Is there an accounting arbitrage between modification and cancellation of an award?
At the beginning of year 1, an entity grants 100 share options to each of its 500 employees. Each grant is conditional upon the employee remaining in service over the next three years. The entity estimates that the fair value of each option is €15.
By the end of year 1, the entity’s share price has dropped. The entity cancels the existing options and issues options which it identifies as replacement options, which also vest at the end of year 3. The entity estimates that, at the date of cancellation, the fair value of each of the original share options granted is €5 and that the fair value of each replacement share option is €8.
40 employees leave during year 1. The entity estimates that a further 70 employees will leave during years 2 and 3, so that there will be 390 employees at the end of year 3 (500 – 40 – 70).
During year 2, a further 35 employees leave, and the entity estimates that a further 30 employees will leave during year 3, so that there will be 395 employees at the end of year 3 (500 – 40 – 35 – 30).
During year 3, 28 employees leave, and hence a total of 103 employees ceased employment during the original three year vesting period, so that, for the remaining 397 employees, the replacement share options vest at the end of year 3.
The intention of the IASB appears to have been that the arrangement should be accounted for in exactly the same way as the modification in Example 32.19 above, since the Basis for Conclusions to IFRS 2 notes:
‘…the Board saw no difference between a repricing of share options and a cancellation of share options followed by the granting of replacement share options at a lower exercise price, and therefore concluded that the accounting treatment should be the same.’ [IFRS 2.BC233].
However, it is not clear that this intention is actually reflected in the drafting of IFRS 2, paragraph 28 of which reads as follows:
‘If a grant of equity instruments is cancelled or settled during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied):
(a) the entity shall account for the cancellation or settlement as an acceleration of vesting, and shall therefore recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period.
(b) any payment made to the employee on the cancellation or settlement of the grant shall be accounted for as the repurchase of an equity interest, i.e. as a deduction from equity, except to the extent that the payment exceeds the fair value of the equity instruments granted, measured at the repurchase date. Any such excess shall be recognised as an expense….
(c) if new equity instruments are granted to the employee and, on the date when those new equity instruments are granted, the entity identifies the new equity instruments granted as replacement equity instruments for the cancelled equity instruments, the entity shall account for the granting of replacement equity instruments in the same way as a modification of the original grant of equity instruments …’. [IFRS 2.28].
As a matter of natural construction, paragraph (a) requires the cancellation of the existing award to be treated as an acceleration of vesting – explicitly and without qualification. In particular there is no rider to the effect that the requirement of paragraph (a) is to be read as ‘subject to paragraph (c) below’.
Paragraph (c) requires any ‘new equity instruments’ granted to be accounted for in the same way as a modification of the original grant of equity instruments. It does not require this treatment for the cancellation of the original instruments, because this has already been addressed in paragraph (a).
Moreover, in order to construe paragraphs (a) and (c) in a manner consistent with the Basis for Conclusions to the standard, it would be necessary to read paragraph (c) as effectively superseding paragraph (a). However, for this to be a valid reading, it would also be necessary to read paragraph (b) as also superseding paragraph (a), and this would produce a manifestly incorrect result, namely that, if an award is cancelled and settled, there is no need ever to expense any part of the cancelled award not yet expensed at the date of cancellation.