Designing share-based payment schemes

Designing share-based payment schemes
Accounting and business considerations under IFRS June 2007

RSM International

Contents
About this publication | 1
The RSM IFRS Champions group | 2
Introduction | 3
IFRS 2 at a glance | 4
1. The value of the option does not derive solely from its intrinsic value | 6
2. Key dates and terms of a share-based transaction | 9
3. Equity-settled and cash-settled share-based payments | 13
4. Market and non-market conditions (true-up model) | 17
5. Beware of modiﬁcations, replacements, settlements and cancellations of granted equity instruments | 21
6. Categories of employees targeted by share-based transaction | 24
7. Equity-settled share-based payments hit the EPS indicator twice | 27
8. The charge to the income statement ultimately affects the ﬁnancial statements of the entity receiving goods or services | 30
9. Not just a case of remuneration… services and goods may also be relevant | 33
10. Newly listed, listed and unlisted entities… complications in calculating volatility | 36
11. Current, deferred taxation and social contribution implications | 39
12. Share-based payment options are measured by applying pricing models | 42
13. Beware the impact of business acquisitions on share-based payments | 46
14. Is the entire value of the stock option award perceived by the option holders? | 49
Glossary | 52

1 | RSM International

About this publication

Principal editors RSM International

Author: The RSM International logo and name are registered trademarks of RSM International Association.
Marco Marcellan RSM International
All rights are reserved. No part of this publication may be reproduced, stored in any system, or
transmitted in any form or by any means whether electronic, mechanical, photocopied, recorded or
Panel of reviewers:
otherwise without the prior permission in writing of RSM International Association.
Chandra Sekaran Albazie & Co, Kuwait (Member of RSM International)
Jason Croall RSM Bird Cameron, Australia (Member of RSM International)

This publication provides information with regard to the application of IFRS 2 — Share-based
payments. The application of IFRS 2 is the responsibility of the management of the relevant entity
and therefore this guide cannot be taken as a definitive reference and does not replace the need
for professional judgment with regard to relevant standards and other requirements and all of the
relevant circumstances relating to the issue under review. Moreover, no reference is made to any real
tax and legal framework.

No responsibility for any errors or omissions nor loss occasioned to any person or organisation acting
or refraining from acting as a result of this publication can be accepted by the author, the reviewers or
RSM International.

Views expressed in this publication are the authors and are not necessarily those of RSM International.

Preparers of IFRS financial statements may wish to seek specific advice from the local member firm of
RSM International.


The RSM IFRS Champions group

This publication has been prepared by the RSM International central IFRS technical team based
in London and has been reviewed by some RSM IFRS Champions from member firms of RSM
International.

In order to provide technical IFRS excellence to its member firms and their clients, RSM International
has created a team of fully dedicated IFRS experts from RSM member firms from all over the world.

These experts meet regularly to discuss leading-edge developments on IFRS and to share experiences
arising from their IFRS work.

RSM International has produced a brochure entitled ‘Your partner in understanding the business
implications of IFRS’. This brochure highlights RSM’s global expertise regarding International Financial
Reporting Standards as well as the contact details of all the members of the RSM Champions group
worldwide.

All IFRS publications can be downloaded from www.rsmi.com. Alternatively, you can contact the RSM
Executive Office in London or your local RSM member firm.

Your partner in
understanding the
s
business implication
of IFRS


Introduction

After a long debate, an International Financial Reporting Standard relating to share-based payments
was issued by the International Accounting Standard Board (IASB) and endorsed by the European
Community (EU) at the beginning of 2005.

Before the introduction of IFRS 2, companies reporting under IFRS that were largely using share-
based payments took advantage of the fact that it represented a valid tool to reward employees as
well as focus them on company targets without affecting income statement performances.

Now, as a result of IFRS 2, costs related to share-based payments have to be charged to the income
statement. This represents the real accounting innovation introduced by IFRS 2. Companies using
share-based payments that have applied IFRS 2 have seen a signiﬁcant impact on results and, in
certain circumstances, rethought company remuneration strategies based on share-based payments.

Moreover, as it requires the use of complex pricing models, IFRS 2 is far from easy to apply. As a result,
it is likely that many companies will need to engage external experts to measure and account for
share-based payments under IFRS 2.

Before developing a share-based payment plan, management should be aware of some of its key
features. By understanding these features more comprehensively, management will have a better
understanding of income statement consequences and signiﬁcantly reduce the impact of complex,
time-consuming and costly accounting requirements.

This guide aims to be a friendly explanation of the key points you need to bear in mind when setting
up a share-based payment plan. If you know these “golden rules”, you can make your accounting
method less complex, reduce your implementation costs and gain a better idea of how future results
will be affected by IFRS 2 accounting rules.


IFRS 2 at a glance

Types of share-based payments
IFRS 2 categorises share-based payments into three major groups:
Equity-settled — where “the entity receives goods or services in exchange for its shares or share options
or other own equity instrument”. [IFRS 2 par. 10]
Cash-settled — where “the entity incurs a liability in exchange for goods or services with a supplier. The
amount of the liability is based on the price or value of the entity’s shares or other equity instruments
of the entity”. [IFRS 2 par. 30]
Choice of settlement — where “both the entity and the supplier of goods or services has a right to choose
the transaction to be settled in cash or with equity instruments of the entity”. [IFRS 2 par. 34]

Scope of IFRS 2
IFRS 2 must be applied by all entities reporting under IFRS, either listed or not listed, as of 1 January
2005. Transitional provisions apply for existing IFRS preparers. For ﬁrst time adopters of IFRS, special
transition rules are stated in IFRS 1.

IFRS 2 applies to a wide range of share-based payment transactions. The most common share-based
payment transaction relates to employee services. However, IFRS 2 also applies to transactions aimed
at the acquisition of goods and services. Goods can include inventories, consumables, tangible /
intangible assets and other non-ﬁnancial assets.

IFRS 2 does not apply to:
Transactions with an employee or other party in his / her capacity as a holder of equity instruments.
[IFRS 2 par. 4]
Transactions in which the entity acquires goods as part of the net assets acquired in a business
combination to which IFRS 3 applies. However, equity instruments granted to employees of the
acquiree in their capacity as employees (e.g. in return for continued service) fall under the scope of
IFRS 2. [IFRS 2 par. 5]
Certain contracts within the scope of IAS 32 and IAS 39. [IFRS 2 par. 6]


IFRS 2 at a glance

Measurement Subsequent re-measurement
IFRS 2 does not clearly state which pricing model should be used for valuation purposes. It simply Equity-settled
points out that any valuation technique adopted by the entity shall be consistent with generally Market conditions are included in the grant date pricing model fair value; therefore, such a fair value
accepted valuation methodologies for pricing ﬁnancial instruments currently used by willing market of the equity instruments is no longer revised after the grant date. [IFRS 2 par. 21]
participants.
Non-market conditions are not considered as input data for the grant date fair value measurement
Equity-settled based on a pricing model. They are assessed in order to revise the number of instruments expected
Measurement is based on the fair value of the instrument granted at grant date. IFRS 2 states that, to vest. (True-up model applied.) [IFRS 2 par. 19]
“The fair value of those equity instruments shall be measured at grant date based on a pricing model.”
The changes in fair value are recognised to the income statement with a corresponding entry to
[IFRS 2 par. 11] “The entity shall measure the goods or services received, and the corresponding
equity. [IFRS 2 par. 10]
increase in equity, directly, at the fair value of the goods or services received, unless that fair value
cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or Cash-settled
services received, the entity shall measure their value, and the corresponding increase in equity, The fair value of the instrument granted is re-measured at each reporting date. The changes in fair
indirectly, by reference to the fair value of the equity instruments granted.” [IFRS 2 par. 10] value are recognised in the income statement and as liabilities in the balance sheet. [IFRS 2 par. 30]
Cash-settled
The entity shall measure the goods or services acquired and the liability incurred at the fair value of
the liability. Until the liability is settled, the entity shall re-measure the fair value of the liability at each
reporting date and at the date of settlement, with any changes in fair value recognised in proﬁt or loss
for the period.” [IFRS 2 par. 30]

Initial recognition
“The entity shall recognise the goods or services received or acquired in a share-based payment
transaction when it obtains the goods or as the services are received.” [IFRS 2 par. 7]
Equity-settled
The expense is recognised to the income statement over the vesting period with a corresponding
entry to equity.
Cash-settled
The expense is recognised to the income statement over the vesting period with a corresponding
entry to liabilities.


1. The value of the option does not derive solely from its intrinsic value

KEY MESSAGE (a) TIME VALUE IS A COMPONENT OF THE FAIR VALUE WHICH CANNOT BE IGNORED
The fair value of an option is made up of two components: intrinsic value and time value. Although the
Section 1

Time value is a component of the intrinsic value would normally represent the major component, time value can be very signiﬁcant as well.
A failure to consider the time value could result in missing a signiﬁcant part of the value of the option or

total value to be charged to the income
even the entire value of the option when they are issued at the money.
(b) TIME VALUE IS CAPTURED ONLY BY APPLYING A PRICING MODEL

statement. High volatility and length The time value can be calculated only by adopting ad hoc pricing models. The complexity of the pricing
model varies depending on the share-based payment characteristics. In cases where in-house expertise is

to expiration increase the time value not available, it could be necessary to request the advice of an external expert.
(c) BOTH VOLATILITY AND THE TIME TO EXPIRATION AFFECT THE TIME VALUE
and therefore the total charge to the The higher the volatility of the underlying instrument and the time to expiration of the option, the higher
the time value of the option. A high volatility and a lengthy time to expiration are always advantageous
income statement. for the option holder.



Section 1

Intrinsic value
+
Time value
=
Fair value



Additional guidance The time remaining to expiration directly affects the possibility for an option to be in the money, or to
Section 1
It can be complex to calculate the value of an option; that’s why the pricing models applied have to increase its fair value before the exercise date. Hence, the longer the time frame, the higher the
take into consideration other factors of the option in addition to the intrinsic value. possibility for an option to be in the money or to increase its fair value before the exercise date.

Basically, the value of an option can be divided into two major components: The volatility is the standard deviation of the change in value of a financial instrument with
a specific time horizon. It is often used to quantify the risk of the instrument over that time
Intrinsic value. This is: “The difference between the fair value of the shares to which the counterparty period. Volatility is typically expressed in annualised terms, and it may either be an absolute
has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the number or a fraction of the initial value. The higher the volatility, the greater the fluctuations of
price (if any) the counterparty is (or will be) required to pay for those shares.” [IFRS 2, Appendix A] the item concerned.
Time value. This is the portion of an option’s premium that exceeds the intrinsic value. The time value
of an option reflects the probability that the option will move in the money. Therefore, the longer The intrinsic value is usually quite a straightforward calculation, but the same cannot be said
the time remaining until expiration of the option, the greater its time value. This is also called for the time value. To calculate the time value, a pricing model is required whose complexity can
extrinsic value. be variable and which usually requires a certain degree of expertise to manage properly.

The concept of time value is fundamental when dealing with any kind of option, and therefore also It should be noted that the time value could represent a very important portion of the entire
when managing share options for the purpose of IFRS accounting. value of the option. It is common for certain share-based payment plans to be granted at fair
value. This means that in such circumstances the intrinsic value of the option is nil at the grant
In substance, the time value combines two major value-holder factors: date. However, if unexpired, the option is valuable itself and its value is represented entirely
by the time value. Therefore, had the time value not been considered, the entire value of the
The remaining time to expiration of the option
option would be missed.
The volatility of the shares


2. Key dates and terms of a share-based transaction

KEY MESSAGE (a) INCOME STATEMENT IS HIT OVER THE VESTING PERIOD
The costs associated with any share-based payment transactions are always charged to the income
Share-based payment costs must be statement over the vesting period. Normally the vesting period runs from the grant date to the vesting
date. However, this is not a definitive rule. If the vest date coincides with the grant date, expenses are
Section 2

charged to the income statement over
charged to the income statement immediately.
(b) VARIABILITY IN SOME OF THE TERMS OF THE STOCK OPTION PLAN, DEPENDING ON MARKET CONDITIONS,

the vesting period. A share-based COULD RESULT IN THE NEED FOR A MORE COMPLEX MODEL
The share-based payment transaction could be set up so that the grant date, number of awards, vesting

payment transaction with variable date and exercise period etc. are variable and depend on stated market conditions. This arrangement
must be incorporated into the pricing model, resulting in a more complex pricing model to manage.

“key dates” is more complex and (c) ASSESSING THE PROFIT OR LOSS IMPACT OF A LONGER TIME TO EXPIRATION
As already mentioned, the longer the time to expiration of an option, the higher the total time value to be
onerous to manage. The length of charged to the income statement. The option life can be extended, expanding the vesting period or the
exercise period after the vesting date. As a rule of thumb, by extending the vesting period, the period-

the plan can be set up in order to
to-period charge should dilute. However, the incremental time value deriving from the extension could
offset such dilution. On the other hand, extending the exercise period should always result in an increase
of the cumulative cost to be charged over the entire vesting period. The actual impact of the option life
stimulate, for example, the extension on a period-to-period income statement charge must be assessed on a case-by-case basis.
(d) MANAGING PERSONNEL
beneficiary’s desired behaviour. Share-based payments are usually part of a larger remuneration package. Their peculiarity resides in the
fact that they include service and / or performance conditions to be fulfilled within a certain period of
time. This means that the way performance conditions are linked to key dates represents a powerful tool
that can be used to stimulate desired behaviours such as loyalty and motivation.



Section 2
Vesting Exercise
period period

Exercise
price

Grant Vesting Exercise
date date date

Option life



Additional guidance The fair value of an option is determined at grant date, which in substance represents the date
When setting up a share-based payment transaction, one of the first steps is to clearly identify the key “when the entity and the employee enter into an agreement, whereby the employee is granted
dates of the transaction itself. It is also crucial to understand how to set up the key dates in order to rights to the share option, provided that specific conditions are met”. [IFRS 2 par. BC 89].
Section 2
have a clear view of how the share-based payment plan will work and how it will affect the company’s
performance. The grant date is crucial. It represents the share-based payments measurement date. Share-
based payments are measured at fair value; therefore the grant date is the date when the
The following are the key dates: share-based payments are initially measured. As we will see later on, the grant date fair value
approach taken by IASB can have significant consequences, particularly for equity-settled
Grant date: “the date at which the entity and another party (including an employee) agree to a instruments.
share-based payment arrangement, being when the entity and the counterparty have a shared
understanding of the terms and conditions of the arrangement. At grant date the entity confers The period during which all the specified vesting conditions of a share-based payment
on the counterparty the right to cash, other assets, or equity instruments of the entity, provided arrangement are to be satisfied is called the vesting period. Normally the vesting period runs
the specified vesting conditions, if any, are met. If that agreement is subject to an approval from the grant date to the vesting date. The share-based payment transaction is charged on a
process (for example, by shareholders), grant date is the date when that approval is obtained.” straight-line basis to the income statement over the vesting period.
[IFRS 2, Appendix A]
Vesting date: the date at which all the specified vesting conditions of a share-based payment As we have said, the exercise date can be represented by a time frame rather than a single
arrangement are to be satisfied. In turn, the vesting period is “the period during which all the date. This type of time frame is called the ‘exercise period’ and represents the period of time
specified vesting conditions of a share-based payment arrangement are to be satisfied”. [IFRS 2, during which the options granted could be exercised. The possibility to exercise the option
Appendix A] within a time frame rather than a fixed date is worth considering for the option holder,
Exercise date: the date at which the option holder exercises the option and obtains the right granted. especially if it extends the option life and therefore increases the value of the option.
Expiration date: the date after which it is no longer possible to exercise the option.
The life of certain common options can be divided into the vesting period and the exercise
period. Given the total length of such an option, the split between the vesting period and
exercise period is not neutral in the option value and therefore in the resulting income
statement charge. Bear in mind that the cost of the share-based transaction is charged to
the income statement over the vesting period. Usually, the exercise period extends after
the vesting date. In that case, the time–frame after the vesting date is not included when
calculating the vesting period.



The share-based payment transaction can be set up so that certain terms of the share-based
transaction — such as the grant date, number of awards, vesting date and exercise period etc. — are
variable. Their variability can depend on both market and / or non-market conditions. As discussed
later, market conditions have to be considered by the pricing model when measuring the grant date
Section 2
fair value. With regard to non-market conditions, the impact on awards expected to vest has to be
reassessed at each reporting date, but is not considered on the grant date fair value pricing model.
This means that market conditions affect the pricing model fair value calculation and therefore will
result in more complex and expensive pricing models.

Motivating employees
So far, we have talked about numbers and income statement impacts. However, it is important to
remember that one of the major goals when choosing the right length of a share-based payment
option should be to achieve desired employee behaviours. For instance, for fast-growing start-up
companies, share-based payments could be an attractive way to motivate employees to achieve their
targets without directly affecting the company’s cash-ﬂows. In today’s highly competitive economic
environment, retaining talent is one of the key factors that determines the success of a company. In
this respect, share-based-payments with a longer vesting period can help inspire loyalty. On the other
hand, a very long vesting period might not be recommended in cases where the company needs
short-term results and wishes to leverage the motivational factor.

In summary, share-based payments can be a good way to help motivate personnel to achieve a
company’s key strategic goals. Therefore share-based payment schemes must be designed to take the
overall strategic corporate picture into consideration.


3. Equity-settled and cash-settled share-based payments

KEY MESSAGE (a) NO FAIR VALUE REMEASUREMENT AFTER INITIAL RECOGNITION FOR EQUITY-SETTLED SHARE-BASED PAYMENTS
For equity-settled share-based payments, the fair value charge to the income statement for awards that
The total charge to the income ultimately vest is not reversed, irrespective of whether market conditions are met or not met at the
exercise date. This means that, if cash-settled share-based payments are out of the money at the exercise

statement for two share-based payment
date, the total charge to the income statement will be nil. Conversely, if equity-settled share-based Section 3
payments are out of the money at the exercise date, there is no reversal of the costs charged to the
income statement.
transactions with identical conditions, (b) CASH-SETTLED SHARE-BASED PAYMENTS MUST BE REMEASURED AT EACH REPORTING DATE

other than the settlement feature (cash Cash-settled options represent liabilities under IFRS. Hence, they have to be fair valued at each reporting
date. Equity-settled options, being equity instruments, need to be fair valued only at the grant date. No
subsequent re-measurement of the fair value is required.
or equity), can result in a signiﬁcantly (c) CASH-SETTLED AND EQUITY-SETTLED: IMPACT ON INCOME STATEMENT “VOLATILITY”

different income statement impact Given the re-measurement feature of the fair value of cash-settled share-based payments at each
reporting date, cash-settled share-based payments result in a higher income statement volatility

on both a period-to-period and/or
compared to equity-settled share-based payments. On the other hand, the period-to-period income
statement charge of equity-settled options is ﬁxed since initial determination or decreases in cases where
non-market conditions are not met.
cumulative basis. In general, equity- (d) PLANNING THE CHARGE TO THE INCOME STATEMENT

settled share-based payments have a As a consequence of the above point, both annual and cumulative income statement charges relating
to equity-settled options are more predictable. Conversely, both annual and cumulative charges to the
income statement of cash-settled share-based payments are less predictable. They are recalculated at
more predictable income statement each reporting date.

impact over the vesting period.
(e) THE KEY DIFFERENTIATING FEATURE IS THE CASH DISBURSEMENT
Another key element of differentiation between equity-settled and cash-settled share-based payments is
that only cash-settled share-based payments involve a cash disbursement (as long as they are exercised
and in the money at exercise date). On the other hand, equity-settled share-based payments do not
involve a direct cash disbursement. However, when equity–settled share-based payments are exercised,
issued shares are paid at a strike price lower than their market value and therefore the cash-in is lower
than it should be.



Equity-settled Section 3

Cash-settled

Choice of cash or
equity settlement



Additional guidance Common examples of cash-settled options are the share appreciation rights (SARs). In fact,
To classify a share-based payment as equity-settled or cash-settled is not a mere academic distinction. in SARs, the value of the underlying share represents in substance solely a parameter for
In general, the classification depends on the way the option is settled and this aspect has a significant reference when calculating the fair value of the option. At exercise date, no shares will be
consequence on how the income statement is charged and the share-based payment is measured. issued or delivered to the option holder.

On the other hand, as far as equity-settled share-based payments are concerned, the IASB has Section 3
The following are the definitions stated by IFRS 2:
adopted the grant date measurement method. At grant date the entity and the employee agree
An equity-settled share-based payment transaction is “a share-based payment transaction in which to exchange a service for an amount of money (remuneration). The fair value of the equity
the entity receives goods or services as consideration for equity instruments of the entity (including instruments granted is used as a surrogate measure of the fair value of the services agreed at
shares or share options”. [IFRS 2 par. 10] that point in time. Once such an agreement is reached, subsequent changes in the fair value
A cash-settled share-based payment transaction is “a share-based payment transaction in which of the equity instrument after grant date are irrelevant. In fact, because of the nature of the
the entity acquires goods or services by incurring a liability to transfer cash or other assets to the equity-settled share-based payment, the uncertainty incorporated into it is already factored
supplier of those goods or services for amounts that are based on the price (or value) of the entity’s into its fair value at grant date.
shares or other equity instruments of the entity”. [IFRS 2 par. 30]
The fair value of an equity-settled option will be charged to the income statement over the
The major difference between the two types of settlement, from both an accounting and vesting period on a straight-line basis, independently of the actual fair value at the exercise
measurement perspective, is that a cash-settled option meets the definitions of a liability according to date.
the IFRS Framework, whilst an equity-settled option always represents an equity instrument. However,
“if the requirements of IAS 32 were applied to equity-settled share-based payment transactions, in If the expense is revised as a result of a change in the estimate driven by non-market
some situations an obligation to issue equity instruments would be classified as a liability. In such conditions, the cumulative charge to the income statement will take place as follows:
cases, final measurement of the transaction would be at a measurement date later than grant date”. Equity-settled: number of awards that eventually vested (only non-market condition considered)
[IFRS 2 par. BC 108] To overcome such inconsistency, “the Board concluded that the requirements in multiplied by the original grant date fair value
IAS 32, whereby some obligations to issue equity instruments are classified as liabilities, should not Cash-settled: number of awards that eventually vested multiplied by the exercise date fair value
be applied in the IFRS on share-based payment. The Board recognises that this creates a difference
between IFRS 2 and IAS 32.” [IFRS 2 par. BC 109]
Most importantly, this means that equity-settled options result in a charge to the income
Cash-settled options, representing liabilities, have to be fair valued at each reporting date and the statement, even though the options are not exercised because they are out of the money.
adjustments are recorded to the income statement; conversely, equity-settled options do not need to However, for equity-settled share-based payments, once the fair value has been fixed at grant
be re-measured after the grant date. date, it will no longer be revised.



Background: Why is the cost of equity-settled share-based payments As a consequence of the above, the cash or equity feature has an impact on the income
not reversed if at the exercise date the options are at or out of the money? statement ultimate charge as well as on the forecast vs actual manageability.
In paragraph 11, IFRS 2 states that “the entity shall measure the fair value of the services received by
As an example, let’s assume that the only difference between two identical share-based
reference to the fair value of the equity instruments granted, because typically it is not possible to
payment transactions is the settlement feature (options issued at the money at grant date and
estimate reliably the fair value of the services received”. Section 3
identical vesting conditions except for cash-settled versus equity-settled). This would be the
impact on the income statement:
The fair value calculation has to be performed at grant date, adopting a valuation methodology which
should “be consistent with valuation methodologies that market participants would use for pricing If at the exercise date the intrinsic value of the option is higher than the grant date fair value, the
similar financial instruments, and should incorporate all factors and assumptions that knowledgeable, cash-settled share-based payment will result in a cumulative charge to the income statement
willing market participants would consider in setting the price”. [IFRS 2 par. BC 305] higher than an equity-settled share-based payment.
If at the exercise date the intrinsic value of the option is lower than the grant date fair value, the
As a consequence, the IASB concluded that the “grant date is the most appropriate measurement date cash-settled share-based payment will result in no charge to the income statement. The
for the purpose of providing a surrogate measure of the fair value of the services received”. [IFRS 2 option expires worthless. On the other hand, equity-settled options will result in a charge to
par. BC 96] income statement based on the grant date fair value even if the options expire worthless.

In summary, the fair value resulting from the pricing model at grant date is regarded as the best Finally, in certain circumstances it might not be straightforward to classify a share-based
estimate of the remuneration granted by the entity to the employee in exchange for the services payment as cash-settled or equity-settled. For instance, in cases where beneficiaries are
expected to be received. Once such remuneration has been agreed, there are no reasons to question granted the possibility to return the options to the issuer, this feature could trigger a cash-
this. In fact, the service to be provided by the employee will not fluctuate according to the subsequent settled classification. In fact, the whole package might meet the definition of a liability and
change in fair value of the option granted. therefore be accounted for accordingly. Each case has to be assessed separately, taking into
consideration all the option’s features and circumstances.
Such an approach is consistent with the general purpose of IFRS 2. In fact, as we already mentioned,
this standard utilises the fair value of the option granted as a surrogate in order to estimate the
remuneration provided by the employee. Hence “the valuation does not attempt to estimate the future
gain, only the amount that the other party would pay to obtain the right to participate in any future
gains. Therefore, even if the share option expires worthless or the employee makes a large gain on
exercise, this does not mean that the grant date estimate of the fair value of that option was unreliable
or wrong”. [IFRS 2 par. BC 295]


4. Market and non-market conditions (true-up model)

KEY MESSAGE (a) MARKET CONDITIONS DIRECTLY AFFECT THE PRICING MODEL APPLICATION
Market conditions have to be taken into account when applying the pricing model. If market conditions
Unusual or complex market conditions are sophisticated, the pricing model has to conform accordingly. Normally this results in a more complex
and costly model being implemented.

could reduce the fair value of the stock On the other hand, non-market conditions do not have to be included in the pricing model; they have to
be considered at grant date and then at each reporting date in order to estimate the impact on vesting

options and, in turn, the total cost conditions for both equity-settled and cash-settled share-based payments. Section 4

charged to income statement, but could
result in the need for more complex and
costly pricing models.



Vesting conditions
Section 4

Service conditions
vs
Performance conditions

Market Non-market
conditions conditions



Additional guidance Non-market conditions: non-market conditions are all those remaining conditions which do not fall
Usually, once a share-based payment transaction is set up, payments are subject to the achievement into the above category.
of certain vesting conditions. Such conditions can affect aspects such as the timing and amount of
payments or any other characteristic of the rights granted. Examples of non-market conditions:
The employee has to work for the entity for a certain period before being entitled to exercise
Vesting conditions the stock options.
IFRS 2 classifies vesting conditions into two categories: “Vesting conditions include service conditions, The entity has to reach a certain level of sales, operating profit, EBTDA, etc. Section 4
which require the other party to complete a specified period of service, and performance conditions, The management has to open a certain number of new stores, branches, subsidiaries etc. by
which require specified performance targets to be met (such as a specified increase in the entity’s a certain date.
profit over a specified period of time).” [IFRS 2, Appendix A]
Examples of market conditions:
Performance conditions
The value of a listed share has to reach a certain level.
In turn, performance conditions fall into two different classes: market conditions and non-market
The value of a listed share has to reach a certain value compared to stock index or other
conditions.
industry-specific stock indexes.
Market conditions: “a condition upon which the exercise price, vesting or exercisability of an equity The TSR (Total Shareholder Return) reaches a certain level.
instrument depends that is related to the market price of the entity’s equity instruments, such as
attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving
a specified target that is based on the market price of the entity’s equity instruments relative to an
index of market prices of equity instruments of other entities.” [IFRS 2, Appendix A]



Calculating fair value at grant date The table below illustrates how market and non-market conditions affect cash-settled and equity-
The major difference between market and non-market conditions is how they affect the calculation of settled share-based payments.
fair value at grant date: Determination of the grant date Determination of
Market conditions have to be taken into account in determining the fair value based on a pricing fair value based on a pricing model vesting conditions
model of the share-based payments at grant date. Vesting Equity or Subsequent Subsequent
Non-market conditions are not taken into account in determining the fair value based on a pricing conditions cash-settled At grant date measurement dates At grant date measurement dates
model of the share-based payments at grant date. That is, they represent a parameter not included Section 4
Market Equity-settled Considered No longer Already No longer
in the pricing model, but are considered in determining the fair value anyway.
conditions in the pricing revised incorporated in revised
model the fair value
Basically, the fair value of the share-based payment is a function of two elements: the fair value of the calculation at
pricing model combined with the estimated impact of non-market conditions. grant date
Cash-settled Considered Revised Already Revised
The characteristic of a performance condition that has to be included or not in a pricing model gives
in the pricing considered in
rise to the following consequences, depending on the type of share-based payment plan:
model the fair value
Equity-settled: market conditions are no longer considered for subsequent measurement of the fair calculation at
value based on a pricing model. However, non-market conditions are revised from the beginning to grant date
estimate awards that will eventually vest.
Non market Equity-settled Not considered Not considered Considered Revised
Cash-settled: the revision of both market and non-market conditions is undertaken at each reporting
conditions Cash-settled Not considered Not considered Considered Revised
date in order to update the fair value of the instrument granted.

In conclusion, when setting up a share-based payment transaction, it is crucial to distinguish
between market and non-market conditions as well as to understand their impact on the pricing
model to be applied. This directly affects how the income statement will be charged.


5. Beware of modifications, replacements, settlements and
cancellations of granted equity instruments

KEY MESSAGE (a) SUBSEQUENT MODIFICATIONS CANNOT REDUCE THE ORIGINAL INCOME STATEMENT CHARGE
In cases where equity instruments are subsequently modified in a way that the fair value of the original
As already discussed, for equity equity instrument at the modification date is higher than the fair value of the modified equity instrument
at the same date, as a minimum the fair value of the original equity instrument has to be recognised.

instruments the IASB has taken a grant
Put another way, only beneficial modifications have to be recognised. Non-beneficial modifications are
ignored.

date fair value approach. This means (b) CANCELLATIONS ARE CONSIDERED VESTING ACCELERATING EVENTS
The cancellation of an equity-settled share-based payment is treated similarly to a modification
Section 5
that modifications, replacements, arrangement, as discussed in the previous paragraph. In substance, the entity has to recognise
immediately the amount that would otherwise have been recognised for services received over the
remainder of the vesting period.
settlements and cancellations of
granted equity instruments cannot in
any way reduce the original grant date
fair value that has to be charged to the
income statement.



Modiﬁcations Cancellations
Section 5

Impact
on income
statement
Replacements Settlements



Additional guidance Basically, IFRS 2 retains a grant date fair value approach for granted equity instruments. An
An entity might decide to modify the terms and conditions on which the equity instruments were entity cannot avoid recognising remuneration expenses based on the grant date fair value.
granted. For instance, the entity can: reduce the exercise price of options granted to employees (i.e. Once share options are granted, their grant date fair value cannot be cancelled or reduced by
reprice the options), which increases the fair value of those options; or extend the option life, which modifying the original terms of the arrangement.
also increases the fair value of those options.
The grant date fair value approach is reaffirmed when dealing with the cancellation or
In such cases IFRS 2 requires the entity to recognise: settlement of granted equity instruments. The cancellation or settlement event is considered
as an acceleration of vesting. As a result, the cost not yet accounted for has to be recognised
1) As a minimum, the cost relating to the grant date fair value of the originally granted equity immediately.
instruments. The true-up model applies in cases where those equity instruments do not vest
Section 5
because of failure to satisfy non-market vesting conditions that were specified in the original It should be noted that if cancelled equity instruments are replaced by new granted equity
arrangement. instruments, the entity must account for the granting of replacement equity instruments in
2) The increase in the total fair value of the share-based payment arrangement resulting from the the same way as a modification of the original grant of equity instruments. In other words,
effects of modifications. In other words, beneficial modifications have to be recognised over the replacements are accounted for in the same way as the modifications previously discussed.
remaining vesting period of newly granted equity instruments.


6. Categories of employees targeted by share-based transactions

KEY MESSAGE (a) THE OPTION LIFE IS AFFECTED BY THE OPTION HOLDER BEHAVIOUR
Employee behaviour can have an impact on the expected option life, especially when the exercise period
Share-based payment plans is particularly long. When larger, less homogeneous groups of people are targeted by a share-based
payment plan, the entity will have to consider more complex factors to determine the option life to be

that embrace different employee
included in the pricing model. In addition, as already mentioned, option life directly affects the cost of the
option.

categories are more complex to Additional guidance

manage and the total income statement
Section 6
charge is affected by employees’
expected behaviour .



Managers

Executives Seniority
Section 6

Age Behaviour Staff
considerations

External providers
of services/goods



A share-based payment plan can be designed just for an entity’s executives, managers and
professional staff, for a combination of those categories of employees, or for all these categories
of employees. It can target employees of the parent company or employees of subsidiaries, and
subsidiaries can be located in more than one country. Moreover, the share-based payment plan can
also be granted to external consultants or external suppliers of services / goods.

Different groups of people with homogeneous characteristics have different behavioural models.
Belonging to one or other behavioural group can have a relevant impact on the expected exercise
date of the option, particularly when the exercise period is especially long. IFRS 2 requires the entity
to take into consideration different expected behaviours of the option holders in case they impact on
the expected exercise date of the options. In particular, it is important to estimate and judge a range of
reasonable expectations regarding the exercise behaviours, ranking them according to the probability Section 6
that they will occur. [IFRS 2, Appendix B 12]

In order to carry out the above “judgmental” categorisation exercise, the entity should consider all
available information as well as past experience, if any.


7. Equity-settled share-based payments hit the EPS indicator twice

KEY MESSAGE (a) EQUITY-SETTLED SHARE-BASED PAYMENTS HIT THE EPS TWICE
Equity-settled share-based payments hit the EPS indicator twice. Firstly as a result of the increase in the
Because of share issuance, number of shares included in the EPS calculation, and secondly because resources received for those
options are consumed. On the other hand, cash-settled share-based payments hit the EPS indicator only

equity-settled share-based payments
once, as no shares are to be issued at exercise date.

reduce EPS more than cash-settled
share-based payments.
Section 7



Equity-settled
EPS

Section 7

Cash-settled

EPS



Additional guidance Example — EPS calculation
There are two EPS indicators under IAS 33: basic EPS and diluted EPS. Entity A has 10,000 total outstanding shares. The profit for the year is £5,000 and is suitable
for EPS calculation. Entity A has granted its executives a share-based payment plan which has
When entities enter into a commitment to issue shares in the future, this results in a modification of had a cumulative fair value charge amounting to £2,000 and involves the issuance of £1,000
the basic EPS indicator once shares are issued. Earnings will have to be divided by a greater number ordinary shares.
of shares and therefore the basic EPS indicator will decrease. This is the case for equity-settled share-
based payments. In fact, once equity-settled share-based payments are granted, they incorporate The EPS calculation is the following: (5,000-2,000) / (11,000) = 0.27.
potential shares whose conversion is subject to some vesting conditions. Therefore, as a general rule,
equity-settled share-based payments have a dilutive effect. More precisely, they have a double dilutive If the same remuneration amount of £2,000 is paid with a cash-settled share-based payment
effect . or any other method not involving the issuance of shares, the EPS would result as follows:

In fact, as clarified by IFRS 2, “the dual effect on EPS simply reflects the two economic events that (5,000-2,000) / 10,000 = 0.30.
have occurred: the entity has issued shares or share options, thereby increasing the number of shares
included in the EPS calculation — although, in the case of options, only to the extent that the options As shown, the EPS relating to the equity-settled share-based plan results in an EPS indicator of Section 7
are regarded as dilutive — and it has also consumed the resources it received for those options, thereby 0.30 compared to 0.27.
decreasing earnings.” [IFRS 2, BC 56]

On the other hand, cash-settled share-based payments ultimately do not result in the issuance of
additional shares. As a consequence they do not have a dual dilutive effect. The dilutive effect is
limited to the decrease of earnings resulting from the charge to the income statement of the cost of
the cash-settled share-based payments.

To sum up, we can say that equity-settled share-based payment transactions hit the EPS indicator
twice whilst cash-settled share-based payment transactions hit the EPS indicator only once.


8. The charge to the income statement ultimately affects the
ﬁnancial statements of the entity receiving goods or services

KEY MESSAGE (a) THE COST IS ACCOUNTED FOR BY THE ENTITY RECEIVING THE GOODS / SERVICES
The expense relating to the share-based payment transactions has to be ultimately recognised in the
The costs relating to share-based income statement of the company receiving the goods / services. This means that, for example, the
issuance of shares from an ultimate parent entity which is not included in the consolidation area does not

payments always hit the income
result in avoiding accounting for IFRS 2 on a consolidation basis, if goods or services are received by an
entity included in the consolidation area.

statement of the entity receiving goods/
services. It does not matter if the share
issuer or cash debtor is the shareholder
or another group entity, even one Section 8
outside the IFRS reporting group.



Parent entity Consoldation level

Subsidiary Subsidiary Company’s level
A C
Subsidiary Section 8

B

Intragroup
share-based
payment schemes



Additional guidance Example
It can be the case that shares are not issued by the company receiving goods and services. This is The Alpha group is listed on the Stock Exchange and is required by local regulators to prepare
a very common practice within groups. In fact, normally share-based payment transactions make consolidated financial statements according to IFRS. The parent company of the Alpha group
reference to the shares of the shareholder or the group’s parent for employees of all the group is 100% held by a holding company which is not listed and does not prepare IFRS financial
entities. statements. The employees of Alpha group (both employees of the parent company and
overseas subsidiaries) are entitled to stock options which, if vesting conditions are met, grant
Furthermore, shares could be issued by the holding company of the IFRS group, which could even the possibility of receiving shares in the holding company.
prepare its financial statements under a different accounting framework.
The Alpha group has to account for the stock options in its consolidated financial statements. In
In any case, whichever is the issuing company of the group, the expense has to be recognised in the fact, the employees have rendered work services to Alpha group and therefore Alpha group is
income statement of the company receiving the goods or services. required to account for the expense relating to the service received.

For instance, if the IFRS reporting entity receives goods or services that are to be paid with shares of In addition, the expense should be accounted for at each subsidiary level, taking into account
another entity which is not controlled by the IFRS reporting parent entity, but is under the control of current and deferred tax consequences based on local tax legislations.
the same holding company, the cost has to be charged to the entity reporting under IFRS anyway.
Section 8
In this case, the holding company in substance has made a capital contribution to the parent company,
which has to be accounted for accordingly in its financial statements.

The key point is that the expense relating to the share-based payment transaction has to be charged
to the income statement of the entity receiving the goods or services, irrespective of who is the share-
issuing or cash-paying company.


9. Not just a case of remuneration… services and goods may also be relevant

KEY MESSAGE (a) SHARE-BASED PAYMENTS DO NOT RELATE SOLELY TO EMPLOYEE SERVICES
IFRS 2 also applies to share-based payments related to services provided by external providers, the
If the fair value of the services or goods exchange for inventories, consumables, property plant and equipment, intangible assets and other non-
ﬁnancial assets.

contributed is not reliably determinable, (b) FAIR VALUE CALCULATION IN CASE GOODS ARE EXCHANGED
In the case of share-based payments involving goods or services, there shall be a rebuttable presumption
the cost of the transaction and therefore that the fair value can be estimated reliably. If this cannot happen, then the entity should make reference
to the fair value of the instrument granted.

the charge to the income statement
must be measured at the fair value of
the awards granted.
Section 9



“Share-based payments do
not just involve employee
remuneration. The purchase
Third party Employee’s of external services or goods
services services can also fall within the scope
Means of of IFRS 2.”
payment for Section 9

Assets Goods



Additional guidance IFRS 2 states that, regarding transactions with parties other than employees, there is a
In a share-based payment transaction, shares are regarded as a means of payment for goods and rebuttable presumption that the fair value of goods or services received by the entity can be
services. This means IFRS 2 is not only applied to share-based payments involving employee services. reliably estimated. However, in cases where this is not possible, the fair value of the goods
IFRS 2 also applies to share-based payment transactions in which the entity receives “inventories, or services received is measured indirectly by estimating the grant date fair value of equity
consumables, property plant and equipment, intangible assets and other non-financial assets”. [IFRS 2 instruments granted. As a result, using the fair value of granted instruments should represent
par 5] a valuable indicator in “directly” assessing the fair value of services or goods in cases where
there is a significant range of discretion. Alternatively, it could represent the “last resort” to
However, as mentioned in the introduction, IFRS 2 does not apply in the following circumstances estimate “indirectly” such fair value.
where goods are purchased:
Moreover, there could be certain transactions in which the entity cannot identify specifically
“transaction with an employee (or other party) in his / her capacity as a holder of equity some or all of the goods or services received. In this situation the rebuttable presumption
instruments” [IFRS 2 par. 4] that the fair value of the goods or services received can be estimated reliably does not apply.
“transaction in which the entity acquires goods as part of the net assets acquired in a business However, this situation does not exempt the entity from applying IFRS 2. Therefore the entity
combination to which IFRS 3 Business Combination applies” [IFRS 2 par. 5] should instead measure the goods or services received by reference to the fair value of the
transaction entered into for the purpose of speculating on the price of commodities but not equity instruments granted. [IFRIC Interpretation 8 — Scope of IFRS 2]
acquiring them. [IFRS 2 par. 6]
The message seems to be quite clear. If options are granted, they must be fair valued, either
directly via the fair value of goods / services received or indirectly via the fair value of granted
options. Section 9


10. Newly listed, listed and unlisted entities… complications in calculating volatility

KEY MESSAGE (a) PRICING MODEL FOR UNLISTED AND NEWLY LISTED COMPANIES
In virtually all cases it should be possible to apply a pricing model for these companies, despite the lack
Even though volatility is not readily of a readily available volatility and share price. This involves further analysis, research and valuation to
obtain the necessary information in order to apply the pricing model.

available in respect of stock option (b) INTRINSIC VALUE
It should almost always be possible to avoid the use of the intrinsic method. It should be noted that, if
schemes for non-listed or newly listed used, the intrinsic method involves a true-up model for both cash-settled and equity-settled share-based
payments. As a result, if the intrinsic value method is used, there is no difference between equity-settled

entities, as a rule of thumb, these and cash-settled share-based payments.

should be evaluated when adopting a
pricing model. This could result in more
complex and onerous administrative
burdens when setting up the pricing Section 10

model for non-listed or newly
listed entities.



Measurement
at fair value Measurement
at intrinsic value

Unlisted and
Listed newly listed
entities entities
Section 10

Use intrinsic value only in rare cases
where the fair value of the equity
instruments cannot be estimated reliably



Additional guidance In the very few cases where the above approach would not be possible, the last resort would be
All the option pricing models require as input data the entity’s share price and the expected volatility. the valuation at intrinsic value. However, as previously explained, the intrinsic value does not
Obviously, for unlisted companies such data is not obtainable from published share quotations. represent the fair value of an option due to the lack of the time value.

The same issue concerns newly listed companies. In fact, such companies normally do not have In this respect, the view of the Board is clear: “these approaches for estimating the expected
sufficient historical data to calculate the expected volatility. In addition, the historical data should volatility of an unlisted entity’s shares are somewhat subjective. However, the Board thought it
cover a length at least equal to the duration of the expected option life. This means that if the entity likely that, in practice, the application of these approaches would result in under-estimates of
has granted an option with an expected life of five years, the entity should extrapolate the expected expected volatility, rather than over-estimates, because entities were likely to exercise caution in
volatility from a share quotation time frame of five years. making such estimates, to ensure that the resulting option values are not overstated. Therefore,
estimating expected volatility is likely to produce a more reliable measure of the fair value of
In spite of the issues abovementioned, IFRS 2 tends to require entities, both listed and unlisted, to share options granted by unlisted entities than an alternative valuation method, such as the
estimate the expected volatility in order to calculate the fair value of the options when adopting a minimum value method.” [IFRS 2 par. BC 140]
pricing model.
In conclusion, the key message of IFRS 2 is that: “in virtually all cases, the estimated fair
Normally, unlisted or newly listed entities should refer to the implied volatility of listed entities that value of employee share options at grant date can be measured with sufficient reliability for
have similar characteristics and are in the same industry sector. the purposes of recognising employee share-based payment transactions in the financial
statements. The Board therefore concluded that, in general, the IFRS on share-based payment
When it is not possible to determine the expected volatility and “the entity has not based its estimate should require a fair value measurement method to be applied to all types of share-based
of the value of its shares on the share prices of similar listed entities, and has instead used another payment transactions, including all types of employee share-based payment. Hence, the
valuation methodology to value its shares, the entity could derive an estimate of expected volatility Board concluded that the IFRS should not allow a choice between a fair value measurement
method and an intrinsic value measurement method, and should not permit a choice Section 10
consistent with that valuation methodology”. [IFRS 2 par. BC 30 and BC 139]
between recognition and disclosure of expenses arising from employee share-based payment
transactions.” [IFRS 2 par. BC 310]


11. Current, deferred taxation and social contribution implications

KEY MESSAGE (a) SHARED-BASED PAYMENTS REQUIRE TAX PLANNING ACTIVITIES
IFRS 2 requires careful tax assessments, especially for share-based payment plans embracing group
Current and deferred taxation must entities located in different countries. In addition, particular attention has to be paid to inter-company
recharge agreements.

be evaluated based on the tax regime (b) DEFERRED TAXATION
Where the expense is deductible for local tax purposes, deferred tax can be recognised if timing
of the entity receiving services/goods. differences exist. It should be noted that, for equity-settled transactions, the tax benefit charged to the
income statement cannot exceed the tax benefit associated to the expense recorded in the financial

Also, inter-company recharges must be statement. Any excess is recorded directly to equity.

assessed based on the tax rules of the
companies involved.

Section 11



Current taxation
Deferred taxation

Tax jurisdiction
Section 11



Additional guidance This means that the future tax deduction has to be based on the available information at each
Tax and contribution implications depend on the regulations of the country where the share-based reporting date e.g. the current share price.
payments expenses are charged. Therefore, if the expense is deductible, the amount deductible, the
calculation methodology and the timing of deduction etc. should be assessed at country level when As mentioned before, the final tax base could be higher or lower than the final charge to the
planning the share-based payment transaction. In addition, for parent entities granting share-based financial statements because of the different measurement basis applied. IFRS 2 sets out the
payment transactions to employees of group entities, there should be consideration as to whether following recognition rules.
such costs are ultimately re-charged to each group entity via inter-company agreements or not.
Equity-settled transactions:
Where the expense is deductible and the amount booked in the financial statements equals the “If the tax deduction is less or equal to the cumulative expense, the associated tax benefits
tax base and the only difference resides in the timing of recognition, this represents a temporary received should be recognised as tax income and included in profit or loss for the period.”
difference according to IAS 12. As a result, “under that Standard, a deferred tax asset is recognised for [IFRS 2 – BC 326 a];
all deductible temporary differences to the extent that it is probable that taxable profit will be available “If the tax deduction received exceeds the cumulative expense, the associated tax benefits
against which the deductible temporary difference can be used (IAS 12, paragraph 24).” [IFRS 2 par. BC received should be recognised directly in equity.” [IFRS 2 par. BC 326 b].
313]
Cash-settled transactions:
However, although the expense is deductible, a problem arises when the tax deduction differs from
the amount of the expenses recognised in the financial statement, because a different measurement All tax benefits should be recognised to profit and loss.
basis is applied. In this respect, the IASB concluded that “the measurement of the deferred tax asset
should be based on an estimate of the future tax deduction. If changes in the share price affect that
future tax deduction, the estimate of the expected future tax deduction should be based on the current
share price”. [IFRS 2 par. BC 324]

Section 11


12. Share-based payment options are measured by applying pricing models

KEY MESSAGE (a) PRICING MODELS
A share-based payment transaction can be designed to combine a considerable number of characteristics.
In-house or outsourced specialists could The table below shows the key points of the most common features and describes their impact on the fair
value as well as the complexity of the pricing model to be adopted.

be necessary to manage pricing models. Increase the complexity
Features of pricing model? Increase the fair value?
Both the complexity of pricing models Variable exercise price YES Depends on circumstances

and the related administrative burden
Variable number of equity awards YES Depends on circumstances
Variable vesting periods subject to YES Depends on circumstances

depend on how the issues highlighted
conditions other than the share price
Multiple market conditions YES NO

in the preceding sections have been Long exercise period
America-Bermudan options
YES
YES
YES
YES
managed in designing the share-based Reload features YES YES
Transferability YES YES
payment plan. Expected dividends YES NO
Multiple behavioural consideration YES Depends on circumstances

Section 12



Black & Scholes model

Pricing
models
Binomial Montecarlo
model simulation Section 12



Additional guidance For the purpose of valuing an option, there are a number of pricing model options. Possibly
IFRS 2 par. 17 states that: “the valuation technique shall be consistent with generally accepted the most famous is the Black and Scholes Pricing Model, introduced in 1973 by Fischer Black
valuation methodologies for pricing financial instruments, and shall incorporate all factors and and Myron Scholes. However, since that time other specialists have revised the model, notably
assumptions that knowledgeable, willing market participants would consider in setting the price.” Robert Merton and Jonathan Ingerson. Therefore, it should be noted that the Black and
Scholes Pricing Method is available in different forms, each with specific characteristics.
IFRS 2 clearly indicates that the fair value of a share-based payment transaction must be fair valued
according to a generally accepted pricing model, and provides some guidance on the pricing models Another common option pricing model is the Binomial Model. This method is based on the
most readily accepted by the financial community. construction of a binomial tree which represents a diagram of different possible paths that the
underlying share price might follow over the life of the option. At each step of the diagram, the
However, it does not indicate that one model must be used in all cases. share price has a certain probability to move up or down. The diagram involves a range of steps
where there is a binomial stock price movement. Thus, the model results in a lattice.
Each share-based payment transaction must be assessed and a proper valuation model chosen
and applied. As a result, the choice of the right pricing model to apply is crucial in order to obtain a The model incorporates an exercise factor, rather than an anticipated exercise date as required
reasonable fair value determination of the option. under the Black Scholes model, which determines the conditions under which employees are
expected to exercise their options. It is defined as a multiple of the exercise price (e.g. 2.3 would
Understanding pricing models involves special mathematical and statistical skills, knowledge and mean that on average employees tend to exercise their options when the stock price reaches
experience. Moreover, it must not be forgotten that the choice of the valuation method has to be 2.3 times the exercise price). This is in fact more reliable than trying to guess the average time
consistent with the current valuation methods commonly used by market participants. Therefore to exercise. For example, trying to estimate an average time after which employees exercise is
awareness of valuation methods currently used by the marketplace is required. likely to be inaccurate. The reason is that during periods when the market is high, employees
are more likely to exercise early, as opposed to times when the market is low. Using an exercise
On this basis, if such expertise is not available internally, it is likely that a financial statement preparer multiple based on a robust theory of stock price behaviour / distribution overcomes these
will need to consult external experts in order to manage the issue. problems.

Section 12



In general, whichever pricing model is chosen, as a minimum, the following factors should be taken
into consideration:
the exercise price of the option
the life of the option
the current price of the underlying shares
the expected volatility of the share price
the dividends expected on the shares (if appropriate)
the risk-free interest rate for the life of the option

However, these are not the only factors to consider. The pricing model should also be tailored in order
to consider market conditions characterising the option, the expected behaviour of option holders,
exercise restrictions in speciﬁed periods, non-transferable features that could trigger early exercise,
etc.

In conclusion, the brief and non-exhaustive considerations mentioned here aim to highlight the
complexity surrounding the determination of the fair value of share-based payments. Preparers
should be aware that option pricing models are likely to require the use of experts to be managed
properly and that, as a general rule, their complexity and cost of implementation result from the
complexity of the share-based payment itself. In other words, the pricing model complexity and
burden can be minimised provided experts in pricing models are involved in the design of the share-
based payments from the beginning.

Section 12

Designing share-based payment schemes

Designing share-based payment schemes

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