Financial Reporting of Defined Contributions, Benefits, and Stock-Based Compensation

Employee Compensation

Employee compensation packages are structured to meet objectives like employee liquidity needs, retention, and motivation. Standard components include salary, bonuses, insurance, pensions, and shares. Compensation amount and composition depend on labor markets influenced by skills, geography, cycle, and laws. Salaries meet the liquidity needs of employees. Bonuses link pay to performance, and non-monetary benefits aid job performance. These elements usually vest shortly after the grant, with related accounting in the same period.

Deferred Compensation

Deferred compensation, which vests over a period, can offer substantial retirement savings and financial benefits to employees, often acting as a powerful tool for employee retention and alignment of stakeholder interests for employers. The financial reporting for such compensation plans is typically more intricate than compensation with immediate vesting. This complexity is due to challenges in accurately measuring the compensation and potential delays between the period of employee service and the timing of cash outflows. Employees might accrue compensation in the present period, yet the actual disbursement occurs in subsequent periods. Additionally, the disbursement amount may be contingent upon various elements, such as the employee’s future salary.

Defined-Benefit Pension Plans

In a defined-benefit pension plan, a firm pledges to provide future retirement benefits, usually based on a percentage of the employee’s final salary. To estimate this future obligation, assumptions regarding retirement age, lifespan, and other factors are necessary. The anticipated future payments are computed and then discounted to their present value using a rate based on bond yields. These assumptions play a crucial role in determining the size of the obligation. Typically, these plans are funded through an independent trust. When the assets in the plan exceed the obligations, a pension asset is recognized; conversely, if obligations surpass assets, a liability is recorded on the company’s 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 using 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 noted 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 instantly recognize actuarial gains and losses in profit and loss, 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.

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.

Share-Based Compensation

Share-based compensation aligns employee and shareholder interests, commonly for senior employees. Both IFRS and US GAAP mandate disclosure of compensation details in annual reports. Additional disclosure might be needed as per regulations. These disclosures help analysts grasp compensation, including share-based arrangements, during the reporting period. This information is often in a proxy statement submitted to the SEC in the US.

Share-based compensation aligns employee and shareholder interests without cash outlay. It is expensed, which reduces earnings, and can dilute EPS. Cash-settled options accrue liabilities. While positively viewed, it can dilute shares, lack proper incentives, and induce risk aversion or excessive risk-taking. Reporting under IFRS and US GAAP involves estimating fair value at the grant date, and expensing over vesting. The financial impact isn’t altered by stock price changes. Plans include stock grants and stock options.

Stock Grants

Financial reporting for stock grants involves recognizing compensation expense based on the fair value of the stock on the grant date, which is generally the market value at that time. For outright stock grants, the compensation expense is reported on the grant date. It is allocated over the employee’s service period, which is typically the current period unless specific future service requirements exist for vesting. Vesting refers to the employee’s right to receive the compensation after fulfilling certain conditions.

Restricted stock grants, another type of stock award, come with certain conditions. Employees may be required to return the shares if they do not meet stipulated conditions, such as remaining with the company for a specified period or achieving certain performance goals. Like outright stock grants, the compensation expense for restricted stock grants is measured as the fair value of the shares issued at the grant date and allocated over the employee’s service period.

Performance shares, granted contingent on meeting performance goals, are another form of stock awards. These goals are often related to accounting earnings or return on assets rather than stock price changes, addressing concerns about the uncontrollable nature of stock prices for compensation purposes. Like other stock grants, the compensation expense for performance shares, calculated as the fair value of the shares issued at the grant date, is allocated over the employee service period. Notably, the use of stock grants, particularly restricted stock units (RSUs), has been on the rise as compared to stock options. The advantage of stock grants is that they retain some value as long as the employer’s stock price is above zero, unlike stock options that can expire worthless.

Stock Options

Like stock grants, the compensation expense related to option grants is reported at fair value under both IFRS and US GAAP, with both standards necessitating the estimation of fair value using a suitable valuation model. Unlike the straightforward market value used for stock grants, the fair value of option grants is not as easily determined, as companies can’t depend on market prices due to the distinctive features of employee stock options that differentiate them from traded options. Various commonly used models, such as the Black-Scholes option pricing model or a binomial model, don’t have a specific preference under accounting standards, but the chosen model should align with fair value measurements, be based on established financial economic theory principles, and encompass all significant characteristics of the award.

Upon selecting a valuation model, a company is tasked with determining various model inputs, which may include the exercise price, stock price volatility, estimated life of each award, estimated number of options that will be forfeited, dividend yield, and the risk-free rate of interest. While some inputs like price exercise are clear at the grant time, others like stock price volatility or the estimated life of stock options are more subjective and can substantially alter the estimated fair value and hence the compensation expense. Variations in these inputs, such as increased volatility, a prolonged estimated life, and a heightened risk-free interest rate, amplify the estimated fair value. At the same time, a higher assumed dividend yield diminishes the estimated fair value, thus significantly influencing the overall fair value of employee stock options.

Accounting for Stock Options

In the realm of accounting for stock options, a pivotal principle is that the value of options granted to employees as a form of compensation should be expensed evenly over the duration in which services are rendered. Several key dates play a role in this accounting process. The grant date, marking the day options are provided to employees, sets the beginning of what’s known as the service period, which typically extends to the vesting date. The vesting date itself is significant as it denotes when employees can start exercising their stock options. Immediate vesting results in the recognition of expense on the grant date. However, if vesting is contingent on a future service period or specific conditions like achieving certain performance or market targets, the compensation expense is distributed over the estimated service period.

The exercise date, on the other hand, refers to the moment employees actualize their options into stock. Options not exercised within a specified timeframe will expire, often five or ten years after the grant date. It’s also noteworthy that the grant date becomes the measuring point for compensation expense when both the number of allocated shares and the option price are clear-cut. If events post the grant date influence the options’ value, the compensation expense is determined once such details become evident.

Other Types of Share-Based Compensation

Stock grants and options provide ownership, while share-based compensations like SARs or phantom stock tie compensation to share value changes without requiring share ownership (cash-settled). SARs link compensation to share price increases, motivating and aligning with shareholders. Advantages include limited risk and no shareholder dilution. Like other share-based compensations, SARs are fairly valued, and expenses are spread over the employee service period. Phantom shares differ by using hypothetical stock performance. They suit private companies or illiquid ones.

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.