Share-Based Payment

At its meeting yesterday in London, the IASB approved the principle that the fair value of stock options given to employees (and others) should be recogised as expense. The Board considered and rejected allowing an option of disclosure in lieu of expensing. For employees, fair value would be measured at grant date; for options given to non-employees, a different measurement date would be used. IASB expects to publish an exposure draft in the fourth quarter. The target effective date would be 1 January 2004, though this is tentative, and the IFRS might include a 'look-back' period to cover options granted after the exposure draft is issued.

Decision Summary:

The Board reviewed a staff paper discussing the accounting treatment of employee share options, with the objective of drawing some overall conclusions, based on discussions of various accounting and measurement issues at earlier Board meetings.

Key decisions taken at earlier meetings:

• Share-based payment to employees. The fair value of share options and other share-based payment granted as part of employee remuneration should be recognised as an expense. Fair value of share-based payment to employees should be measured at grant date.
• Share-based payment to non-employees. The fair value of share-based payment given to non-employees is the fair value of the goods and services received measured at the date when the goods are received or the services are provided.
• No exemptions. The standard should not provide any exemptions from measuring fair value of employee share options.

Recognition vs. disclosure. The project manager noted that many respondents to the G4+1 paper had asked for convergence with the US approach, set out in FAS 123, which allows a choice between recognition and disclosure. She outlined the problems with the US approach that had caused the Board to reject it, noting in particular the considerable evidence that disclosure is not an adequate substitute for recognition.

Reliable measurement. The next issue was whether reliable measurement is possible, a question on which the Board had consulted with an advisory committee and had also recently met with a panel of experts. Two Board members reported on the outcome of the meeting with the panel of experts, which had included among others Myron Scholes, who had won the Nobel Prize for his work on the Black-Scholes model. There was wide agreement among the panel members that the Board had addressed the right issues and considered them thoroughly. In the light of these and earlier discussions, the Board concluded that it is possible to reliably estimate the fair value of share options. Accordingly, the Board agreed that a standard should require all share options granted to be measured at fair value and expensed.

The Board next considered a series of shorter papers dealing with specific accounting and measurement issues:

Other feature of employee share options. The discussion was concerned particularly with reload features that may make it difficult to measure fair value at grant date. Under FAS 123 a reload feature is treated as a new grant if it is too complex to include in the fair value measurement of the initial grant. The Board considered and rejected such an approach, favouring no exception to the general principles, no matter how complex an option may be.

Accounting for own shares held. It was agreed that the scope exclusion in SIC 16 should be removed, so that it would apply to such shares. It was also noted that, by the time a standard is issued, the requirements of SIC 16 may instead be reflected in IAS 32.

Accounting for tax effects of share-based payment transactions. Tax relief in respect of share options granted can arise at a different time from compensation expense, and can be for a different amount. The Board agreed that temporary differences are adequately dealt with by IAS 12; however, an issue arises where the amount of tax relief exceeds the compensation expense. It was noted that FAS 123 treats the excess in such circumstances as additional paid in capital. The majority of Board members favoured recognising any excess tax relief as a tax credit in the income statement as and when it arises. It was agreed, however, that the Board should look again at the extent to which this approach ties in with IAS 12.

Definition of grant date. In some circumstances, shareholder approval is required before an entity can enter into an employee share option plan. This raises the question of whether grant date should be the date that the plan is agreed with employees, subject only to shareholder approval, or the later date of that approval. The Board was asked to consider a proposal that grant date should be the date of substantive agreement with employees; however, after some discussion, the Board concluded that the word 'substantive' should be deleted, so that grant date would be the date that final authority was given to a plan.

Measurement date when the transaction is measured at the fair value of the goods or services received. The Board agreed that the fair value of such goods or services should be measured at the date of receipt, but this prompted a long discussion on whether this was consistent with the grant date approach proposed for employees. After some debate, the Board agreed that the approaches were consistent, noting that the reasons for favouring grant date for employees are as follows:

• the objective, whether measuring share options granted to employees or to third parties, is to measure the fair value of (goods or) services received;
• for third parties, it will generally be possible to measure this directly;
• for employees, it may not be possible to measure services directly, and therefore the fair value of share options granted should be used as a surrogate;
• the majority view of the Board is that the fair value of services is most likely to correspond to the fair value of options at the date agreement is reachedži.e. grant datežbecause subsequent changes in option fair values are unlikely to reflect changes in the value of services. (In other words, the grant date value is recognised over the period of employee services, because this is the best estimate of the value of those services.)

'In substance' repricing. Issues arise when the terms of share options are amended after the grant date, for example by repricing or by cancellation (usually accompanied with a replacement issue). Should such changes be treated as an amendment to the original issue or as a new issue, and to what extent should accounting entries be reversed on a cancellation? The Board was asked to consider a proposal that a standard should avoid including a 'bright line' rule, and should instead give guidance on when a repricing has in substance occurred. This prompted considerable discussion, with the Board finally agreeing that:

• once options have been granted, the associated expense should continue to be recognised as long as the employee is providing the service, even if the options are subsequently cancelled;
• where replacement options are granted, these are treated as a new issue, and measured at full fair valuežunless they are explicitly linked to cancelled options, in which case the incremental fair value will be measured.

Consequential amendments to other accounting standards. The Board noted that on issue of a share-based payments standard consequential amendments would be required to IAS 19, IAS 32, and SIC 16.

Employee share plans with cash alternatives. The key accounting issues for share plans that offer cash alternatives are whether and when a liability or equity interest arises, measurement of those liabilities and equity interest, and accounting for their settlement. There was general agreement that an equity interest arises when delivery of shares becomes more likely than a cash payment. At that time, the plan may result in a compound financial instrument that would have to be split into its equity and debt components. Although IAS 32 says that the equity component of a compound instrument is measured residually, in this case the equity component cannot be measured by subtracting the value of the debt instrument from the plan's entire value since that entire value is unknown. The liability component would have to be remeasured to fair value with changes in fair value going into the income statement. Disclosure should be required of the extent that such plans were subsequently settled in cash.

Transition. The Board considered transitional arrangements and agreed that the standard, including tax effects, should apply retrospectively, but only to options granted after the date of issue of an exposure draft of the standard. Liabilities in cash-settled schemes would require a full retrospective application. The same implementation requirements would be applicable for first-time adopters of IFRS. If an exposure draft is issued in the fourth quarter 2002, as planned, the final standard could not be issued much before the end of 2003. It was agreed that, if a standard is issued by the end of 2003, it should be effective for periods beginning on or after 1 January 2004.

Overall decision. After concluding discussion of the individual matters, the Chairman asked the Board members whether in principle they would agree to issue a standard based around these decisions. One Board member registered a preference for service date rather than grant date, but the large majority confirmed they would not oppose a standard. Accordingly, the project director was asked to begin drafting a standard for the Board to consider.

Two additional issues: The Board agreed that two final issues would be brought back to the Board later in the week:

• The interaction of the tax benefit proposal above with IAS 12.
• Certain issues over the remeasurement of cash stock appreciation rights (SARs) and the interaction with IAS 39.

Insurance Contracts

This was entirely to an educational session. Two very simple insurance contracts were highlighted, in order to:

• Focus on the interaction between different parts of the contracts and hence to demonstrate how profits can arise from insurance business.
• Illustrate how different accounting models deal with such contracts.

• Approaches to deriving risk margins under the DSOP.
• How the different accounting models behave when faced with changes from the initial assumptions (in particular, it was agreed that there would be some discussion of how the US FAS 97 approach would operate if the lock-in requirement was removed).
• The impact of applying the DSOP model to non-insurance business, such as airline frequent flyer programs.

17 July 2002

Consolidation, Including Special Purpose Entities

Discussion centred around the following three papers:

• Paper A that discusses some of the high-level conceptual issues that arise
• Paper B is staff summary of the comments received from IFRIC members and others on SIC-12, Consolidation - Special Purpose Entities.
• Paper C sets out some of the high-level issues that are raised by the recent FASB proposals on the consolidation of SPEs.

Paper A - high-level conceptual issues

Discussions started by trying to get a basic framework in place to solve basic issues such as why do we consolidate, when do we consolidate and how do we consolidate. A control-based approach was proposed with a reporting entity notion, defining the reporting entity by reference to the assets it controls. The focus is on providing the most useful information to users and not reflecting the legal form. Inter-group transactions will be eliminated.

The Board discussed extensively what is meant by control. The Board tentatively concluded that control exists if the reporting entity has the ability to control the decision making within the enterprise. An equity shareholding is not necessarily needed for control to exist. Control can be established by way of a management contract. The Board was supportive of a definition of control that is similar to the one in IAS 27, with the wording changed slightly to reflect the ability to control rather than the power to control.

The Board discussed some examples. If A owns B, but C has options to acquire all of A's shares in B, then C has the ability to control B and must consolidate B even if the option as have not actually been exercised. In this case A is seen as an agent for C.

If severe restrictions on control are in place, the Board agreed that control is removed from the reporting entity. This can happen in circumstances such as bankruptcy (an EITF decision deals with this issue) or government restrictions being in force (in countries like Arabia). In South America, there is a requirement in some countries for more than 50% of the shares to be held locally - this would not, by itself, indicate control.

Paper B - comments received on SIC-12

The scope of the new IFRS should be wider than just SPEs. The board talked about a concept of 'Control so as to benefit'.

The Board wants to produce one IFRS with the same principles applicable to all. Separate rules will not be produced for SPEs, but the IFRS will include a list of indicators of the ability to control. This will include benefits received that indicate control, which are more relevant to SPEs. If a reporting entity has the majority of the risk and benefits, then the SPE must be consolidated.

Paper C - issues arising on the FASB draft Interpretation

In the United States, FASB has issued an exposure draft of an Interpretation on Consolidation of Special Purpose Entities. The Board broadly agreed with the principles in the FASB draft Interpretation. However they wanted to change the definition of control to be more like that of IAS 27. The FASB draft included 3 proposed exceptions for:

• Entities that are consolidated by a substantive operating entity,
• 'Qualifying' SPEs as defined in FAS 140, and
• SPEs that hold certain financial assets.

Example: Company A gave assets to an SPE in exchange for some cash and a fee used to extract profits from the SPE. The SPE has an asset manager and an insurance policy and is financed by bank debt. Company A should consolidate this SPE even though it has no equity shareholding as it has the ability to control the SPE by extraction of profits.

Where there are debt and equity shareholders, consolidation should be on a basis of the risks and benefits.

The Board acknowledged that consolidation decisions are often not clear cut. The overall substance of the intercompany relationship must be considered.

The meeting ended with the project manager agreeing to develop a framework and set of criteria for the consolidation process that would be discussed at the next meeting with the National Standard Setters.

18 July 2002

Deposit-Taking, Lending, and Securities Activities: Disclosure and Presentation

The Board discussed a proposed exposure draft developed by staff based on the discussions of the Board (November 2001 meeting) and its advisory committee (January and March 2002 meetings). The discussions were characterised as 'preliminary' and it was noted that the next meeting of the advisory committee was scheduled for September 2002.

The proposed scope of the standard is 'activity-based' - capturing all entities with deposit-taking, lending, and securities activities. Therefore, treasury functions in non-financial entities would be within its scope.

The Board supported an underlying principle of the risk-related disclosure that the disclosures should provide the user with a view 'through the eyes of management', albeit with specified minimum disclosures.

Significant points raised in this preliminary discussion included the following:

• The Board was concerned about the volume of requirements and resulting disclosure in the draft exposure draft. The detail seems somewhat inconsistent with a 'principle-based' approach to standards.
• The draft Standard seems to overlap with other disclosure requirements, particularly those in IAS 32 (as proposed to be revised).
• The Board was concerned that the proposed disclosure of 'operational risk' is too broad or too general. The Board will ask the project advisory committee to consider how much of the proposed disclosure should be included in the 'Management's Discussion and Analysis' rather than in the financial statements. Another possibility is to issue implementation guidance rather than a Standard.
• The Board will ask the advisory committee to revisit the definition of 'operational risk', in particular to remove overlap with other specified risk types, and to clarify the distinction between solvency and liquidity risk.
• More clarity in defining 'securities activities' is required.
• The Board was not convinced of the usefulness of the proposed balance sheet and income statement classifications and asked for greater clarity on how these would interact with IAS 1 and the performance reporting project.
• The Board expressed a tentative preference that the disclosures in the draft exposure draft be implemented as application guidance for IAS 32. IAS 32 would need to be reviewed to eliminate inconsistencies with the material coming from this project and to address overlaps and discontinuities. This might require a relatively pervasive review of that standard.
• The Board rejected the proposed exemption for wholly-owned subsidiaries. With such an exemption, disclosures would only be given at group level.

Convergence Topics

The Board discussed certain areas of difference among major national accounting standards and IAS where there are opportunities for convergence. The Board noted that IASB is making an effort, in all of its projects, to converge IFRS with national standards, particularly with US GAAP. For the project to be successful, the national standard setters must similarly work to amend their standards. IASB will communicate potential areas where national standard setters could act to achieve convergence when the IASB meets with the national standard setters in September (at FASB) and October (general meeting with liaison standard setters).

The following standards were considered to identify whether a discrete convergence project might produce high quality solutions in a relatively short time:

Convergence: Post-Employment Benefits

At the June meeting the Board agreed to add a post-employment convergence project to its active agenda. At this meeting the Board considered the first issue in the project -- the recognition of actuarial gains and losses (the unexpected changes in the value of the plan). The Board noted that resolving this issue depends, in part, on the format of the performance report.

IAS 19 and all national standards on pensions currently in force allow deferral of actuarial gains and losses in some way. This is not the case with the new UK standard FRS17, which is currently optional and will come into force in 2005). IAS 19 and FAS 87 also allow full immediate recognition as an option.

After discussion, the Board was asked to vote whether the '10% corridor' and 'smoothing' elements of IAS 19 should be removed. A majority of the Board members favoured eliminating both the corridor and spreading of actuarial gains and losses, subject to the discussion of the treatment of service costs during the vesting period. The staff will prepare a paper on this for the next meeting.

Business Combinations - Phase 2

The Board agreed that certain items will not be measured at fair value at the time of a business combination: deferred income tax assets and liabilities and benefit plan obligations.

The Board discussed whether the occurrence of a business combination should affect the fair value measurement of acquired assets and liabilities. For example, should the acquirer's credit rating affect the measurement of the acquiree's liabilities assumed. The Board noted that under FASB Concepts Statement 7, the most relevant measure of a liability always reflects the credit standing of the entity obliged to pay. The Board concluded that this requires further study.

The FASB and IASB have tentatively decided that this project will exclude issues related to the initial recognition and measurement of benefit plan obligations. However, within the scope of the project the Board will consider the measurement where the business combination itself affects the measurement of the post-employment benefit obligations. The Board considered three recommendations in this area, as follows:

• Recommendation 1: The assumptions of the acquirer in respect of future salaries, staff turnover etc should be used where the acquirer has a different assessment of future events to the acquiree. This was agreed by the Board.
• Recommendation 2: If the acquirer will change the plan of the acquiree to provide benefits to employees of the acquiree that are compatible with the benefits provided to its own employees or to curtail or terminate the plan, this should be treated as a post-acquisition event and not affect the measurement on acquisition. The Board supported this recommendation and noted that it differs from the current FASB position.
• Recommendation 3: If the acquirer is required to amend the plan as a condition of the business combination imposed by the owners of the acquiree, this should be included in the cost of acquisition. The Board deferred decision on this issue.

The Board discussed IAS 37 and the treatment of contingent liabilities on acquisition, including contractual termination benefits (such as golden parachutes) that arise as a result of an acquisition and restructuring provisions. No decisions were reached.

19 July 2002

Reporting Performance

The Board has begun to use the term 'statement of comprehensive income' rather than 'statement of performance'. This is consistent with the terminology in FASB Statement 130.

The Board discussed how to report the performance of cash flow hedges. Under IAS 39, for a cash flow hedge, the gain or loss on the hedging instrument is initially recognised directly in equity. Subsequently, the amounts recognised directly in equity are included in net profit or loss in the same period or periods during which the hedged asset or liability acquisition or firm commitment or forecasted transaction affects net profit or loss (for example, when the acquired asset is depreciated or when a forecasted sale actually occurs). The result is that income or expenses on the hedging instrument is recognised in the same period as those on the hedged items. In the case of acquired assets, including the gain or loss on the hedging instrument as part of the cost basis of the acquired asset (with consequenial adjustment of depreciation) is known as 'basis adjustment'.

The Board considered four alternative presentation approaches for cash flow hedges:

• Retaining the IAS 39 approach, sometimes called 'recycling with basis adjustment'.
• No recycling. This, in effect, is a prohibition of cash flow hedge accounting because the gain or loss on the hedging instrument would be recognised immediately rather than deferred in equity.
• Quasi-recycling. Under this approach, income and expenses on the hedging instrument are reported in a separate 'cash flow hedging' category in the statement of comprehensive income and are subsequently recycled within the statement of comprehensive income into the same line item in which the hedged item is reported.
• Basis adjustment. The income and expenses on hedging instruments are deferred in equity the balance sheet until the hedged item is recognised.

The Board instructed its staff to prepare a summary paper on the project that will be discussed at meetings of the Board, national standard setters, and Standards Advisory Council in September, October and November. Field visits with financial statement preparers and users are also planned.

Regarding how to proceed in this project, the Board decided that the project should move directly to an exposure draft, rather than first issuing a discussion paper. Publication of the ED is planned for first quarter 2003. Click here for a Timetable for IASB projects.

This summary is based on notes taken by observers at the IASB meeting and should not be regarded as an official or final summary.