Following international financial reporting standards (IFRS) isn’t a legal requirement in every country, but IFRS 2 is an indispensable set of guidelines on share-based payments and stock option expensing.
Private and public companies are required to prepare financial statements (e.g. for the board, investors) at regular intervals, including the balance sheet and income statement. These statements include all costs associated with the business, and equity schemes have a compensation “cost” that needs to be included. IFRS 2 is an international accounting standard for calculating this cost.
Let's explore how IFRS 2 works for companies, and which issues and questions are thrown up for businesses seeking to get on top of their share-based payment transactions and compliance.
What is IFRS 2?
Issued by the International Accounting Standards Board (IASB), IFRS 2 is the accounting standard that deals specifically with share-based payments. IFRS 2 sets out how companies of all sizes should expense share-based payments in their financial reporting.
Companies use IFRS 2 to establish the fair value of share-based payments, or the compensation stakeholders receive in the form of equity stakes. (IFRS 2 also covers contractors who are paid in shares, and any cash payments with a value connected to share price, but these are less common.) The standard doesn’t cover investors, since they acquire shares by purchasing them, rather than in exchange for goods or services.
Types of share based payment transactions
There are a few different types of transaction that are classed as share-based payment arrangements and which fall into the scope of IFRS 2. Let's break down the difference between equity-settled and cash-settled transactions.
An equity settled share based payment is any transaction in which goods or services are exchanged for equity instruments (e.g. shares or options).
Cash settled transactions
A cash settled share based payment is a transaction where goods or services are exchanged for cash or other assets where the value of the cash or cash equivalents are derived from the value of equity instruments.
Handling terminations and forfeitures
Share option grants are usually terminated when employees leave the business. Terminations are important for IFRS expenses because they change the amount the employee will be compensated, which has a knock-on effect for the company's expenses.
Companies also have to estimate the amount of grants they expect to be terminated in each reporting period. This is known as the forfeiture rate. Because it's hard to predict when any given employee will move on from the business, finance teams need to give estimates that are then adjusted in subsequent reporting periods. It's important to reconcile new forfeiture estimates with past estimates – which are rarely perfectly accurate – on an ongoing basis.
Calculating fair value and the Black-Scholes model
Calculating the fair value of stock options is vital for companies, but it involves some hard formulas.
Whatever the type of share or option, IFRS 2 requires all stock-based compensation to be recorded as an expense. In order to record the expense, you must calculate the fair value of the equity instruments you’re using as payment. In the case of employee equity, it needs to be the fair value on the date that you grant the options.
IFRS 2 does not include a specific formula to calculate this – a common misconception. You can choose whichever model you feel most accurately fits your situation to calculate the fair value of the entity’s shares.
There are a variety of option pricing models to choose from, but one of the most commonly used and most recognised is the Black-Scholes model. This was published in 1973 by economists Fischer Black and Myron Scholes and their collaborator Robert Merton. It aims to take the guesswork out of how much the derivatives of financial assets like stock options are worth, based on five inputs:
- Volatility: How much the stock’s value increases or decreases over time, determined by the standard deviation of log returns.
- Stock price: How much the stock is being traded for at the time you’re doing the calculation.
- Strike / exercise price: How much the stock will be purchased for when it is exercised.
- Time until option expires: How long the option is valid.
- The risk-free interest rate: How much interest you would expect to accumulate if the stock was subject to no risk. You can use an online calculator to generate this number.
Here's the formula:
Many companies spend significant sums on consultations with expensive lawyers or accountants to get this stuff right. That's no longer necessary with Ledgy. With all your share-based payment transactions in one place, you can run your Black-Scholes calculations for you, right in the app. Learn more about Ledgy's Financial reporting features here.
How IFRS 2 compares to other accounting standards
IFRS 2 is not the only set of accounting and governance principles out there. Many companies work according to US GAAP (Generally Accepted Accounting Principles) standards. US GAAP covers similar areas to IFRS 2, particularly in the guidance laid out in the standard ASC 718 which is set out by the Financial Accounting Standards Board (FASB). Although it is not required in every state, it is frequently used on the federal level by the US Securities and Exchange Commission (SEC). For example, publicly traded companies are required to submit US GAAP-compliant financial statements.
The differences between ASC 718 and IFRS 2 are not particularly stark. Perhaps the most significant distinction comes down to the way ASC 718 allows companies to expense graded employee equity. Whereas IFRS 2 requires companies to record the cost of equity in each year individually, in certain circumstances, ASC 718 allows companies to record the cost all in one go as a single expense.
As with IFRS 2, ASC 718 requires American companies to calculate the fair value of their stock options. In addition, the Internal Revenue Service (IRS), America’s tax service, requires private companies to complete 409A valuations to establish the fair market value of their common stock. Companies have to complete a 409A valuation at least every 12 months and in response to major events, such as before issuing their first common stock options, after a funding round, or before an exit.
Both ASC 718 and 409A valuations, like IFRS 2, are usually calculated using the Black-Scholes model. Although companies can complete their 409A valuation in-house, this leaves them vulnerable if a tax authority later questions the valuation technique.
Having an objective valuation process creates easier and fairer conversations with investors and other stakeholders as you scale. Service providers offering add-on in-house valuations may be incentivised to give their customers a flattering metric to report back to investors. Ledgy partners with Aranca, a globally recognised third party valuation specialist, to give our customers the reassurance that valuations obtained with Ledgy are objective and sustainable as they scale over time. (Learn more about all Ledgy's integrations here!)
IFRS 2: at the heart of financial reporting in scaling companies
Because share-based payment transactions need to pass audits, getting IFRS 2 calculations right is important. Companies can pay many thousands of pounds, euros or dollars for an external law firm or other third-party service providers. Ledgy's Enterprise customers benefit from share-based payment reporting that complies with IFRS 2 guidance built in to the product, available whenever it's required. Learn more about the benefits of our Enterprise pricing plan.
Do I need to comply with US GAAP as well as IFRS 2?
Companies do not tend to abide by both standards at the same time; if a company is headquartered in the US or has a particularly high degree of commercial exposure there, or if it is planning to list on a US stock exchange, it may make sense to adopt US GAAP methodologies and standards.
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