vesting definition

Grant Thornton International CL 35 2 June 2006 Jenny Lee Project Manager IFRS 2 Amendment International Accounting Standards Board 30 Cannon Street London, EC4M 6XH Email: CommentLetters@iasb.org Exposure Draft of Proposed Amendments to IFRS 2 Share-Based Payment: Vesting Conditions and Cancellations Grant Thornton International is pleased to comment on the International Accounting Standards Board's (the Board) Exposure Draft of Proposed Amendments to IFRS 2 Share-Based Payment: Vesting Conditions and Cancellations (the Exposure Draft). We do not agree with this proposal. This letter explains our principal concerns and suggestions. The Board might also wish to refer to our comment letter of 28 February 2005 on IFRIC Draft Interpretation D11 Changes in Contributions to Employee Share Purchase Plans ("D11"), which goes into more detail in some areas (attached for convenience). We believe that the Board's proposed treatment of cancellations by the counterparty will not faithfully represent the underlying transaction. These proposals seem to be motivated primarily by anti-avoidance concerns and convergence with US Generally Accepted Accounting Practice (US GAAP), rather than by achieving the most appropriate accounting practice. . 1 Whilst we support the Board's efforts to promote convergence with US GAAP, we believe this must always be on the basis of high quality solutions. In this case, we consider that any presumption of convergence with US GAAP should be rebutted in favour of accounting that most faithfully represents the transactions undertaken. As explained under "other comments" below, we also question whether or not the proposals will actually achieve convergence in all circumstances. In our view, cancellations by the counter-party are different in substance from cancellations by the entity. For example, a counter-party cancellation is only of their participation in the scheme whereas the entity's cancellation is usually of the whole scheme. Cancellation by the counter-party through failure to meet a condition of the award represents failure to meet a performance obligation in an exchange contract. Our view remains that this type of cancellation by the counterparty is appropriately dealt with as a failure to meet a performance vesting condition. Question 1 - Vesting Conditions The Exposure Draft Proposes that vesting conditions should be restricted to performance conditions and service conditions. Do you agree? If not, what changes do you propose, and why? We disagree. The intention of the proposed amendment seems to be to address accounting for cancellations by the counter-party, rather than to improve the existing definition per se. For the reasons explained below, we prefer the existing definition, which is intuitive i.e. vesting conditions are simply conditions to be satisfied by the counterparty in order for the award to vest. The Exposure Draft at BC2 suggests that vesting conditions should be restricted to conditions that ensure the counterparty "pays" for the award. Reference is made to BC171 of IFRS 2. This argument is applied to justify the proposed restriction of vesting conditions to service conditions and performance conditions. We observe that this seems to take the discussion in BC171 of IFRS 2 somewhat out of context (that part of the Basis for Conclusion being concerned with the applicability of vesting conditions to option pricing models). More importantly:  we consider that the proposed revised definition, although more restrictive, will lead to greater uncertainty in practice. This is because it defines vesting conditions by reference to two terms that are themselves undefined (service conditions and performance conditions). In practice, many schemes include conditions that are not linked unambiguously to individual contribution but rather, for example, to overall corporate performance. We anticipate confusion and uncertainty as to whether conditions that appear to meet the 2 existing definition of a vesting condition are service conditions or performance conditions.  We see no sound basis to treat requirements for employees to make contributions or purchase matching shares differently to various other performance conditions. Such conditions can represent an attempt to secure additional commitment to the employer and are not therefore unrelated to service or performance. In our view, this type of condition is therefore no less indicative of paying for the award (i.e. providing services) than, say, a condition based on entity-wide earnings growth. The Board has also noted at BC 213 to IFRS 2 that failure to meet a performance target does not necessarily indicate that the employee has not provided service. The Board nonetheless decided to require such performance conditions to be treated in a way that reduces the cumulative expense to zero when awards do not vest due to their non-achievement. Having accepted this ambiguity, seeking to distinguish performance conditions from other obligations of the employee seems artificial. Question 2 - Cancellations The Exposure Draft proposes that cancellations by parties other than the entity should be accounted for in the same way as cancellations by the entity. Do you agree that all cancellations should be treated in the same way? If not, please specify the nature of any differences between types of cancellations and explain how they influence the selection of appropriate accounting requirements. As noted above, we do not agree. We are concerned that the proposal will result in different accounting treatments for essentially similar situations. For example, no expense would be recognized for employees who have the opportunity to participate in a share scheme, but decide not to. However, a full and accelerated expense would be recognized for employees who join the scheme and cancel later. It is not clear to us that the "non-joiners" have provided less service than employees who join and then fail to meet a condition. We recognize that the primary objective of IFRS 2 is to measure the value of goods and services received. IFRS 2 gives effect to this by assuming that an award (including a conditional award) of equity instruments to employees indicates that incremental services have been (or will be) received. Obviously, there are circumstances in which this assumption can be challenged but we nonetheless support it. However, to the extent that an assumption of incremental services is valid, it seems equally valid that a decision by an employee to forfeit his/her rights (in effect to return the instruments to the employer) indicates that the incremental services will not be rendered. 3 Further, we note that generally if an employee is offered an element of remuneration based on completion of a particular task or performance by that employee (rather than a corporate task or performance) and that performance is not achieved by the employee, there will be no expense finally reported, even if the employee's performance may have been deemed to be enhanced in the period when the task was being attempted. It is not clear why there should be a different result in this case. We understand from the Basis for Conclusions to IFRS 2 (BC222 to BC236) that the Board's reasons for requiring accelerated expense recognition for employer cancellations were to: (i) counter perceived avoidance opportunities (BC 237); (ii) achieve consistency with the treatment of modifications; and (iii) reflect the Board's view (at BC 233) that a cancellation is unlikely without some compensation to the counterparty. We find these reasons persuasive in the context of employer cancellations, but it is not obvious that they apply to cancellations by employees. In particular, an employer cancelling a scheme may generally need to provide a substitute form of incentive to maintain the aggregate level of remuneration. By contrast, employees cancelling their individual participation in a scheme are not generally compensated. We strongly disagree with the Board's comments at BC13 that it can be difficult to identify whether the cancellation was by the entity or the counter-party. We accept that making that assessment may require the exercise of professional judgement. However, this is surely entirely appropriate in a principles-based system. As noted above, we believe that accounting standards made on antiavoidance premises tend to make poor principles-based standards. If the rules in the proposed amendment are included in IFRS 2 as written, we would anticipate that schemes would be developed with different legal form, to avoid the effects of these rules. We do not believe that that would be a helpful outcome. We believe that a requirement for an employee to make regular plan contributions (or to hold matching shares) meets the existing IFRS 2 definition of a vesting condition. Failure to meet such a condition should therefore be accounted for similar to a forfeiture, in accordance with IFRS 2 paragraphs 19 and 20. We believe this is the most appropriate accounting treatment within the existing IFRS 2 methodology. We consider that ceasing to recognize future expense from the date of cancellation is also a reasonable approach and consistent with the core principle of IFRS 2, since it recognizes an expense during, and only during, the period of employees' participation in the scheme. 4 Finally, we question the Board's assertion at BC10 that the fair value of the award takes into account the probability of cancellation by the counter-party (which is cited as a reason for rejecting reversal of the expense). Fair value seeks to measure what a willing market participant would pay for the award (ignoring vesting conditions). For an award of share options, any recipient is by definition able to choose not to exercise its option. The possibility that the recipient might chose to forego his/her entitlement through deciding not to meet a condition of the award does not to our understanding alter the (fair) value of that award since its should not alter the amount that a willing market participant should be prepared to pay. Question 3 - Effective date and transition The proposed changes would apply to periods beginning on or after 1 January 2007, and would be required to be applied retrospectively. Earlier adoption would be encouraged. Are the proposed effective date and transition appropriate? If not, what do you propose, and why? Should the Board decide to proceed with this proposal and issue a revision before the end of 2006, we consider the proposed effective date and transition to be appropriate. Other comments The Board asserts at BC 20 that the relevant requirements of the US standard SFAS 123 (R) are the same as the exposure draft. We are concerned that this may not be the case in all circumstances, for the following main reasons:  Although SFAS 123 (R) restricts vesting conditions to service and performance conditions, those terms are defined in detail in the US standard. Those terms are not defined in IFRS 2. It is unclear from the exposure draft whether the Board considers that its proposals will achieve fully converged definitions of vesting, service and performance conditions. On the face of it, the proposals would appear to achieve a converged definition of vesting conditions, but not of service and performance conditions. We recommend that the Board clarifies this matter. SFAS 123 (R) paragraph 33 sets out requirements on accounting for awards that are indexed to a factor in addition to the entity's share price. If that factor is not a market, performance or service condition, the scheme should be liability classified, with the additional factors shall be reflected in estimating the fair value if the award. This guidance appears to have no equivalent in 5  IFRS 2. The Board's proposal to restrict the definition of vesting conditions might give rise to the identification of more "additional factors" that do not fit the amended definition of vesting conditions, and are not cancellations. The absence of guidance in IFRS 2 would then become a more significant issue.  It is explicit in SFAS 123 (R) that market conditions are not vesting conditions. This is not explicit in IFRS 2 (even if the treatment of market conditions is generally consistent between the standards). We do not consider that the accounting for employee cancellations of the type envisaged is in entirely clear under SFAS 123 (R). We note that FASB Technical Bulletin 97-1 Accounting under Statement 123(R) for Certain Employee Stock Purchase Plans with a Look-Back Option (FTB 97-1) addresses the accounting for certain schemes with look-back options. Paragraph 20 of FTB 97-1 says "Any decreases in withholding amounts (or percentages) should be disregarded for purposes of recognizing compensation cost unless the employee services that were valued at the grant date will no longer be provided to the employer due to a termination. However, no compensation should be recognized for awards that an employee forfeits because of failure to satisfy a service requirement for vesting."  For these reasons, we recommend that the Board considers very carefully whether or not these proposals will actually achieve convergence. ************ If you have any questions on our response, or wish us to amplify our comments, please contact our Executive Director of Global Standards, Ms April Mackenzie (april.mackenzie@gt.com or telephone +1 212 542 9789), or our Director of International Financial Reporting, Andrew Watchman (andrew.watchman@gtuk.com or telephone + 44 870 991 2721). Yours sincerely Barry Barber Worldwide Director of Audit and Quality Control Grant Thornton International April Mackenzie Executive Director of Global Standards Grant Thornton Internationa 6 Grant Thornton International 399 Thornall Street Edison, New Jersey 08837 United States of America +1 732-516-5500 Telephone +1 732-516-5509 Fax 28 February 2005 Mr. Kevin Stevenson Chairman International Financial Reporting Interpretations Committee 30 Cannon Street London EC4M 6XH United Kingdom By email: CommentLetters@iasb.org IFRIC Draft Interpretation D11 Changes in contributions to employee share purchase plans Grant Thornton International supports the work of the International Financial Reporting Interpretations Committee (IFRIC) and welcomes the opportunity to provide input to IFRIC’s Invitation to Comment on Draft Interpretation D11. General Comment We do not agree with the draft Consensus in paragraph 4 of the draft Interpretation. We do not believe that an employee ceasing to contribute to an employee share purchase plan (ESPP) is a cancellation to be accounted for under paragraph 28(a) of IFRS 2 Sharebased Payment. Our view is that IFRS 2 prescribes that the requirement for an employee to save with the ESPP represents a vesting condition and should be accounted for under IFRS 2 as such. We are of the opinion that the accounting treatment proposed would lead to inconsistent accounting treatment in identical situations and would fail to give a faithful representation of transactions and events required by paragraph 13 of IAS 1 Presentation of Financial Statements. 7 We are aware of another possible approach, not countenanced by D11 that regards such an ESPP as an equity-settled share-based payment scheme with a cash alternative. Under such an approach, the accounting on the employee ceasing to contribute would reflect the position more appropriately than accounting as a cancellation. We consider that the IFRIC should determine whether this approach is relevant to the underlying fact patterns that D11 addresses. Specific Comments Our specific comments follow. Cancellation by Employer? In terms of changes to grants of equity instruments, IFRS 2 focuses on changes that are made by employers. It is silent on the actions of employees (except in terms of not meeting vesting conditions). In IFRS 2, where an employer cancels a plan, the equity instruments are assumed to vest immediately and the total remuneration charge is recognized immediately. A case can be made for such immediate vesting as the entity is in control and may be unable to cancel without providing the employee with other “compensation”. In addition, the requirement for the total charge to be recognized immediately is a means of preventing an entity from canceling plans and avoiding recognizing the remuneration expense (see paragraph BC237 of IFRS 2). The draft Interpretation implies that when an employee ceases to contribute to an ESPP, the equity instruments effectively vest immediately, the same effect as when the instruments are cancelled by the entity. Employees opt out for different reasons to an entity canceling a plan. Also IFRS 2 paragraph 28, referring to cancellation by an entity, specifically does not apply to grants cancelled by forfeiture when vesting conditions are not satisfied, which is the case here. We consider that the draft Interpretation does not make a robust case for why a cancellation by the employee is considered to be the same as a cancellation by the entity. Is the contribution a prepayment of the exercise price? Paragraph BC3 of the draft Interpretation states that the employee's contributions represent payment of the purchase price of the shares. We do not consider this statement to be evident, as implied by the draft Interpretation, or appropriate. An employee deciding to contribute to an ESPP is not under an obligation to use the cash saved on their behalf to exercise the share option. Indeed, even after the share options have vested the employee might still choose to recoup their cash saved rather than exercise their options. This is evident in the accounting for such savings: they are not reported on the entity balance sheet because they are an asset of the employee. It is therefore inappropriate to presume that the requirement to continue to save under this type of plan represents the prepayment of the exercise price of the share options. 8 The requirement to save represents a performance condition? Paragraph BC7 of the draft Interpretation states that the requirement to pay the share purchase price is neither a service condition nor a performance condition. However, we do not consider that the requirement to save with an ESPP represents the prepayment of the exercise price of the share options. We consider that the requirement imposed by the plan on the employee to save is a condition that must be performed by the employee. Non-performance of this condition results in the share options not vesting. Therefore, the appropriate accounting treatment is to "true-up" the charge when this condition is failed. A performance condition might require an entity to achieve a certain performance target, a division of an entity to achieve a target, or an individual employed by the entity to achieve some individual measure of performance. For example, an employee might be awarded a variable number of share options on the basis of the number of external investors that the employee successfully persuades to invest in the entity. We also draw your attention to the definition of a vesting condition in Appendix A to IFRS 2. This states that a vesting condition is a "condition that must be satisfied for the counterparty to become entitled to receive … equity instruments of the entity, under a share-based payment arrangement". Applying this definition leads us to the conclusion that the requirement to save is a vesting condition. No argument is presented in BC7 for why such a requirement for the employee to perform is not a vesting condition. Moreover, in the case of an employee not continuing to save, the entity now knows that not as many equity instruments will vest. Under paragraph 20 and paragraph IG10 of IFRS 2, an entity is required to recognize goods or services received based on the best estimate of the number of instruments expected to vest and revise that estimate, if necessary, if subsequent information indicates that the number of equity instruments expected to vest differs from previous estimates. On vesting date, the adjustment is to equal the instruments that ultimately vest. We think that this supports the case that not continuing to save is a vesting issue rather than a cancellation issue. Paragraph BC8 of the draft Interpretation states that treating the requirement to save as a performance condition undermines the requirements of IFRS 2. We do not agree with this assessment. The classification as a performance condition is a separate exercise and the accounting treatment follows as a result of this classification. We consider that treating the requirement to save as a performance condition will result in more appropriate and consistent accounting, as illustrated by the scenarios presented below. Possible scenarios Scenario 1 Three employees decide to join Company A's ESPP. They start to contribute to this plan on 1 January 2005. Employee A On 1 December 2005 Employee A informs the Company that he wishes to cease contributing to the plan with immediate effect. 9 Under the draft Interpretation, the Company would expense immediately all of the remaining expense that would have been recognized over the remaining vesting period of the ESPP in relation to that employee. Employee B As above, but the reason that the employee wishes to cease saving is that she is intending to resign her employment once she has secured an offer of new employment. The accounting treatment in this scenario would be the same as for the scenario above. Employee C As above but, on 1 December 2005, the employee has secured an offer of employment from another company. He resigns and ceases both saving and employment at 31 December 2005 . The accounting treatment under this scenario would be to "true-up" the expense, i.e. write back that expense that had already been charged for this employee's participation in the ESPP. Comment: The outcomes of these scenarios are inconsistent as a result of the accounting treatment suggested by the draft Interpretation. We consider it inappropriate for the expense to be accelerated in relation to employee B while being “trued up” for employee C. The obvious extension of this is that a Company would need to ascertain whether an employee had ceased saving in the plan as a precursor to leaving employment or because the employee wished to use these saving in another manner. Indeed, the likelihood of the employee informing the company that he/she intends to resign, where no replacement offer of employment has been received, seems remote. To compound this problem, it is likely that different reporting entities will come to different conclusions as to the reasons for employees ceasing to save, resulting in inconsistent financial information being produced. Scenario 2 Where a company offers an ESPP to all or a large proportion of its employees, this offer will likely be taken up by many of those eligible, regardless of whether the employees concerned can afford to save the relevant amount on a regular basis. There is no downside for the employee in starting to save, because they can recoup their savings without penalty if they stop saving. The affordability, to the employees, of such a scheme will no doubt become obvious within a few months, possibly as few as one or two, and many will stop saving. At this point, under the draft Interpretation, the company will need to recognize immediately the amount that otherwise would have been recognized over the remainder of the vesting period. The result will be that those companies offering such ESPPs will experience a disproportionately large expense in the first year of operation of these schemes. We do 10 not consider this to be economic reality. We consider that the true situation would be more faithfully represented if the requirement to continue to save were to be treated as a performance condition. Alternative View – Counterparty with Choice of Settlement There is an alternative to the proposed Consensus in paragraph 4 of D11 in respect of an employee who, while remaining in the entity’s employ, ceases to contribute to an ESPP, such as a Save-As-You-Earn (SAYE) scheme An employee share purchase scheme where an employee contributes SAYE plan could essentially be viewed as a share-based payment arrangement where the employee has a choice of settlement alternatives, that is, the employee has a choice between receiving cash at any time during the life of the plan, and receiving shares by foregoing the cash. The cash alternative is the payment which the employee can demand at any time during the life of the plan. The equity alternative is the shares which the employee can choose to receive on maturity of the plan. The liability component is the cash and the equity component is an option to receive shares. The employer discharges the liability component by making payments into the SAYE plan. The employer discharges this liability over the life of the plan rather than accruing for it. In this way, the cash alternative vests rateably over the life of the plan whereas the equity alternative only vests on maturity of the plan. If the plan runs for the full-term, and the employee takes the cash component, the employer would have already made the necessary payments into the SAYE plan and settled the liability. The equity component will have been recognized and will not reverse. If the plan runs for the full-term, and the employee chooses the equity alternative, the liability (being the cash payments plus interest) will be transferred direct to equity as consideration for the equity instruments issued. If the employee chooses to discontinue the plan at any stage prior to the maturity of the plan, the employee has elected to take the vested cash alternative and foregoes the equity component. The liability in respect of the cash alternative will already have been settled by the payments into the SAYE plan and any charge to date in respect of the equity component will remain in equity but no further charge will be recognized because the share-based payment has been settled. We consider that acceptance of this alternative view would mean that there is no requirement for an Interpretation in relation to the issue as set out in paragraph 3(a) of the draft Interpretation. Instead, paragraphs 35 to 40 of IFRS 2 would apply to such plans. This approach could be seen as consistent with the requirements of IFRS 2. It would overcome some of the issues raised earlier in this submission in relation to the draft 11 Interpretation. There may be issues under some fact patterns as to the nature of the accumulating cash amounts: they are essentially the asset of the employee, and in some cases their function is only to provide some degree of certainty that the employee will have the funds to purchase the shares on vesting. We recommend the IFRIC to investigate the possibilities of utilizing this approach. If you should need any further information on our submission, please contact our Director of International Financial Reporting, April Mackenzie (april.mackenzie@gt.com or phone +1 (212) 624 5428). Yours sincerely Barry Barber Worldwide Director of Audit and Risk Management April Mackenzie Director of International Financial Reporting l 12