Changes to how share-based payments are expensed (plus a reminder of the effect of modifying or cancelling a share-based payment grant)

Recent big share price falls in expectation of downgraded earnings have resulted in many companies contemplating cancelling or modifying options and other equity-based long-term incentive grants. If in this situation, board remuneration committees need to understand that the cancelled or modified grants will still have to be expensed, in addition to the expensing required for any new or replacement grants.

On top of this, the Australian Accounting Standards Board has this month advised of an accounting treatment clarification to how share based payments are expensed.

Consistent with amendments made to IFRS 2 Share-based Payment in January 2008 by the International Accounting Standards Board, the Australian Accounting Standards Board (AASB) has issued amendments to AASB 2 Share-based Payments to clarify that:

• Vesting conditions must be either service conditions or performance conditions, and that other features of share-based payment transactions are not vesting conditions (this is important when valuing and expensing such transactions); and

• All cancelled share-based payments should receive the same accounting treatment, regardless of who makes the cancellation

Expensing treatment re non-market and market vesting conditions

Expense treatments vary according to whether a payment is subject to non-market or market vesting conditions.  This needs to be understood by company management and remuneration committee directors, as each treatment makes a considerable difference to how executive pay is expensed and shown in the directors’ report remuneration tables, as well as overall company expenses for employee share based payments. 

For expensing purposes, non-market vesting conditions are taken into account in estimating the number of equity instruments in a grant that will vest during the vesting/performance period.  These estimates are updated annually during the vesting period, subject to “truing up” at vesting date so that the number of equities expensed reflects the number for which the non-market vesting conditions are satisfied

Market conditions are taken into account in estimating the fair value of the equity instruments granted.  The fair value of equity instruments subject to a market condition must be expensed to the extent that other (non-market) vesting conditions (e.g. the requirement that the employee remains in service until the end of the performance period) are met, irrespective of whether the market condition is satisfied.

Many remuneration committees have determined that the non-market method of expensing represents a “truer and fairer” reflection of the cost of long-term incentive plans than the alternative market method.  This is one of several reasons that there is a shift away from assessing performance on relative total shareholder return (TSR), which is a market method, to alternatives such as earnings per share (EPS) growth, a non-market method.

New definition of “vesting conditions”

“Vesting conditions” are now defined to be “…either service conditions or performance conditions.  Service conditions require the [employee] to complete a specified period of service.  Performance conditions require the [employee] to complete a specified period of service and specified performance targets to be met…”

Treatment of non-vesting conditions

In general terms, a non-vesting condition is one that does not determine whether the entity receives the services that entitle the employee to the share-based payment.  Examples of such a condition are:

• an arrangement that provides for the employee to make contributions over time towards the exercise price of a share-based payment; or
• continuation of the plan by the employer.

The amendments to AASB 2 specify that, like market conditions, non-vesting conditions shall be taken into account when estimating the fair value of the equity instruments granted.  The fair value of equity instruments subject to non-vesting conditions must be expensed to the extent that non-market vesting conditions (e.g. a service requirement) are met, irrespective of whether the non-vesting conditions are satisfied.

A non-vesting condition could include, for example, a requirement for the employee to contribute to a portion of the equity cost in a “savings” type of plan.

Modification or cancellation of a grant of equity instruments

As a minimum, an employer must expense the grant date fair value of any equity instruments it grants, unless those equity instruments do not vest because of the failure to satisfy a vesting condition (other than a market condition) that was specified at grant date.  This applies irrespective of any modifications to the terms and conditions on which the equity instruments were granted, or a cancellation or settlement of that grant.  In addition, the employer must expense the effects of modifications that increase the total fair value of the share-based payment arrangement or are otherwise beneficial to the employee.

AASB 2 previously specified the accounting treatment that applies “If the employer cancels or settles a grant of equity instruments during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied)…”.   The amendments to AASB 2 have re-worded this so that the same accounting treatment applies “If a grant of equity instruments is cancelled or settled during the vesting period…”, i.e. no matter who initiates the cancellation or settlement.

Note that cancellation or settlement is expensed in the same way as an acceleration of vesting of equity instruments i.e. the amount that would otherwise have been expensed over the remainder of the vesting period is recognised immediately. 

These amendments to AASB 2 were made in AASB 2008-1, Amendments to Australian Accounting Standard – Share-Based Payments: Vesting Conditions and Cancellations, which is available from the AASB website HERE.  They are applicable to annual reporting periods beginning on or after 1 January 2009, with early adoption permitted for annual reporting periods beginning on or after 1 January 2005 but before 1 January 2009.

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