International Financial Reporting Standards

IFRS 2

While many continue to debate the timing and likelihood of the United States adopting IFRS, Equity Methods has been supporting clients in IFRS-related issues since 2007. While we believe a decision to abandon GAAP for IFRS could be the single greatest accounting regime change ever implemented (SOX would look like a walk in the park), we are sensitive to the issues companies with foreign-filing subsidiaries are facing today.

Given how a majority of countries have already adopted IFRS in place of their local GAAP, most multinational US-based firms are likely to have foreign subsidiaries currently complying with IFRS. The parent has two choices with regard to how it manages the IFRS reporting for its subsidiaries:

Low Control Strategy

  • Parent exercises little control over the processes of its foreign-filing subsidiaries. The parent provides consumable data because it maintains responsibility for tracking award data, but does not perform any calculations and leaves this task to the subsidiaries themselves.
  • This approach minimizes time burdens on the US parent but results in a significant duplication of work, since each subsidiary will build similar processes and procedures to apply the same exact accounting.
  • Furthermore, the low control strategy exposes the parent to risk. In our experience, subsidiaries lack a critical mass of expertise in the area of stock-based compensation, and each is prone to performing its accounting slightly differently, and potentially, incorrectly.
  • Whereas two years ago most US parents adopted a low control strategy, we see a trend in the opposite direction and agree a higher control strategy constitutes a best practice.
  

High Control Strategy

  • This strategy entails the parent exercising a high control over the reporting processes of its non-US subsidiaries. The parent will generally create financial reports and provide these to the subsidiaries, which they merely need to review, adjust (if appropriate) and then book.
  • While this may cost the parent additional resources upfront, it is by far the most efficient approach. The parent, possessing critical mass, institutionalizes a process that is not person-dependent.

IFRS 2 creates a number of new accounting challenges not currently encountered under US GAAP:

 

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Valuation

Tranche-level valuation requires separate estimation of expected life for each tranche within a grant.

  • Because the only permitted amortization method is Graded (which treats each tranche as a standalone grant), each tranche must be separately valued using a distinct expected life assumption. This stands in contrast to policy under US GAAP, whereby most companies develop an overall expected term assumption for a grant (that represents an average of the tranches).

Exercise and forfeiture assumptions need to be developed at the country level as per IFRIC 11.

  • This requires companies to test whether employees in each country exhibit distinct exercise patterns and/or forfeiture rate patterns instead of pooling them together.
  • The challenge that arises is that such an approach may not improve the reliability of the estimate when sample sizes are low within countries. Judgment must be applied as to whether and how country data are pooled together when building valuation assumptions.

Lattice models may be required more frequently under IFRS 2.

  • The language in IFRS 2, coupled with it being a principles-based standard, makes it probable that auditors will require companies to formally compare and contrast different valuation models, and select the one that yields the best estimate of fair value.
  • Academic research, including that quoted within ASC 718, does note that the Black-Scholes formula can yield similar values to those produced by best-of-breed lattice models; however, the research also clearly illustrates that under many circumstances, one model is clearly preferable over another.
  • We anticipate that auditors and regulators under an IFRS-based accounting standard will significantly increase the burden for companies to test and prove the appropriateness of their selected valuation model.

 

Expense Reporting

All awards must be amortized using a Graded Attribution Model.

  • This approach treats each award tranche as a standalone grant. Typically, this results in an accelerated amortization schedule, as each tranche begins vesting on the same date but ends on its own vesting date.
  • This requirement is generally straightforward and should not be a large burden for companies to adopt.

Share withholding requires subsequent selling of withheld shares in open market to avoid liability accounting.

  • Net-settlement provisions require that the net settlement portion of the award be accounted for as a liability.
  • Unclear as to whether the re-measurement occurs on a fair value or intrinsic value basis.

Payroll charges are recognized as liabilities and thus re-measured each period.

  • Unclear as to whether the re-measurement occurs on a fair value or intrinsic value basis.

 

Deferred Tax Reporting

Accounting for deferred taxes is arguably the greatest area of difference between ASC 718 and IFRS 2 (and ASC 740, formerly SFAS 109, and IAS 12, the IFRS equivalent of SFAS 109).

The first major difference is that, under IFRS 2, and unlike ASC 718, the cumulative deferred tax asset (DTA) recorded on non-statutory awards in a jurisdiction where a tax deduction is permitted is not equal to the statutory tax rate in that jurisdiction times the grant-date fair value of the awards granted.

  • IFRS 2 requires companies to continuously update (remeasure) the DTA based on changes in the share price.
  • Remeasurement of the DTA each period should occur on an intrinsic value basis.

IFRS 2 also eliminates the concept of the APIC Pool, which exists only under US GAAP.

  • With no APIC Pool concept under IFRS, all tax deficiencies result in increased tax expense.
  • Windfalls are thus recorded in the balance sheet (equity), but shortfalls are recorded in the income statement (in tax expense).

Important implications:

  • Requisite period-to-period remeasurements will result in significant income statement volatility relative to the ASC 718 and FAS 109 accounting model. The absence of an APIC Pool means the income statement will be directly affected.
  • As a result of the IFRS 2 deferred tax accounting model, a company will experience more frequent changes to its effective tax rate.

A number of accounting policy issues also remain unresolved:

  • Treatment of ISOs – if a company finds that empirically many employees liquidate their ISOs through a disqualifying disposition, should deferred tax assets be set up during vesting (on the basis of IFRS being a principles-based standard)?
  • Should an APIC Pool be tracked at the tranche level or the award level?
  • Should the presentation of tax windfalls and shortfalls be reported in operating cash flows or financing cash flows?

Relevant Whitepapers

Introduction to IFRS 2 | 2010



Relevant Issue Alerts

ECIA: How Unrefined Expected Term Approaches Create Audit Risk | 2010

ECIA: Best Practices in ASC 718 Forfeiture Rate Estimation | 2009

ECIA: Identifying and Optimizing a Fragmented ASC 718 Process | 2010