Introduction to employee stock option valuation under IFRS 2

IFRS 2, Share-based Payment requires compliant companies to measure the fair value of the employee stock options granted to employees and to recognise this amount as an expense. In this article we introduce the key elements of employee stock option valuation under IFRS 2, Share-based Payment.     

Options

• An option refers to the right to buy or sell an asset, or to receive a payment, at a future date, for a specified price. The employee stock option is a right rather than an obligation, so the owner of a stock option will choose not to exercise the option if it is not profitable to do so.  
• A ‘call’ option is the right to buy an asset, and a ‘put’ option is the right to sell an option.
• Employee stock options are often, but not always, call options over the shares of the employing company.

Employee share option valution under IFRS 2, Share-based Payment
The fair value of an option under IFRS 2, Share-based Payment is “…the amount for which [the option] could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction.”

The valuation of employee stock options which are cash-settled is different than the valuation of employee stock options which are equity-settled or where there is a choice of settlement on the part of the option issuer or holder. IFRS 2, Share-based Payment requires that the fair value of options deemed to be cash-settled be updated at each reporting date.

If the employee stock options are deemed to be settled in equity IFRS 2, Share-based Payment requires compliant companies to measure the fair value of the employee stock options granted to employees only at the date that they are granted. Companies must then recognise the aggregate fair value of the employee stock option for the best estimate of the number of equity-settled options expected to vest.  

The total expense will therefore be based on the number of equity instruments that eventually vest given the following formula:

Fair value    x    Number expected to vest

The number expected to vest can be revised if subsequent information indicates that the number expected to vest differs from previous estimates. Adjustments can then be made, if necessary, to the expense recorded in subsequent years’ financial statements. Because the fair value component of the equity settled employee stock option value expense is not updated, it is important to determine this value correctly and with accuracy and precision. The key to coming to a correct employee share option valuation is to consider all of the relevant and material assumptions, and to then choose a valuation model to determine fair value which reflects these assumptions.

Vesting conditions under IFRS 2, Share-based Payment
Vesting conditions are conditions that must be satisfied for the employee to become entitled to receive the right to exercise granted options, and hence may have a substantial impact on option value. Vesting conditions include service conditions which require the employee to complete a specified period of service, and performance conditions, which require specified performance targets to be met (such as a specified increase in the company’s profit over a specified period of time).

If the employee stock options granted vest immediately, the expense shall be recognised in full. If the employee stock options do not vest immediately, the company shall presume that the services to be rendered (in exchange for the receipt of the granted options) will be received over the vesting period, with the expense allocated evenly over the period of vesting.

IFRS 2, Share-based Payment makes a distinction between the treatment of market and non-market-based performance/vesting conditions. Market vesting conditions are those related to the market price of an entity's equity, such as achieving a specified share price or a specified target based on a comparison of the entity's share price with an index of share prices of other entities. Market-based performance conditions must be taken into account when determining the fair value.  

Non-market vesting conditions, such as earnings targets, or public share offerings, cannot be taken into account when estimating the fair value of equity instruments in an employee stock option valuation. Instead, non-market vesting conditions are reflected by adjusting the number of equity instruments which are expected to vest.

Summary
In its requirements, the intention of IFRS 2, Share-based Payment is to match the service provided by employees with the expense of their compensation. In the case of employee stock options, the value of this compensation is usually contingent on service provided and other elements.