According to IFRS 2, share-based payment transactions are categorized as three types: equity-settled, cash-settled, and a choice of settlement in equity or in cash. Employee share option plan (ESOP) is an example of equity-settled transactions. Share Appreciation Rights (SAR) falls into the category of cash-settled transactions.
IFRS 2 covers recognition, measurement and disclosure of share-based payment transactions. The recognition and measurement are affected by both transaction types and market or non-market performance conditions. Market conditions are defined as the conditions upon which the exercise price, vesting, or exercisability of an equity instrument depends on the market price of the entity's equity instruments. Level of disclosures has also been required to raise under the standard. Among the accounting treatments, estimating the fair value of the ESO from the perspective of the employer will be the main focus to the management of most companies. It could also be the most difficult issue when applying this new standard.
Under IFRS 2, both listed and unlisted entities will need to estimate the fair value of its ESO that were granted after 7 November 2002 and had not yet vested on 1 January 2005. Valuation should be determined by reference to market price. If market price of share options does not exist, IFRS 2 would require an option valuation model be applied for the valuation of ESO. All option pricing models should take into account, as a minimum, the following factors:
(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.
Above are also the common factors that influence market value of exchange traded options. Since they could have a significant impact on the option valuation, the determination of these variables requires a large amount of professional judgements and assumptions, especially for shares of unlisted entities.
IFRS 2 provides application guidance on estimating the fair value of share options granted. In addition to the six factors above, it requires that other factors that knowledgeable, willing market participants would consider in setting the price shall also be taken into account. To properly evaluate ESO, the additional elements could include vesting period, forfeitability, possibility of early exercise and non transferability. All these restrictions and factors will have an effect to reduce the value of option. Also, separating options by groups of recipients with relatively homogeneous exercise behaviour for more accurate valuation should also be considered.
According to IFRS 2, adoption of pricing model for ESO valuation is part of an entity's selection of new accounting policies and should be applied consistently to similar share-based payment transactions. In past, Black Scholes model is the most commonly used methodology for option valuation. Binomial model is another widely accepted model. IFRS 2 does not specify which pricing model should be used or is preferred. However, it indicates that Black Scholes model could fail to incorporate some unique features for ESO valuation, such as possibility of early exercise and change of expected volatility over the option's life. Comparison of different option pricing models is discussed in more details in a separate article. In general, more flexible option pricing models can be applied to incorporate the variety of factors and assumptions in ESO valuation.
In rare cases, the entity may be unable to estimate reliably the fair value of the equity instruments granted at the measurement date. In these rare cases only, the entity shall instead measure the equity instruments at their intrinsic value.
Given the potential impact on their bottom line and the professional judgements required for various pricing models, it is widely expected that more companies will seek opinion from independent professionals in valuing their ESO. Independent valuer can help the management better gauge and understand the existing compensation package with share options. Should you require any assistance for ESO valuation or related advisory service, please do not hesitate to contact us.