Employee Compensation

Employee compensation packages are structured to achieve various objectives, including meeting employees’ liquidity needs, retaining them, and motivating their performance. Common components of employee compensation include salary, bonuses, health, and life insurance premiums, defined contribution and benefit pension plans and share-based compensation.

Salary addresses employees’ liquidity needs. Bonuses, typically paid in cash, link pay to performance, motivating and rewarding employees for achieving short or long-term goals. Non-monetary benefits, such as health and life insurance, housing, and vehicles, facilitate employees’ job performance. Salary, bonuses, and non-monetary benefits generally vest (i.e., employees earn the right to the consideration) immediately or shortly after they are granted.

For financial reporting, a company records compensation expenses on the income statement in the period when the compensation vests. Immediate or short-term vesting simplifies the accounting for salary, most non-monetary benefits, and bonuses. When an employee earns the salary or bonus, an expense is recorded at the fair value of the compensation, and a cash outflow or accrued compensation liability (a current liability) is recognized. Expenses and cash outflows for short-term compensation are often well-matched.

Deferred Compensation

While  salaries,bonuses, and non-monetary benefits tend to vest immediately, deferred compensation vests over time, providing employees with retirement savings and financial benefits and serving as a retention and alignment tool for employers.

Financial reporting for deferred compensation plans is more complex than for immediately vesting compensation due to measurement challenges and the time lag between employee service and cash outflows. Employees might earn compensation in the current period but receive it in the future, with the amount based on factors such as future salary or the employer’s stock price, requiring management judgment and assumptions.

Pensions and other post-employment benefits are common types of deferred compensation. Two common pension plans are defined contribution and defined benefit plans.

Defined Contribution Plans

In a Defined Contribution (DC) pension plan, financial reporting is relatively straightforward. The employer’s obligation is limited to the contributions it has agreed to make to the plan. In each period, the employer records an expense for the amount of its contribution to the employees’ pension funds. Since the employer has no further obligations regarding the amount that will be available to employees upon retirement, there are no liabilities recorded on the balance sheet relating to the pension plan beyond any contributions that are due but have not yet been paid on the balance sheet date.

The contributions are generally reported as an operating expense in the employer’s income statement. The exact line item can vary but is often included under “Employee Benefit Expenses” or a similar category. In terms of cash flow, these contributions are classified as operating activities, reflecting the cost of employing labor for the period. Unlike defined benefit plans, the employer does not need to make assumptions about future salary levels, years of service, or other actuarial assumptions, and there is no concern about underfunded or overfunded pension liabilities.

On the employee’s side, the contributions made by the employer are added to the employee’s pension fund assets, which are invested and will be used to provide retirement benefits to the employee. The employee typically has some choice regarding how the assets in their pension fund are invested and bears the investment risk, meaning the benefits received upon retirement depend on the investment performance of the pension fund assets. Comprehensive disclosures about the plan assets, including investment strategies and major categories of plan assets, are generally not required in the employer’s financial statements under a defined contribution plan.

Defined Benefit Plans

Under a defined-benefit pension plan, a company promises future benefits to employees during retirement. For example, a company might promise employees annual pension payments equal to 50% of their final salary until death. To measure this obligation, the company must make several assumptions, such as the employee’s expected salary at retirement and their life expectancy post-retirement. The company estimates these future payments and discounts them to present value using a discount rate equivalent to the yield on a high-quality corporate bond.

Most defined-benefit pension plans are funded through assets held in a separate legal entity, typically a pension trust fund. The company makes contributions to the fund, which are invested until needed to pay retirees. If the fair value of the plan’s assets exceeds the present value of the estimated pension obligation, the plan has a surplus, and the company reports a net pension asset on its balance sheet. Conversely, if the present value of the estimated pension obligation is greater than the fair value of the plan’s assets, the plan has a deficit, and the company reports a net pension liability on its balance sheet.

Defined-Benefit Plans Under IFRS

Under IFRS, alterations in the net pension asset or liability are categorized into three broad components. The first two, recognized as pension expenses on the income statement, are employees’ service costs and the net interest expense or income accrued on the initial net pension asset or liability.

The service cost is the present value of the increase in the pension benefit an employee earns by providing an additional year of service, including any effects from plan changes, known as past service costs. Net interest expense or income represents the time-induced change in the present value of the net defined benefit pension asset or liability, calculated as the product of the net pension asset or liability and the discount rate.

The third component, “remeasurements,” is recognized in other comprehensive income and includes actuarial gains and losses and the actual return on plan assets less any return included in the net interest expense or income. These remeasurements are not amortized into profit or loss over time.

Actuarial gains and losses emerge when changes occur in the assumptions used for estimating pension obligations, such as employee turnover, mortality rates, retirement ages, and compensation increases.

The actual return on plan assets, encompassing interest, dividends, and other income, including realized and unrealized gains or losses, generally differs from the amount recorded in net interest expense or income. This discrepancy arises as the actual return includes diverse asset classes, whereas the net interest calculation is based on a rate reflective of a high-quality corporate bond yield.

Defined-Benefit Plans Under US GAAP

Under US GAAP, variations in net pension asset or liability each period consist of five components, with some recognized immediately in profit and loss and others in other comprehensive income and subsequently amortized into profit and loss over time. The components acknowledged on the income statement in the period incurred include (I) employees’ service costs for the period, (II) interest expense accrued on the initial pension obligation, and (III) the expected return on plan assets, which diminishes the recognized expense.

The remaining two components, (IV) past service costs and (V) actuarial gains and losses, follow a different accounting treatment. Past service costs are reported in other comprehensive income in the period they arise and later amortized into pension expense over the employees’ future service period covered by the plan.

Similarly, actuarial gains and losses are initially recognized in other comprehensive income and then amortized over time into pension expense, permitting companies to “smooth” the impact on pension expense over time for these elements. Although US GAAP allows companies to recognize actuarial gains and losses in profit and loss instantly, this practice is not mandatory.

In terms of classification, pension expense on the income statement aligns with a functional basis similar to other employee compensation expenses. For manufacturing firms, pension expenses related to production employees augment inventory and are expensed through the cost of sales (cost of goods sold). For non-production employees, these expenses are recorded under selling, general, and administrative expenses. Despite its significance, pension expense is typically not directly reported on the income statement, and detailed disclosures are inclusively presented in the financial statement notes.

Share-Based Compensation

Share-based compensation is another type of deferred compensation that aims to align employees’ interests with those of shareholders. Unlike pension plans, share-based compensation is typically concentrated among senior-level employees such as executives and directors.

Both IFRS and US GAAP require companies to disclose key elements of management compensation in their annual reports, with regulators possibly requiring additional details. These disclosures help analysts understand the nature and extent of compensation, including share-based payment arrangements during the reporting period.

For financial reporting, under both IFRS and US GAAP, companies estimate the fair value of share-based compensation at the grant date and recognize it as compensation expense over the vesting period. Changes in stock price after the grant date do not affect financial reporting. The specifics of financial reporting depend on the type of plan. Two common forms of equity-settled share-based compensation are stock grants and stock options.

Advantages and Disadvantages of Share-Based Compensation

Share-based compensation has the advantage of potentially requiring no cash outlay, as it aims to align employee interests with those of shareholders. However, it is treated as an expense and reduces earnings even when no cash is exchanged.

Share-based compensation has several drawbacks. Issuing shares to employees dilutes existing shareholders. Additionally, recipients may have limited control over the company’s market value, meaning share-based compensation might not always incentivize the desired behavior and could improperly reward or penalize performance.  For instance, increased ownership might lead managers to avoid risks, fearing a significant drop in market value and personal wealth, which could result in less profitable projects. Conversely, awarding stock options could lead to excessive risk-taking, as options have skewed payouts that reward the upside while limiting the downside to zero, prompting managers to pursue high-risk, high-reward investments.

Stock Grants

Stock Options

Similar to stock grants, the compensation expense related to option grants is reported at fair value under both IFRS and US GAAP. The fair value of these options must be estimated using an appropriate valuation model.

While the fair value of stock grants is usually based on the market value at the grant date and also adjusted for dividends before vesting, the fair value of option grants needs to be estimated. This is because employee stock options typically have features that differ from traded options, making market prices unsuitable for measurement. Choosing the right valuation model is critical in estimating fair value.

Common models include the Black-Scholes option pricing model and binomial models. Accounting standards do not mandate a specific model but require that the chosen method should:

1. Align with fair value measurement principles,
2. Be grounded in established financial economic theory,
3. Reflect all substantive characteristics of the award.

Once a valuation model is chosen, companies must determine the model’s inputs, which typically include the exercise price, stock price volatility, estimated life of the option, estimated forfeiture rate, dividend yield, and the risk-free interest rate. Different assumptions combined with various valuation models can significantly affect the estimated fair value of employee stock options.

Accounting for Stock Options

In accounting for stock options, the value of options granted to employees as compensation must be expensed ratably over the period during which services are provided. Several key dates are involved in this process: the grant date, vesting date, exercise date, and expiration date.

• Grant Date: This is when the options are initially granted to employees. The service period, which is typically the time between the grant date and the vesting date, is when compensation expense is recognized. The grant date is also when the compensation expense is measured if the number of shares and the option price are known. If the value of the options depends on events occurring after the grant date, the compensation expense is measured when those events are known.
• Vesting Date: This is the date when employees can first exercise their stock options. Vesting can occur immediately or over a specified period. If the options vest immediately, the expense is recognized on the grant date. If the options vest after a specified service period, the compensation expense is allocated over that period. For options conditional on achieving performance or market conditions, the expense is recognized over the estimated service period.
• Exercise Date: This is when employees exercise their options and convert them into stock.
• Expiration Date: If the options are not exercised, they expire at a predetermined date, usually 5 or 10 years from the grant date.

When an option is exercised, the market price at that time is not considered. The expense is calculated based on the fair value at the grant date and is recognized over the vesting period.

The accounting for option exercise is akin to stock issuance. Upon exercise, the company increases its cash for the exercise price paid by the option holder and credits common stock for the par value of the issued stock. Additional paid-in capital is increased by the difference between the par value of the stock and the sum of the grant date fair value of the option and the cash received.

The main accounting requirements for stock options are:

1. Recognize compensation expenses based on the fair value of the option on the grant date. Since no cash is exchanged at the grant, the corresponding entry is additional paid-in capital.
2. Spread the grant date fair value as compensation expense over the vesting period.
3. upon exercise, increase equity by the grant date fair value of the options plus the cash received from the employee.

As the expense is recognized over the vesting period, it reduces retained earnings. The corresponding increase in paid-in capital ensures there is no net impact on total equity.

Other Types of Share-Based Compensation

Stock grants and stock options allow employees to gain ownership in the company. Other forms of share-based compensation, such as stock appreciation rights (SARs) or phantom stock, provide compensation based on changes in share value without requiring employees to hold the shares. As such, these are known as cash-settled share-based compensation.

SARs compensate employees based on the increase in the company’s share price, motivating employees and aligning their interests with shareholders. Two additional advantages of SARs include:

• Limited risk aversion: Employees have limited downside risk and unlimited upside potential, similar to stock options.
• No dilution of shareholder ownership.

On the other hand, SARs are valued at fair value, and the compensation expense is spread over the employee’s service period. Phantom share plans are similar but differ in that compensation is based on hypothetical stock performance rather than the company’s actual stock.

Question 1

Which statement is most likely correct about the financial reporting of defined benefit pension plans under IFRS?

1. Actuarial gains and losses are recognized as pension expenses over time.
2. The service cost component includes interest income on plan assets.
3. The net pension asset or liability changes have three components recognized on the income statement.

Solution

The correct answer is C.

Under IFRS, the change in the net pension asset or liability each period is generally viewed as having three components, two of which (service costs and net interest expense or income) are recognized as pension expense on the income statement. The third component, remeasurements, is recognized in other comprehensive income and is not amortized into profit or loss over time.

A is incorrect because under IFRS, actuarial gains and losses (part of remeasurements) are recognized immediately in other comprehensive income, not recognized as pension expenses over time.

B is incorrect because the service cost component does not include interest income on plan assets. Instead, it represents the present value of the increase in pension benefits earned by employees during the current period, and it does not have a direct connection with the interest income on plan assets. The interest income on plan assets is part of the net interest on the net defined benefit liability (asset), which is another component separate from the service cost.