International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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number expected to be employed at the end of the vesting period as estimated at the
cancellation date) rather than on 460 employees (the number in employment at the
cancellation date). As discussed in Example 30.28 at 7.4.3 above, either approach may
be adopted but the selected approach should be applied consistently.
The illustrative examples above involve a relatively straightforward fact pattern where,
as at the date of cancellation and replacement, there was an amount to accelerate in
respect of the cancelled awards and an incremental fair value associated with the
replacement awards. In other scenarios, the two accounting outcomes might result in
greater divergence. For example, if the cancelled awards were expected never to vest,
because performance conditions had become unachievable and this had been the
conclusion for some time (see 7.4.3 above), the cancelled awards might have a value of
zero on a cancellation basis and the full value of the replacement awards would be
recognised. If modification accounting were applied, however, the entity would have to
recognise the grant date fair value of the cancelled awards plus any incremental value
of the replacement awards over the fair value of the cancelled awards as at cancellation
date. The latter approach might result in a significantly higher cost.
The discussion above relates to situations in which awards are cancelled and replaced
for reasons other than expected, or actual, failure by the counterparty to meet a service
condition. Changes to awards in contemplation, or as a consequence, of cessation of
employment are considered at 5.3.9.B above and at 7.5 and 7.6 below.
7.4.4.C
Replacement of vested awards
The rules for replacement awards summarised in paragraph (c) at 7.4 above apply ‘if a
grant of equity instruments is cancelled or settled during the vesting period ...’. [IFRS 2.28].
However, if the original award has already vested when a replacement award is granted,
there is no question of accelerating the cost of the cancelled award, as it has already
been recognised in full during the vesting period. The issue is rather the treatment of
the new award itself. IFRS 2 does not explicitly address this point but it appears that
such a replacement award should be treated in the same way as a completely new
award. In other words, its full fair value should be recognised immediately or, if there
are any vesting conditions for the replacement award, over its vesting period.
By contrast, the rules for modification of awards discussed in 7.3 above apply whether
the award has vested or not. Paragraphs 26 and 27 of IFRS 2 (modifications) are not
restricted to events ‘during the vesting period’ in contrast to paragraph 28 (cancellation
and settlement, including replacement awards), which is restricted to events ‘during the
vesting period’. [IFRS 2.26-28].
This has the effect that the accounting cost of modifying an already vested award (i.e.
the incremental fair value of the modified award) may, at first sight, appear to be lower
than the cost of cancelling and replacing it, which requires the full fair value of the new
award to be expensed. However, the full fair value of the new replacement award will
be reduced by the fair value of the cancelled award that the employee has surrendered
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as part of the consideration for the new award. This analysis will, in many cases, produce
an accounting outcome similar to that of the modification of an unvested award.
7.5
Replacement and ex gratia awards on termination of employment
When an employee’s employment is terminated during the vesting period of an award of
shares or options, the award will typically lapse in consequence. It is common in such
situations, particularly where the employee was part of the senior management, for the
entity to make an alternative award, or to allow the employee to retain existing awards, as
part of the package of benefits agreed with the employee on termination of employment.
Generally, such an award is an ex gratia award – in other words, it is a discretionary
award to which the outgoing employee had no legal entitlement under the terms of the
original award. However, a number of plan rules set out, in a ‘good leaver’ clause
(see 5.3.9 above), the terms on which any ex gratia award may be made, usually by
applying a formula to determine, or limit, how much of the original award can be
considered to have vested.
In many cases the award will be made on a fully vested basis, i.e. the employee has full
entitlement without further conditions needing to be fulfilled. In other cases, however,
an employee will be allowed to retain awards that remain subject to the fulfilment of
the original conditions (other than future service). Whichever form the award takes, in
IFRS 2 terms it will be treated as vesting at the date of termination of employment
because any remaining conditions will be accounted for as non-vesting conditions in
the absence of an explicit or implied service condition (see 3.2 above).
As discussed at 7.4.1.A above, IFRS 2 requires an entity to apply forfeiture (rather than
cancellation) accounting to awards that lapse if an employee is unable to satisfy a service
condition for any reason. In amending the standard to make clear that forfeiture accounting
applied to the termination of employment, the IASB did not specifically address the
accounting for any replacement or ex gratia awards on termination of employment.
If the original award is accounted for as a forfeiture and any previously recognised cost
reversed in anticipation of the employee’s expected departure, it perhaps follows that any
replacement award will be treated as a completely new award and recognised and
measured based on its own grant date. However, the standard is not clear and there might
be situations where entities consider it more appropriate to apply modification accounting
(recognising the original grant date fair value of the award that would otherwise be
forfeited on its original terms (because the service condition would not be met) plus the
incremental value of the modified terms). In the absence of clarity in IFRS 2, we believe
that judgement will be required based on the specific facts and circumstances and the
extent to which the changes to the arrangements are considered to be a waiver of existing
conditions in connection with the cessation of employment rather than the introduction
of a discretionary replacement arrangement on completely new terms.
Example 30.30: Replacement award on termination of employment
At the beginning of year 1, an executive is granted the right to 10,000 free shares on condition of remaining
in service until the end of year 3. The fair value of the award at grant date is £2.00 per share.
At the end of year 2, the executive’s employment is terminated and he therefore loses his right to any shares.
However, as ex gratia (voluntary) compensation, the remuneration committee awards him 6,667 shares
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vesting immediately. As at the end of year 2 the share price was £4.00, and the fair value of the original
award was £3.60 per share. (This is lower than the current share price because the holder of a share is
entit
led to receive any dividends paid during year 3 whereas the holder of an unvested right to a share is
not – see 8.5.4 below.)
This raises the question of how the ex gratia award of 6,667 shares should be accounted for. The factors to
be considered in determining the grant date in such cases are discussed further at 5.3.9 above. For the purposes
of this Example, it is assumed that the replacement award is treated as having been granted, or the original
award is treated as having been modified, at the end of year 2 rather than the terms being in place as at the
beginning of year 1.
Where the lapse is treated as a forfeiture, the entity:
• reverses the cost already booked for the award of £13,333 (10,000 shares × £2 × 2/3); and
• recognises the cost of the ex gratia award (at the fair value at that award’s grant date) of £26,668
(6,667 shares × £4).
This results in a net charge on termination of £13,335.
If the lapse is treated as a modification of the original award, the entity:
• accelerates the cost not yet booked for the original award of £6,667 (10,000 shares × £2 = £20,000, less
£13,333 already recognised – see above) as there is no future service period; and
• treats the ex gratia award as a replacement award at incremental value. The fair value of the replacement
award of £26,668 (6,667 shares × £4 – see above) is compared to the fair value of the original award of
£36,000 (10,000 shares × £3.60). Since the fair value of the replacement award is less than that of the
original award, there is no incremental cost required to be recorded under IFRS 2.
This results in a net charge on termination of £6,667.
Example 30.30 assumes that the entity treats the entire award as the unit of account. An
entity that has instead made a policy choice to base its modification accounting on an
individual share or option as the unit of account (see further discussion at 7.3.4 above)
will have a different accounting outcome.
7.6
Entity’s plans for future modification or replacement of award –
impact on estimation process at reporting date
As discussed at 6.1.1 and 6.1.2 above, IFRS 2 requires an entity to determine a cumulative
IFRS 2 charge at each reporting date by reference to the ‘best available estimate’ of the
number of awards that will vest (within the special meaning of that term in IFRS 2).
In addition to the normal difficulties inherent in any estimation process, it is not entirely
clear which anticipated future events should be taken into account in the IFRS 2
estimation process and which should not, as illustrated by Example 30.31 below.
Example 30.31: Estimation of number of awards expected to vest – treatment of
anticipated future events
At the beginning of year 1, an entity granted an award of 1,000 shares to each of its 600 employees at a
particular manufacturing unit. The award vests on completion of three years’ service. As at the end of year 1,
the entity firmly intends to close the unit, and terminate the employment of employees, as part of a
rationalisation programme. This closure would occur part way through year 2. The entity has not, however,
announced its intentions or taken any other steps so as to allow provision for the closure under IAS 37 –
Provisions, Contingent Liabilities and Contingent Assets (see Chapter 27 at 6.1).
Under the original terms of the award, the award would lapse on termination of employment. However, the
entity intends to compensate employees made redundant by changing the terms of their award so as to allow
full vesting on termination of employment.
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What is the ‘best estimate’, as at the end of year 1, of the number of awards expected to vest? Specifically
should the entity:
(a) ignore the intended closure altogether, on the grounds that there is no other recognition of it in the
financial statements;
(b) take account of the impact of the intended closure on vesting of the current award, but ignore the intended
future change to the terms of the award to allow vesting; or
(c) take account of both the intended closure and the intended change to the terms of the award?
In our view, there is no basis in IFRS 2 for accounting for an anticipated future change to the
terms of an award. The entity must account for those awards in issue at the reporting date,
not those that might be in issue in the future. Accordingly we do not consider approach (c)
above to be appropriate if any change to the issued awards was simply an intention.
Equally, we struggle to support approach (a) above. IFRS 2 requires the entity to use its
‘best available estimate’ and its best available estimate as at the end of year 1 must be that
the unit will be closed, and the employees’ employment terminated, in year 2. This view
is supported by the fact that, unlike IAS 36 – Impairment of Assets (see Chapter 20) and
IAS 37 – Provisions, Contingent Liabilities and Contingent Assets (see Chapter 27), IFRS 2
does not explicitly prohibit an entity from taking account of the consequences of
reorganisations and similar transactions to which it is not yet committed.
Accordingly, we believe that approach (b) should be followed under IFRS 2.
The entity’s best estimate at the end of year 1 must be that none of the awards currently
in place will vest (because all the employees will be made redundant and so will not meet
the service condition before the end of the vesting period). It therefore applies forfeiture
accounting at the end of year 1 and reverses any cost previously recorded for the award.
When the terms of the award are changed at the time of the redundancy in year 2 to
allow full vesting, the entity will either recognise the full cost of the new award (as all
cost relating to the original award has been reversed) or will treat the revised
arrangement as a modification of the original award that is beneficial to the employee.
In effect, the modification approach is based on a view that the original award is not
now going to lapse because it will be modified before employment ceases and the
forfeiture crystallises. In our view, in the absence of clarity in IFRS 2, the entity should
assess the more appropriate approach based on the particular facts and circumstances.
Either approach will have what many may see as the less than ideal result that the entity
will recognise a credit in profit or loss in year 1 and an expense in year 2, even though
there has been no change in management’s best estimate of the overall outcome. This
follows from the analysis, discussed above, that we do not believe that the entity can
account in year 1 for the award on the basis of what its terms may be in year 2.
The best estimate is made as at each reporting date. A change in estimate made in a later
period in response to subsequent events affects the accounting expense from that later
period only (i.e. there is no restatement of earlier periods presented).
7.7
Two awards running ‘in parallel’
In some jurisdictions, it is not straightforward to cancel or modify an award. This may
be because cancellation or modification triggers either a legal requirement for the
entity to pay compensation to the holder, or adverse tax consequences for the holder.
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In such cases, where an award has become unattractive (for example, because it is
‘out-of-the-money’), the entity may issue a second award rather than cancel or modify
the original award. The second award cannot be designated as a replacement award,
because the original award is still in place. The entity therefore has two awards
running ‘in parallel’.
However, a mechanism is then put in place to ensure that the employee can receive
only one award. For instance, if the original award were 1,000 options, it might be
replaced with a second award of 1,000 options, but on condition that, if options under
one award are exercised, the number of options exercisable under the other award is
correspondingly reduced, so that no more than 1,000 options can be exercised in total.
The accounting for such arrangements is discussed in Example 30.32 below.
Example 30.32: Two option awards running in parallel
At the beginning of year 1, an entity granted 1,000 A options to an employee, subject to non-market vesting
conditions. The grant date fair value of an A option was €50.
As at the beginning of year 2, the entity’s share price is significantly below the exercise price of an
A option, which now has a fair value of €5. Without modifying or cancelling the A options, the entity
awards the employee 1,000 new B options. The B options are subject to non-market vesting conditions
different in nature from, and more onerous than, those applicable to the A options, but have a lower
exercise price. The terms of the B options include a provision that for every A option that is exercised, the
number of B options that can be exercised is reduced by one, and vice versa. The fair value of a B option
at the beginning of year 2 is €15.
Clearly, the employee will exercise whichever series of options, A or B, has the higher intrinsic value. There
are four possible outcomes:
1. Neither the A options nor the B options vest.
2. Only the A options vest.
3. Only the B options vest.
4.
Both the A options and B options vest and the employee must choose which to exercise. Rationally, the
employee would exercise the B options as they have the lower exercise price.
In our view, the B options are most appropriately accounted for as if they were a modification of the