Financial Reporting

Considerations in IFRS 2: Share-based payment transactions

The International Financial Reporting Standard (IFRS 2) requires a company to record share-based payment transactions in its financial statements, which include transactions with employees or other parties that are settled in cash, other assets, or the equity instruments of the enterprise.

Applicability

IFRS 2 governs the grant of rights or options to workers or others in the company’s stock. The granting of shares or stock options to employees and directors is a widespread practice in most businesses. Furthermore, corporations may from time-to-time grant share options to creditors. Transactions involving the issuance of shares or share options are referred to as “share-based payment transactions” in general.

The major part of these transactions includes the corporation getting employment services, directorship services, or other products or services, and the company, in turn, settling the provision of goods or services in the form of shares or share warrants. The majority of the shares are equities of the business.

The valuation of the equity component, the initial recognition of these transactions, and the distribution of the cost of goods/services over accounting periods are the most important considerations in share-based payment transactions. The standard’s principal goal is to make sure that the cost of shares or share options awarded in share-based payment transactions is expensed, assuming that such shares/share options were issued at a price less than their fair value. That shall mean that, if shares or share options have been issued at their fair value, then determining the expense for the acquisition of goods/services is straightforward, i.e., the expenditure is equal to the fair value of the shares/share options.

It is also important to highlight that the Standard only applies where shares or share options have been offered for the purpose of acquiring goods/services. That is, the issuance of shares to existing owners, whether without or with insufficient consideration, is a transaction with shareholders (bonus shares or the issuance of shares with a bonus component) and does not fall under this criterion.

IFRS 2 is applicable to all entities. There is no exception for private or small businesses. Furthermore, subsidiaries that use their parent’s or another subsidiary’s stock as payment for goods or services are subject to the Standard. But, other than for the procurement of goods and services, IFRS 2 does not apply to share-based payment transactions. Dividends, the acquisition of treasury shares, and the issuing of additional shares fall outside of its purview.

Kinds of share-based payment transactions

There are three forms of share-based payment transactions, namely equity-settled, cash-settled, and optionally-settled.

• An equity-settled transaction occurs when an entity gets products or services that are settled by the issuance of equity instruments (i.e., shares or share options).
• A cash-settled transaction occurs when an entity obtains products or services at a price determined by the price of the entity’s equity instruments. In other words, it is almost as if the entity issued equity instruments in exchange for cash, but instead of cash, it receives goods/services in exchange. It may not be difficult to comprehend that, because the value of products and services acquired equals the fair value of equity instruments, the issuance of equity instruments is just a means of payment. As a result, under the cash-settled option, the issuance of stock instruments is merely a means of satisfying a financial obligation.
• If either the business or the counterparty has the choice of settling the transaction in equity or cash, then the transaction is said to be optionally equity or cash-settled.

Recognition and measurement

When the entity issues equity-settled instruments, it must record a credit to the applicable equity account, as well as an asset if the products or services obtained for the issue qualify to be considered as an asset, or as an expense if the products or services obtained for the issue do not qualify to be considered as an asset. For example, equity instruments issued to employees will result in an expense, whereas those issued for the acquisition of machinery will result in an asset.

If the entity acquires goods/services as a result of cash-settled instruments, a liability is created. It is important to note that while cash-settled instruments are simply a method of settling a liability, acquiring goods or services would result in the development of a financial liability rather than an equity instrument.

According to the standard, the fair value of products or services obtained in place of equity instruments could be difficult to calculate, especially in the case of employee stock options. As a result, in such transactions, the fair value of goods/services is determined by reference to the fair value of equity instruments.

There is typically a grant date, a vesting date, and an exercise date in the scenario of equity-settled instruments, especially those given to employees. A vesting date is a date on which the equity instrument becomes vested, i.e., when the employee/worker becomes entitled to the equity instrument. Usually, an employee must work for a specified number of years following the grant date before becoming eligible for the equity instrument, i.e., prior to the vesting date.

If vesting occurs immediately, it is assumed that the services relevant to the equity instrument have been obtained, leading to the instant recording of an expense and credit to the equity account. If vesting occurs in the future, the services would be deemed to have been obtained during the vesting period, which is the time between the grant date and the vesting date when the vesting criteria are met, such as the required duration of employment being fulfilled.

The standard provides recommendations on how to determine the fair value of equity instruments and when to do so. The fair value of equity instruments is determined on the grant date in the case of employee stock options, and on the date of acquisition of the goods/services in the case of equity instruments granted to others. It also states that in exceptional circumstances where the fair value of equity instruments cannot be determined with confidence, the intrinsic value of the equity instruments may be used instead.

In the case of cash-settled instruments, the fair value of the goods/services is significant, and it is recorded as a liability. In the case of optionally settled share-based payment plans, the company must treat it as a cash-settled plan to the degree that responsibility for payment for the goods/services has been established, and as an equity-settled plan for the remainder.

Further, according to IFRS 2, the fair value of equity instruments provided must be determined using market prices if available, as well as the terms and conditions under which the equity instruments were awarded. In the absence of appropriate market pricing, fair value is calculated using a valuation technique to calculate what the price of the equity instruments would have been in an arm’s length transaction between informed, competent parties on the measurement date. The standard is silent on which model should be utilized.

Fair value should be estimated at the grant date in the case of transactions involving the fair value of equity instruments given (such as transactions with employees). The fair value of the products or services received should be calculated at the time of receipt of those products or services for transactions measured at the fair value of the products or services received.

For both public and unlisted firms, IFRS 2 requires that the share-based payment transaction be assessed at fair value. In those “few circumstances” when the fair value of the equity^[1] instruments cannot be properly assessed, IFRS 2 allows the use of intrinsic value (that is, the fair value of the shares less exercise price). This isn’t just measured at the time of grant, though. At each reporting date until the final settlement, a company would have to remeasure intrinsic value.

Disclosure requirements

This standard specifies a variety of disclosure requirements that allow financial statement readers to comprehend:

• the nature and scope of share-based payment arrangements in place during the time period
• in what manner the fair value of goods or services obtained, or the fair value of equity instruments granted, was calculated throughout the period
• the impact of share-based payment transactions on the corporation’s profit or loss and financial position throughout the period

Conclusion

The purpose of IFRS 2 is to define an entity’s financial reporting when it engages in a share-based payment transaction. It specifically requires the company to record the consequences of share-based payment transactions, including expenses associated with transactions in which share options are awarded to workers, in its Profit & Loss statement.

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