquiree award at the acquisition date that relates to pre-combination services is a payment to the employees in their capacity as owners of the business. This value is accounted for as part of consideration.

 The rationale behind allocating replaced award

This is an anti-abuse provision that prevents acquirers from reducing the post combination income statement charge by providing a replacement award of the same value as the original award and reducing the original vesting period, to push a greater proportion of the value into the consideration for the business combination.

Vesting period completed before combination, and additional employee services not required

Acquiree awards Vesting period completed before the business combination Replacement awards Additional employee services are not required after the acquisition date The acquirer issues replacement awards with an IFRS 2 value (marked-based measure) of C110 at the acquisition date. These replace acquiree awards with an IFRS 2 value of C100 at the acquisition date. No post-combination services are required for the replacement awards, and the acquiree’s employees had rendered all of the required service for the acquiree awards as of the acquisition date. The excess of C110 over C100 is recognised as a post-combination remuneration cost in the acquirer’s income statement.

No post-combination service is required from the acquiree’s employees, and so C10 is immediately recognised in the acquirer’s post-combination income statement. The acquiree’s replacement share-based payment awards are fully vested, and no service is required after the acquisition date. Therefore, the amount attributable to pre-combination service is the market-based measure of the acquiree’s awards (C100) at the acquisition date. That amount is included in the consideration transferred in the business combination. The entries in the financial statements of the acquirer in relation to the awards are:

Dr Net assets and goodwill acquired 100

Dr Income statement – remuneration cost 10

Cr Equity 110 to recognise share-based payment awards issued.

Vesting period completed before combination, and additional employee services not required

Acquiree awards Vesting period completed before the business combination Replacement awards Additional employee services are not required after the acquisition date

An acquirer exchanges replacement awards that require no post-combination service for share-based payment awards of the acquiree for which employees had not yet rendered all of the service as of the acquisition date. The terms of the replaced acquiree awards did not eliminate any remaining vesting period on a change in control. The market-based measure of both awards is C100. The employees have already rendered two years of service, and the replacement awards do not require any post-combination service. The total vesting period is two years (the vesting period for the original acquiree award completed before the acquisition date (two years) plus the vesting period for the replacement award (zero years)). The portion of the IFRS 2 measure of the replacement awards attributable to pre-combination services equals the IFRS 2 measure of the acquiree’s awards (C100) multiplied by the ratio of the pre-combination vesting period (two years) to the greater of the total vesting period (two years) and the original vesting period of the acquiree’s award (four years). C50 (C100 × 2/4 years) is attributable to pre-combination service and is included in the consideration transferred for the acquiree. The remaining C50 is attributable to post-combination service. The acquirer recognises the entire C50 immediately as remuneration cost in the post-combination financial statements, because no post-combination service is required.

Acquirer extends vesting period, and awards have incremental fair value

An acquirer exchanges replacement awards that require a period of postcombination service longer than one year for share-based payment awards of the acquiree, for which the acquiree’s employees had not yet rendered all of the service at the acquisition date. This replacement award has incremental fair value. The example deals not only with the accounting in the acquirer’s financial statements, but also with the accounting in the acquiree’s financial statements.

Example

Entity A acquired entity B and was obliged to replace entity B’s share option scheme. At the acquisition date, employees have provided two out of the four years of service required in order for the share options to vest. Employees are required to provide three further years of service in order to become entitled to their options. However, because the exercise price is reduced, the replacement share option award has incremental fair value. The IFRS 2 fair value of the original share option award, measured at the grant date, was C800 and, at the acquisition date, it is C1,000. The IFRS 2 fair value of the replacement share option award is C1,500. Entity A The replacement share option award requires three years of post-combination service. Employees have already rendered two years of service, so the total vesting period is five years.

The portion attributable to pre-combination services equals the fair value of entity B’s share option award at the acquisition date (C1,000) multiplied by the ratio of the pre-combination vesting period (two years) to the greater of the total vesting period (five years) and the original vesting period of entity B’s award (four years).

Thus, C400 (1,000 × (2/5)) is attributable to precombination service and is consideration under IFRS 3. The remaining C600 (1,000 − 400) is attributable to post-combination service. The incremental fair value of the replacement award of C500 (1,500 − 1,000) is also attributable to post-combination service. Therefore, C1,100 (600 + 500) is recognised as compensation expense in entity A’s post-combination financial statements over the remaining vesting period (three years).

Entity B The award has been modified at the acquisition date. Entity A, the parent entity, has granted, and has the obligation for, an equity-settled award from that date. Hence, IFRS 2 applies, and entity B should continue to account for the award as equity-settled from the date of acquisition. The vesting period has been extended, but the award’s original fair value (C800) will continue to be spread over the original four years. The cumulative charge would be C400 (2 × (800 ÷ 4)) at the acquisition date, and C200 will be charged each year for the next two years. The incremental fair value (C500) will also be spread over the three years from the acquisition date.

Acquirer has no obligation to replace awards, and award continues unchanged

Entity E acquired entity F on 30 June 20X5. The original vesting period of entity F’s employee share option scheme was four years. The fair value of the awards was C100 at the acquisition date. Entity E was not required to replace entity F’s employee share option scheme, and the scheme continued unchanged. Entity E Entity E allocates the acquisition date fair value between consideration of C50 (100 × 2/4 years) and post-combination employee compensation expense of C50 (100 × 2/4). Entity E must use the acquisition date fair value, and not the original grant date fair value, because the measurement date cannot be before the date when entity F is acquired. Entity F Entity F granted an equity-settled share-based payment award on 30 June 20X1. The original grant date fair value is recognised over the four-year vesting period. There is no change to the original award, and so the accounting in entity F continues unchanged.

Acquirer has no obligation to replace awards that would expire as a result of the business combination, but chooses to do so

If the acquirer is not obliged to replace the acquiree’s awards but chooses to do so voluntarily, the entire IFRS 2 value of the replacement awards at the acquisition date is charged to the post-combination income statement as employee services. This amount might or might not be spread over a vesting period, depending on the circumstances.

Cash settlement initiated by the acquirer

Cash settlement of the acquiree’s share-based payment requires much of the same analysis as replacement awards. Cash payments made by the acquirer to settle vested awards are included in the consideration transferred for the acquiree, up to the amount equal to the fair value of the acquiree’s awards measured at the acquisition date. If the cash payment is greater than the fair value of the acquiree’s awards, the excess fair value amount is an expense incurred by the acquirer outside the business combination, rather than consideration transferred for the acquiree. The excess amount of cash paid over the fair value of the acquiree’s awards is, therefore, immediately recognised as an expense in the post-combination financial statements.

If cash payments are made by the acquirer to settle unvested awards, the acquirer has effectively accelerated the vesting of the awards by eliminating the post-combination service requirement and settled the award for cash. The portion attributable to pre-combination service provided to the acquiree is included in the consideration transferred for the acquiree. The remaining cash payment to the acquiree, attributable to the post-combination service, is immediately recognized as an expense in the post-combination financial statements. An acquirer might make a cash payment in exchange for unvested awards of the acquiree and require additional post-combination service, with the cash payment made after the additional vesting period. The acquirer will need to determine the portions of the payment attributable to pre combination service and post-combination service.

The amount attributable to pre-combination service is determined by multiplying the fair value of the acquiree award by the ratio of the portion of the pre-combination vesting period completed before the payment to the greater of the total vesting period and the original vesting period of the acquiree award. This amount is included in consideration transferred for the acquired business. The amount attributable to post-combination service would be recognised in the post-combination financial statements over the remaining service vesting period.

Acquirer extends vesting period and settles in cash

Entity C acquired entity D on 31 December 20X1 and was obliged to replace share awards granted by entity D to its employees. At the acquisition date, employees have provided two out of the four years of service required in order for their share award to vest. Following the acquisition, employees are required to provide three further years of service (that is, until 31 December 20X4) in order to become entitled to their award. Employees will receive cash equal to the fair value of shares in entity D, rather than entity D shares as originally intended. The IFRS 2 fair value of the original share award, measured at the grant date, was C800. At the date of acquisition, the fair value of both the original award and the replacement award is C1,000.

No incremental value has been provided as a result of the acquisition. Entity C has agreed to pay C1,000 in cash on 31 December 20X4, provided that employees remain in employment until that date. Entity C The consideration of C1,000 is allocated by multiplying it by the ratio of the portion of the vesting period completed (two years) to the greater of the total vesting period (two completed years, plus the three remaining years) and the original vesting period of the acquiree award (four years).

Therefore, C400 (1,000 × 2/5) is allocated to the consideration for the acquisition, and the remaining C600 will be recorded as a post-combination employee compensation expense, provided that the employee meets the service condition. (Note: the time value of money has been disregarded for simplicity in this example.) The portion of the liability recognised as part of the acquisition is considered to be consideration. The portion of the future payment that is considered to be employee compensation and is accrued over the three-year service period. Entity D The award has been modified at the acquisition date.

Entity C, the parent entity, is granting, and has the obligation for, a cash-settled award from that date. Entity D should continue to account for the award as equity-settled, as required by IFRS 2. The extension of the vesting period from four to five years would be ignored by entity D, because this is non-beneficial to the employee.

Cash settlement initiated by the acquiree

The acquiree might choose to cash settle the outstanding awards before the acquisition. However, these transactions, including the timing of the transaction, should be carefully assessed to determine whether the cash settlement, or a portion thereof, was arranged primarily for the economic benefit of the acquirer. The form of the transaction might indicate that the acquiree initiated the cash settlement; but, in substance, the acquirer might have reimbursed the acquiree for the cash settlement. If the acquirer reimbursed the acquiree for the cash settlement, the accounting by the acquirer should generally be the same as if the acquirer had settled the awards directly. The settlement is recorded in the acquiree’s financial statements before the business combination if the acquiree cash settles its awards and the transaction was for the acquiree’s economic benefit. [IFRS 2 para 28].

Apparent cash settlement of awards by the acquiree

Entity D (the acquiree) cash settles the outstanding unvested awards held by its employees immediately before its acquisition by entity C (the acquirer). The amount of cash paid by entity D is C100, which is equal to the current fair value of the awards. The employees have completed 75% of the service required to vest in the awards at the time of settlement. Entity C determines whether a portion of the consideration transferred for entity D is attributable to the settlement of unvested awards held by entity D’s employees. The settlement of the portion of the unvested awards not attributable to pre-combination services might be a transaction arranged primarily for the economic benefit of entity C. Factors to consider in this analysis (as addressed in para B50 of IFRS 3) include: The reasons for the transaction: why did entity D elect to cash settle the outstanding awards?

Who initiated the transaction: did entity C direct entity D to settle the awards?

Was the settlement a condition of the acquisition? The timing of the transaction: was the settlement in contemplation of the business combination? Entity D was directed by entity C to settle the awards. The settlement of the unvested awards was a transaction arranged primarily for the economic benefit of entity C. Therefore, a portion of the total cash consideration transferred is attributed to the cash settlement of the awards, and it is excluded from consideration transferred for entity D. The fair value of the unvested awards not attributable to pre-combination services (C25, which is the fair value of the award of C100 × remaining vesting period of 25%) is the amount that would be excluded from consideration transferred and recognised as expense in entity C’s post-combination financial statements. The C25 is recognised immediately, because no post-combination service is required. The entries recorded in entity C’s financial statements at the acquisition date are:

Dr Income statement remuneration expense 25

Cr Consideration 25

to reduce consideration included in the business combination accounting in respect of employee remuneration costs.

Estimates of vesting expectations

The IFRS 2 value of replacement awards attributable to both precombination services (and part of consideration) and to post-combination services is adjusted for the number of share-based payment awards expected to vest. For example, if the IFRS 2 value of the amount of the replacement award that is attributable to pre-combination services is C100 and the acquirer expects that 80% of the awards will vest, C80 is included in consideration.

The number of replacement awards expected to vest is the best available estimate at the acquisition date.

The tax effects of replacement share-based payment awards are recognised in accordance with IAS 12.