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BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

To recognise equity-settled share-based payment transactions, it is necessary to decide how the transactions should be measured. The Board began by considering how to measure share-based payment transactions in principle. Later, it considered practical issues arising from the application of its preferred measurement approach. In terms of accounting principles, there are two basic questions:
(a) which measurement basis should be applied?
(b) when should that measurement basis be applied?

To answer these questions, the Board considered the accounting principles applying to equity transactions. The Framework states: Equity is the residual interest in the assets of the enterprise after deducting all of its liabilities … The amount at which equity is shown in the balance sheet is
dependent upon the measurement of assets and liabilities. Normally, the aggregate amount of equity only by coincidence corresponds with the aggregate market value of the shares of the enterprise …

The accounting equation that corresponds to this definition of equity is: assets minus liabilities equals equity

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Equity is a residual interest, dependent on the measurement of assets and liabilities. Therefore, accounting focuses on recording changes in the left side of the equation (assets minus liabilities, or net assets), rather than the right side. Changes in equity arise from changes in net assets. For example, if an entity issues shares for cash, it recognises the cash received and a corresponding increase in equity. Subsequent changes in the market price of the shares do not affect the entity’s net assets and therefore those changes in value are not recognised.

Hence, the Board concluded that, when accounting for an equity-settled share-based payment transaction, the primary accounting objective is to account for the goods or services received as consideration for the issue of equity instruments. Therefore, equity-settled share-based payment transactions should be accounted for in the same way as other issues of equity instruments, by recognising the consideration received (the change in net assets), and a corresponding increase in equity.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Given this objective, the Board concluded that, in principle, the goods or services received should be measured at their fair value at the date when the entity obtains those goods or as the services are received. In other words, because a change in net assets occurs when the entity obtains the goods or as the services are received, the fair value of those goods or services at that date provides an appropriate measure of the change in net assets.

However, for share-based payment transactions with employees, it is usually difficult to measure directly the fair value of the services received. As noted earlier, typically shares or share options are granted to employees as one component of their remuneration package. It is usually not possible to identify the services rendered in respect of individual components of that package. It might also not be possible to measure independently the fair value of the total package, without measuring directly the fair value of the equity instruments granted. Furthermore, options or shares are sometimes granted as part of a bonus arrangement, rather than as a part of basic remuneration, eg as an incentive to the employees to remain in the entity’s employ, or to reward them for their efforts in improving the entity’s performance. By granting share options, in addition to other remuneration, the entity is paying additional remuneration to obtain additional benefits. Estimating the fair value of those additional benefits is likely to be difficult.

Given these practical difficulties in measuring directly the fair value of the employee services received, the Board concluded that it is necessary to measure the other side of the transaction, ie the fair value of the equity instruments granted, as a surrogate measure of the fair value of the services received. In this context, the Board considered the same basic questions, as mentioned above:
(a) which measurement basis should be applied?
(b) when should that measurement basis be applied?

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Measurement basis

The Board discussed the following measurement bases, to decide which should be applied in principle:
(a) historical cost
(b) intrinsic value
(c) minimum value
(d) fair value.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Historical cost

In jurisdictions where legislation permits, entities commonly repurchase their own shares, either directly or through a vehicle such as a trust, which are used to fulfil promised grants of shares to employees or the exercise of employee share options. A possible basis for measuring a grant of options or shares would be the historical cost (purchase price) of its own shares that an entity holds (own shares held), even if they were acquired before the award was made.

For share options, this would entail comparing the historical cost of own shares held with the exercise price of options granted to employees. Any shortfall would be recognised as an expense. Also, presumably, if the exercise price exceeded the historical cost of own shares held, the excess would be recognised as a gain.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

At first sight, if one simply focuses on the cash flows involved, the historical cost basis appears reasonable: there is a cash outflow to acquire the shares, followed by a cash inflow when those shares are transferred to the employees (the exercise price), with any shortfall representing a cost to the entity. If the cash flows related to anything other than the entity’s own shares, this approach would be appropriate. For example, suppose ABC Ltd bought shares in another entity, XYZ Ltd, for a total cost of CU500,000,14 and later sold the shares to employees for a total of CU400,000. The entity would recognise an expense for the CU100,000 shortfall.

But when this analysis is applied to the entity’s own shares, the logic breaks down. The entity’s own shares are not an asset of the entity.15 Rather, the shares are an interest in the entity’s assets. Hence, the distribution of cash to buy back shares is a return of capital to shareholders, and should therefore be recognised as a decrease in equity. Similarly, when the shares are subsequently reissued or transferred, the inflow of cash is an increase in shareholders’ capital, and should therefore be recognised as an increase in equity. It follows that no revenue or expense should be recognised. Just as the issue of shares does not represent revenue to the entity, the repurchase of those shares does not represent an expense.

Therefore, the Board concluded that historical cost is not an appropriate basis upon which to measure equity-settled share-based payment transactions.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Intrinsic value

An equity instrument could be measured at its intrinsic value. The intrinsic value of a share option at any point in time is the difference between the market price of the underlying shares and the exercise price of the option.

Often, employee share options have zero intrinsic value at the date of grant—commonly the exercise price is at the market value of the shares at grant date. Therefore, in many cases, valuing share options at their intrinsic value at grant date is equivalent to attributing no value to the options.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

However, the intrinsic value of an option does not fully reflect its value. Options sell in the market for more than their intrinsic value. This is because the holder of an option need not exercise it immediately and benefits from any increase in the value of the underlying shares. In other words, although the ultimate benefit realised by the option holder is the option’s intrinsic value at the date of exercise, the option holder is able to realise that future intrinsic value because of having held the option. Thus, the option holder benefits from the right to participate in future gains from increases in the share price. In addition, the option holder benefits from the right to defer payment of the exercise price
until the end of the option term. These benefits are commonly referred to as the
option’s ‘time value’.

For many options, time value represents a substantial part of their value. As noted earlier, many employee share options have zero intrinsic value at grant date, and hence the option’s value consists entirely of time value. In such cases, ignoring time value by applying the intrinsic value method at grant date understates the value of the option by 100 per cent.

The Board concluded that, in general, the intrinsic value measurement basis is not appropriate for measuring share-based payment transactions, because omitting the option’s time value ignores a potentially substantial part of an option’s total value. Measuring share-based payment transactions at such an understated value would fail to represent those transactions faithfully in the financial statements.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

Minimum value

A share option could be measured at its minimum value. Minimum value is based on the premise that someone who wants to buy a call option on a share would be willing to pay at least (and the option writer would demand at least) the value of the right to defer payment of the exercise price until the end of the option’s term. Therefore, minimum value can be calculated using a present value technique. For a dividend-paying share, the calculation is:
(a) the current price of the share, minus
(b) the present value of expected dividends on that share during the option term (if the option holder does not receive dividends), minus
(c) the present value of the exercise price.

Minimum value can also be calculated using an option pricing model with an expected volatility of effectively zero (not exactly zero, because some option pricing models use volatility as a divisor, and zero cannot be a divisor).

The minimum value measurement basis captures part of the time value of options, being the value of the right to defer payment of the exercise price until the end of the option’s term. It does not capture the effects of volatility. Option holders benefit from volatility because they have the right to participate in gains from increases in the share price during the option term without having to bear the full risk of loss from decreases in the share price. By ignoring volatility, the minimum value method produces a value that is lower, and often much lower, than values produced by methods designed to estimate the fair value of an option.

The Board concluded that minimum value is not an appropriate measurement basis, because ignoring the effects of volatility ignores a potentially large part of an option’s value. As with intrinsic value, measuring share-based payment transactions at the option’s minimum value would fail to represent those transactions faithfully in the financial statements.

BASIS FOR CONCLUSIONS ON IFRS 2 MEASUREMENT OF EQUITY-SETTLED

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