International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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A options. In substance the A options have been modified by adding alternative non-market vesting
conditions with a different option exercise price.
On the date of the substantive modification, the entity estimates the fair value of both the original and
modified options and calculates the incremental fair value of the modification. As only one series of options
can be exercised, we believe that the most appropriate treatment is to account for whichever award the entity
believes, at each reporting date, is more likely to be exercised. This is analogous to the accounting treatment
we suggest in Example 30.12 at 6.2.5 above and in Example 30.17 at 6.3.6 above.
If the entity believes that neither award will vest, any expense previously recorded would be reversed.
If the entity believes that only the A options will vest, it will recognise expense based on the grant date fair
value of the A options (€50 each).
If the entity believes that only the B options will vest, it will recognise expense based on:
(a) the grant date fair value of the A options (€50 each) over the original vesting period of the
A options, plus
(b) the incremental fair value of the B options, as at their grant date (€10 each, being their €15 fair value
less the €5 fair value of an A option), over the vesting period of the B options.
If the entity believes that both the A options and B options will vest, it follows the accounting treatment of
outcome 3 above (i.e. vesting of the B options). This is because the employee will either choose the B options
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or, if the employee decides to choose the A options, the entity has to expense both the value of the A options
and the incremental value of the B options because that incremental value relates to a vested award.
The entity revises the assessment at each reporting date and at the end of the vesting period when the actual
outcome is known, so that the cumulative expense is based on the actual outcome.
Examples of other types of arrangement with multiple outcomes are illustrated at 6.2.5
above and at 10.3 and 15.4 below.
7.8
Share splits and consolidations
It is common for an entity to divide its existing equity share capital into a larger number
of shares (share splits) or to consolidate its existing share capital into a smaller number
of shares (share consolidations). The impact of such splits and consolidations is not
specifically addressed in IFRS 2, and a literal application of IFRS 2 could lead to some
rather anomalous results.
Suppose that an employee has options over 100 shares in the reporting entity, with an
exercise price of £1. The entity undertakes a ‘1 for 2’ share consolidation – i.e. the
number of shares in issue is halved such that, all other things being equal, the value of
one share in the entity after the consolidation is twice that of one share before
the consolidation.
IFRS 2 is required to be applied to modifications to an award arising from equity
restructurings. [IFRS 2.BC24]. In many cases, a share scheme will provide for automatic
adjustment so that, following the consolidation, the employee holds options over
only 50 shares with an exercise price of £2. As discussed at 5.3.8.A above, all things
being equal, it would be expected that the modified award would have the same fair
value as the original award and so there would be no incremental expense to be
accounted for.
However, it may be that the scheme has no such provision for automatic
adjustment, such that the employee still holds options over 100 shares. The clear
economic effect is that the award has been modified, since its value has been
doubled. It could be argued that, on a literal reading of IFRS 2, no modification has
occurred, since the employee holds options over 100 shares at the same exercise
price before and after the consolidation. The Interpretations Committee discussed
this issue at its July and November 2006 meetings but decided not to take it onto
its agenda because it ‘was not a normal commercial occurrence and ... unlikely to
have widespread significance’.23 This decision was re-confirmed by the
Interpretations Committee in March 2011.24 In our view, whilst it seems appropriate
to have regard to the substance of the transaction, and treat it as giving rise to a
modification, it can be argued that IFRS 2 as drafted does not require such a
treatment, particularly given the decision of the Interpretations Committee not to
discuss the issue further.
Sometimes, the terms of an award give the entity discretion to make modifications at a
future date in response to more complex changes to the share structure, such as those
arising from bonus issues, share buybacks and rights issues where the effect on existing
options may not be so clear-cut. These are discussed further at 5.3.8.A above.
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8
EQUITY-SETTLED TRANSACTIONS – VALUATION
8.1 Introduction
The IASB provides some guidance on valuation in Appendix B to the standard, which
we summarise and elaborate upon below. The guidance is framed in terms of awards to
employees which are valued at grant date, but many of the general principles are equally
applicable to awards to non-employees valued at service date. [IFRS 2.B1].
As discussed in more detail at 4 to 7 above, IFRS 2 requires a ‘modified grant-date’
approach, under which the fair value of an equity award is estimated on the grant date
without regard to the possibility that any service conditions or non-market performance
vesting conditions will not be met. Although the broad intention of IFRS 2 is to
recognise the cost of the goods or services to be received, the IASB believes that, in the
case of services from employees, the fair value of the equity instruments awarded is
more readily determinable than the fair value of the services received.
As noted at 5.1 above, IFRS 2 defines fair value as ‘the amount for which an asset could
be exchanged, a liability settled, or an equity instrument granted could be exchanged,
between knowledgeable, willing parties in an arm’s length transaction’.
IFRS 2 requires fair value to be based on the market price of the equity instruments,
where available, or calculated using an option-pricing model. While fair value may be
readily determinable for awards of shares, market quotations are not available for long-
term, non-transferable share options because these instruments are not generally traded.
As discussed further at 8.2.2 below, the fair value of an option at any point in time is
made up of two basic components – intrinsic value and time value. Intrinsic value is the
greater of (a) the market value of the underlying share less the exercise price of the
option and (b) zero.
Time value reflects the potential of the option for future gain to the holder, given the
length of time during which the option will be outstanding, and possible changes in the
share price during that period. Because market price information is not normally available
for an employee share option, the IASB believes that, in the absence of such information,
the fair value of a share option awarded to an employee generally must be estimated using
an option-pricing model. [IFRS
2.BC130]. This is discussed further at 8.3 below.
The discussion below aims to provide guidance on the valuation of options and similar
awards under IFRS 2; it is not intended to provide detailed instructions for constructing
an option pricing model.25
The approach to determining the fair value of share-based payments continues to be that
specified in IFRS 2 as share-based payments fall outside the scope of IFRS 13 which applies
more generally to the measurement of fair value under IFRSs (see Chapter 14). [IFRS 2.6A].
8.2 Options
8.2.1
Call options – overview
Before considering the features of employee share options that make their valuation
particularly difficult, a general overview of call options may be useful.
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Call options give the holder the right, but not the obligation, to buy the underlying shares
at a specified price (the ‘exercise’ or ‘strike’ price) on, or before, a specified date. Share-
based payments take the form of call options over the underlying shares.
Options are often referred to as American or European. American options can be
exercised at any time up to the expiry date, whereas European options can be exercised
only on the expiry date itself.
The terms of employee options commonly have features of both American and
European options, in that there is a period, generally two or three years, during which
the option cannot be exercised (i.e. the vesting period). At the end of this period, if the
options vest, they can be exercised at any time up until the expiry date. This type of
option is known as a Window American option or Bermudan option.
A grant of shares is equivalent to an option with an exercise price of zero and will be
exercised regardless of the share price on the vesting date. Throughout the discussion below,
any reference to share options therefore includes, to the extent applicable, share grants or
zero strike price options. There is further discussion of grants of free shares at 8.7.1 below.
8.2.2
Call options – valuation
As noted in 8.1 above, option value consists of intrinsic value and time value. For a call
option, intrinsic value is the greater of:
• the share price less the exercise price, and
• zero.
Figure 30.2 below sets out the intrinsic value (or payoff) for a call option with an
exercise price of $5.00.
Figure 30.2:
Intrinsic value of a call option
Call option
value ($)
Exercise price
Underlying
share price
$2.50
$5.00
$7.50
Out-of-the-money
In-the-money
At-the-money
A call option is said to be ‘in-the-money’ when the share price is above the exercise price
of the option and ‘out-of-the-money’ when the share price is less than the exercise price.
An option is ‘at-the-money’ when the share price equals the exercise price of the option.
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The time value of an option arises from the time remaining to expiry. As well as the share
price and the exercise price, it is impacted by the volatility of the share price, time to
expiry, dividend yield and the risk-free interest rate and the extent to which it is in- or out-
of-the-money. For example, when the share price is significantly less than the exercise
price, the option is said to be ‘deeply’ out-of-the-money. In this case, the fair value consists
entirely of time value, which decreases the more the option is out-of-the-money.
The main inputs to the value of a simple option are:
• the exercise price of the option;
• the term of the option;
• the current market price of the underlying share;
• the expected future volatility of the price of the underlying share;
• the dividends expected to be paid on the shares during the life of the option (if any); and
• the risk-free interest rate(s) for the expected term of the option.
Their effect on each of the main components of the total value (intrinsic value and time
value) is shown in Figure 30.3 below.
Figure 30.3:
Determinants of the fair value of a call option
Option value
=
Intrinsic value
+
Time value
Volatility
Share price
Interest rate
less
Time to expiry
exercise price
Dividend rate
Employee options
Vesting period
Early exercise
Non-transferability
Performance hurdles
The effect of these inputs on the value of a call option can be summarised as follows:
If this variable increases,
the option value ...
Share
price
Increases
Exercise
price Decreases
Volatility
Increases
Time to expiry
Usually increases*
Interest
rate Increases
Dividend
yield/payout
Decreases
*
In most cases the time value of an option is positive. Whilst an American option always has positive or
zero time value, a European option may have a zero or negative time value when there is a high dividend
yield and the option is considerably in-the-money. In this case, as the time to expiry increases, a
European call option will reduce in value (negative time value) and an American call option will stay
constant in value (zero time value).
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The factors to be considered in estimating the determinants of an option value in the
context of IFRS 2 are considered in more detail at 8.5 below.
8.2.3
Factors specific to employee share options
In addition to the factors referred to in 8.2.2 above, employee share options are also
affected by a number of specific factors that can affect their true economic value. These
factors, not all of which are taken into account for IFRS 2 valuation purposes (see 8.4
and 8.5 below), include the following:
• non-transferability (see 8.2.3.A below);
• continued employment requirement (see 8.2.3.B below);
• vesting and non-vesting conditions (see 8.2.3.C below);
• periods during which holders cannot exercise their options – referred to in various
jurisdictions as ‘close’, ‘restricted’ or ‘blackout’ periods (see 8.2.3.D below);
• limited ability to hedge option values (see 8.2.3.E below); and
• dilution effects (see 8.2.3.F below).
8.2.3.A Non-transferability
Holders of freely-traded share options (i.e. those outside a share-based payment
transaction) can choose to ‘sell’ their options (typically by writing a call option on the
same terms) rather than exercise them. By contrast, employee share options are
generally non-transferable, leading to early (and sub-optimal) exercise of the option.
This will lower the value of the options.
8.2.3.B
Continued employment requirement
Holders of freely-traded share options can maintain their positions until they
wish to
exercise, regardless of other circumstances. In contrast, employee share options cannot
normally be held once employment is terminated. If the options have not vested, they
will be lost. If the options have vested, the employee will be forced to exercise the
options immediately or within a short timescale, or forfeit them altogether, losing all
time value. This will lower the value of the options.
8.2.3.C
Vesting and non-vesting conditions
Holders of freely-traded share options have an unconditional right to exercise their
options. In contrast, employee share options may have vesting and non-vesting
conditions attached to them, which may not be met, reducing their value. This is
discussed in more detail in 8.4 below.
Although a non-market vesting condition reduces the ‘true’ fair value of an award, it
does not directly affect its valuation for the purposes of IFRS 2 (see 6.2 above).
However, non-market vesting conditions may indirectly affect the value. For example,
when an award vests on satisfaction of a particular target rather than at a specified time,
its value may vary depending on the assessment of when that target will be met, since
that may influence the expected life of the award, which is relevant to its fair value
under IFRS 2 (see 6.2.3 and 8.2.2 above and 8.5.1 below).
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8.2.3.D
Periods during which exercise is restricted
Holders of freely-traded American or Bermudan share options can exercise at any time
during the exercisable window. In contrast, employees may be subject to ‘blackout’
periods in which they cannot exercise their options, for example to prevent insider
trading. While this could conceivably make a significant impact if the shares were
significantly mis-priced in the market, in an efficient market blackout periods will only
marginally decrease the value.
8.2.3.E
Limited ability to hedge option values
In the case of freely-traded share options, it is reasonable to justify the theoretical
valuation on the basis that, for any other value, arbitrage opportunities could arise
through hedging. In contrast, employee share options are usually awarded only in
relatively small amounts, and the employees are usually subject to restrictions on share
trading (especially short selling the shares, as would be required to hedge an option).