equity settlement)
This section is written with a focus on awards with contingent cash settlement.
However, similar considerations will apply in a situation where it is the settlement in
equity that depends on the outcome of circumstances outside the control of the entity
or both the entity and the counterparty.
Rather than giving either the entity or the counterparty a general right to choose
between equity- or cash-settlement, some awards require cash settlement in certain
specific and limited circumstances but otherwise will be equity-settled. These
arrangements are referred to by IAS 32 as contingent settlement provisions and are
driven by the occurrence or non-occurrence of specific outcomes rather than by choice
(see Chapter 43 at 4.3). In the absence of specific guidance in IFRS 2, questions then
arise as to whether such an award should be accounted for as equity-settled or cash-
settled and whether this should be re-assessed on an ongoing basis during the vesting
period. This is a subject that has been considered by both the Interpretations Committee
and the IASB and their discussions are considered further at 10.3.5 below.
In the sections below we consider:
• two different approaches to the assessment of awards with contingent cash
settlement (see 10.3.1 to 10.3.2 below);
• awards that require cash settlement on a change of control (see 10.3.3 below); and
• the accounting treatment for changes in the manner of settlement where the award
is contingent on future events (see 10.3.4 and 10.3.5 below).
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10.3.1
Approach 1 – Treat as cash-settled if contingency is outside entity’s
control
One approach might be to observe that the underlying principle that determines
whether an award is accounted for as equity-settled or cash-settled under IFRS 2
appears to be whether the reporting entity can unilaterally avoid cash-settlement
(see 10.1 and 10.2 above). Under this approach, any award where the counterparty has a
right to cash-settlement is always treated as a liability, irrespective of the probability of
cash-settlement, since there is nothing that the entity could do to prevent cash-
settlement. By contrast, an award where the choice of settlement rests with the entity
is accounted for as a liability only where the entity’s own actions have effectively put it
in a position where it has no real choice but to settle in cash.
Applying this approach, it is first of all necessary to consider whether the event that
requires cash-settlement is one over which the entity has control. If the event, however
unlikely, is outside the entity’s control, then under this approach the award should be
treated as cash-settled. However, if the event is within the entity’s control, the award
should be treated as cash-settled only if the entity has a liability by reference to the
criteria summarised in 10.1 and 10.2 above.
Whilst, in our view, this is an acceptable accounting approach, it does not seem
entirely satisfactory. For example, in a number of jurisdictions, it is common for an
equity-settled share-based payment award to contain a provision to the effect that, if
the employee dies in service, the entity will pay to the employee’s estate the fair value
of the award in cash. The analysis above would lead to the conclusion that the award
must be classified as cash-settled, on the basis that it is beyond the entity’s control
whether or not an employee dies in service. This seems a somewhat far-fetched
conclusion, and is moreover inconsistent with the accounting treatment that the entity
would apply to any other death-in-service benefit under IAS 19. IAS 19 would
generally require the entity to recognise a liability for such a benefit based on an
actuarial estimate (see Chapter 31 at 3.6), rather than on a presumption that the entire
workforce will die in service.
10.3.2
Approach 2 – Treat as cash-settled if contingency is outside entity’s
control and probable
It was presumably considerations such as those above that led the FASB staff to provide
an interpretation26 of the equivalent provisions of FASB ASC 718 – Compensation –
Stock Compensation (formerly FAS 123(R) – Share-Based Payment) regarding awards
that are cash-settled in certain circumstances. This interpretation states that a cash
settlement feature that can be exercised only upon the occurrence of a contingent event
that is outside the employee’s control does not give rise to a liability until it becomes
probable that that event will occur.27
In our view, an approach based on the probability of a contingent event that is outside
the control of both the counterparty and the entity is also acceptable under IFRS and
is frequently applied in practice. The implied rationale (by reference to IFRS
literature) is that:
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payment
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• IFRS 2 clearly notes a number of inconsistencies between IFRS 2 and IAS 32
(see 1.4.1 above) and so there is no requirement to follow IAS 32 in respect of
contingent cash settlement arrangements; and
• it is therefore appropriate to have regard to the principles of IAS 37 in determining
whether an uncertain future event gives rise to a liability. IAS 37 requires a liability
to be recognised only when it is probable (i.e. more likely than not) to occur (see
Chapter 27).
The impact of Approach 1 and Approach 2 can be illustrated by reference to an award that
requires cash-settlement in the event of a change of control of the entity (see 10.3.3 below).
10.3.3
Application of Approach 1 and Approach 2 to awards requiring cash
settlement on a change of control
It is not uncommon for the terms of an award to provide for compulsory cash-
settlement by the entity if there is a change of control of the reporting entity. Such a
provision ensures that there is no need for any separate negotiations to buy out all
employee options, so as to avoid non-controlling interests arising in the acquired entity
when equity-settled awards are settled after the change of control.
The question of whether or not a change of control is within the control of the entity is
a matter that has been the subject of much discussion in the context of determining the
classification of certain financial instruments by their issuer, and is considered more
fully in Chapter 43 at 4.3.
If the facts and circumstances of a particular case indicate that a change of control is
within the entity’s control, the conclusion under either Approach 1 or Approach 2 above
would be that the award should be treated as cash-settled only if the entity has a liability
by reference to the criteria summarised in 10.2.1 above.
If, however, the change of control is not considered to be within the control of the
reporting entity, the conclusion will vary depending on whether Approach 1 or
Approach 2 is followed. Under Approach 1, an award requiring settlement in cash on a
change of control outside the control of the entity would be treated as cash-settled,
however unlikely the change of control may be. Under Approach 2 however, an award
requiring settlement in cash on a change of control outside the control of the entit
y
would be treated as cash-settled only if a change of control were probable.
A difficulty with Approach 2 is that it introduces rather bizarre inconsistencies in the
accounting treatment for awards when the relative probability of their outcome is
considered. As noted at 10.1.5 above, an award that gives the counterparty an absolute
right to cash-settlement is accounted for as a liability, however unlikely it is that the
counterparty will exercise that right. Thus, under this approach, the entity could find
itself in the situation where it treats:
• as a liability: an award with an unrestricted right to cash-settlement for the
counterparty, where the probability of the counterparty exercising that right is less
than 1%; but
• as equity: an award that requires cash settlement in the event of a change of control
which is assessed as having a 49% probability of occurring.
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In our view, an entity may adopt either of these accounting treatments, but should do
so consistently and state its policy for accounting for such transactions if material.
In selecting an accounting policy, an entity should however be aware of the IASB’s
discussions on whether an approach based on the ‘probable’ outcome should be applied
or whether an approach based on the accounting treatment for a compound instrument
should be used (see 10.3.5 below).
There is further discussion at 15.4 below of awards that vest or are exercisable on a
flotation or change of control, including the question of whether a cash-settlement
obligation rests with the entity itself or with other parties involved in the change of
control (see 15.4.6 below).
10.3.4
Accounting for change in manner of settlement where award is
contingent on future events outside the control of the entity and the
counterparty
When, under Approach 2 above, the manner of settlement of an award changes solely
as a consequence of a re-assessment of the probability of a contingent event, there is
neither settlement of the award nor modification of its original terms (see 10.3.4.A below
for discussion of awards that have also been modified). The terms of the award are such
that there have been two potential outcomes, one equity-settled and one cash-settled,
running in parallel since grant date. It is as if, in effect, the entity has simultaneously
issued two awards, only one of which will vest.
At each reporting date the entity should assess which outcome is more likely and
account for the award on an equity- or cash-settled basis accordingly. In our view, any
adjustments arising from a switch between the cumulative amount for the cash-settled
award and the cumulative amount for the equity-settled award should be taken to profit
or loss in the current period. This is similar to the approach for an award with multiple
independent vesting conditions (see 6.3.6 above).
When applying an approach where the two outcomes have both been part of the
arrangement from grant date, an entity measures the fair value of the equity-settled
award only at the original grant date and there is no remeasurement of the equity-settled
award on reassessment of the settlement method. As the cash-settled award would be
remeasured on an ongoing basis, a switch in the manner of settlement during the period
until the shares vest or the award is settled in cash could give rise to significant volatility
in the cumulative expense. At the date of vesting or settlement, however, the cumulative
expense will equate to either the grant date fair value of the equity-settled approach or
the settlement value of the cash-settled approach depending on whether or not the
contingent event has happened.
The situation discussed in this section (i.e. an arrangement with two potential outcomes
from grant date because the manner of settlement is not within the control of either the
entity or the counterparty) is not the same as an award where the manner of settlement
is entirely within the entity’s control. Where the entity has such control and therefore a
choice of settlement, a change in the manner of settlement is treated as a modification
with a potential catch-up adjustment through equity (see 9.4 and 10.2.3 above).
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payment
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As noted at 10.3.5 below, discussions by the Interpretations Committee indicated a
preference for treating an award as equity-settled or cash-settled in its entirety, based
on the probable outcome, rather than as a compound instrument, but subsequent
discussions by the IASB were divided.
10.3.4.A
Distinction between re-assessment of settlement method and
modification of terms of award
Some awards include arrangements for contingent cash-settlement if an event outside
the control of the entity and the counterparty, such as some forms of exit, has not
happened within a certain timescale. During the initial period of such an arrangement
there might be an expectation that the exit (or other event) will take place. In this case,
the award would be treated as equity-settled using an approach based on the probability
of this outcome, as outlined at 10.3.4 above. However, if it is decided, close to the end
of the period during which equity-settlement would apply, to modify the terms of the
award so that this period is extended, the entity needs to re-assess the arrangement on
both its original and modified terms.
It might therefore be the case that cash-settlement under the original terms of the award
becomes the more likely outcome for a short time and that the entity has to switch the
award from an equity-settled to a cash-settled basis in line with the guidance at 10.3.4
above. If a modification is then made to extend the period during which the award can
be equity-settled and hence the settlement in cash once again becomes less likely, the
entity should then switch again to an equity-settled basis of accounting using
modification accounting (see 9.4.2 above).
10.3.5
Manner of settlement contingent on future events: discussions by the
IASB and the Interpretations Committee
Following an earlier request to the Interpretations Committee for clarification on how
share-based payment transactions should be classified and measured if the manner of
settlement is contingent on either:
• a future event that is outside the control of both the entity and the counterparty;
or
• a future event that is within the control of the counterparty,
the IASB agreed that transactions in which the manner of settlement is contingent on future
events should be considered together with other issues relating to IFRS 2 (see 3.4 above).28
Prior to discussion by the IASB, the Interpretations Committee discussed the matter
again in May 2013, noting that paragraph 34 of IFRS 2 requires an entity to account on
a cash-settled basis if, and to the extent that, the entity has incurred a liability to settle
in cash or other assets. However, it was further noted that IFRS 2 only provides
guidance where the entity or the counterparty has a choice of settlement and not
where the manner of settlement is contingent on a future event that is outside the
control of both part
ies. The Interpretations Committee also observed that it was
unclear which other guidance within IFRS and the Conceptual Framework would
provide the best analogy to this situation. It was concluded that there was significant
diversity in practice.29
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In September 2013, the Interpretations Committee noted that the results of additional
outreach indicated that shared-based payment transactions in which the manner of
settlement is contingent on a future event within the control of the counterparty (but
not the entity) are not significantly widespread and so the Committee decided not to
add this element of the original submission to its agenda.30
The Interpretations Committee also returned to the question of accounting when the
manner of settlement is contingent on a future event that is outside the control of both
the entity and the counterparty. It was noted that such arrangements are settled either
in cash or in equity instruments in their entirety and that neither party to the
arrangement has control over the manner of settlement. Accordingly, the Committee
observed that the share-based payment should be classified as either equity-settled or
cash-settled in its entirety depending on which outcome is probable.
The Interpretations Committee also discussed the accounting for a change in
classification of the transaction arising from a change in the more likely settlement
method. A majority of the Committee thought that there should be a cumulative
adjustment recorded at the time of the change of classification, in such a way that the
cumulative cost would be the same as if the change of classification had occurred at
the inception of the arrangement (see 10.3.4 above). The Committee decided to
recommend that the IASB make a narrow-scope amendment to IFRS 2 based on the
approach above.31
The IASB discussed these recommendations in February 2014. Some IASB members
expressed concern over use of a ‘probable’ approach for deciding the classification of a
share-based payment. They took the view that such share-based payment transactions
were similar to those in which the counterparty has a choice of settlement method
because the entity does not have the unconditional right to avoid delivering cash or
other assets. Therefore they considered that such arrangements should be accounted
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