IFRS 2 Part 2 – Cash-settled share-based payments and transactions with a choice of settlement

Part 1 – Equity settled share-based payments discussed the basic principles underpinning share-based payment transactions and focussed on equity-settled share-based payments. It would be useful if you read it before proceeding to study this second article.

2.2 – Cash–settled Share-based Payments

Cash-settled share-based payments to employees usually take the form of share appreciation rights (SARs). A SAR is a right to receive a cash payment at a fixed future date or dates based in some way on the movement in the entity’s share price. These arrangements also have vesting conditions that are in many ways similar to those found in equity-settled share-based payments. There are two important differences though:

• Because payments to the relevant employees are ultimately in cash the credit entry will be to liabilities rather than to equity during the vesting period.
• Because the SAR will ultimately be settled by a cash payment the fair value estimate used to account for the arrangement will be based on the latest information at each reporting date, rather than continuing to use the fair value on the grant date (the practice adopted for equity-settled share-based payments).

EXAMPLE 1
Theta prepares financial statements to 31 December each year. On 1 January 20X3 Delta granted 400 SARs each to 80 employees. The SARs vest on 31 December 20X5 provided the relevant employees remain in employment with Theta until that date. The SARs can be exercised (payment claimed) on  31 December 20X5.The exercise price (the ‘intrinsic value’ of one SAR) is the share price at the date of exercise. The following information is relevant:
 

All employees exercised their SARs on 31 December 20X5. The fair value of a SAR is estimated using a pricing model. Two of the inputs to the model are the current share price and its expected future change. This is why the fair value of a SAR differs from its intrinsic value on any date other that the final exercise date.

Using example 1 the following illustrates the calculations required to account for this share-based payment for the years ended 31 December 20X3, 20X4 and 20X5:
 

Notice that, for cash-settled share-based payment transactions, the fair value figure that is used in the computations is the fair value at the end of the reporting period.

2.2 – Share-based payment transactions which provide a choice of settlement
Some share-based payment transactions allow the counter-party (usually an employee) a choice of receiving settlement either in cash or by the issue of an equity-based instrument.

If the counterparty has the right to choose whether the share-based payment is settled in cash or shares/share options, the entity has granted a compound financial instrument. This therefore becomes slightly more complex and like any compound instrument the share-based payment must be split between the debt component and the equity component.

The debt component will be measured at the grant date accounted for as a cash-settled transaction, creating a liability. The liability will be re-measured at fair value at each reporting date until settlement (the normal accounting treatment for cash-settled share-based payment transactions).

The equity component will be measured as the residual interest at the grant date (see below). This will be accounted for as an equity-settled share-based payment and is not re-measured (the normal accounting treatment for equity-settled share-based payment transactions).

The residual interest at the grant date is the difference between the total fair value of the compound instrument and the fair value of the debt component.

EXAMPLE 2
Omega prepares financial statements to 31 December each year. On 1 January 20X3 Omega offers an executive the right to receive, on 31 December 20X4:

• Either a cash payment equal to the value, at 31 December 20X4, of 5,000 shares; or
• 6,000 shares. A condition of the issue is that these shares, cannot be sold by the executive before 31 December 20X6.

The rights will only vest if the executive remains employed by Omega, and provides service, in the two year period from 1 January 20X3 to 31 December 20X4. The executive is expected to remain in employment, and so become unconditionally entitled to the rights. Share price movements for Omega over the two-year period are as follows:
 

The fair value of the share alternative  is estimated as $9 each. (An option pricing model is used to arrive at this estimate. You would not be required to compute this figure in the DipIFR examination).

We compute the fair value of each component at 1 January 20X3 (the grant date) as follows:

• The fair value of the debt component of each right is $50,000 (5,000 X $10).
• The fair value of the equity alternative is $54,000 (6,000 X $9 ).
• Therefore the fair value of the equity component of the compound instrument is  $4,000 – ($54,000 – $50,000). This is often referred to as the residual interest..

The equity component of the compound interest (residual interest) is accounted for as an equity-settled share-based payment by recognising $4,000 in equity over the two-year vesting period. Each year there will be a credit to equity and a debit to employee remuneration of $2,000 ($4,000 X ½).

The debt component is re-measured at the end of each period in accordance with the principles laid out in section 2.2 of this article for cash-settled share-based payments. The amounts are shown in the following table and before any settlement takes place.
 

Overall, then, at 31 December 20X5, the vesting date, Omega will show a liability of $60,000 and a credit in equity of $4,000. If the executive chooses to receive cash then Omega will credit cash and debit liabilities with $60,000. If they choose the share route then Omega will credit equity and debit liabilities with $60,000.

Closing remarks

IFRS 2 is a highly examinable standard at DipIFR. It is recommended that all students study the principles in both part 1 and 2 of this article thoroughly.

Written by a member of the DipIFR examining team