Share-Based Payment Under HKFRS 2: Two Key Judgements Beyond the Option Model

Executive Summary

Discussions about share-based payment valuation often begin with the option model, volatility and option life. In our discussions with companies and audit teams, however, two judgements often take more time to resolve: where the conditions attached to an award should be reflected, and how changes to awards already granted should be accounted for. Both directly affect valuation and expense recognition.

The first determines which conditions enter fair value and which affect vesting estimates. The second determines whether a modification affects the value of the instruments, the number expected to vest, or the timing of recognition. The standard provides a framework, but applying it to specific terms still requires judgement. Familiarity with option pricing alone may not answer either question.

If that starting point is wrong, even an accurately calculated model may measure factors that should not be included. This article examines the distinctions that matter in practice and their consequences, with an index of standard references and implementation examples for further reading.

Scope: This article addresses equity-settled employee awards that can be measured at fair value. Cash settlement, cash alternatives and changes in settlement classification require separate analysis. “Expense” is used to describe service costs; costs that qualify for recognition as an asset require the corresponding treatment.

1. Why a Failed Condition Can Produce Different Outcomes

Appendix A of HKFRS 2 distinguishes service conditions from performance conditions, with performance conditions divided into market and non-market conditions. A performance condition must include an explicit or implicit service requirement and satisfy the requirements linking the performance target to the service period. A reference to “profit”, “regulatory approval” or a “milestone” is therefore insufficient to determine classification. The complete terms must be examined to establish the nature of the target and the service requirement.

The table below summarises the treatment. The explanations of reversals assume no separate modification, cancellation or settlement.

A missed profit target and a missed share price target can therefore produce different expense outcomes. A market condition is already reflected in grant-date fair value, so its failure alone does not trigger a reversal. A non-market performance condition affects the vesting estimate. If the employee also fails to complete the service period, however, the market-condition rule cannot by itself justify retaining the entire expense.

Non-vesting conditions: check for cancellation

Under paragraph 28A, if the entity or counterparty can choose whether to meet a non-vesting condition and fails to meet it during the vesting period, the failure is treated as a cancellation. This can require immediate recognition of the amount otherwise attributable to the remaining vesting period, rather than continued recognition on the original schedule.

In IG Example 9A, an employee's decision to stop making savings contributions triggers this cancellation treatment. It should not be confused with an award forfeited because a service condition is not met.

2. The Model Must Capture the Terms: There Is No Universal Model Choice

Market conditions must enter fair value, but not every market condition is path-dependent. A requirement for the share price to remain above a threshold for consecutive trading days depends on the price path during the period. The model must capture that feature; simulation or an appropriate lattice model may be considered. A target measured only at a specified date calls for an approach suited to its particular structure.

The review question is: how does the valuation method capture this condition? If a standard Black-Scholes calculation is followed by an adjustment outside the model, the basis for that adjustment must be explained. The model's name alone does not establish whether the treatment is appropriate.

Conversely, the probability of failing a non-market vesting condition, such as a profit target, should not be used to discount each instrument's grant-date fair value. An entity may still analyse the likelihood of achieving the target to support its vesting estimate. The analysis must be applied in the correct part of the measurement.

Paragraph 21 and paragraphs B4–B7 require the relevant terms to be reflected; they do not prescribe one model for every market condition.

3. Modifying Existing Awards: Identify What Has Changed

When a share option scheme is amended, the first step is to identify whether the new terms affect awards already granted and which grant batches are affected. A scheme-wide amendment may affect awards with different vesting status and remaining service periods. One overall conclusion at scheme level may therefore be insufficient.

Paragraph 27 and paragraphs B42–B44 preserve the original grant's measurement basis while recognising modifications that increase value or otherwise benefit employees. The original grant cost is not, however, an unconditional minimum expense: the exception for failure to satisfy a service or non-market vesting condition specified at grant date must still be considered.

A beneficial modification does not necessarily create incremental fair value. Relaxing a non-market profit target affects vesting estimates; shortening a service period may principally change recognition timing. These consequences require separate analysis.

Repricing: compare two values at the same modification date

Reducing the exercise price of an existing option is the modification example addressed in paragraph 26 and B43(a). Incremental fair value is measured as:

Fair value under the new terms at the modification date − fair value under the original terms at the modification date.

Both valuations use the modification date. Comparing the modified value directly with the original grant-date value would mix market movements with the effect of changing the terms. Even if the share price has fallen, lowering the exercise price may increase option value and create additional cost.

If repricing occurs during the vesting period, incremental fair value is generally recognised from the modification date to the vesting date of the modified instruments. The original grant-date cost continues under its applicable recognition basis. Any simultaneous change to vesting conditions must also be assessed.

If modification occurs after vesting, incremental fair value is generally recognised immediately. If an additional service period is required before the employee becomes unconditionally entitled to the modified instruments, recognition takes place over that additional period. The actual terms determine whether that requirement exists.

Cancellation and replacement awards: distinguish two situations

Cancellation without designated replacement awards. Cancellation or settlement during the vesting period is generally treated as accelerated vesting under paragraph 28(a), with immediate recognition of the amount otherwise attributable to the remaining period. Forfeiture caused by failure to meet a vesting condition should not automatically be treated as cancellation. Separately issued awards not identified as replacements on their grant date are accounted for as new grants.

New awards identified at grant date as replacements for cancelled awards. Paragraph 28(c) requires modification accounting for the original grant. It should not mechanically be treated as full acceleration of the old award plus an entirely separate new grant. Incremental fair value is the difference between the replacement instruments' fair value and the cancelled instruments' net fair value.

That net fair value is based on the cancelled instruments' fair value immediately before cancellation, less any payment to the employee on cancellation treated as a deduction from equity under paragraph 28(b). Where payments are made, any separate expense requirement must also be assessed.

4. Practical Review: Connect the Terms to the Accounting

For companies and finance teams: Assemble the grant terms and amendments for each batch, identifying service requirements, performance targets, vesting and exercise provisions. Assess the cost and recognition timing before making changes, rather than working backwards from a valuation report at year-end.

For audit teams: Reconcile condition classifications to the underlying documents, checking for omissions or double counting between fair value and vesting estimates. Distinguish failed conditions from cancellations when examining missed targets, employee departures, discontinued contributions and cancelled awards. A general description that an award has “lapsed” is not enough.

For valuation practitioners: Explain how the model captures conditions included in fair value and which conditions are addressed through vesting estimates. For modifications, distinguish original grant-date cost from the modification-date values under the original and new terms, and explain the purpose of each figure.

5. Standard and Implementation Guidance Index

Read each example with its specific facts and assumptions. Where a performance condition changes the exercise price or vesting period, rather than simply determining whether an award vests, a simplified adjustment to instrument numbers alone is insufficient.

Additional Considerations: Equity Value and Volatility Need Their Own Support

Equity value for unlisted entities. The latest financing price can provide important evidence, but the transaction date, rights attached to the investors' shares and subsequent business and market changes must be considered. In some of our pre-IPO valuations, management forecasts support an income approach, with financing prices and backsolve analysis providing cross-checks. This is a judgement about methodology, not a requirement to use an income approach for every pre-IPO share-based payment valuation.

Volatility observation period. The historical period should reasonably correspond to the option's expected term, taking account of early exercise, available trading history and how representative the data is. Expected term need not equal contractual life. A shorter observation period requires an explanation and supporting evidence, rather than selection solely for data convenience. Relevant considerations appear in B25–B30.

Conclusion

Share-based payment analysis begins with the terms: identify what affects fair value and what affects vesting estimates, then determine whether subsequent events represent failed conditions, modifications or cancellations. Documenting that reasoning gives companies, auditors and valuers a common basis for assessing the amount and timing of expense recognition.

References

• Hong Kong Institute of Certified Public Accountants, HKFRS 2 Share-based Payment, revised 2022-09: Appendix A; paragraphs 7–9, 19–21A and 26–28A; B4–B7, B25–B30 and B42–B44.
• Implementation Guidance accompanying HKFRS 2, 2022 edition: IG Examples 2–9A. The guidance explains application and is not part of the standard itself.

This article is for general information and does not constitute audit, accounting or valuation advice. Readers should refer to the applicable HKFRS 2 / IFRS 2 text and assess the specific arrangement.

About MILES Valuation Advisory Limited

MILES Valuation Advisory Limited is an independent valuation advisory firm based in Hong Kong, providing business valuation, purchase price allocation, impairment testing, share-based payment and financial instrument valuation services. Its work emphasises supporting evidence, documentation and clear explanations for audit review.