Financial Reporting Update

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1 Financial Reporting Update October 2004 Issue 8 KPMG HONG KONG - PROFESSIONAL PRACTICE For the first time the HKICPA has issued an accounting standard on transactions settled in shares or other forms of share-based consideration HKFRS 2 "Share-based Payment" The HKICPA has adopted International Financial Reporting Standard, IFRS 2, as "HKFRS 2". HKFRS 2 is applicable to all entities adopting HK GAAP, whether listed or unlisted. This new standard's focus is on accounting for transactions where the reporting entity pays for goods and services by giving: In this issue: Transactions within the scope of HKFRS 2 2 Basic recognition principles 4 Disclosure requirements 8 the entity's own shares or other equity instruments (such as share options over its own shares); or other assets (generally cash), where the amount payable will be linked to the price of the entity's own shares or other equity instruments (e.g. warrants). Transitional provisions for existing HKFRS reporters 8 Transitional provisions for first-time adopters of HKFRSs 9 Appendix 1: Simplified overview of the basics of HKFRS 2 11 Appendix 2: A closer look at the accounting requirements 12 Common abbreviations defined: HKICPA - Hong Kong Institute of Certified Public Accountants (previously known as Hong Kong Society of Accountants) SSAP - Statement of Standard Accounting Practice HKAS - Hong Kong Accounting Standard HKFRS - Hong Kong Financial Reporting Standard Such transactions are termed "share-based payment" (SBP) transactions. The scope of the standard also extends to recording the value of certain SBP benefits given by other group companies or their shareholders, if they relate to goods or services provided to the entity. For example, if a parent grants options over its own shares to employees of a subsidiary, the subsidiary may have to apply HKFRS 2 to those benefits in its own financial statements. HKFRS 2 is effective for annual periods beginning on or after 1 January It contains special transitional arrangements, which are looked at in more detail below. Also, entities are allowed to adopt early. This Update gives an introduction to the principles and requirements of HKFRS 2, for you to use as your first point of reference when approaching this new standard. It includes, by way of appendices to this Update, a flowchart that summarises the basics of HKFRS 2 and a closer look at the measurement and recognition requirements. IFRS - International Financial Reporting Standard 1 FRU issue 8 (October 2004)

2 Overview HKFRS 2 introduces specific accounting requirements for an area where only disclosure requirements currently exist in HKFRSs. These disclosure requirements are currently found in SSAP 34, Employee benefits, and are deleted via a consequential change set out at the end of HKFRS 2. HKFRS 2 sets out how entities must recognise and measure SBP transactions with both employees and non-employees. It will require recognition at fair value for all goods and services received, including employee services, where payment is made in shares or options, as well as when payment is in cash (or other assets), the amount of which is linked to the entity's share price. HKFRS 2 also includes new disclosure requirements. This new standard applies to all entities, listed and unlisted. HKFRS 2, and its source IFRS 2, will no doubt be causing some concern amongst preparers of financial statements, not least for the following reasons: the requirements will introduce charges to the income statement where previously there were none; the requirements involve fair valuing instruments that may have no readily available market price; and there is no clear guidance in the standard as to how these requirements interrelate with company law requirements concerning the equity part of the balance sheet. All SBP transactions under which goods or services are received by the entity are within the scope of HKFRS 2, except for: - certain future commodities contracts; and - shares issued for acquisition of net assets in business combinations (HKFRS 2.2, 5, 6) The standard does not concern itself with other transactions involving equity, when the counterparty is acting in the role of a shareholder. For example, it has no relevance when warrants are issued to existing shareholders, in their capacity as shareholders. Also shares issued as consideration in a business combination are outside the scope of HKFRS 2 (instead they are dealt with under HKFRS 3, Business Combinations). In this overview we introduce the following topics: transactions within the scope of HKFRS 2; basic recognition principles; disclosure requirements; transitional provisions for existing HKFRS reporters; and transitional provisions for first time adopters of HKFRSs. As mentioned above, Appendix 1 includes a flowchart to summarise the rules to be applied to SBP transactions and Appendix 2 takes a closer look at the accounting requirements. Transactions within the scope of HKFRS 2 The objective of HKFRS 2 is to ensure that all SBP transactions are recognised in the financial statements and are measured at fair value. A SBP transaction is defined as a transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares and share options), or receives goods/services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price of the entity's share price or other equity instruments of the entity. There are two exclusions: commodities contracts that fall under paragraphs 8 to 10 of HKAS 32 or pararaphs 5-7 of HKAS 39. These are commodities contracts that can be settled net in cash, rather than physical delivery, provided they were not entered into and continue to be held for the purpose of receipt of the commodity in accordance with the entity's expected purchase or usage requirements; and the acquisition of net assets in business combinations. FRU issue 8 (October 2004) 2

3 The diagram below illustrates the types of transactions that are within the scope of HKFRS 2: Transactions within the scope of HKFRS 2 This could be the employees of A or other providers of goods or services (e.g. advertising agents), Counterparty provided that the counterparty is not acting as a shareholder Goods (e.g. fixed assets, inventories, other consumables) Services (e.g. hours worked by employees, advertising or consulting services received) Forms of share-based payment (SBP) e.g.: A's shares (newly issued) Options over A's shares; or Cash or other assets of an amount linked to A's share price Reporting entity A Example: the amount of cash consideration varies depending on the increase in A's share price (i.e. share appreciation right) The scope of HKFRS 2 extends to cover SBP consideration provided by: - the entity's shareholders; and - other entities in the same group. (HKFRS 2.3) HKHKFRS 2 has a broader application than simply where the reporting entity and the counterparty are the only parties involved in the transaction. Its scope extends to other situations in which the entity receives goods or services, where the entity's parent, or another group entity provide equity instruments as consideration for those goods or services. A common example is where the employees of a subsidiary are given options over shares in the parent company. In this case the subsidiary has to apply HKFRS 2. This is summarised in the diagram below: Other types of SBP transactions to be recognised by entity A: Counterparty Goods or Services Equity settled SBP consideration given in exchange: A's equity instruments (already in issue) Equity instruments of entities in the group to which A belongs Entity A Specified parties related to A: A's shareholders members of the group to which A belongs: - parent company - own subsidiaries - fellow subsidiaries This introduces a requirement for entity A to record these particular related party transactions at fair value, with the opposite entry being to equity as a form of capital contribution. 3 FRU issue 8 (October 2004)

4 Basic recognition principles Where to recognise the debits and credits? The basics of the debits and credits are illustrated below: Goods or services received by reporting equity exchange Share based consideration given to counterparty (including employees) debit credit or credit asset or expense depending on type of goods or services received liabilities if it is a cashsettled SBP equity if it is an equitysettled SBP The debit entry The debit entry is charged to profit or loss unless the goods/services qualify for recognition as assets. (HKFRS 2.8, 9) Liabilities are credited where the consideration to be given for the goods/services received is in the form of cash or other assets (HKFRS 2.7) The location of the debit entry is determined based on normal accounting principles. For example, if the SBP relates to services rendered by employees who work on a production line, the debit would generally be recorded as part of inventory, whereas the charge for head office management staff would generally be recognised in the income statement as and when incurred. Crediting liabilities As shown in the diagram, the credit for a SBP transaction is recorded in liabilities (until settled) if the transaction is a "cash-settled" SBP. These are defined as SBPs where the consideration to be paid will be cash or other assets, the amount of which will be based on the price (or value) of the entity's shares or other equity instruments of the entity. Example 1a: cash consideration contingent on share price performance Company B makes a deal with an advertising agency, whereby part of the cash payable to the agency will be determined based on the extent to which Company B's share price increases over the six month period following a major advertising campaign. Company B will record a liability when the advertising services are provided, based on the terms of the agreement and the relevant share price performance (measurement is discussed more fully below). As a result, both reported profits and net assets decrease by the amount recorded for the services received. Equity is credited in all other SBP transactions (HKFRS 2.7) Crediting equity As shown in the diagram, the credit for all other SBP transactions is recorded in equity. This has the effect in equity of contra-ing the reduction in retained profits. In other words, although accounting for equity settled SBP transactions under HKFRS 2 will reduce reported profits, it will not reduce net assets. This is shown in the following examples. FRU issue 8 (October 2004) 4

5 Example 1b: shares issued in an equity-settled SBP In year 1 Company B instead agrees to give the advertising agency 20 shares (nominal value of $1) in payment for the advertising campaign it ran in year 1. The fair value of the services the agency provided in exchange are estimated to be $200 Year 1 journals: Debit Credit Advertising expenses (income statement) 200 Nominal value of share capital 20 Share premium account Relevant extracts from income statement Year 1 Advertising expenses (200) ==== Relevant extracts from balance sheet Nominal value of share capital 20 Share premium account Retained earnings / accumulated losses (200) Shareholder's funds - ==== Note that the charge to the income statement has not resulted in any decrease in net assets. Instead, the effect on the balance sheet has been the same as if capitalising retained earnings. 1 HKFRS 2 does not specify exactly where the amount in equity should be recognised as this would be a matter for company law. In this example, we have assumed that the excess of the value of the services received over the nominal value of the shares issued would be taken to the share premium account under section 48B of the Hong Kong Companies Ordinance. Example 1c: options granted and then exercised In year 1 Company B instead agrees to grant the advertising agency 100 options to subscribe for shares (nominal value of $1) at an exercise (strike) price of $10 at any time over the next 5 years, in payment for the advertising campaign it ran in year 1. The advertising services received are valued at $200, resulting in a computed option premium of $2 per option. In year 2 the agency exercises all its options when the market price of B's shares was $15. Year 1 journals: Debit Credit Advertising expenses (income statement) 200 Capital reserve (option premium) 200 NB: as the services have been provided and the advertising agency is unconditionally entitled to the options, the value of the services received is recognised in full in year 1. The timing of when to recognise conditional SBP transactions is looked at more closely in Appendix 2. This is particularly relevant where the services are provided by employees and are subject to vesting conditions. 5 FRU issue 8 (October 2004)

6 Year 2 journals: Debit Credit Nominal value of share capital 100 Share premium account 1,100 Capital reserve (option premium) 200 Cash at bank 1,000 NB: the share price of Company B's shares in year 2 is irrelevant to the increase in equity in year 2. The shares issued on exercise of the options have been recorded at the cash exercise price paid by the advertising agency ($1,000) plus the amount recorded as the option premium when the services were received. However, as in example 1b, it is a matter for company law as to whether, and how much of, the option premium should be recorded as share premium. Relevant extracts from income statement Year 1 Year 2 Advertising expenses (200) -- ==== ==== Relevant extracts from balance sheet Cash at bank 1,000 ==== Nominal value of share capital Share premium account - 1,100 Capital reserve (option premium) Retained earnings / accumulated losses (200) (200) Shareholder's funds - 1,000 ==== ==== In this third example, the effect on reported profit and net assets in year 1 is the same as in example 1b i.e. although the advertising expenses reduce the reported profit for the period, there is no overall impact on net assets. In year 2 the increase in shareholders funds of $1,000 arises solely from the cash paid by the advertising agency on exercise of its options. The shares issued by company B at this point are recorded at total proceeds of $1,200, being $1,000 received in cash and $200 received in the form of services provided in year 1. NB: if the agency had not exercised the options and instead allowed them to lapse, then the capital reserve would generally be released to retained earnings (subject to any company law restrictions). This release would be by way of a reserve transfer within equity and not through the income statement. Appendix 2 to this Update contains a further worked example showing the entries made when the equity-settled SBP arrangement involves a vesting period. How to measure the debits and credits? The requirements for measurement and timing of recognition for each of the following categories are looked at more closely in Appendix 2 to this Update: equity-settled SBP transactions (e.g. shares and share options); cash-settled SBP transactions (e.g. share appreciation rights); and transactions where there is a choice of cash or equity settlement for either the reporting entity or the counterparty. FRU issue 8 (October 2004) 6

7 Basic formula In brief the key points are as follows: Equity-settled SBP transactions (e.g. shares and share options) Calculating the charge to the income statement (or increase in assets, e.g. inventories) in any period involves applying the following formula (HKFRS 2.10, 20) : A: Fair value of the individual equity instrument, measured at measurement date B: Number of instruments expected to vest X = C: Total amount to be recognised for the goods/ services received How to measure the fair value of an individual equity instrument? To calculate the fair value of each individual instrument, the rules vary depending on whether the transaction is with a third party or an employee. They also vary depending on whether the fair value of the goods or services can be reliably measured and, if not, whether the fair value of the equity instruments can be reliably measured. (HKFRS 2.10, 11, 13) If measuring the fair value of an equity instrument, market conditions (such as conditions relating to the performance of the share price in a specified period) attaching to that grant would need to be taken into account. However, other vesting conditions, such as length of service, would not be. Intrinsic value should only be used in rare circumstances. (HKFRS 2.19, BC77-79) When to recognise the transaction? If the instruments vest immediately, then the charge is generally recognised immediately. (HKFRS 2.14) If the instruments do not vest immediately, then the charge is generally spread pro-rata over the vesting period. No changes, other than transfers within equity (such as when options are exercised or lapse), are made after the instruments vest. (HKFRS 2.15, 23) Subsequent re-measurement The fair value of each instrument is not re-estimated. However the total charge being spread over a vesting period will be re-estimated at each reporting date to take into account changes in estimates of how many instruments will vest (e.g. based on employee turnover rates) under the nonmarket vesting conditions attached to the grant. Also, where the length of the vesting period depends on non-market vesting conditions being met, this variable is also re-estimated at each reporting date until the instrument has vested. (HKFRS 2.15, 19) Cash-settled SBP transactions (e.g. share appreciation rights) How to measure the transaction? At initial recognition the liability (and debit entry) is measured at the fair value of the liability, irrespective of the nature of the counterparty or goods or services provided. (HKFRS 2.30) When to recognise the transaction? Cash settled SBP transactions are recognised initially when the goods or services are provided. (HKFRS 2.32) Subsequent re-measurement After initial recognition the fair value of the liability is re-measured at each balance sheet date until settlement. Changes as a result of the remeasurement of the fair value are recognised in the income statement, even if initial cost is recognised as an asset (e.g. as part of inventories). (HKFRS 2.30) 7 FRU issue 8 (October 2004)

8 Transactions where there is a choice of cash or equity settlement for either the reporting entity or the counterparty HKFRS 2 has detailed rules on how to deal with such transactions and the accounting depends on who has the choice to determine the form of settlement: Where the counterparty has the choice, then a compound instrument exists, whose components need to be accounted for separately as equity and liability, following the rules set out above. (HKFRS ) Where the entity has the choice, it should account for the transaction as an equity-settled transaction, unless in substance it has a present obligation to settle in cash (e.g. where it has a past practice of settling in cash if the counterparty requests it). (HKFRS ) The disclosure requirements state three overall aims of the information that is to be provided (HKFRS 2.44, 46, 50) Disclosure requirements The disclosure requirements in HKFRS 2 are set out under 3 basic aims. These are that the information disclosed should enable users of the financial statements to understand: the nature and extent of SBP arrangements that existed during the period; how the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined; and the effect of SBP transactions on the entity's profit or loss for the period and on its financial position. The detailed requirements to meet these aims are set out in non-bold paragraphs. These have equal status to the bold paragraphs and are therefore mandatory (HKFRS 2.45, 47-49, 51) A further catch-all paragraph requires more disclosure to be given if the three aims are not met (HKFRS 2.52) HKFRS 2 contains transitional provisions which limit the extent to which the measurement and recognition requirements have to be applied retrospectively to SBP transactions (HKFRS ) The two key dates for determining whether HKFRS 2 has to be applied in full are: - 7 November 2002; and - the first day of the annual accounting period in which HKFRS 2 is adopted. (HKFRS 2.53, 60) The rest of the requirements are set out in non-bold paragraphs. However, as bold and non-bold paragraphs now have equal status, where any of these paragraphs ask for specific information to be disclosed, this should be understood to be a mandatory requirement. For example, paragraph 47 sets outs a lengthy list of details that en entity should disclose in respect of fair valuation, such as the option pricing model used to measure the fair value of share options, the inputs to that model and how volatility was determined. All of this information should be given if the SBP transactions are material. In addition, HKFRS 2 contains a catch-all paragraph, which states that if complying with the specific detailed requirements does not satisfy the three principles in paragraphs 44, 46 and 50 (as set out above), then further information should be disclosed as necessary to satisfy them. Transitional provisions for existing HKFRS reporters HKFRS 2 is effective for annual periods beginning on or after 1 January Earlier adoption is permitted, provided disclosure is made of this fact. The disclosures set out in HKFRS are applicable whether or not HKFRS 2's full requirements are applied to the transaction (HKFRS 2.56). These disclosure requirements relate to the nature and extent of SBP transactions and are similar to those currently in SSAP 34 for employee equity compensation plans. However, the standard contains transitional provisions that limit the extent to which the measurement and recognition requirements have to be applied retrospectively to SBP transactions. These transitional provisions vary depending on whether the transactions were on or before 7 November 2002 or after that date. The reference to 7 November 2002 is to that exact date, not to accounting periods beginning or ending before or after that date. For example, a grant of share options on 7 November 2002 does not fall within the scope of the measurement and recognition requirements of HKFRS 2, whereas a grant of options on 8 November 2002 does, even though the entity's year-end may be 31 December 2002 (i.e. both transactions were within a period which began before 7 November 2002). FRU issue 8 (October 2004) 8

9 For existing HKFRS reporters, the provisions also vary depending on the position "at the effective date" of HKFRS 2. This date will be the first day of the annual accounting period in which HKFRS 2 is first adopted as follows: Year end Latest acceptable "effective date" of HKFRS 2 31 December 1 January March 1 April June 1 July 2005 The following table sets out the extent to existing HKFRS reporters have to apply the rest of the requirements in HKFRS 2 (i.e. the measurement and recognition requirements) to SBP transactions based on the position at these two dates i.e. 7 November 2002 and the "effective date" of HKFRS 2. SBP transactions: Does HKFRS 2 apply in full to: Original grant? Modifications before effective date? Modifications on or after effective date? All equity-settled grants made on or before 7 November 2002 Optional 1 Optional 2 Yes, mandatory Equity-settled grants made after 7 November 2002, but already vested before the effective date Optional 1 Optional 2 Yes, mandatory Equity-settled grants made after 7 November 2002 and still unvested on the effective date Yes, mandatory retrospective adoption (HKFRS 2.53 & 55) Yes, mandatory retrospective adoption (HKFRS 2.53 & 55) Yes, mandatory adoption (HKFRS 2.57) Cash settled SBP transactions, where the liability is still outstanding at the effective date Cash settled SBP transactions, where the liability has been settled before the effective date Yes, mandatory retrospective adoption, at least as far back as 7 November 2002 (HKFRS 2.58) Optional restatement e.g. of comparatives (HKFRS 2.59) Notes: 1 Entities may (but need not) apply HKFRS 2 to these SBP transactions if, and only if, the fair value of those equity instruments has been disclosed publicly. If HKFRS 2 is applied, then it should be adopted retrospectively (HKFRS ). 2 HKFRS 2 does not contain specific transitional provisions covering these circumstances. However, if the recognition and measurement principles of HKFRS 2 were applied to the original grant (see note 1), it would seem inconsistent for the later modifications to the grants not to be accounted for under HKFRS 2. However, by analogy with HKFRS 2.54 and 57, it would seem acceptable for the modifications to be accounted for under HKFRS 2, even when the original grant is not. Transitional provisions for first-time adopters of HKFRSs HKFRS 2 is first effective for first time HKFRS adopters on the later of 1 January 2005 and the date of transition to HKFRS (HKFRS 2.C8) The transitional provisions for first time HKFRS adopters are the same as those applicable to existing HKFRS reporters as set out above, except that the date when HKFRS 2 is first effective for first time HKFRS adopters is the later of 1 January 2005 and the "date of transition" to HKFRS (being the first day of the earliest period of comparatives presented in the first annual financial statements prepared under HKFRSs). For entities with 31 December year-ends, there is no difference in effect when HKFRS 2 is adopted in However, for those with other year-ends this can result in a different treatment of SBP transactions in the transitional period by an existing reporter compared to a first time adopter. The same difference would arise between existing reporters and first-time adopters of IFRSs. 9 FRU issue 8 (October 2004)

10 Example: Entities C and D are identical in the following respects: their year end is 31 March; they are preparing financial statements under HKFRSs for the year ending 31 March 2006, with one year of comparatives; this is the first year that they will adopt HKFRS 2; and in February 2004 they issued share options to their employees, and these options vested in February The only difference between C and D is that C has a history of preparing financial statements in accordance with HKFRSs, whereas D is adopting HKFRSs for the first time in its 2005/6 financial statements. The application of the transitional provisions to C and D's share options is as follows: Entity C (existing reporter) Entity D (first time adopter) Effective date of HKFRS 2 First day of accounting Later of date of period on or after transition (i.e. 1 January 2005 = 1 April 2004) and 1 April January 2005 = 1 January 2005 Applicability of HKFRS 2's Optional (vested before Mandatory (vested after measurement and effective date of effective date of recognition requirements 1 April 2005) 1 January 2005) to options granted The practical effect is that, while entity C can ignore HKFRS 2, except to make disclosures of comparative information as would be required under HKFRS , entity D has to make retrospective adjustments to calculate the fair value of the options at the date of grant and to spread the charge over the vesting period. As can be seen, HKFRS 2 introduces detailed and specific requirements for transactions that involve settlement in equity instruments or in assets, the amount of which is determined by reference to the value of an entity's equity instruments. This will most commonly, but not exclusively, affect listed companies and companies within listed groups, who have used the liquidity of their shares to reward others for goods or services provided. For such companies, care will need to be taken to make sure that the requirements are complied with. To assist those affected by HKFRS 2 or contemplating a SBP transaction, the following appendices contain: a flow chart summarising the basics of HKFRS 2; and a closer look at the accounting requirements. This material is intended as an introduction to HKFRS 2 and should not be relied upon as a substitute for reading the standard. Should you have further questions concerning this standard or its application, please talk to your usual KPMG contact. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation KPMG, the Hong Kong member firm of KPMG International, a Swiss cooperative. All rights reserved. Printed in Hong Kong. FRU issue 8 (October 2004) 10

11 Appendix 1: Simplified overview of the basics of HKFRS 2 Share-based payment ("SBP") Will the SBP be settled in the entity's own equity instruments 1? Yes No Fair value the liability "Cash settled SBP" 2 for the goods/ services received at each balance sheet date until settled Recognise 4 the services over the vesting period. "Equity settled SBP" Is the counterparty an employee? Yes Fair value 3 the equity instruments at the date granted Yes (to both questions) If the fair value has been estimated with reference to the equity instruments, then also re-estimate the number of instruments that will vest, and/or the length of vesting period, at each balance sheet date until vested No (1) Is the SBP in exchange for services, and if so, (2) is the counterparty required to complete a period of service before the SBP vest? Can the goods or services received be reliably measured? Yes Fair value the goods and services at the date received No (to either question) Recognise 4 the cost of the goods or services immediately No Fair value 3 the equity instruments at the date the goods or services are received 1 For the purposes of HKFRS 2, "equity instruments" include those issued by the entity's parent or another entity in the same group (see "Transactions within the scope of HKFRS 2" section on page 2 of this Update). 2 For the purposes of HKFRS 2, "cash settled SBP" also includes those transactions where the entity has incurred an obligation to transfer assets other than cash. 3 In the rare cases that the fair value of the equity instruments cannot be reliably measured the intrinsic value should be used instead. 4 The cost of the goods or services received is charged to income statement unless the goods/services qualify for recognition as assets. For cash-settled SBP transactions, the credit is recorded as liability whereas the credit of an equitysettled SBP transaction is recorded in equity. See "Basic recognition principles" section on page 4 of this Update for further details on the double entry required. 11 FRU issue 8 (October 2004)

12 Appendix 2: A closer look at the accounting requirements The purpose of this appendix is to provide further understanding of the requirements of HKFRS 2. It looks firstly at some key definitions and concepts used in the standard and then considers the measurement and recognition requirements relating to: equity-settled SBP transactions (e.g. shares and share options); cash-settled SBP transactions (e.g. share appreciation rights); and transactions where there is a choice of cash or equity settlement for either the reporting entity or the counterparty. The appendix is not intended to be a substitute for the standard and reference should be made to the standard and its implementation guidance in cases of doubt or when applying HKFRS 2 to a particular transaction. Definitions and concepts Appendix A to HKFRS 2 contains a glossary of terms used in HKFRS 2. When considering the specific requirements relating to the various types of SBP, it is important to take these into account. In particular, an understanding of the following concepts is fundamental to applying the standard correctly: equity instrument; fair value; grant date; vesting; and employees. Equity instrument Equity instruments are defined in HKFRS 2 in the same way as in other IFRSsourced standards (for example, HKAS 32, Financial Instruments: disclosure and presentation). They are contracts that evidence a residual interest in the assets of an entity after deducting all of its liabilities i.e. they are generally the ordinary shares of a company. However, there are 2 important points to note: the definition of equity instrument extends to contracts that will be settled by the entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash (or other financial asset) (HKAS 32.22) i.e. it extends to options (warrants) issued by entity; and Fair value Grant date for the purposes of HKFRS 2, the definition also extends to equity instruments of other entities in a group to which the reporting entity belongs, when they are transferred to other parties (including employees) in exchange for goods or services provided by those parties to the reporting entity (HKFRS 2.3). Fair value is defined in HKFRS 2 in the same way as in many other IFRS-sourced standards, being the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction. There is only one definition of fair value in HKFRS 2. However, the important point to note is that there are differing rules on how that fair value should be arrived at depending on the nature of the SBP transaction i.e. in some cases it is calculated by reference to the goods or services received and in others by reference to the consideration given. The rules are summarised in the diagram in Appendix 1 to this Update, and looked at more closely below. The grant date is defined as the date when the entity and the counterparty (including employees) have a shared understanding of the terms and conditions of the arrangement. However, if the grant is conditional upon an approval process (e.g., from the shareholders of the entity), then the grant date cannot be earlier than the date when this approval is obtained. FRU issue 8 (October 2004) 12

13 Vesting Identification of grant date is important since the grant date may be the date at which the fair value of equity instruments should be estimated, as explained below. However, the grant date is not necessarily the same date as the goods or services are received: these may have been received before the grant date or afterwards. The meaning of "to vest" is "to become an entitlement". The concept of vesting is important for the purpose of determining when an entity should recognise services received, as explained further below. HKFRS 2 states that under a SBP arrangement the counterparty's right to receive cash, other assets or equity instruments, vests upon satisfaction of any vesting conditions. This point in time is defined as the "vesting date" with the period between this date and the grant date being the "vesting period". The timeline below illustrates these dates in an example share option award arrangement between an employer and its employees. Grant date Vesting period Year 1 Year 2 Year 3 Vesting date Vesting period - the period during which all the nonmarket vesting conditions are to be satisfied Exercise date Time Grant date - the date at which the entity and another party have a shared understanding of the terms and conditions of the arrangement Vesting date - the date when the conditions for entitlement are satisfied i.e. grant becomes unconditional Exercise date is the date when options are exercised (may or may not happen) Vesting conditions In many cases there are conditions related to the vesting or exercisability of the equity instruments granted to employees. That is, although the equity instruments may have been granted, the employees (or other counterparty) do not become entitled to any benefits from those instruments until certain conditions have been met. A common example is requiring the employees to remain with the company for a further minimum period of time. HKFRS 2 distinguishes between the following types of conditions: service conditions, which require the counterparty (usually an employee) to complete a specified period of service; and performance conditions, being either: - market conditions, where vesting or exercisability of an equity instrument is related to the market price of the entity's equity instruments (e.g., the shares must reach a specific share price); or - non-market conditions, where vesting or exercisability of an equity instrument is related to specific performance targets (e.g., a specified increase in profit). That is, the condition relates to the "performance" of the entity or the price of its shares or other equity instruments. 13 FRU issue 8 (October 2004)

14 Vesting conditions can affect the recognition of SBP transactions in either or both of the following ways: they would be taken into account when estimating the length of the vesting period over which the charge should be spread; and they may be taken into account in arriving at the fair value of the transaction. Employee Further details on this are given below. As discussed more fully below, HKFRS 2 contains different rules for calculating fair value depending on whether the counterparty is regarded as employee or not. The meaning of the wording "employee" within the context of HKFRS 2 is therefore key to applying the standard correctly. As stated in a footnote to HKFRS 2.11, throughout the standard, where the word "employees" is used, this should be taken to mean "employees and those providing similar services" as defined in Appendix A to HKFRS 2. Appendix A defines "employees and those providing similar services" as follows: "Individuals who render personal services to the entity and either: (a) (b) (c) the individuals are regarded as employees for legal or tax purposes, the individuals work for the entity under its direction in the same way as individuals who are regarded as employees for legal or tax purposes, or the services rendered are similar to those rendered by employees. For example, the term encompasses all management personnel, i.e. those persons having authority and responsibility for planning, directing and controlling the activities of the entity, including non-executive directors." As a results of categories (b) and (c) the term may also include some outsourcing and secondment arrangements. Equity-settled SBP transactions HKFRS 2 has adopted the modified grant date approach to accounting for equitysettled SBP transactions. Under this approach, the measurement of such transactions with vesting conditions is based on the following formula: A: Fair value of the individual equity instrument, measured at the measurement date B: Number of instruments expected to vest X = C: Total amount to be recognised for the goods/ services received Therefore, measuring and recognising equity settled SBP transactions requires taking some or all of the following steps, to the extent the effect is expected to be material: 1. estimating the fair value of the individual equity instrument; 2. identifying the vesting period (if any); 3. estimating the number of instruments that are expected to vest at the end of the vesting period; and 4. spreading the total fair value (being the fair value of each instrument multiplied by the number expected to vest) over the vesting period (if any). If there is no vesting period, then recognising the charge immediately. Each of these steps is considered in turn below, using the concepts and defined terms introduced above. FRU issue 8 (October 2004) 14

15 Step 1: estimating the fair value of the individual equity instruments Estimating the fair value of the individual equity instruments involves determining the appropriate basis of measurement and then applying that basis at an appropriate point in time. The rules in HKFRS 2 concerning these two matters are broadly as follows: Basis of measurement As with any non-cash settled transaction, there are two possible ways of arriving at the value of the transaction: by reference to what the entity has received, or by reference to what the entity has given up. In the case of SBP transactions, HKFRS 2 sets out specific rules as to which basis of measurement should be used. These rules are as follows: Measurement by reference to goods and services received (HKFRS 2.10, 13) The fair value of a SBP transaction is based on the fair value of the goods or services received if the counterparty is not an employee of the entity, provided the fair value can be reliably measured. It is a presumption in HKFRS 2 that such fair value can be reliably measured and the standard expects it to be rare that this presumption is rebutted. For example, where goods have been received in exchange for options or shares, then the cash price alternative for the goods would generally be taken as the fair value of the transaction. Measurement by reference to the fair value of the equity instruments granted (HKFRS ) This measurement basis should be used in the following situations: if the counter party is an employee; or if the fair value of the goods or services received from a non-employee cannot be reliably estimated (which is expected to be rare). (HKFRS 2.24) (HKFRS ) The only exception from estimating fair value of the equity instruments in these circumstances would be where the fair value of the equity instrument could not be reliably estimated. HKFRS 2 states that this should be rare. If such a situation exists then the intrinsic value should be used instead to measure the transaction. "Intrinsic value" is defined in Appendix A to HKFRS 2 and HKFRS contains detailed rules on how this measurement basis is to be applied. If the fair value is being estimated by reference to the equity instruments granted, the fair value should be determined as follows: If market prices exist for the equity instruments granted, then the estimate of fair value should be based on these market prices. If no market prices exist for the equity instruments granted (e.g. shares of unlisted entities), then the fair value of equity instruments granted is estimated using a valuation technique. (HKFRS ) Appendix B to HKFRS 2 Typically, a market price will not exist for equity instruments granted to employees due to the conditions attached to their grant. Accordingly, the use of a valuation technique generally is necessary if the effect would be material. HKFRS 2 requires the valuation technique used to be consistent with generally accepted valuation methodologies for pricing financial instruments, but does not require use of a specific valuation model. Appendix B to HKFRS 2 has detailed guidance on estimating the fair value of shares and share options, focusing on the specific terms and conditions that are common features of a grant of share or share options to employees. This appendix is an integral part of the standard and therefore where it is explicit on how amounts should be calculated, its guidance must be followed. Where the amounts are material to the financial statements it may be necessary to engage the services of a professional valuer in order to arrive at a reasonable estimate of fair value. This is not, however, explicitly required by the standard. 15 FRU issue 8 (October 2004)

16 (HKFRS 2.19, 21 & App A) When calculating the fair value with reference to the equity instruments, vesting conditions are taken into account, but only to the extent that they are "market conditions". For example, the fair valuation would take into account any terms of the arrangement that required the entity's share price to achieve a minimum level of performance relative to a stock price index. The valuation is not subsequently revised for any changes in expectations as to whether those conditions will be met. Measurement date (HKFRS 2.13) (HKFRS 2.11) (HKFRS 2.15) If the counterparty is not an employee of the entity, the fair value is measured at the date when the entity receives the goods or services. This is irrespective of whether the measurement basis is the fair value of the goods/services received, or the equity instruments granted. Since in most cases the fair valuation should be based on the value of the goods and services received, this is consistent with general principles on accounting for non-cash transactions. If the counterparty is an employee, the measurement date is the grant date of the arrangement. The fair value of the individual instrument is not re-measured after that date. Step 2: identifying the vesting period (if any) Where the provider of the services has to complete a further period of service before becoming entitled to the instruments it will be necessary to identify the vesting period over which the charge should be recognised. (HKFRS 2.15(b)) In many cases the period is a specified period of time, such as the options do not vest until the employee has completed a further 3 years with the entity. However, if a performance condition (e.g. the entity has to achieve a target profit) is attached to the grant, then the vesting date may not be fixed. In such cases it is necessary to estimate the vesting period at the grant date. This estimate would take all vesting conditions into account, including market conditions. At subsequent period ends the estimate would be re-visited, except to the extent it relates to market conditions. (HKFRS 2.21) An exception is where the only condition of vesting is a market condition. In this case, as the fair valuation takes into account the market condition, the goods or services are recognised immediately on receipt of the goods/services, irrespective of whether the market condition is met. Step 3: estimating the number of instruments expected to vest As stated above, the measurement of equity settled SBP transactions with vesting conditions is based on the following formula: A: Fair value of the individual equity instrument, measured at measurement date B: Number of instruments expected to vest X = C: Total amount to be recognised for the goods/ services received (HKFRS 2.19, 20) "A" is calculated as per step 1 above and is not re-estimated in subsequent periods. However, at each year-end "B" is re-estimated to take account of forfeitures to date and revised estimates of the number of forfeitures expected in the remaining vesting period. On the vesting date the estimates are subject to one final revision, so that ultimately the amount recognised for goods or services received shall be based on the number of instruments that actually vest. The original and revised estimates of the number of instruments expected to vest (i.e. B) take into account all vesting conditions except market conditions. That is, the estimates take into account the likelihood of service conditions (such as the employee being required to remain employed by the company for a certain number of years) and non-market performance conditions (such as the company achieving a certain profit target) being met. FRU issue 8 (October 2004) 16

17 (HKFRS 2.23) (HKFRS 2.14) (HKFRS 2.15) (HKFRS 2.21) No further changes are made after vesting date to the amounts recognised as debits and credits (see page 4 of this Update). However, if, for example, some of the vested options lapse unexercised, HKFRS 2 does not preclude a transfer within equity i.e. it would be acceptable under HKFRS 2 to transfer any related capital reserve, which had been created during the vesting period, to retained earnings, if the options lapsed unexercised. Step 4: recognising the fair value If the equity instruments vest immediately there is a presumption that the services rendered as consideration for the equity instruments granted have been received and the fair value of the equity instruments is recognised immediately with a corresponding increase in equity. This is illustrated in example 1b on page 5 of this Update. If the instruments do not vest immediately, the total fair value of grants subject to vesting conditions ("C" in step 3) is recognised ratably over the vesting period, even if the grant does not vest pro rata. For example, if options are granted subject to a three-year service condition, and all options are forfeited if service is less than three years, recognition of the service cost cannot be deferred until service is complete, if the service condition is expected to be satisfied. As mentioned above, an exception is where the only condition of vesting is a market condition. In this case, as the fair valuation takes into account the market condition, the goods or services are recognised immediately on receipt of the goods/services, irrespective of whether the market condition is met. Simple example of an equity settled SBP arrangement with vesting conditions The following simplified example illustrates the principles discussed in this 4-step approach. At the beginning of year 1 an entity granted 500 employees 10 share options each, on the condition that they would remain with the company for 3 years. The options could be exercised at any time after 3 years for a 12 month period at an exercise price of $10 each. At the date of grant each option had a fair value of $1, excluding the 3 year vesting rule, but taking into account the other features of this option such as the period during which it could be exercised. A vesting period of 3 years was identified, based on the service condition. Over the following 4 years the calculations under HKFRS 2 were as follows: At the end of year 1 it was estimated that only 75% of the workforce will meet the vesting condition. The total fair value of the SBP arrangement was therefore calculated to be: $1 x (500 x 10 x 75%) = $3,750 1/3 of this ($1,250) was recognised as employee expense in year 1 (credit capital reserve in equity). At the end of year 2, the estimate of the numbers of instruments that would vest was revised to 70%. The total fair value of the SBP arrangement was therefore revised to be: $1 x (500 x 10 x 70%) = $3,500 Cumulatively, 2/3 of this ($2,333) should have been recognised by the end of year 2. As the year 1 charge was $1,250, a further $1,083 was charged as employee expense in year 2 (credit capital reserve in equity). The squaring-up to a 70% expected vesting result is therefore recognised immediately, rather than being spread over the remaining vesting period. 17 FRU issue 8 (October 2004)

18 At the end of year 3, 90% of the eligible employees were still with the company. 4,500 options were issued to the employees and the final total fair value of the SBP arrangement was calculated to be: $1 x (500 x 10 x 90%) = $4,500 Cumulatively, $2,333 had been recognised by the end of year 2. A further $2,167 was therefore charged as employee expense in year 3 (credit capital reserve in equity). During the 4 th year, 60% of the employees exercised their options while the remainder let them lapse unexercised. The entries in that year would be as follows: Debit cash: exercise price received 27,000 Debit capital reserve: option premium received 2,700 Credit: Share capital/premium 29,700 Debit capital reserve: lapsed option premium 1,800 Credit retained earnings: lapsed option premium 1,800 Note that HKFRS 2.23 states that, when options lapse unexercised after vesting, transfers within equity (e.g. between the option premium reserve and retained earnings) are not precluded. Whether they are allowed would be a matter for company law. Likewise, HKFRS 2 does not deal with the question of how much should be recorded as share premium if the options are exercised. Summary Yr 1 Yr 2 Yr 3 Yr 4 Total Income statement charge 1,250 1,083 2, ,500 ===== ===== ===== ===== ===== Effect on net assets ,000 ===== ===== ===== ===== Share capital/premium 29,700 Capital reserve 1,250 2,333 4,500 0 Retained earnings (1,250) (2,333) (4,500) (2,700) Total equity ,000 ===== ===== ===== ===== (HKFRS 2.22, 26-29) Other issues HKFRS 2 also includes specific requirements regarding modifications to terms and conditions of SBP plans, cancellations and reload features. It also addresses repurchases of vested equity instruments and requires that, if the repurchase is for an amount in excess of the equity instrument's thencurrent fair value, the amount exceeding fair value must be recognised immediately as an expense. (HKFRS ) Cash-settled SBP transactions Cash-settled SBP transactions result in a cash payment (or transfer of other assets) based on the price of the entity's equity instruments (e.g., share price). A common example is where employees are promised cash payments if the entity's share price reaches a certain target within a specified period of time. When the goods or services are received, the entity measures the goods/ services received, and the liability incurred, at the fair value of the liability. The fair value of the goods/services received is not relevant to the measurement of the liability, whether or not the counterparty is an employee. Its only relevance would be if an asset was recorded as a result of the SBP transaction and there were doubts about its recoverability. This is not expected to be common. If the rights do not vest immediately, then the initial measurement of the liability is done as the services are rendered. FRU issue 8 (October 2004) 18

19 HKFRS 2 emphasises that the liability for cash-settled SBP transactions should be measured at its fair value rather than its intrinsic value. The fair value is expected to be higher because the instrument's fair value is not only its current settlement value, but also the potential future increase in the amount payable. (HKFRS ) (HKFRS 2.30) Once the goods or services have been provided and hence a liability has been initially recognised, the entity should re-measure the fair value of that liability at each balance sheet date until it is settled and on final settlement. If the costs of the SBP transaction are of the type that qualify for recognition as assets (e.g. they relate to factory workers whose wages are included in inventory) care should be taken when re-measuring the liability at each balance sheet date to separately identify new liabilities being initially recognised for services provided in the period, from changes in the fair value of liabilities initially recognised in previous periods. HKFRS 2 is clear that the latter (i.e. any re-measurement changes after initial recognition) should be recognised directly in the income statement. Choice to settle in cash or equity Complex requirements apply for SBP transactions where either the entity or the counterparty may choose whether the transaction is settled in cash or equity instruments: (HKFRS ) (HKFRS 2.34, 41-43) Where the counterparty has the choice, then a compound instrument exists, whose components need to be accounted for separately as equity and liability, following the rules set out above, if material. Where the entity has the choice, it should account for the transaction as an equity-settled transaction, unless in substance it has a present obligation to settle in cash. The standard gives examples of such situations as follows: - the choice of settlement in shares has no commercial substance (e.g. because the entity is legally prohibited from issuing shares); - the entity has a past practice or a stated policy of settling in cash; or - the entity generally settles in cash whenever the counterparty asks for cash settlement. Such circumstances can be common in employee share option schemes. These SBP arrangements would then be accounted for as a cash-settled SBP transaction. HKFRS 2 contains further detail on how these basic principles should be applied. 19 FRU issue 8 (October 2004)

20 FRU issue 8 (October 2004) 20

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