8.2 Equity-settled and cash-settled transactions

Share-based payments are a crucial part of employee compensation, coming in two main flavors: equity-settled and cash-settled. These transactions involve companies giving employees shares or cash based on share prices in exchange for their work.

Equity-settled deals involve giving actual company shares, while cash-settled ones promise cash payments tied to share prices. The accounting for these differs in timing, expense recognition, and remeasurement requirements, impacting a company's financial statements differently.

Accounting for Share-Based Payments

Equity-Settled Transactions

• Entity receives goods or services as consideration for its own equity instruments or rights to equity instruments
• Measure goods or services received and corresponding increase in equity directly at fair value of goods or services received
• Measured at grant date and not subsequently remeasured
• Increase equity rather than creating a liability
• Examples:
  • Stock options granted to employees
  • Restricted stock units (RSUs) awarded to executives

Cash-Settled Transactions

• Entity acquires goods or services by incurring a liability to transfer cash or other assets based on entity's share price
• Recognize goods or services acquired and liability incurred at fair value of the liability
• Remeasure liability at each reporting date and at settlement date
• Create a liability rather than increasing equity
• Examples:
  • Stock appreciation rights (SARs)
  • Phantom stock plans

Key Differences

• Measurement timing varies between equity-settled (grant date) and cash-settled (each reporting date)
• Accounting treatment differs in expense recognition location (equity vs. liability)
• Remeasurement requirements differ (equity-settled not remeasured, cash-settled remeasured)

Fair Value of Equity Instruments

Option Pricing Models

• Typically use Black-Scholes or binomial models to measure fair value
• Key inputs for option pricing models include:
  • Current share price
  • Exercise price
  • Expected volatility (based on historical stock price movements)
  • Expected dividend yield
  • Risk-free interest rate (usually based on government bond yields)
  • Expected term of the option
• Market conditions incorporated into fair value measurement at grant date
• Non-market vesting conditions (service conditions) adjusted through quantity of awards expected to vest

Other Equity Instruments

• Restricted stock units (RSUs) fair value based on current market price of underlying shares
  • Adjust for expected dividends during vesting period
• Employee stock purchase plans (ESPPs) fair value includes:
  • Value of the discount offered to employees
  • Look-back option value, if applicable (right to purchase at lower of beginning or ending price)

Examples

• Stock option fair value calculation: $Fair Value = C = Se^{-qt}N(d_1) - Xe^{-rt}N(d_2)$ Where: S = current stock price X = exercise price t = time to expiration r = risk-free interest rate q = dividend yield N() = cumulative normal distribution function

• RSU fair value calculation: $Fair Value = Current Share Price - Present Value of Expected Dividends$

Modifications, Cancellations, and Settlements

Modifications

• Classify as beneficial, neutral, or detrimental based on impact on award fair value
• Beneficial modifications require recognition of incremental fair value
  • Recognize over remaining vesting period in addition to original grant date fair value
• Example:
  • Reducing exercise price of stock options from $50 to $40
  • Incremental fair value = New fair value at $40 - Original fair value at $50

Cancellations and Replacements

• Cancellations of equity-settled awards accelerate recognition of remaining unrecognized expense
• Replacements of cancelled awards treated as modifications
  • Recognize incremental fair value over new vesting period
• Example:
  • Cancel underwater stock options and replace with new at-the-money options
  • Recognize remaining expense of old awards immediately
  • Spread incremental value of new awards over new vesting period

Settlements

• Cash-settled award settlements measured at fair value at settlement date
  • Recognize difference between carrying amount and settlement amount in profit or loss
• Early exercise of equity-settled awards treated as cancellation and repurchase
  • Immediately recognize any unrecognized expense
• Example:
  • Cash out stock appreciation rights (SARs) before original settlement date
  • Measure liability at settlement date fair value
  • Recognize difference between this and previous carrying amount in profit or loss

Tax Implications of Share-Based Payments

Temporary Differences

• Share-based payments can create temporary differences between carrying amount and tax base
• Deferred tax assets recognized for deductible temporary differences
  • Recognize to extent probable that taxable profit will be available to utilize the difference
• Example:
  • Accounting expense recognized over vesting period
  • Tax deduction only available at exercise (creating a temporary difference)

Equity-Settled Transactions

• Tax deduction typically based on intrinsic value at exercise date
  • May differ from expense recognized for accounting purposes
• Tax benefit exceeding cumulative expense recognized recorded directly in equity
• Shortfall recognized in profit or loss
• Example:
  • Cumulative expense recognized: $100,000
  • Tax deduction at exercise: $150,000
  • Record $50,000 excess tax benefit directly to equity

Cash-Settled Transactions

• Tax base of liability typically equals its carrying amount
  • Results in no temporary difference at each reporting date
• Changes in expected tax benefits recognized in profit or loss
  • Exception for amounts previously recognized in equity
• Example:
  • SAR liability carrying amount: $200,000
  • Tax base: $200,000
  • No temporary difference to account for