Introduction
Share-based payments are used as compensation for employees and non-employees alike. It’s essential that companies granting equity to employees and other stakeholders do so in a compliant manner.
For these companies, adhering to IFRS 2 – the international accounting standard governing share-based payments – eases dialogues with investors, tax authorities, auditors and potential acquirers. The simpler these conversations, the higher the likelihood of a successful fundraising, audit, or exit.
But day-to-day pressures can distract founders and operators from doing this necessary work. The upshot? Many companies that approach corporate milestones, like IPOs, fundraising, audits or acquisitions, come to an uncomfortable realisation: to obtain compliance with IFRS 2, they need to retrospectively account for historic expenses relating to share-based payments.
How you account for payments made in shares, or cash payments based on a share price, has a significant effect on your balance sheet, not to mention your cap table. So getting the transition to IFRS 2 right really matters. Let’s walk through the key considerations.
When should you move to IFRS?
IFRS 2 is just one of 17 separate standards to adhere to when adopting International Financial Reporting Standards (IFRS), so making the decision to transition to adhere to the requirements of IFRS is a significant undertaking. It is not possible to comply with a national accounting standard but opt to account for share-based payments under IFRS 2. A full conversion to all IFRS regulations is required in order to comply with IFRS guidance.
Before bringing share-based payments in line with IFRS 2, it’s important to prepare internal and external stakeholders for the bigger project of wholesale IFRS adoption. Audits aren’t essential for most small, young companies, but once companies hit a certain size, audits become a fact of life. And when auditors begin assessing your business, it’s expected that you’ll follow a national or international accounting standard. Many companies use local generally accepted accounting principles (GAAP) as their financial framework. US GAAP and UK GAAP are both well-established and understood by auditors. For companies operating internationally and dealing with reporting in multiple jurisdictions, IFRS is increasingly the default approach.
The first IFRS standard is IFRS 1, which provides a framework designed to help companies transitioning to IFRS.
IFRS 1
IFRS 1 provides a framework to help companies get financial statements and disclosures in order in line with IFRS guidance. The IFRS Foundation says:
“IFRS 1 requires an entity that is adopting IFRS Standards for the first time to prepare a complete set of financial statements covering its first IFRS reporting period and the preceding year.”
Under IFRS 1, organisations need to prepare an opening statement of financial position (SOFP) that recognises all assets and liabilities required by IFRS, and to reclassify assets and liabilities (including equity) in line with IFRS guidance.
Organisations also need to disclose certain figures relating to fair values of previous grants that were produced under the country-specific generally accepted accounting principles (GAAP). Each organisation also needs to explain what moving to IFRS will do to its financial position, and how cash flows and balance sheets might be affected going forward.
The scope of IFRS 2
If you want your share-based payments to be compliant with IFRS 2, that means committing to granular reporting on the expenses associated with those share-based payments. From Deloitte:
“IFRS 2 Share-Based Payment requires an entity to recognise share-based payment transactions (such as granted shares, share options, or share appreciation rights) in its financial statements.”
But what is a share-based payment?
In these transactions, an entity receives goods or services in exchange for consideration in the form of equity instruments, or cash or other assets for amounts that are based on the price (or value) of equity instruments.
Goods or services received in a share-based payment transaction are measured at fair value. Goods are recognised when they are obtained, and services are recognised over the period over which they are received.
So which transactions are affected by IFRS 2? KPMG states that it is a requirement to apply IFRS 2 to the following grants:
- Grants made after November 7th 2002, that vest after the date of transition to IFRS 2;
- Liabilities arising from cash-settled share-based payment transactions that will be settled after the date of transition;
- And any modifications of awards on or after the date of transition, even where the original grant is not accounted for under IFRS 2
Otherwise-exempt grants
Organisations may also wish to retroactively apply IFRS 2 to otherwise-exempt grants that don’t fit the above categories. As Croner-i says:
In paragraph 54 of IFRS 2, the entity is encouraged, but not required, to apply the requirements of the IFRS to other grants of equity instruments […] if the entity has disclosed publicly the fair value of those equity instruments, measured at the measurement date.
If the organisation has previously based equity-settled or cash-settled transactions on a fair value, it may be appropriate to apply IFRS. KPMG’s opinion is that companies are able to assess each of these otherwise-exempt grants on a case-by-case basis. Companies do not have to attribute a share-based payment cost to any otherwise-exempt share-based payments that fall outside IFRS 2’s scope.
Grandfathering
It’s reasonable for companies to have made certain accounting decisions relating to share-based payments before transitioning to IFRS 2. IFRS 1 stipulates that when organisations transition to IFRS, certain optional exemptions can be made for instruments that would be excessively difficult to update in accordance with IFRS guidance. For any share-based payments that are ‘grandfathered’ (retained at the transition date), KPMG’s view is that when transitioning to IFRS, companies can either elect to reverse share-based payment costs booked under previous GAAP or not, as long as the approach is practised consistently. More detail can be found on page 326 of KPMG’s IFRS 2 handbook.
Classifying share-based payment transactions
Share-based payments are classified based on whether the company in question decides to award its own equity instruments, or cash or other assets that happen to be linked to a share price, in return for goods or services received.
It’s important for companies adhering to IFRS 2 to clearly differentiate between the grants that are equity-settled and those that are cash-settled. They are treated very differently from an accounting perspective: as the name implies, equity-settled grants are treated as an equity entry, whereas cash-settled grants are treated as liabilities on the balance sheet.
Market and non-vesting conditions are reflected in the initial measurement of fair value. In equity-settled transactions, fair value is not remeasured post-grant date. In cash-settled transactions, the liability is remeasured when there are material changes to fair value, up to the settlement date.
So what are the key differences in the treatment of equity-settled and cash-settled transactions under IFRS 2?
Equity-settled transactions
In equity-settled transactions, “an entity recognises a cost and a corresponding entry in equity”, as KPMG states. Measurement is based on the fair value of the equity instruments granted, calculated at the grant date. There is no subsequent ‘true-up’ to account for differences between the expected and the actual outcome of the transaction.
Equity-settled share option agreements can be harder to measure than cash-settled transactions. Popular share or option grants that are usually equity-settled include conventional stock options, warrants, and RSUs.
Market and non-vesting conditions are reflected in the initial measurement of fair value, with no subsequent true-up for differences between expected and actual outcome.
The estimate of the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied is revised during the vesting period such that the cumulative amount recognized is based on the number of equity instruments for which the service and non-market conditions are ultimately satisfied.
Cash-settled transactions
IFRS 2 also covers cash transactions that are linked to equity, “such as a bonus that’s paid based on the share price of an entity.”
KPMG’s definition (found on page 51 of its IFRS 2 handbook) is as follows:
“A ‘cash-settled share-based payment transaction’ is a share-based payment transaction in which the entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity.”
Compared to equity-settled transactions, cash-settled transactions are relatively simple to calculate. They require the company to establish how much is expected to be paid out in the relevant transactions; how likely the company feels it is that the conditions of the provision will be met; and how many employees are expected to benefit from share-based payments in the relevant accounting period.
Then, the expense is recorded over the period it’ll be earned. If a cash bonus is paid out over, say, four years, the expense can be spread over the four years and recorded as a liability. Popular share types that are often treated as cash-settled transactions include phantom or virtual shares.
It’s relatively easy to account for cash-settled transactions as the reference is often clearly measurable (e.g. the most recent share price).
Classifying vesting conditions
Conditions that determine whether and/or when the entity receives the required services – essentially, whether an employee or another stakeholder qualifies to receive the benefits of the share-based payment – are classified as vesting or non-vesting conditions.
There are a few types of vesting and non-vesting condition. Often, companies use service conditions, market conditions and performance conditions to determine whether the share-based payment is earned (vesting), and when the share-based payment is received (non-vesting).
- A service condition is usually a given length of time that an employee remains in service with their employer before they become entitled to their share-based payment.
- A market condition occurs when “the vesting or exercisability of an equity instrument is related to the market price (or value) of the entity’s equity instruments”, according to KPMG. An example of a market condition might be a targeted increase in the company’s share price that occurs during the service period. Market conditions might be vesting or non-vesting conditions, and they are closely related to performance conditions.
- A performance condition might be a financial target, such as a revenue or profitability target, that is not related directly to the company’s share price or other equity instruments
In equity-settled share-based payments, market and non-vesting conditions are reflected in the initial measurement of fair value, with the treatment of grants depending on subsequent vesting conditions
Here’s a simplified overview of the treatment of different types of condition when dealing with equity-settled share-based payments (adapted from IFRScommunity.com):
Reporting and disclosures
Organisations must prepare to report on several important pieces of information. Some of these metrics will change significantly from one reporting period to another.
- Nature and terms of share-based payment arrangements: A company must disclose the nature and terms of its share-based payment arrangements, including:
- The types of share or option granted
- Any vesting arrangements or conditions
- The exercise price (also known as the strike price) paid by employees or other equity owners
- Share option expiry dates, if any exist
- Fair value and FV calculations: Companies must disclose the fair value of the share-based payments granted during the period, either individually or in aggregate, and how the fair value was determined. For more on calculating fair value, read this Ledgy blog post.
- Total compensation expense: A company must disclose the total compensation expense encompassing all share-based payments during the relevant period.
- Vesting conditions: A company must disclose the vesting conditions for any share-based payments, including vesting conditions (e.g. tenure or performance-related).
- Forfeitures: companies must disclose the proportion of employees’ equity it expects to be forfeited in the relevant accounting period. When an employee leaves a company or is otherwise terminated, expenses need to be adjusted to reflect any terminated unvested shares. Expenses are not adjusted for terminations of vested shares since vested shares are considered compensated under IFRS 2.
- Information about the employees and directors who participate in the share-based payment arrangements, including the number of individuals participating in the arrangements, the number and types of awards granted, and the aggregate fair value of the awards granted.
Summary
As companies scale and mature, there is less room for error in accounting and financial reporting. Investors, auditors and tax authorities all look for companies to consistently adhere to national or international reporting standards. That’s what makes IFRS so important. And for those companies that handle share-based payments, IFRS 2 is especially pertinent.
implementing IFRS 2 for the first time involves granular reporting and disclosures on a range of data points relating to your current and, in certain cases, historic equity-settled and cash-settled share-based transactions. It also means deciding how you’ll deal with more complex accounting going forward, such as your treatment of forfeitures and terminations.
This can seem intimidating for many companies, especially those that are growing quickly and grappling with constant internal change. But IFRS 2 gives you a solid foundation for fundraising discussions, audits, valuations and transaction conversations. So software that reduces the admin load of IFRS 2 compliance, and which gives you greater confidence in your share-based payment data, can give you a significantly better financial reporting experience.
Ledgy’s share plan management equips teams to handle the complexity of IFRS 2 reporting. We help you calculate the fair value of share-based payments in-app using different methodologies, including Black-Scholes and Monte Carlo models. Ledgy then packages all your data for easy export, creating smoother conversations with regulators and other stakeholders.
Learn much more about Ledgy’s approach to IFRS 2 and financial reporting, and for a fuller conversation just book a demo with one of our team.