IASB Made Changes to IFRS 2 Share-based Payment Accounting
Domestically, all eyes were on the FASB and its ASC 718 updates this year. But the International Accounting Standards Board (IASB) hasn’t been idle. On June 20, it finalized three amendments to IFRS 2 Share-based Payment.
IASB initiated its project in April 2014, around the time that FASB kicked off its post-implementation review of ASC 718. IASB’s project wasn’t as broad as FASB’s, nor were its changes so drastic. But they still yield material improvements for filers who are directly subject to IFRS 2, as well as US-based multinational firms subject to statutory accounting abroad under IFRS 2.
IASB’s amendments aim to clarify the requirements for three main topics:
- Treatment for tax withholding requirements with net settlement features.
- Fair value measurement of cash-settled awards.
- Accounting for cash-settled to equity-settled modification.
The IFRS 2 amendments go into effect for annual periods beginning after January 1, 2018. Early adoption is accepted, the transition method is prospective, and retrospective adoption is permitted if the company has sufficient information without the use of hindsight.
Treatment for tax withholding requirements with net settlement features
A “net-settlement” feature refers to an arrangement where the employer withholds a portion of the shares at release, then pays the tax in cash on employees’ behalf. Awards with net settlement features generally have two main benefits. One is that employees needn’t pay taxes out of pocket. The other is that there will be less dilution, as employers are essentially “repurchasing” shares.
Even when ASC 718 was being drafted in 2004, net-settlement features were thought to trigger liability classification because they commit the company to a cash obligation without any promise of an offset to the cash. FASB caved for pragmatic reasons, thus allowing equity classification to be preserved as long as withholding took place up to the minimum statutory level (that’s changing under ASU 2016-09). Well, the IASB didn’t cave.
The prior guidance in IFRS 2 requires companies to apply liability treatment for the portion of an award allocated to the withholding taxes, but apply equity treatment to the remaining portion. In other words, the shares handed to the employee are equity instruments, but the shares withheld for taxes are liability instruments. Critics argued this was impractical. They said that from a principles perspective, liability classification was inappropriate since the withheld shares funded the cash obligation.
IASB concurred that the costs of the prior guidance exceed the benefit. Under the new guidance, the requirement to bifurcate between equity and liability classification is relaxed so that the entire award maintains equity treatment.
The IASB clarified that this is a narrow-scope exception. That is, equity treatment is preserved only if the company is actually obligated to withhold shares to pay taxes. Still concerned that net-settlement creates a de facto cash obligation, the amendment requires companies to disclose an estimate of the amount expected to be paid to tax authorities when that amount is material. When trying to estimate the payout on options that are midway through their life and not at-the-money, our recommendation is to use a lattice model instead of the current intrinsic value.
Does that mean IFRS 2 now agrees with ASC 718 on how to handle net-settlement provisions? Not really. Interestingly, the IFRS 2 amendment converges with the old ASC 718 (prior to ASU 2016-09), in which withholding up to the minimum statutory rate does not trigger liability accounting. However, as ASU 2016-09 becomes effective, the two accounting requirements will remain at odds.
Fair value measurement of cash-settled awards
Under IFRS 2, fair values for cash-settled awards must be remeasured every reporting period until settlement (a.k.a. “mark to market”). However, IFRS 2 is silent on how vesting and non-vesting conditions affect the fair value measurement for cash-settled awards. Practices vary due to ambiguity. Some companies reflect the non-market performance conditions in the fair value measurement, and other don’t.
The June 20 amendment makes it clear that vesting conditions should not be incorporated in the fair value measurement, but non-vesting conditions and market conditions should be. Performance conditions should result in a reassessment of the expected payout each period based on the current estimate of the performance outcome. This agrees with the approach to measuring equity-settled awards. It also converges with the treatment under ASC 718.
For most companies, we don’t expect this to change anything.
Accounting for cash-settled to equity-settled modification
IASB’s third amendment is focused on modifying a cash-settled award to be equity-settled. Under the prior guidance, there was ambiguity around how to treat any fair value difference between the modification-date valuation of the cash-settled instrument and the new equity-settled instrument.
The amendment clarifies that in this case, the following must be done:
- Reverse the liability recorded as of the modification date.
- Record the vested portion of the modification-date fair value to equity.
- Identify any differences between (a) and (b), and record these immediately in the P&L. The remaining value of the award is recognized from the modification date to the service completion date.
However, as a practical matter, a liability-to-equity modification shouldn’t change the underlying fair value of an instrument if nothing changes the other provisions. In our experience, this flavor of modification occurs when a company doesn’t have enough shares reserved, so they issue a cash-settled instrument expecting to modify it to equity once they acquire more shares in their plan.
These amendments likely mean big policy changes for filers who are directly subject to IFRS 2. Given the variation in practice, it also brings greater comparability among filers. Amendments like this are interesting, because they show how highly principles-based standards can result in too little comparability as companies draw very different interpretations. The amendments, which take the form of rules, will bring greater clarity and thus comparability to share-based payment accounting under IFRS 2.
From a statutory accounting perspective, multinational US-based filers subject to GAAP with foreign operations abroad are also subject to IFRS 2. So these amendments apply to them as well.
But multinational US-based firms have rather different approaches to their statutory reporting requirements. Some have a “high control” strategy in which they run the IFRS 2 calculations from the home office, and then farm the reports out to local controllers abroad. Others have a “low control” strategy in which they give local controllers raw data and let them fend for themselves.
We expect to see more scrutiny applied to the statutory accounting responsibilities of US-based multinationals. Therefore, we tend to favor a high control strategy. Ultimately, IASB’s amendments provide a strong impetus for companies to review their end-to-end IFRS 2 accounting procedures.