CHAPTER TWO

SHARE-BASED COMPENSATION
Introduction
Many organizations issue payments to their employees that are derived in some manner from the
price of company stock. These payments may ultimately be paid in cash or shares. Similarly,
though less commonly, share-based payments may be made to people or entities outside of the
business, such as when legal services are paid for with company shares. The accounting for these
payments varies, depending upon how they are calculated and paid. In this chapter, we address the
various scenarios under which different types of accounting for share-based payments are applied.
2.1. Overview of Share-based Payments
There are a number of possible ways in which a company could issue shares as a form of payment,
perhaps through the outright issuance of shares, or share options, or warrants. No matter which
method of payment is employed, the overriding goal of the accounting for these payments is to
charge their effects to expense or an asset. More specifically, the accounting can fall into one of
the following areas:
• Equity-settled, share-based payment. If the company only pays with its shares, it records an
increase in equity, with an offsetting debit to the relevant asset or expense account to which the
payment relates.
• Cash-settled, share-based payment. If the company pays an amount in cash that is calculated
from a certain number of shares, it records a liability, with an offsetting debit to the relevant asset
or expense account to which the payment relates. There may also be situations in which the firm
receives goods or services, and the terms of the arrangement give the supplier a choice of settling
in cash or through the issuance of equity instruments. these issues will explore further in the
following sections.
2.2. Share-based Payments Settled with Equity
As noted in the last section, equity-settled, share-based transactions are recorded as an
increase in equity, with an offsetting debit to the relevant asset or expense account to which
the payment relates. This measurement should be based on the fair value of the goods or
services received. If it is not possible to measure their fair value, measure the transaction at
the fair value of the equity instruments that are used to settle the liability. The following
additional issues may apply:
• Payments to employees. When services are rendered by employees or others providing similar
services, it is usually not possible to measure the transaction at the fair value of the services
received. Accordingly, measure these transactions at the fair value of the equity instruments
granted, as of the grant date. This is a significant issue, since it applies to share options granted to
employees.
• Payments to parties other than employees. When share-based payments are made to parties
other than employees, it is assumed that the fair value of the goods or services received can be
estimated in a reliable manner. The fair value of these items should be measured at the date when

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the company receives the goods or the services are rendered. If it is not possible to measure the
fair values of the goods or services received, use the fair value of the equity instruments paid as of
the date when the company receives the goods or the services are rendered.
EXAMPLE
Snyder Corporation orders specially-designed GPS chips from a supplier, for inclusion in its next
GPS satellite. As an inducement to deliver the chips by August 31, Snyder offers 5,000 shares to
the supplier. The GPS chips are custom-designed for Snyder, so it is not possible to directly
determine their fair value. As an alternative, Snyder values the inducement transaction using the
market price of its shares on the August 31 delivery date, which is £10 per share. This results in
the recognition of a £50,000 expense on the delivery date.

• Unidentifiable goods or services. If the fair value of the goods or services to be received is
less than the fair value of the equity consideration paid, this may mean that additional
unidentifiable goods or services are yet to be received. If so, measure the unidentifiable items as
the difference between the fair values of the identifiable items and the equity consideration as of
the grant date.
• Vesting. There is not usually a vesting period associated with equitypaid in exchange for goods
or services. If there is no vesting, recognize the asset or expense associated with an equity payment
at once. If there is a vesting period, it is assumed that the related services will be rendered during
the vesting period, which means that the related expense is recognized over the vesting period.
Also, if equity instruments do not vest because a vesting condition was not satisfied, do not
recognize any asset or expense related to the transaction.
• Market conditions. A market condition may be included in a vesting arrangement, such as
requiring that a company’s share price reach a certain point before an option can be exercised.
When estimating fair value, take the existence of market conditions into account. However, once
fair value has been established, the related amounts of goods or services are to be recognized, even
if it is found by the end of the vesting period that the market condition has not been met.
• Reload feature. A share option may contain a reload feature, where an employee is
automatically granted additional options if he or she exercises existing options and uses shares to
satisfy the exercise price. When there is a reload feature, do not include it in the estimation of the
fair value of options granted. If a reload feature is triggered, account for it as an entirely new option
grant.
• Subsequent measurement. Once a share-based payment has been measured and equity has
been increased by the amount measured, there is no subsequent adjustment to equity. For example:
✓ An expense is recognized for options granted in exchange for services, but the option
recipient later forfeits the options.The issuing company cannot reverse its expense
recognition.
✓ An employee never exercises vested options, so they lapse. The issuing company cannot
reverse the amount of compensation expense related to the options.
EXAMPLE

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Luminescence Corporation issues 10,000 share options to a key employee, with a four-year vesting
period. The shares have a fair value of £80,000 as of the grant date, so the company recognizes
compensation expense related to the options of £20,000 in each of the next four years.
Luminescence issues 5,000 share options to another employee, which will vest when the
development of a product has been completed and it is launched. The estimated amount of time
required to develop the project is an additional 12 months. On the grant date, the options are valued
at £36,000. Accordingly, the company recognizes compensation expense related to the options of
£3,000 per month. If the estimated duration of the development process changes, the company
should adjust its recognition period to match the revised estimate. Luminescence issues 12,000
share options (valued at £80,000) to the supplier of the company’s computer support services,
which shall vest over the next year in proportion to the number of service requests resolved within
one hour. Based on historical results, the company controller ratably accrues an expense of £60,000
to reflect the estimated issuance of 75% of the options. Once the year is complete, it is apparent
that the supplier has been worse than usual at responding to service calls, and so is only entitled to
62% of the original option grant, which is £49,600. Accordingly, the controller adjusts the expense
to £49,600 for the year. Luminescence issues 4,000 share options to an attorney who handles the
company’s trademark litigation. The options are contingent upon the price of the company’s stock
exceeding £15 within the next 12 months. The attorney is expected to meet all other service
conditions associated with the grant. Accordingly, the company recognizes the fair value of the
grant over the 12-month period, irrespective of whether the market condition feature is met.
Luminescence grants 200,000 restricted stock units to its chief engineer, which vest on the grant
date. The fair value of the grant is £500,000, which is triple his compensation for the past year.
Under the terms of the arrangement, the RSUs will only be transferred to the engineer ratably over
the next five years if he complies with the terms of the non-compete agreement. Since the RSUs
are essentially linked to the non-compete agreement, and the amount of the future payouts are quite
large, it is evident that the arrangement is really intended to be compensation for future services
yet to be rendered to the company. Consequently, the appropriate accounting treatment is not to
recognize the expense at once, but rather to recognize it ratably over the remaining term of the
non-compete agreement.

When it is not possible to measure the fair value of goods or services received, the alternate
valuation technique is to use the fair value of the equity instruments granted. This fair value should
be based on available market prices, adjusted for any special terms and conditions associated with
the equity instruments granted. If it is not possible to derive a market price for the equity
instruments, the alternative is to use an accepted valuation methodology for pricing financial
instruments. Models that are commonly used to derive fair value are the Black-Scholes-Merton
formula and the lattice model. Key characteristics of these models are:
• Black-Scholes-Merton formula. Assumes that options are exercised
at the end of the arrangement period, and that price volatility, dividends, and interest rates are
constant through the term of the option being measured.

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• Lattice model. Can incorporate ongoing changes in price volatility
and dividends over successive time periods in the term of an option. The model assumes that at
least two price movements are possible in each measured time period. A key component of the
value of a company’s stock is its volatility, which is the range over which the price varies over
time, or is expected to vary. Since an employee holding a stock option can wait for the highest
possible stock price before exercising the option, that person will presumably wait for the stock
price to peak before exercising the option. Therefore, a stock that has a history or expectation of
high volatility is worth more from the perspective of an option holder than one that has little
volatility. The result is that a company with high stock price volatility will likely charge more
employee compensation to expense for a given number of shares than a company whose stock
experiences low volatility. Stock price volatility is partially driven by the amount of leverage that
a company employs in its financing. Thus, if a business uses a large amount
of debt to fund its operations, its profit will fluctuate in a wider range than a business that uses less
debt, since the extra debt can be used to generate more sales, but the associated interest expense
will reduce net profits if revenues decline.
EXAMPLE
Armadillo Industries grants an option on £25 stock that will expire in 12 months. The exercise
price of the option matches the £25 stock price. Management believes there is a 40% chance that
the stock price will increase by 25% during the upcoming year, a 40% chance that the price will
decline by 10%, and a 20% chance that the price will decline by 50%.
The risk-free interest rate is 5%. The steps required to develop a fair value for the stock option
using the lattice model are:
1. Chart the estimated stock price variations.
2. Convert the price variations into the future value of options.
3. Discount the options to their present values.
The following lattice model shows the range and probability of stock
prices for the upcoming year:

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In short, the option will expire unexercised unless the stock price increases. Since there is only a
40% chance of the stock price increasing, the present value of the stock option associated with that
scenario can be assigned the following expected present value for purposes of assigning a
fair value to the option at the grant date: £5.95 Option present value × 40% Probability = £2.38
Option value at grant date
EXAMPLE
Armadillo Industries issues stock options with 10-year terms to its employees. All of these options
vest at the end of four years (known as cliff vesting). The company uses a lattice-based valuation
model to arrive at an option fair value of £15. The company grants 100,000 stock options.
On the grant date, it assumes that 10% of the options will be forfeited. The exercise price of the
options is £25. Given this information, Armadillo charges £28,125 to expense in each month. The
calculation of this compensation expense accrual is: (£15 Option fair value × 100,000 Options ×
90% Exercise probability) ÷ 48 Months= £28,125
It is possible that the fair value of the equity instruments granted cannot be determined. If so,
measure these items based on their intrinsic value, which is the difference between their fair value
and the amount the recipient must pay to acquire the shares. This amount is to be measured at the
end of each reporting period, through the final settlement, exercise, or forfeiture date, with all
changes being recognized in profit or loss. The final amount recognized is only based on the final
number of shares that vest or are exercised. Only in this case is it permissible to reverse an expense
accrual for an expense that was previously recognized in relation to shares that do not vest or
options that are not exercised. The following two additional scenarios may apply to the intrinsic
value measurement methodology:
• If settlement of a share-based payment occurs during a vesting period, treat the early settlement
as accelerated vesting, which means that all remaining expenses that would have been recognized
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in a later period are recognized in the settlement period.
• When an option holder pays the issuer on the settlement date, treat this payment as repurchase
of equity instruments, which is a deduction from equity. However, in the unlikely case that the
payment from the option holder is greater than the intrinsic value of the equity instruments being
bought, recognize the difference as an expense.
EXAMPLE
Underwater Anomalies, which conducts shipwreck searches, has not uncovered a profitable wreck
for some time, and so is reduced to paying for services with share options. Each option has an
exercise price of £2 and a fair value of £10. The intrinsic value of each option is therefore £8,
which is the difference between the fair value and exercise price. It is not uncommon for a business
to alter the terms under which equity instruments were issued. For example, it may have originally
issued share options at an exercise price that is now well above the market price of the company’s
shares, and so institutes a modification to reduce the exercise price. The following accounting
applies to these modifications for equity instruments issued to both employees and outside parties:
• Minimum recognition. The minimum amount to recognize is the fair value of the equity
instruments granted, unless the instruments do not vest. This minimum level of recognition applies,
even if there are subsequent modifications to the terms under which an instrument was granted,
and even if the instrument is subsequently cancelled.
• Additional recognition. If terms modifications are favorable to the recipient of an equity
instrument (that is, the fair value is increased), recognize the incremental increase in value.
• Cancellation or settlement. If an equity issuance is cancelled or
settled (but not forfeited), account for the event as though the vesting period has been accelerated.
This means that the remaining expense that would have been recognized over subsequent periods
is recognized entirely in the current period. If any payment is made to the recipient of a grant when
the grant is cancelled or settled, account for it as though the equity instrument had been
repurchased, which is a reduction of equity. If this payment exceeds the fair value of the grant,
recognize the difference as an expense.
• Replacement. If an equity instrument is essentially cancelled and replaced by a new equity
instrument, the minimum accounting is to recognize the fair value of the equity instruments
originally granted, plus any increase in the compensation paid to the recipient through the new
issuance. This incremental change in fair value is the fair value of the replacement instruments,
less the net fair value of the cancelled instruments. Net fair value is the fair value of the cancelled
instruments just prior to their cancellation, minus the amount of any payment made to the recipient
that is considered a deduction from equity.
EXAMPLE
The board of directors of Armadillo Industries initially grants 5,000 stock options to the
engineering manager, with a vesting period of four years. The shares are worth £100,000 at the
grant date, so the controller plans to recognize £25,000 of compensation expense in each of the
next four years. After two years, the board is so pleased with the performance of the engineering
manager that they accelerate the vesting schedule to the current date. The controller must therefore

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accelerate the remaining £50,000 of compensation expense that had not yet been recognized to the
current date.
EXAMPLE
Armadillo Industries issues 10,000 stock options to various employees in 20X1. The designated
exercise price of the options is £25, and the vesting period is four years. The total fair value of
these options is £20,000, which the company charges to expense ratably over four years, which is
£5,000 per year. One year later, the market price of the stock has declined to £15, so the board of
directors decides to modify the options to have an exercise price of £15. Armadillo incurs
additional compensation expense of £30,000 for the amount by which the fair value of the modified
options exceeds the fair value of the original options as of the date of the modification. The
accounting department adds this additional expense to the remaining £15,000 of compensation
expense associated with the original stock options, which is a total unrecognized compensation
expense of £45,000. The company recognizes this amount ratably over the remaining three
years of vesting, which is £15,000 per year.

2.3. Share-based Payments Settled with Cash

As noted earlier, cash-settled, share-based payments are recorded as a liability, with an offsetting
debit to the relevant asset or expense account to which the payment relates. The amount of this
liability is measured at the fair value of the goods or services acquired, and is continually
remeasured in each reporting period until the liability is settled. If the fair value changes during
this measurement period, the change is recognized at once in profit or loss.
A common application of the cash settlement concept is when employees are granted share
appreciation rights, under which they are paid cash if the underlying company shares increase in
value. Assuming that there is indeed a run-up in the price of the company’s stock, the value of the
stock appreciation rights increases over time, which results in an increase in the associated
recognition of compensation expense.
When share appreciation rights are granted, it is assumed that the corresponding service period has
already been completed (unless there is evidence to the contrary), which means that the full amount
of associated cost for the goods or services provided are recognized as expense on the grant date.
Conversely, if the rights apply to a service period that has not yet occurred, the expense is
recognized over that period.
EXAMPLE
Uncanny Corporation grants 20,000 share appreciation rights (SARs) to its chief executive officer
(CEO). Each SAR entitles the CEO to receive a cash payment that equates to the increase in value
of one share of company stock above a baseline value of £25. The award cliff vests after two years.
The fair value of each SAR is calculated to be £11.50 as of the grant date. The entry to record the
associated amount of compensation expense for the first year is:

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At the end of the first year of vesting, the fair value of each SAR has increased to £12.75, so an
additional entry is needed to adjust the vested amount of compensation expense for the £12,500
incremental increase in the value of the award over the first year (calculated as £1.25 increase in
SAR fair value × 20,000 SARs × 0.5 service period). At the end of the vesting period, the fair value
of each SAR has increased again, to £13.00, which increases the total two-year vested
compensation expense for the CEO to £260,000. Since £127,500 of compensation expense has
already been recognized at the end of the first year, the company must recognize an additional
£132,500 of compensation expense.

2.4. Share-based Payments with Cash Alternatives

Some share-based payment instruments allow either the issuer or the recipient of an equity
payment to select settlement in cash or equity. In these cases, the issuer should account for the
transaction as though it were a cash-settled share-based transaction, if there is a liability to settle
in cash. Otherwise, the transaction is treated as a payment that is settled with equity. These
transactions are handled differently, depending upon whether the counterparty or the issuing entity
can select the form of payment. The following subsections address the alternative treatments.
2.5. Counterparty Has Choice of Settlement
When the issuer of an equity instrument has granted the recipient the right to choose cash or equity
as payment, this is essentially a compound financial instrument that contains debt (i.e., the right to
receive cash) and equity components. The accounting for this situation is:
• Parties other than employees. When such a compound financial instrument is issued to an
entity other than an employee, and when the fair value of the goods or services provided can be
measured directly, the proper measurement is to subtract the fair value of the debt component from
the fair value of the goods or services received, to arrive at the value of the equity component.
• Transactions with employees. When such a compound financial instrument is issued to an
employee, separately measure the fair values of the debt component and the equity component.
The fair value of the instrument is the combined fair values of these two elements. When the
instrument is eventually settled, the liability portion of the compound financial instrument is to be
remeasured to its fair value. The accounting then varies, depending on the manner of payment:
• Paid with equity. If the transaction results in only equity instruments being issued to the
recipient, the liability is then shifted into equity, and is considered to be the consideration paid for
the equity instruments issued.
• Paid with cash. If the transaction results in only cash being paid in settlement, the cash payment
settles the full amount of the liability. If there was an equity component to the transaction that had
already been recognized in equity, there is no change to its previous recognition.
EXAMPLE
Subterranean Access buys drilling equipment for £300,000 on March 31. The supplier has the
option of being paid with either 50,000 Subterranean shares on December 31 or a cash payment in
one month that will equal the market price on that date of 40,000 shares. The company’s controller
estimates that the end-of-year option has a fair value of £375,000 and the one-month option has a

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fair value of £275,000. When Subterranean receives the drilling equipment, the controller should
debit the fixed asset account for £300,000, credit a liability account for £275,000 (which represents
the cash option) and credit equity for £25,000. The £25,000 portion of the entry represents the
difference between the price of the drilling equipment and the fair value of the associated liability.

2.6. Issuer Has Choice of Settlement

If the issuing entity can choose whether to pay in stock or cash, it must decide whether there is a
current obligation to pay in cash. This is the case when the use of equity instruments is impossible
(such as when there is no authorization to issue additional shares), there is a corporate policy to
pay in cash, past practice has been to always settle in cash, or to settle in cash when requested to
by the counterparty. If there is a current obligation to pay in cash, account for the transaction as a
cash-settled share-based payment. When a cash payment is made, treat it as a deduction from
equity. If there is no obligation to pay in cash, account for the transaction as an equity-settled share-
based payment. When an equity payment is made, no further accounting is required, beyond the
initial recognition of the payment on the date of grant. When the issuing entity can choose between
modes of payment, the usual alternative is to pick the choice having the lower fair value. If the
entity instead elects to pay using the choice that has the higher fair value, charge the difference in
the fair values of the choices to expense as of the settlement date.
2.7. Share-based Payment Disclosures
When a business is involved in share-based payment arrangements, it should disclose the following
information in the notes accompanying its financial statements:
• Descriptions. Describe each type of share-based payment arrangement in use during the period,
including their terms, vesting requirements, maximum option term, and whether settlement is in
cash or equity. This information can be aggregated for similar types of arrangements.
• Option information. Describe the number and weighted average exercise prices for options
outstanding at the beginning of the reporting period, as well as separately for those options granted,
forfeited, exercised, and expired during the period, and separately for those options outstanding at
the end of the period, and exercisable at the end of the period.
• Exercised options. If options were exercised during the period, disclose the weighted average
share price on the exercise date. This information can instead be a weighted average share price
during the period, if options were exercised several times during the period.
• Options outstanding. For those options remaining outstanding at the end of the period, note
the range of exercise prices and the weighted average contractual life remaining. In those cases
where the entity derived the fair value of goods or services received, or of equity instruments
issued, provide the following information about fair values:
• Share options. If share options were granted, disclose the weighted average fair value of these
options as of the measurement date, plus the option pricing model used and the inputs to that
model, how expected volatility was determined and the extent to which it was based on historical
volatility information, and how other option features were incorporated into the fair value
measurement.

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• Other equity instruments. If equity instruments other than share options were granted during
the period, disclose the number and weighted average fair value of these items as of the
measurement date, how fair value was determined, how expected dividends were incorporated into
the fair value calculation, and how other instrument features were incorporated into the fair value
measurement.
• Modified arrangements. If a share-based payment was modified during the period, explain
the modifications, note the incremental change in fair value resulting from the modifications, and
disclose how the incremental change in fair value was determined. It may also be necessary to
disclose the following information:
• Fair value measurement. If the fair values of goods or services received were used to value
share-based payments, disclose how the fair values were determined. If it was not possible to
derive the fair values of goods or services, state this point and why it was not possible to do so.
• Expenses. Disclose the total expense derived from share-based payment transactions in which
the goods or services received were immediately charged to expense. Separately disclose that part
of the expense arising from equity-settled share-based payments.
• Liabilities. Note the total carrying amount of liabilities derived from share-based payment
transactions at the end of the period, as well as the total end-of-period intrinsic value of those
liabilities for which the counterparty’s rights have vested.

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