IFRS 2 – Share-based Payment
Why do entities grant shares or share options to employees and other parties?
Grants of shares or share options to employees constitute a common method of compensating employees, directors, and senior executives. In addition, certain entities may issue shares or share options to other parties, such as professional service providers and other suppliers. The advantage of using this tool for employee compensation is twofold: on the one hand, it constitutes compensation that does not require an outflow of cash or other economic resources; on the other hand, this form of compensation ties the employee to the value of the company’s shares and creates a clear incentive for the employee to maximise the share price. In other words, equity-based compensation plans create a link between the employee’s personal goals and the business objectives of the reporting entity, since as the company’s share price rises, so does the value of the employee’s compensation, and vice versa.
In which types of entities are equity-based compensation plans most commonly used?
As a result, such grants are common in technology companies in their early stages, which, despite their limited resources, are required to employ highly skilled personnel. This method is also used in compensating senior executives to create alignment between the company’s objectives and those of management, and to reduce the conflict of interest that sometimes exist between management and the company’s shareholders (the “agency problem”). Additional advantages of using equity-based compensation plans include:
- Equity-based compensation plans increase the reporting entity’s equity and reduce its exposure to hostile takeovers.
- Employe options improve the reporting entity’s cash flows when options are exercised by receiving the exercise price.
- Savings in issuance costs – issuing equity instruments to external parties generally involves significant issuance costs (including “marketing” costs). By issuing equity instruments to employees, the reporting entity saves a significant portion of these costs.
What types of conditions are commonly attached to share-based payment arrangements?
Since after the grant the employee may sell their shares or exercise the options, different types of conditions have developed that tie the employee to the reporting entity for a certain period. These include equity instruments that vest only if a minimum period of service is completed, or if certain performance conditions are met during the period, such as achieving specified profitability targets.
What is the main accounting issue addressed by IFRS 2?
The main issue regarding the accounting treatment of options or shares granted to employees and others is whether, and how, to reflect in the financial statements the benefit component that the employee receives. From an economic perspective, the issuance of share options (or shares) to employees is similar to a regular issuance of share options (or shares), since in this case the reporting entity receives services in exchange for issuing the share options (or shares), which are economically equivalent to receiving cash or other assets in a regular issuance.
How can the issuance of shares or options to employees be explained economically?
To illustrate the accounting meaning of issuing share options (or shares) to employees, one may view the issuance economically as two simultaneous notional transactions: in notional transaction A, the reporting entity pays cash to the employee for their services while in notional transaction B, the reporting entity issues share options (or shares) to the employee in exchange for the cash the employee received under notional transaction A. The overall effect is that no cash actually flows, since the employee “deposits” the notional cash received in exchange for the equity instruments. However, from an accounting perspective, notional transaction A leads to recognition of wages as an expense (unless capitalized as an asset), while notional transaction B leads to recognition of equity instruments within equity. Although the overall sum of the transactions generally does not affect the reporting entity’s total equity (recognition of wage expense on the one hand, and recognition of equity instruments for the same amount on the other) and does not affect its cash flows, it does have implications for reported results.
Why was the accounting treatment of share-based payments historically controversial?
This logic has formed the basis of accounting standards for the treatment of equity-based compensation plans, both in IFRS Accounting Standards and in US GAAP. However, this accounting treatment was controversial for many years, and was significantly influenced by companies’ reporting interests, particularly in the U.S. The following are some of the main arguments historically raised against this accounting treatment:
- “Recognition of wage expenses is inappropriate since there is no actual outflow of economic resources, and therefore the recognition of wage expenses is inconsistent with the definition of an expense in the Conceptual Framework.”
- “The reporting entity does not incur any cost, since there is no outflow of cash (or other assets). The shareholders bear the cost, which is expressed through dilution of their holdings in the entity.”
- “The transaction is between the shareholders and the employees rather than between the reporting entity and the employees.”
- “The purpose of granting options to employees is to increase the value of the reporting entity. As a result, in many cases, following an increase in the entity’s value, there is no dilution in the value of the shareholders’ holdings.”
- “It is not possible to reliably measure the fair value of the granted options (which are generally not listed), and therefore the financial statements should not include amounts whose measurement is unreliable.”
How do these arguments conflict with the Conceptual Framework for Financial Reporting?
It appears that these arguments do not align with the principles of the Conceptual Framework for Financial Reporting, according to which equity-related components arising from transactions between the reporting entity and its shareholders should not be recognised in profit or loss, as well as with the presumption that fair value of options can be reliably estimated using option pricing models. When a reporting entity grants shares or options to its employees for free or at a discount, the shareholders of the reporting entity economically bear the actual cost of the employee services, since their ownership percentage is diluted without any inflow of cash. In other words, the shareholders “pay” the employees’ wages by being diluted in their holdings. Therefore, to achieve an appropriate separation between the profit or loss element and the equity element, the cost of the services should be recognised as an expense (the performance element), while the benefit element should be recognised as an owner contribution (the equity element). Moreover, the first argument mentioned above is also incorrect: although the services received from the employee generally do not meet the definition of an asset, the reporting entity consumes these services over time, and accordingly, the services received during the period can be viewed as an asset consumed (i.e., an asset that was recognised and consumed simultaneously). Thus, in substance, the reporting entity pays its employees for their services by means of options and other equity instruments, which serve as substitutes for wages.
What are the core requirements of IFRS 2?
IFRS 2 requires reporting entities to recognise in the financial statements share-based payment transactions, including transactions with employees or other parties, that are settled in cash, in other assets, or in the entity’s equity instruments. The Standard also prescribes fair value–based measurement principles and additional guidance for the accounting treatment of the different types and characteristics of equity-based compensation plans. Furthermore, the Standard establishes the accounting treatment of employee options in intra-group transactions, for example, where a parent grants the employees of its subsidiary equity instruments of the parent.
Why is applying IFRS 2 in practice often complex?
Although the guiding principle, under which equity benefits granted to employees should be recognised and measured, is inherently “simple,” the practical implementation of this principle across the variety of existing plans and different circumstances may be complex and require judgment. This is due, among other things, to significant reliance on sensitive fair value estimates of these equity benefits, as well as on determining the exact timing at which this fair value should be measured. The numerous accounting scandals in the U.S. relating to backdating of equity grants to employees demonstrate the sensitivity of these determinations, their reporting implications, and therefore the crucial importance of understanding the Standard’s requirements and applying them rigorously.