Accounting for Share-Based Payments Chapter 18 Accounting for Share-Based Payments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Learning objectives Upon completing this chapter readers should be able to State which share-based payments are covered by AASB 2 ‘Share-based Payment’; Understand the reasons that ultimately led to the development of AASB 2; Understand what is meant by ‘equity-settled share-based payments’ and ‘cash-settled share-based payments’ and be able to provide the necessary accounting entries for such transactions; Understand how to measure share-based payment transactions; Understand the effect of various vesting conditions on the accounting treatments required for share-based payments; Explain some possible economic implications of the release of AASB 2; and Describe the disclosure requirements of AASB 2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Introduction to share-based payments The requirement to account for various share-based payment transactions is relatively new and are included in AASB 2 ‘Share-Based Payment’ In the past, many share-based transaction were not attributed a cost (for example, share options provided to employees) despite the fact that the use of such instruments as share options in employee reward structures was widespread The introduction of AASB 2 was relatively unpopular with business as it forced them to put a cost on transactions that were previously often treated as being of no cost There was great disparity in treatment of share-based payment transactions. Made inter-firm comparison difficult. This lead to a perceived need for an accounting standard Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Definition of a share-based payment transaction A transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options), or acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price of the entity’s shares or other equity instruments of the entity. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Scope of AASB 2 According to AASB 2, par. 2, an entity shall apply AASB 2 in relation to (a) equity-settled share-based payment transactions, in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options); (b) cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity; and (c) transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Accounting for equity-settled share-based transactions General rule provided at par. 10 of AASB 2 For equity-settled share-based payment transactions, the entity shall measure the goods or services received, and the corresponding 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 services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. AASB 2 defines fair value as The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted between knowledgeable, willing parties in an arm’s length transaction. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Accounting for equity-settled share-based transactions (cont) The is a general presumption that transactions with employees cannot be reliably measured on the basis of the value of the services provided. Par 11 states To apply the requirements of paragraph 10 to transactions with employees and others providing similar services, the entity shall measure the fair value of the services received by reference to the fair value of the equity instruments granted, because typically it is not possible to estimate reliably the fair value of the services received, as explained in paragraph 12. The fair value of those equity instruments shall be measured at grant date. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Accounting for equity-settled share-based transactions (cont) Worked Example 18.1 (p. 633) considers the case in which the fair value of goods to be received can be measured reliably. Worked Example 18.2 considers the case in which the value of services cannot be determined reliably paragraph 7 of AASB 2 requires an entity to recognise the goods or services received or acquired when the goods are obtained or the services provided if the goods or services were received in an equity-settled share-based payment transaction, an increase in equity is recognised. if they were received as part of a cash-settled share-based transaction, a liability is to be recognised consistent with paragraph 8 of AASB 2, if the goods or services do not meet the AASB Framework’s criteria for the recognition of an asset, the related expenditure is to be expensed Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Accounting for equity-settled share-based transactions (cont) Have the entitlements to the equity instruments vested? Something ‘vests’ if it has become an unconditional entitlement Whether an entitlement has vested will have implications for when the associated asset or expense will be recognised If the equity investments vest at ‘grant date’ the entity will recognise the whole transaction on that date on the assumption that the ‘counterparty’ has rendered services in full in return for the equity instrument Conversely, if the equity instruments do not vest at grant date there is a presumption that they are a payment for services to received during the vesting period Consider Worked Example 18.3 – employee costs with a vesting period Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Measuring fair value of equity instruments Easier if instruments traded on a stock exchange If not traded, then estimates of market value must be made In the absence of market values, fair value might be determined by way valuation techniques, such as option pricing models. Such models take account of (a) the exercise price of the option; (b) the life of the option; (c) the current price of the underlying shares; (d) the expected volatility of the share price; (e) the dividends expected on the shares (if appropriate); and (f) the risk-free interest rate for the life of the option. Where fair value cannot be determined then equity instruments are to be measured at their ‘intrinsic value’ Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Cash-settled share-based payment transactions Defined as a 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 the entity’s shares or other equity instruments of the entity. Required accounting treatment (par. 30) For cash-settled share-based payment transactions, 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 remeasure 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. Consider Worked Example 18.6 (p. 645) - share appreciation rights Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Share-based payment transactions with cash alternatives This is the third (and final) category of share-based payment transactions covered by AASB 2 Defined as transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier with the choice of whether the entity settles in cash or by issuing equity instruments Where the other party to the transaction has the right to demand cash or equity settlement, the transaction may be considered to give rise to a compound financial instrument with both a liability and an equity component. The equity component would be measured as the difference between the fair value of the goods and services received and the fair value of the liability component as at the date on which the goods and services are provided Consider Worked Example 18.7 (p. 647) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Summary of some of the main elements of AASB 2 Scope of AASB 2: Applies to share-based transactions involving both employees and non-employees Basis of measurement: Fair value Measurement date: Grant date When is cost recognised? If involving a period of service the expense is recognised over the period of the service (vesting period). If shares or options vest immediately the fair value is expensed at the grant date What option pricing model is to be used? If the options are short term, generally the Black-Scholes option pricing model would be used, otherwise other option pricing models might be employed. The models need to take into account the exercise price; current price; expected volatility; expected dividends; risk-free rate of return; and the life of the options Cash-settled share-based payment transactions - debt or equity? Cash-settled share-based payment transactions are to be measured at fair value and disclosed as a liability. Fair value is remeasured at each reporting date and the movement in fair value is to be treated as part of profit or loss. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Possible economic implications of AASB 2 Given that a cost must now be attributed to items such as share options do we consider that this will impact the propensity of firms to use them? What economic implications might follow if firms reduce their usage of incentive schemes based on share options? Does the issue of share options actually ‘cost’ the firm anything? Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Disclosure requirements AASB 2 requires extensive disclosure under three main headings. The entity is required to provide information to enable the users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the period; how the fair value of the goods or services received or the fair value of the equity instruments granted during the year was determined; and the effect of expenses arising from share-based transactions on the entity’s profit or loss for the period and on its financial position Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan