How to test share-based payment vesting conditions (service vs performance vs market)

Testing share-based payment vesting conditions means classifying each condition attached to a grant as a service condition, a non-market performance condition, or a market condition, because the classification determines how the expense is re-estimated through the vesting period: service and non-market performance conditions are re-estimated every period based on the current probability of vesting, while a market condition is factored into the grant-date fair value once and never revisited regardless of how likely it now looks to be met.

Why this classification is the single highest-risk judgement in the ESOP file

Treating a market condition — such as a share price or total shareholder return target — as if it were a non-market performance condition and re-estimating the charge each period based on how likely the target now looks to be achieved is the most frequent misclassification, and it moves the expense in exactly the wrong direction compared to what the standard requires.

The testing sequence

1. 01Obtain the scheme document and list every distinct condition attached to each grant or trancheContinued employment to a date, a specific performance metric such as revenue or EBITDA growth, and a market-based metric such as share price or TSR relative to a peer group can all appear on the same grant and need to be separated out.
2. 02Classify each condition using its actual definition, not the scheme's own label for itA service condition requires only continued employment; a non-market performance condition depends on the entity's own operations or a specific market or non-market event unrelated to the entity's share price; a market condition is related to the market price of the entity's own equity instruments, directly or through an index.
3. 03Confirm the market condition was built into the grant-date valuation modelA market condition should be reflected through the option pricing model used at grant date — for example through a Monte Carlo simulation for a TSR target — and the resulting fair value is then never adjusted for the market condition's subsequent likelihood of being met.
4. 04Recompute the period expense for service and non-market performance conditions using the current best estimateThe estimate of the probability of vesting should be updated based on the latest information available at each reporting date, and the cumulative expense trued up accordingly — test that this re-estimation was actually performed this period, not carried forward unchanged.
5. 05Confirm no re-estimation was applied to the market condition componentEven where a TSR target now looks unlikely to be met, the expense already recognised for that tranche is not reversed purely because the market condition looks less achievable — the award still vests for accounting purposes as long as the service condition is satisfied.
6. 06Test for a modification where the terms of a condition were actually changedA change to the performance target itself, rather than a change in how likely it is to be met under the original target, is a modification and is accounted for separately, typically resulting in incremental expense for any increase in fair value.