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BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

When it developed ED 2, the Board first considered conceptual arguments relating to the recognition of an expense arising from equity-settled share-based payment transactions, including arguments advanced by respondents to the Discussion Paper and other commentators. Some respondents who disagreed with the recognition of an expense arising from particular share-based payment transactions (ie those involving employee share options) did so for practical, rather than conceptual, reasons. The Board considered those practical issues later (see paragraphs BC294–BC310).

The Board focused its discussions on employee share options, because that is where most of the complexity and controversy lies, but the question of whether expense recognition is appropriate is broader than that—it covers all transactions involving the issue of shares, share options or other equity instruments to employees or suppliers of goods and services. For example, the Board noted that arguments made by respondents and other commentators against expense recognition are directed solely at employee share options. However, if conceptual arguments made against recognition of an expense in relation to employee share options are valid (eg that there is no cost to the entity), those arguments ought to apply equally to transactions involving other equity instruments (eg shares) and to equity instruments issued to other parties (eg suppliers of professional services).

The rationale for recognising all types of share-based payment transactions—irrespective of whether the equity instrument is a share or a share option, and irrespective of whether the equity instrument is granted to an employee or to some other party—is that the entity has engaged in a transaction that is in essence the same as any other issue of equity instruments. In other words, the entity has received resources (goods or services) as consideration for the issue of shares, share options or other equity instruments. It should therefore account for the inflow of resources (goods or services) and the increase in equity. Subsequently, either at the time of receipt of the goods or services or at some later date, the entity should also account for the expense arising from the consumption of those resources.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

Many respondents to ED 2 agreed with this conclusion. Of those who disagreed, some disagreed in principle, some disagreed for practical reasons, and some disagreed for both reasons. The arguments against expense recognition in principle were considered by the Board when it developed ED 2, as were the arguments against expense recognition for practical reasons, as explained below and in paragraphs.

Arguments commonly made against expense recognition include:
(a) the transaction is between the shareholders and the employees, not the entity and the employees.
(b) the employees do not provide services for the options.
(c) there is no cost to the entity, because no cash or other assets are given up; the shareholders bear the cost, in the form of dilution of their ownership interests, not the entity.

(d) the recognition of an expense is inconsistent with the definition of an expense in the conceptual frameworks used by accounting standard-setters, including the IASB’s Framework for the Preparation and Presentation of Financial Statements.9
(e) the cost borne by the shareholders is recognised in the dilution of earnings per share (EPS); if the transaction is recognised in the entity’s accounts, the resulting charge to the income statement would mean that EPS is ‘hit twice’.
(f) requiring the recognition of a charge would have adverse economic consequences, because it would discourage entities from introducing or continuing employee share plans.‘The entity is not a party to the transaction’

Some argue that the effect of employee share plans is that the existing shareholders transfer some of their ownership interests to the employees and that the entity is not a party to this transaction.

The Board did not accept this argument. Entities, not shareholders, set up employee share plans and entities, not shareholders, issue share options to their employees. Even if that were not the case, eg if shareholders transferred shares or share options direct to the employees, this would not mean that the entity is not a party to the transaction. The equity instruments are issued in return for services rendered by the employees and the entity, not the shareholders, receives those services. Therefore, the Board concluded that the entity should account for the services received in return for the equity instruments issued. The Board noted that this is no different from other situations in which equity instruments are issued. For example, if an entity issues warrants for cash, the entity recognises the cash received in return for the warrants issued. Although the effect of an issue, and subsequent exercise, of warrants might be described as a transfer of ownership interests from the existing shareholders to the warrant holders, the entity nevertheless is a party to the transaction because it receives resources (cash) for the issue of warrants and further resources (cash) for the issue of shares upon exercise of the warrants. Similarly, with employee share options, the entity receives resources (employee services) for the issue of the options and further resources (cash) for the issue of shares on the exercise of options.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

‘The employees do not provide services’

Some who argue that the entity is not a party to the transaction counter the points made above with the argument that employees do not provide services for the options, because the employees are paid in cash (or other assets) for their services.

Again, the Board was not convinced by this argument. If it were true that employees do not provide services for their share options, this would mean that entities are issuing valuable share options and getting nothing in return. Employees do not pay cash for the share options they receive. Hence, if they do not provide services for the options, the employees are providing nothing in return. If this were true, by issuing such options the entity’s directors would be in breach of their fiduciary duties to their shareholders.

Typically, shares or share options granted to employees form one part of their remuneration package. For example, an employee might have a remuneration package consisting of a basic cash salary, company car, pension, healthcare benefits, and other benefits including shares and share options. It is usually not possible to identify the services received in respect of individual components of that remuneration package, eg the services received in respect of healthcare benefits. But that does not mean that the employee does not provide services for those healthcare benefits. Rather, the employee provides services for the entire remuneration package.

In summary, shares, share options or other equity instruments are granted to employees because they are employees. The equity instruments granted form a part of their total remuneration package, regardless of whether that represents a large part or a small part.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

‘There is no cost to the entity, therefore there is no expense’

Some argue that because share-based payments do not require the entity to sacrifice any cash or other assets, there is no cost to the entity, and therefore no expense should be recognised.

The Board regards this argument as unsound, because it overlooks that:
(a) every time an entity receives resources as consideration for the issue of equity instruments, there is no outflow of cash or other assets, and on every other occasion the resources received as consideration for the issue of equity instruments are recognised in the financial statements; and
(b) the expense arises from the consumption of those resources, not from an outflow of assets.

In other words, irrespective of whether one accepts that there is a cost to the entity, an accounting entry is required to recognise the resources received as consideration for the issue of equity instruments, just as it is on other occasions when equity instruments are issued. For example, when shares are issued for cash, an entry is required to recognise the cash received. If a non-monetary asset, such as plant and machinery, is received for those shares instead of cash, an entry is required to recognise the asset received. If the entity acquires another business or entity by issuing shares in a business combination, the entity recognises the net assets acquired.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

The recognition of an expense arising out of such a transaction represents the consumption of resources received, ie the ‘using up’ of the resources received for the shares or share options. In the case of the plant and machinery mentioned above, the asset would be depreciated over its expected life, resulting in the recognition of an expense each year. Eventually, the entire amount recognised for the resources received when the shares were issued would be recognised as an expense (including any residual value, which would form part of the measurement of the gain or loss on disposal of the asset). Similarly, if another business or entity is acquired by an issue of shares, an expense is recognised when the assets acquired are consumed. For example, inventories acquired will be recognised as an expense when sold, even though no cash or other assets were disbursed to acquire those inventories.

The only difference in the case of employee services (or other services) received as consideration for the issue of shares or share options is that usually the resources received are consumed immediately upon receipt. This means that an expense for the consumption of resources is recognised immediately, rather
than over a period of time. The Board concluded that the timing of consumption does not change the principle; the financial statements should recognise the receipt and consumption of resources, even when consumption occurs at the same time as, or soon after, receipt.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

‘Expense recognition is inconsistent with the definition of an expense’

Some have questioned whether recognition of an expense arising from particular share-based payment transactions is consistent with accounting standard-setters’ conceptual frameworks, in particular, the Framework, which states:

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

Some argue that if services are received in a share-based payment transaction, there is no transaction or event that meets the definition of an expense. They  contend that there is no outflow of assets and that no liability is incurred. Furthermore, because services usually do not meet the criteria for recognition as an asset, it is argued that the consumption of those services does not represent a depletion of assets.

The Framework defines an asset and explains that the term ‘asset’ is not limited to resources that can be recognised as assets in the balance sheet (Framework, paragraphs 49 and 50).11 Although services to be received in the future might not meet the definition of an asset,12 services are assets when received. These assets are usually consumed immediately. This is explained in FASB Statement of Financial Accounting Concepts No. 6 Elements of Financial Statements:

Services provided by other entities, including personal services, cannot be stored and are received and used simultaneously. They can be assets of an entity only momentarily—as the entity receives and uses them—although their use may create or add value to other assets of the entity …

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

This applies to all types of services, eg employee services, legal services and telephone services. It also applies irrespective of the form of payment. For example, if an entity purchases services for cash, the accounting entry is:
Dr Services received
Cr Cash paid

Sometimes, those services are consumed in the creation of a recognisable asset, such as inventories, in which case the debit for services received is capitalised as part of a recognised asset. But often the services do not create or form part of a recognisable asset, in which case the debit for services received is charged immediately to the income statement as an expense. The debit entry above (and the resulting expense) does not represent the cash outflow—that is what the credit entry was for. Nor does it represent some sort of balancing item, to make the accounts balance. The debit entry above represents the resources received, and the resulting expense represents the consumption of those resources.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

The same analysis applies if the services are acquired with payment made in shares or share options. The resulting expense represents the consumption of services, ie a depletion of assets.

To illustrate this point, suppose that an entity has two buildings, both with gas heating, and the entity issues shares to the gas supplier instead of paying cash. Suppose that, for one building, the gas is supplied through a pipeline, and so is consumed immediately upon receipt. Suppose that, for the other building, the gas is supplied in bottles, and is consumed over a period of time. In both cases the entity has received assets as consideration for the issue of equity instruments, and should therefore recognise the assets received, and a corresponding contribution to equity. If the assets are consumed immediately
(the gas received through the pipeline), an expense is recognised immediately; if the assets are consumed later (the gas received in bottles), an expense is recognised later when the assets are consumed.

Therefore, the Board concluded that the recognition of an expense arising from share-based payment transactions is consistent with the definition of an expense in the Framework.

BASIS FOR CONCLUSIONS ON IFRS 2 RECOGNITION OF EQUITY-SETTLED

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